Key takeaways:
公司是资源/利益转换器；
不存在具有一致性的公司利益，只有各个stakeholders的各自利益，它们之间存在各种各样的冲突；
需要从经济实质的角度来考察会计报表科目，例如有些长期资产具有非常好的流动性，因此在经济实质上是流动资产；而working capital对于going concern而言在很大程度上是长期资产，流动性很差。 在特定情况下，负债具有权益的性质，权益也可以具有高等级债券的性质。总之，最重要的是经济实质，而非会计科目名称。
INTRODUCTION
We now believe that a principal advantage to buy-and-hold investors in being holders of common stocks of companies with strong financial positions is that such strong financial positions permit reasonably competent managements with five-year or so time horizons to be opportunistic (i.e., the managements are able to take advantage of markets that are inefficient inherently from a five-year point of view). For example, sometime during the five-year period there is likely to be a buoyant equity market into which to sell common stock issues at extremely attractive prices (for the company and the insiders) or interest rates in credit markets are likely to become extremely low.
Diversification is only a surrogate, and usually a damn poor surrogate, for knowledge, control, and price consciousness.
We now believe that for the vast majority of companies and investors, wealth creation takes precedence over any concept of primacy of the income account, albeit that for many companies they have little choice but to create wealth through either cash flows or earnings, both derived from income accounts.
Before an equity investment is made, Third Avenue Value Fund reviews comprehensively all SEC disclosures about management compensation, entrenchment, and stock ownership, as well as the choices managements make in choosing how to account (e.g., whether to expense stock options).
We believe that the new academic discipline, behavioral finance, has very limited applicability to safe and cheap investing. Behaviorists are people who believe that more than economic rationality drives market forces. Market participants are also influenced by emotions – fear, greed, political correctness, style, and fashion. Behaviorists, though, seem to ignore the basic point that even if investors were reasonably rational, it is context rationality that counts. Different market participants have different rationalities. What is rational for safe and cheap investors (e.g., ignore near-term market swings) would be utterly irrational for heavily margined day traders who know little or nothing about the securities they buy and sell, and vice versa.
A good example of an inherently inefficient market is one in which a well-financed manager, venture capitalist, real estate investment builder, or LBO promoter can afford to have a five-year time horizon regarding when or how the business will access capital markets. The manager, venture capitalist, real estate activist, or LBO promoter will know that sometimes in equity markets there will be initial public offering (IPO) booms, and sometimes in credit markets interest rates will be extraordinarily low. Taking advantage of this knowledge makes a market inefficient inherently from the point of view of a sophisticated manager dealing with relatively complex securities or situations, where the manager has a long time horizon, and where the manager controls the timing of when to access capital markets.
It is a myth from a safe and cheap point of view that most markets are efficient or tend toward instantaneous efficiency because an army of trained analysts causes it to be so. First, the army probably has been trained by financial academics who are strictly top-down analysts. Second, the army is mostly analyzing the wrong things.
They primarily believe in:
• Primacy of the income account
• Short-run outlooks
• Technical considerations (e.g., predictions about the near-term outlook for the general market, or a possible overhang of specific securities being readied for sale)
• What the numbers are rather than what the numbers mean
The safe and cheap investor has much less need for diversification than most OPMI’s and can afford profitably to concentrate a portfolio into relatively few issues. The safe and cheap investor is dealing in variables that are more accurately measurable than seems to be the case for OPMI’s involved with conventional security analysis. The safe and cheap investor tries to buy into the existing situation, “What Is,” at a discount from readily ascertainable estimates of net asset value provided that the company is comfortably financed. In certain areas, e.g. income producing real estate companies and most financial institutions, net asset values are something that can reasonably be estimated. In contrast, in conventional security analysis, the primary efforts revolve around predictions of the future – either earnings or discounted cash flows, or both. It seems as if most predictions of the future turn out to be wrong most of the time. Diversification does provide some protection for portfolios against being wrong in the analysis of individual securities. The analyst using conventional tools needs this diversification protection more so than the safe and cheap investor.
