Saturday, May 7, 2011

The Aggressive Conservative Investor: Chapter 9

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.

Investors must understand the financial realities that are ever-present in the US corporate world. To that end, the authors discuss four factors that drive the behaviour of actors in the financial world.

The first factor driving behaviour is tax considerations. Actors will always seek to have control of when a tax payment becomes due and to change to the bracket or type of tax applied that would reduce the tax rate.

The second factor has to do with the concept of "Other People's Money". An example of this are deposits that banks accept and the float insurance companies receive from customers. The authors detail an example of how a "promoter" can use other people's money to secure a significant investment without having to use his own money. The authors argue that other people's money can be useful in enhancing returns, but like all financial innovations, taken to the extreme it can also be very destructive.

The third factor driving behaviour is termed "Something Off The Top" (SOTT). Every party tries to get SOTT in a transaction, though recipients of SOTT may not feel they are receiving anything undue. Managements often feel that shareholders are getting a free ride off of their work, while shareholders may feel that management receives all sorts of benefits for running the company. Public investors are advised to avoid investing in companies where management has a disdain for shareholders, as they are in a position to grab a ton of SOTT at the shareholder's expense.

The last factor is termed the "Accounting Fudge Factor" (AFF). This is where accounting decisions are made (and there is much flexibility to do so) in order to achieve a positive result in one of the other three factors.

Shareholders must consider the interaction of these factors when they make their investment decisions.

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