Saturday, May 21, 2011

The Aggressive Conservative Investor: Chapter 13

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.

This chapter is all about earnings. Consistent with what has been written thus far in the book, the authors immediately dispel the primacy of earnings.

The authors argue that companies add wealth in three ways, of which earnings are only a component. Firms also add wealth through unrealized appreciation and through the realization of this appreciation. Of the three methods of wealth accumulation, the authors argue that earnings are the least desirable, to the extent that earnings are the least tax-sheltered of the three methods. In private companies, for example, owners will tend to show low earnings (in order to lower taxes) even though wealth may be growing. The authors use the term "earnings power" to describe the wealth earned from all three methods, of which earnings only constitutes one such method.

The authors also dispel the notion that earnings can often be used as a predictor of future earnings. They believe assets are a better indicator of future earnings, and describe a couple of examples where either high returns on assets were unsustainable (and thus earnings were a poor predictor of future earnings) or where low returns resulted in asset conversions or changes at the company that raised earnings to a rate commensurate with the company's assets.

But assets and earnings aren't unrelated. For many firms, retained earnings constitute a large portion of the company's assets. As such, firms that have strong earnings histories will also have high levels of assets.

The authors don't believe that investors can be single-minded about whether they look at a company's assets or its earnings power. Most securities in the investor's portfolio should be strong on both counts.

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