Portfolio analysis differs from individual securities analysis. For portfolios, there is no such thing as a value trap. If a portfolio performs poorly over time, blame it on poor analysis, not on value traps where cheap common stocks stay cheap forever.
Safe and cheap investors are first safety conscious and then price conscious.
The basic interest of most market participants is wealth creation, an asset value concept, not discounted cash flow (DCF). DCF is just one method of creating wealth, and a method that frequently carries tax disadvantages. Over 80% of Third Avenue Value Fund’s common stock portfolio consists of securities that were acquired at prices well below estimates of readily ascertainable net asset values. Current and immediately prospective price earnings ratios are either downplayed in most safe and cheap analyses or ignored.
There is a long-term arbitrage between business value and common stock prices: if common stock prices are high relative to business value, go public; if common stock prices are low relative to business value, go private, or semiprivate.
Fairness in financial dealings is obtained in the price and other terms that would be arrived at in a transaction between a willing buyer and a willing seller, both with knowledge of the relevant facts; and neither under any compulsion to act. In a going private situation, one is faced with a willing-buyer (who frequently is also a fiduciary), coerced-seller situation. An OPMI becomes a coerced seller when forced to sell because buyers obtaining the requisite vote, say 50% of those voting, force all stockholders to sell. The requisite vote is obtained using corporate proxy machinery. Sometimes an OPMI becomes a forced seller because of almost certain prospects that there will no longer be a market for the security held after a transaction is consummated. In a coerced-seller situation, fairness opinions need to be used and should be based on simulating the prices and other terms that would have existed were there actually a willingbuyer – willing-seller situation.
One can’t understand corporate finance if all one does is look at corporations and securities wholly, or mostly, from the point of view of common stockholders who are OPMIs. This is what most financial academics do, and this seems to be what most sell-side analysts do. To understand corporate finance you have to be cognizant of the interests and beliefs of other important constituencies – managements, creditors, promoters, underwriters, and governments.
Any and all resource conversion activities (e.g., mergers and acquisitions, IPOs, restructuring troubled companies, refinancings) involve huge costs payable to investment bankers, commercial bankers, brokers, lawyers, accountants, lenders, and promoters. This expense problem seems exacerbated for small cap companies.
In the financial world, it tends to be misleading to state “There is no free lunch.” Rather the more meaningful comment is “Somebody has to pay for lunch.”
Substantive consolidation of the interests of the company itself and its OPMI stockholders is a relatively rare special case. The company is the company. The company is not the management. The company is not its stockholders. Virtually all safe and cheap analyses treat the company as a stand-alone. For example, it should be recognized that stock options are a stockholder problem and only rarely a company problem. If one analyzes a company as if the person were a long-term creditor, there usually is a world of difference between paying management members with cash or equity interests. Cash payments could detract from creditworthiness while equity payments probably don’t.
The worth of any security is the present value of the future cash bailouts to be received by security holders. Cash bailouts come from three sources:
• Cash distributions by issuers in the forms of interest, principal, premiums, paid to creditors; dividends, and securities repurchases, paid to stockholders
• Sales to a market
• Control
Passive securities, for most economic purposes, are a different commodity from control securities, albeit they are identical in legal form. From a safe and cheap point of view, if a passive security of a reasonably financed company is to become a control security, the holder is entitled to a premium price.
The liability side of the balance sheet is a lot more than obligations and net worth. Rather, it is a layer cake consisting of at least the following:
• Secured obligations
• Unsecured obligations
• Subordinated obligations
• Liability reserves, which analytically have an equity component
• Preferred stocks
• Common stocks
• Common stock derivatives
Whether an issue is debt or equity depends on where you sit. To senior lenders, subordinated debt is a form of equity. To common stockholders, subordinated debt is debt.
