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With the crash of 2008 still ringing in the market's collective ears, the value investing philosophy has never seemed more relevant or sound. But in the eighty years since Benjamin Graham and David Dodd's Security Analysis took the investing world by storm, much has changed in the investing environment.
Working from the simple guiding principle that "safe and cheap" is the most reliable way to minimize investment risk while maximizing long-term returns, Whitman, over the course of his more than fifty years as an investor and fund manager, has developed an investing approach that has made fortunes for his many clients--and himself--in all economic climates.
A book that is sure to become an investing classic, Modern Security Analysis reveals the details of Whitman's approach to analyzing businesses and the securities they issue.
While conventional approaches to investing, including Graham and Dodd fundamentalism and academic finance, take a top-down approach to analyzing securities and businesses, the bottom-up approach you'll discover here looks at companies not merely as aggregates of operational cash flows and earnings--their pure going concern attributes--but also as entities actively involved in wealth-creating "resource conversion" activities. In essence, that entails identifying a company's potential for generating wealth in many different ways, in addition to flows from operations, including mergers and acquisitions, spinoffs, recapitalizations, liquidations, changes of control, having attractive access to capital markets, and more.
Clearly accessible with the help of numerous examples and several case studies, Martin Whitman and co-author Professor Fernando Diz describe proven methods for:
Offering a unique opportunity to learn a proven, time-tested alternative to conventional security analysis from an investing legend, this book is must-reading for finance professionals, including security analysts, money managers, institutional investors, finance academics, and economists as well as anyone seeking to invest with a large margin of safety.
MARTIN J. WHITMAN is Chairman of the Third Avenue Funds and founder of Third Avenue Management, an investment adviser to private and institutional clients. Mr. Whitman has proven for more than fifty years that active, opportunistic investors can find under-priced securities in companies with strong balance sheets. He is also an adept control investor who was an important participant in the rehabilitation of Nabors Industries and Covanta Energy, among others. He was Third Avenue's Chief Investment Officer from its founding through January 2010.
For over thirty years, Mr. Whitman was a Distinguished Management Fellow at the Yale School of Management. He is also an honorary trustee at Syracuse University which is also home to the Whitman School of Management. He is a frequent speaker and commentator within the financial services community.
FERNANDO DIZ is the Managing Director of the Orange Value Fund, LLC, the Martin J. Whitman Professor of Finance and the Director of the Ballentine Investment Institute at Syracuse University. He teaches classes in value, control and distress investing and created and directs the two-year Orange Value Fund program. He is the co-author with Martin J. Whitman of Distress Investing: Principles and Technique. Professor Diz received his MSc and PhD degrees from Cornell University.
Acknowledgments xv
Introduction 1
Part One The Foundations of Modern Business and Security Analysis 9
Chapter 1 The Scope of Fundamental Finance, Investing, and the Investor Landscape 11
Investing versus Speculating 12
The OPMI Defined 17
Activists 18
Summary 18
Chapter 2 A Short Introduction to the Going Concern and Resource Conversion Views of Businesses 19
Methods of Wealth Creation 20
The Pure Going Concern View 21
The Resource Conversion View 23
Summary 25
Chapter 3 Substantive Consolidation and Structural Subordination 27
Substantive Consolidation Not of Prime Importance 29
The Accounting for Stock Options Controversy in Light of the Substantive Consolidation Doctrine 32
Structural Subordination Not a Significant Factor 37
Lack of Progress in Eurozone Crisis Resolution: The Failure to Use Substantive Consolidation 40
Summary 41
Chapter 4 The Substantive Characteristics of Securities 43
Types of Securities for Analytic Purposes 44
Control versus Non-Control Securities 44
