Sunday, May 29, 2011

The Aggressive Conservative Investor: Chapter 16

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 explores the topic of investing in companies that are losing money. The authors argue that while conventional wisdom suggests buying the stocks of only high-quality, profitable companies, the investor will often overpay for these issues because of their popularity. On the other hand, many pricing advantages can be found among issues where losses have been sustained, but where there is reason to believe they will not persist.

There are a few ways that gains can be realized from companies in loss positions. There can be an improvement in the utilization of assets (perhaps through new management), or there could be an asset conversion which releases resources, with the proceeds accruing to shareholders.

Another way value can be unlocked in a losing company is through tax losses. The authors detail an example where a profitable company was able to buy a money-losing company at a bargain, improve its operations, and finance expansion with tax losses that would have otherwise had to be paid. However, the authors warn that the benefits of tax gains should not override the other components of an analysis of a losing company, for tax losses are not worth much if losses persist.

The reader is asked to note the difference between economic losses and accounting losses when analyzing a company. A firm may take a large accounting write-down in order to make future profits look high, but this is simply an accounting ploy. An exception to this can be in the banking industry, where rising interest rates force banks to take losses on loan portfolios, only to see the banks then use the proceeds from loan repayments towards higher-interest earning assets. Here, a loss in the present does lead to future gains.

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