Charpter 1 An Overview
We differ from most others writing about fundamental security analysis and corporate finance. It is our view that other fundamentalists have a tendency to apply to all companies tools of analysis that in fact are applicable only to that small minority of companies which are large, stable and seasoned enterprises engaged in continuous operations. Such businesses are strict going concerns – that is, they are engaged in a particular type of operation to be financed in the future in about the same way they have been in the past. It is our view that an analysis that is useful for evaluating stable going concerns is of limited help when applied to businesses involved, even partially, in what we call asset-conversion activities – that is, mergers, acquisitions, or the purchase, sale or distribution of assets in bulk; major financial restructurings or recapitalizations; sales of control or contests for control; or the creation of tax shelter. And most businesses seem to be engaged, at least to some extent, in asset conversion. We believe it is necessary to distinguish between asset-conversion analysis and going-concern analysis.
Our underlying thesis is that in both fundamental security analysis and corporate finance a key element to be emphasized is financial position, measured by a concern’s ability to have and to create liquidity (either from surplus cash or from other assets readily convertible into cash, such as a portfolio of blue-chip corporate stocks and bonds whose resale is not restricted); by an ability to generate surplus cash from operations; by an ability to borrow; or by an ability to market new issues of equity securities.
In contrast to our emphasis on financial position, conventional fundamental analysis rests on a primacy-of-earnings theory—that is, reported earnings are a principal determinant of common-stock prices. To us, the primacy-of-earnings approach is valid in special cases – that is, it is more applicable than a financial-position approach for those common-stock traders whose one consuming interest is day-to-day stock market fluctuations. It seems reasonable to suppose that most of the time, accounting earnings as reported will have a more significant impact on immediate stock prices than will perceived changes in financial position. Yet, we view financial position as normally the more fundamental factor because it is a better aid in understanding a business than are reported earnings, especially since most enterprises are not strict going concerns. In addition, most securities holders, including creditors, are not stock traders. Primacy-of-earnings concepts therefore appear to be more limited in applicability than is popularly supposed.
Workout investing is a subgroup of special-situation investing. A workout investment is one in which a financially strong security is priced below a conservative estimate of a realistic value, and the investor has reason to believe that an asset-conversion event might take place within a given time span. The asset-conversion event could be a merger or an acquisition, the sale of assets, a liquidation, a reorganization, a contest for control or a share-repurchase program.
Charpter 2 The Financial-Integrity Approach to Equity Investment
It has been our observation that the most successful activists have had much the same approach to investing that the most sophisticated creditors have had toward lending. Essentially, these people approach a transaction with two attitudes, the first having to do with their order of priorities. In looking at a transaction, the single most important question seems to be, What have I got to lose? Only when it seems that risks can be controlled or minimized does the second question come up: How much can I make?
The second attitude has to do with a basic feeling that risk – how much one can lose—is essentially measured internally, not externally. The possibilities of unsatisfactory results from an investment or loan are to be found internally in the performance of the underlying business and the resources in the business, not externally in the market prices at which a company’s securities might trade. Successful activists and creditors, while not unmindful of the “value messages” that are delivered by markets, tend not to be overly influenced by such messages. Their attitude is, As far as my objectives are concerned, I know much more about the situations in which I invest or in which I lend than the stock market does.
Companies with strong financial positions tend to be less risky than those not as well situated. Furthermore, they tend to be more expandable because of their greater ability to obtain new funds. These companies also are the most attractive candidates for asset conversion activities, such as mergers and acquisitions, liquidations, share repurchases, takeovers and other changes in control.
Our views as developed in this book are that attractive equity investments for outside investors ought to have the following four essential characteristics:
1. The company ought to have a strong financial position, something that is measured not so much by the presence of assets as by the absence of significant encumbrances, whether a part of a balance sheet, disclosed in financial statement footnotes, or an element that is not disclosed at all in any part of financial statements.
2. The company ought to be run by reasonably honest management and control groups, especially in terms of how cognizant the insiders are of the interests of creditors and other security holders.
3. There ought to be available to the investor a reasonable amount of relevant information, although in every instance this will be something that is far short of “full disclosure” – the impossible dream for any investigator, whether activist, creditor, insider or outside investor.
4. The price at which the equity security can be bought ought to to be below the investor’s reasonable estimate of net asset value.
