Saturday, April 16, 2011

The Aggressive Conservative Investor: Chapter 2

Martin Whitman founded Third Avenue Value Fund some twenty years ago. Over that time period, the fund has beaten the returns of the S&P 500 by several points annually. In The Aggressive Conservative Investor, Whitman collaborates with Martin Shubik to discuss a concept that they call "safe and cheap" investing.

The authors believe that successful activist investors, creditors and private owners share two common attitudes towards investing that regular investors would do well to internalize. The first concerns their perspective towards losses vs gains. The authors argue that the most successful activists first consider how much they can lose before asking the question of how much they can gain.

The second attitude concerns their perspective of risk. To successful activists, risk is not measured externally (e.g. as a function of price volatility), but rather internally as a function of the quality of the security and its financial position.

This leads the authors to describe a philosophy of investing that they believe leads to superior returns in the long-haul relative to the market. They call it the "Financial-Integrity Approach To Equity Investing". Under this approach, a security may only be considered for purchase if the following four tenets are met:

1) The underlying company has a strong financial position (more important than strong assets is the lack of significant obligations)

2) An honest management and control group

3) A reasonable amount of relevant information about the security is available

4) It is priced below the investor's estimate of net asset value

The authors take care to note that just because a security meets these requirements does not make it suitable for purchase; rather, it must meet all four criteria to be even considered for purchase.

Even though the authors believe an investor following this philosophy will do well, they note that it has several disadvantages. For one thing, it requires a lot of reading and understanding of numerous documents/filings. Furthermore, since the investor is not in a control position, he has no control of the timetable of when he will be in a position to buy/sell the security. Finally, there are only a small subset (many of which are illiquid!) of the market's securities that fit into these criteria.

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