Saturday, April 23, 2011

The Aggressive Conservative Investor: Chapter 5

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 argue that there is risk in every investment. No amount of research can completely eliminate risk. Even if the investor does an absolutely thorough job analyzing a company, his analysis could be wrong, he could misappraise management, future unexpected events could occur, and/or the market may never recognize a company's true value. But using the techniques described in the book, investors should seek to tip the scales of the risk-reward ratio in their favour.

Most investors judge a stock's risk by the quality of the issuer. A well-known company, judged by others to be a quality issuer, is often considered a low-risk security by investors. The problem with this line of thinking, according to the authors, is that the fact that the company is a "quality issuer" would already be ingrained in the stock's price. As such, investors often pay a premium for such issues.

But what is considered a quality issuer changes over time. The authors describe a number of examples through the decades where quality companies have inevitably declined in prominence over time. These stocks in effect suffer a double-whammy of negative returns, as the companies decline in both earnings and in price multiples (e.g. their P/E ratios) as they lose their "quality" status.

Nevertheless, for investors will little knowledge of the market and a weak understanding of companies, a diversified quality-issue portfolio is likely appropriate. But for investors who are willing to take the time to understand a company, the authors argue that the issuer's quality is only one of three factors influencing risk, with the other two being price and financial position.

Smart investors with a deep understanding of a company seek to reduce risk by purchasing when the price is low (relative to the investor's estimate of the company's value). In this view of risk, risk actually reduces as upside potential increases. This is in contrast to the prevailing view in the finance industry, where conventional wisdom suggests that only by taking more risk can an investor achieve higher returns.

Finally, the third element of risk is financial position. Even the safest investment of all (e.g. US treasuries) can become a casino-style gamble if financed with 95% leverage. Some value investments can take years to play out, and therefore a strong financial position is important to be able to outlast the bad times.

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