These four elements are the sine qua non for an investment commitment using the financial-integrity approach, because their presence results in a minimization of investment risk. But they are not simply by their presence sufficient reasons for an investment commitment. The absence, however, of any one of them is reason enough to forgo any passive investment, regardless of how attractive it might appear based on other standards.
When purchasing equity securities, an outside investor using our approach will not acquire a position for his portfolio unless he believes that the value represented by the particular security is good enough, based on the four essential elements. He does not consciously try to outperform the market over the short run. Thus, investigation in areas other than financial integrity will tend to be emphasized less than it would be if the investor was striving for more immediate performance. First, little or no time is spent attempting to gauge the general market outlook, examining technical positions or making business-cycle predictions. Put simply, there is no attempt to hold off buying until the investor believes stock prices are near bottom. Rather, the primary motivation for purchases is that values are good enough. Second, comparative analysis, though always a useful tool, tends to be less important than in other forms of fundamental analysis. The reason, of course, is that the investment goal for outside investors is to concentrate on acquiring reasonable values rather than on getting the best possible values.
It is our observation that in bear markets, equity securities that are attractive by our standards may decline in price as much as, if not more than, many general market securities and market indexes. Also, in certain types of frothy markets (such as the new-issue boom of 1967 and 1968) price performance for securities attractive by financial-integrity standards tends to be much less favorable than is the case for many market indexes. Yet, we have no doubt that over time and over all types of markets, the average diligent unaffiliated investor emphasizing this approach will obtain much more satisfactory results, and a higher total return, than could be obtained using any other method of investment available to him. That is why the approach generates confidence and comfort, and why almost all deal men, creditors, major investment bankers, insiders and owners of private businesses with whom we have dealt emphasize it in committing their own funds.
Most important, since the control and noncontrol groups value using the same standards, there tend to be clear conflicts of interest between insiders and outsiders. Insiders sometimes will create additional values for themselves by forcing out outsiders via the corporation’s proxy machinery that they control, by short-form mergers* or by the use of coercive tender offers. Force-outs sometimes can be at extremely low prices, because the insiders, by their actions (or lack of actions), have contributed to the depression of stock prices. This conflict of interest presents a realistic threat that limits the appeal of a number of equity securities that would otherwise seem attractive using our approach.
*In a short-form merger, stockholders can be forced out of a company in a merger or similar transaction, and have no right to vote on the transaction.
The conventional view of risk in equity securities involves only quality-of-the-issuer considerations. Our approach is different. For us, risk in equity securities has three distinct elements: quality of the issuer, price of the issue and financial position of the holder.
In the management of securities portfolios, a positive cash-carry is frequently important – that is, the cash return from holding securities ought to be greater than the cash cost of owning the securities. This sometimes can also be important under our approach because both patience and the use of other people’s money are easier to come by if the cash return from investments exceeds the cash cost of owning them.
Charpter 3 The Significance of Market Performance
The typical well-run fire and casualty insurance company is, in part, an example of a dollar-averaging investor. Its performance is measured essentially by its net investment income – income from dividends and interest after all investment expenses except taxes. The insurance company’s investment departments normally receive continuous new injections of cash from the underwriting departments, growing out of increases in premium volume and, it is hoped, from underwriting profits. For such companies, as long as interest is not defaulted and dividend rates on securities held in portfolios are not reduced or eliminated, the lower the market value of the portfolio, the higher the returns that will be earned on the new funds being invested.
Charpter 5 Risk and Uncertainty
For example, in the era before the 1920’s, the foremost blue chips were railroads and traction companies. Included among these high-quality issuers was the Pennsylvania Railroad, which until its 1968 merger to form Penn Central Company had a dividend record dating back to 1848. In the 1920’s, investment trusts and utility holding companies were regarded as high-quality issuers. In recent years, common stocks such as the Great Atlantic and Pacific Tea Company have been wrongly acclaimed as high quality. The damage done to investors who purchased stock based on the high-quality reputation of these issuers tended to take the form of double stock-price depreciation: first the shares went down because earnings declined; then the shares went down even more when the issuers lost their highquality image and the high price-earnings ratios evaporated.