Control and Non-Control Pricing and Arbitrage 45
Terms of Securities as Options 49
What a Security is Depends on Where You Sit 50
Summary 55
Chapter 5 Primacy of the Income Account or Wealth Creation? What are Earnings, Anyway? 57
Wealth or Earnings? 59
Influence of Reported Earnings on Common Stock Prices 61
The Long-Term Earnings Record 63
Parsing the Income Account 64
Summary 68
Chapter 6 Net Asset Value: The Static and Dynamic Views 69
The Graham and Dodd View on NAV 71
The Financial Accounting View on NAV 72
Our View on NAV 73
The Usefulness of NAV in Security Analysis 75
The Importance of NAV Dynamics 78
NAV as One Measure of Resources 83
NAV as One Measure of Potential Liquidity 84
Limitations of NAV in Security Analyses 89
Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE 93
Net Nets Redefined 94
OPMI Investing in Companies with Growing NAVs 96
Summary 101
Chapter 7 Creditworthiness 103
Creditworthiness from the Borrowing Entity Point of View 105
Capital Structure 107
Capital Structure from the Corporate Perspective 107
Factors Affecting Capital Structure 112
Conservative Capital Structures 117
Summary 118
Chapter 8 What Matters is Investment Risk 119
There is No General Risk-Only Specific Risk 120
The Components of Investment Risk 122
Successful People Avoid Investment Risk 123
Methods to Avoid Investment Risk 125
Safe and Cheap Investing and Minimizing Investment Risk 127
Summary 130
Chapter 9 Shareholder Distributions from the Company Point of View 131
Cash Dividends or Retained Earnings 132
Stock Dividends 135
Stock Repurchases 138
Distribution of Assets Other than Cash 141
Liquidation 141
Summary 142
Chapter 10 Roles of Cash Dividends in Security Analysis and Portfolio Management 143
The Three Conventional Theories 145
Cash Dividends as a Factor in Market Performance 149
The Placebo Effect of Cash Dividends 151
Cash Dividends and Portfolio Management 151
Cash Dividends and Legal Lists 154
Cash Dividends and Bailouts 154
The Goals of Securities Holders 156
Summary 157
Chapter 11 The Appraisal of Managements and Growth: GARP versus GADCP 159
New Framework for the Appraisal of Managements 160
Managements Attuned to OPMI Interests 161
Managements as Resource Converters 162
Tradeoffs 165
Growth: GARP versus GADCP 166
Growth at a Reasonable Price (GARP) 167
Growth at Dirt Cheap Prices (GADCP) 168
Summary 170
Chapter 12 The Significance (or Lack of Significance) of Market Performance 173
Market Performance and the Character of a Portfolio 176
Market Performance of Portfolios versus Individual Securities 177
Outsiders, Insiders, and Market Price 179
Professional Money Managers and Beating the Market 180
Perspective on Bailouts and the Significance of Market Performance 181
Summary 182
Chapter 13 How Much Diversification? 185
Portfolio Diversification versus Securities Concentration 186
Corporate Diversification versus Concentration 190
Summary 191
Chapter 14 Toward a General Theory of Market Efficiency 193
The Determinants of Market Efficiency 195
External Forces Influencing Markets Explained 198
Great Economists Can Learn a Lot from Value Investors 199
Markets Where External Disciplines Seem to Be Lacking 206
Market Efficiency and Fair Prices in Takeovers 211
Summary 213
Part Two Putting It All Together: Safe and Cheap Investing versus Conventional Approaches 215
Chapter 15 Safe and Cheap Investing 217
The Safe and Cheap Approach 218
Benefits of the Safe and Cheap Approach for the OPMI 220
Restrictions and Demands of the Safe and Cheap Approach 222
Summary 231
Chapter 16 Graham and Dodd Placed in Context 233
The OPMI Defined 235
The OPMI Perspective of Analysis 236
The Going Concern and Investment Company Views of Businesses 238
Primacy of the Income Account and Wealth Creation 238
Primacy of the Income Account, Dividends, and Corporate Uses of Cash 240
Primacy of the Income Account and the Appraisal of Managements 240
Primacy of the Income Account and Top-Down versus Bottom-Up Analysis 241
Primacy of the Income Account and Diversification 241
Primacy of the Income Account and Growth Stocks 242
Market Risk versus Investment Risk and Margin of Safety 242
The Importance of Market Performance 243
Uses and Limitations of Financial Accounting 244
Substantive Consolidation 245
Compensation of Promoters 245
Do Stock Market Prices Reflect Corporate Values? 245
Trade-Offs 247
Modern Capital Theory versus Graham and Dodd 247
Summary 248
Chapter 17 Academic Finance: Modern Capital Theory 249