An inappropriate financial position can also arise because an investor does not have enough funds to live on. There are many examples of investors who suffer large losses in an apparently undervalued security because they do not have the financial position (or temperament) to tough it out. Many of the most successful long-term investments of the last ten years, which appreciated from five to ten times cost, were in issues which paid small or no dividends and on which the holders realized no profits or paper losses for two, three or even four years. Examples are Tokio Marine and Fire Insurance, Fargo Oils, H. J. Heinz and Northwest Bancorporation.
The astute person examines consequences as well as odds.
In contrast, a workout- or special-situation investor emphasizes price of the issue rather than quality of the issuer. It is not that the special-situation investor sacrifices safety for yield, but rather that he finds safety in a low price.
Charpter 6 Following the Paper Trail
It is important to note, of course, that the lack of soft information on the paper trail is a much less serious shortcoming for the longterm investor than it is for the trader. For the trader, a near-term earnings forecast or dividend action may be the only disclosure of interest. The long-term investor, especially the investor whose analysis rests on the financial-integrity approach, is resource-conscious; the hard information disclosed by the paper trail is of great importance to him in virtually all his evaluations. Furthermore, for this investor an apparent low price relative to an estimate of the resources in the business can compensate for the risks inherent in knowing less about a company than would be optimal. This safety valve does not exist for the trader who is seeking the best possible near-term market performance.
Charpter 8 Generally Accepted Accounting Principles
There are, however, all sorts of economic phenomena that create value and income that are not part of GAAP. ……These key intangibles include the following:
• The first intangible involves debt finance. A lack of debt or an ability to create new debt is frequently a most important asset. In principal areas of corporate finance—such as underwriting, private placements, and mergers and acquisitions, as well as in the financial-integrity approach to fundamental analysis – a key variable almost all practitioners focus on is a lack of debt. The quality of the balance sheet tends to be a far more important consideration in corporate finance than the quantity of net assets on the balance sheet, or reported net worth, as is pointed out in Chapter 12, “Net Asset Values.” Yet lack of debt is largely ignored or played down in conventional fundamental security analysis, in part because, we suspect, unlike earnings and book value, GAAP does not measure an absence of obligations per se.
• The second intangible involves equity finance. The price at which its common stock sells can be a highly important company asset (or liability), especially to any company planning to issue its stock either to raise new money or to obtain additional assets via merger and acquisition. (An acquisition-hungry company using its stock when it is selling at one hundred times earnings and ten times book value to acquire a solidly financed, profitable firm selling at, say, close to book value is said to be trading with “Chinese dollars” or “funny money.”) The stock price conceivably can be important, too, to almost any company planning new financing, even if only short-term bank loans, since there is sometimes (though far from always) a tendency by outsiders to give considerable weight to the stock price in determining how much a company’s equity is worth.
Financial strength does not arise solely out of a lack of existing debt or an ability to create new debt, but may also exist because of the presence of low-cost long-term debt.
There are myriad other intangibles that are not part of GAAP but that are frequently important and even crucial in security analysis and corporate finance. In brief, these other intangibles can include the following:
1. Long-term, favorable (or unfavorable) contracts with key employees, customers and vendors
2. Trade names and patents
3. Distribution channels, such as dealer organizations
4. Manufacturing know-how
5. Licenses to do business
6. Tax-loss carry-backs (worth cash) and tax-loss carry-forwards (which we believe tend to be worthless unless they are usable in clean, or relatively debt-free, shells; )
There is a final point about intangibles that is almost an aside. GAAP becomes increasingly less descriptive of phenomena in our economy as intangibles become more important as the principal elements of value and the principal sources of income. Intangibles are becoming increasingly prevalent as more and more of the United States’ Gross National Product is derived from personal services. GAAP provides good objective bench marks to value the output of steel mills; GAAP does not provide equally good bench marks at all to value the worth of a citizen’s medical degree.