The MCT Point of View 253
Equilibrium Pricing is Universally Applicable 254
The Outside Passive Minority Investor is the Only Relevant Market 260
Diversification is a Necessary Protection against Unsystematic Risk 261
Systematic Risk Exists 262
Value is Determined by Forecasts of Discounted Cash Flows 262
Companies are Analyzed Basically as Going Concerns; Investors in Marketable Securities are Analyzed as Investment Companies 264
Investors are Monolithic: Their Unitary Goal is Risk-Adjusted Total Return, Earned Consistently 266
Market Efficiency Means an Absence of Market Participants Who Earn Excess Returns Consistently or Persistently 267
General Laws are Important 269
Risk is Defined as Market Risk 271
Macro Considerations are Important 272
Creditor Control is a Nonissue 273
Transaction Costs are a Nonissue 273
Free Markets are Better than Regulated Markets 273
The Outside Passive Minority Investor Market is Better Informed than Any Individual Investor 275
Markets are Efficient or at Least Tend Toward an Instantaneous Efficiency 275
Summary 276
Chapter 18 Broker-Dealer Research Departments and Conventional Money Managers 277
How Research Departments and Conventional Money Managers Think 279
Problems Faced by Research Departments and Conventional Money Managers 282
Summary 292
Part Three Real-World Considerations 295
Chapter 19 Uses and Limitations of Financial Accounting 297
The Conventional Approaches 299
Financial Accounting Reports as Objective Benchmarks 302
Generally Accepted Accounting Principles as Defining Reality for Certain Specific Purposes 309
Generally Accepted Accounting Principles as a Road Map for Due Diligence and Less Thorough Investigations 310
Summary 319
Chapter 20 Company Disclosures and Information: Following the Paper Trail in the United States 321
Narrative Disclosures in the United States 322
The Documents and How to Read Them 327
What the Paper Trail Does for the Outside Investor 328
What the Paper Trail Doesn't Do 331
How Good is the Paper Trail? 334
Summary 335
Chapter 21 Buying Securities in Bulk 337
Methods for Acquisition of Common Stocks 338
Acquisition of Voting Equities through Exchanges of Securities 343
Acquisition of Control without Acquiring Securities by Using the Proxy Machinery 345
Summary 346
Part Four Understanding Resource Conversion 347
Chapter 22 A Short Primer on Resource Conversion 349
Long-Term Arbitrage between OPMI Prices and Control Values 350
More Aggressive Employment of Existing Assets 355
Merger and Acquisition Activity 355
Corporate Contests for Control 356
Going Private and Leveraged Buyouts 359
Summary 368
Chapter 23 Restructuring Troubled Companies 369
The Five Basic Truths of Distress Investing 370
Rehabilitation of Troubled Entities 380
Summary 391
Chapter 24 The Role of Government in Reorganizations 393
Bailouts or Capital Infusions? 394
Too Big to Fail is a Phony Concept 395
The Government and Private Sector are in Partnership Whether They Like It or Not 396
Wall Street Professionals and Corporate Executives are All in the Business of Creating Moral Hazards 398
Taxpayer Bailouts are a Phony Concept 398
A Revolution in Corporate Reorganizations and Liquidations May Have Occurred in 2009 with the Chapter 11 Reorganizations of General Motors, Chrysler, and CIT Corporation 399
Strict Regulation of Financial Institutions is Absolutely Necessary 399
Summary 400
Part Five Active Investors Buy and Sell Common Stocks on an Advantageous Basis 401
Chapter 25 The Economics of Private Equity Leveraged Buyouts 403
The 2005 Acquisition of Hertz Global Holdings and Subsequent Events as a Prime Example 404
Super-Attractive Access to Capital Markets 404
Cash Payments to Sponsors and Sponsor-Controlled Funds 409
Sponsors' Control of Hertz 410
Sponsors Attuned to the Needs of Bankers and the Wall Street Underwriting Community 411
Questions about LBOs 412
Summary 413
Chapter 26 The Use of Creative Finance in a Corporate Takeover 415
The Case 415
The Postscript 427
Investment Lessons 428
The Appraisal of Management 430
Spotting Doable Deals 431
Summary 432
Chapter 27 The Use of Creative Finance to Benefit Controlling Stockholders 433
The Problems Faced in the Schaefer Corporation Deal 435
The Background of the Deal 435
Discount Purchases of Restricted Corporate Stock 437
Corporation's Acquisition of Brewing 440
Problems and Wealth Creation Potentials for the Parties in Interest 449
Summary 467
Glossary of Acronyms 469
About the Authors 471
Index 473