GAAP cannot be flexible enough to recognize that economic substance frequently differs from physical fact and legal definition. For example, many noncurrent, fixed assets are in reality subject to asset conversion and thus are highly liquid and very marketable, whereas other assets defined as current cannot as a practical matter be turned into cash; these current assets are locked up, dedicated to the continuing operations of going concerns.
The same type of rigidity has to govern GAAP on the liability side of the ledger. From the point of view of senior lenders, subordinated debentures are equity; from the point of view of common stockholders, subordinated debentures are debt. GAAP tends to adopt the common shareholders’ point of view. For the creditor or investor, however, neither the common stockholder nor GAAP is necessarily realistic, though both are legally correct. In the case of companies heavily in debt and with little or no equity – say, Cadence Industries in 1975 or Rapid American in 1971 – the analyst concentrating on economic substance would view the outstanding subordinated debentures as the common stock, and the company’s common stocks as voting warrants. Such a change in approach, which is impractical for GAAP, may make appraisal much simpler and more feasible for the analyst.
Charpter 9 Tax Shelter (TS), Other People’s Money (OPM), Accounting Fudge Factor (AFF) and Something off the Top (SOTT)
Besides tax considerations, the use of funds provided by others in one form or another is part of almost every business transaction that takes place. Many people involved with corporations try to obtain other benefits out of the association for themselves or for the corporation. We characterize all such benefits as something off the top, or SOTT, which means different things to different users of it. For example, to a company, something off the top may mean diversified income, freedom from regulation, and political clout. To a public company, it may also mean control of the registration process, together with an ability to sell equity securities at an ultrahigh price, so that new productive assets can be obtained on an advantageous basis via either a public offering or a merger and acquisition program. To management, something off the top means not only salaries, bonuses, stock options, expense accounts and perquisites such as prestige and big offices, but also power and operating control. In a public company, this includes control of the registration process and proxy machinery. Finally, not being an insider can occasionally even serve as a form of something off the top to those outside securities holders who eschew any of the responsibilities that go with being an insider, and who want nothing more than absolute passivity, liquidity and marketability.
Tax considerations, other people’s money, something off the top and the accounting fudge factor are facts of commercial and bureaucratic life, the underlying factors that motivate decisionmakers to act as they do. We are not concerned here with whether they are “fair” or socially beneficial; such considerations are counterproductive to achieving an understanding of the way our system operates. They are there; they are useful to different groups in different ways; and as long as people do not all have absolutely identical wants, no system can be designed without them.
Something off the top: some preliminaries
Every economic entity – corporations, managements, securities holders—tries to obtain something off the top, even though various recipients of SOTT may not regard themselves as having obtained special advantages. Most unaffiliated security holders are unaware of possible beliefs by managements that outside stockholders are taking unfair advantage of insiders. The insider, on the other hand, may say, as many do, “Isn’t it a shame that I have to break my back to make my sixty percent of the company valuable while the other owners do nothing but obtain a free ride?” From his point of view, the stockholders may be getting a free ride.
Certainly, outside investors have a form of SOTT that appears to be almost unique in our society. Ownership of assets in any form usually entails considerable responsibilities – whether it is keeping the lawn in front of the house you own mowed, or the customers and employees of the business you control satisfied. Not so the passive, individual investor. His ownership of assets carries with it no obligations or responsibilities to others. Moreover, unlike the insider, he is free to sell his securities without restriction, and does not have to comply with Securities and Exchange Commission rules and regulations, or to deal with lawyers and accountants.
Yet, make no mistake, public shareholders pay a high price for the luxury of passivity. They cannot obtain the information available to insiders. They have little or no influence on how the resources in which they have invested are used. Above all, they get no return from the company for their ownership interest other than that to which their security holding entitles them.
Contrast this with the position of the insider. To him, security ownership may be of only incidental value compared with all the benefits he can obtain from his relationship with a company – not only salaries but a myriad of perquisities ranging from wellappointed offices to opportunities to buy cheap stock. The insider can obtain PPM – power, prestige and money.
The value of control, whether positive or negative, has to be appraised on a company-by-company basis. The responsibilities a control group must assume may outweigh any possible benefits – especially when the enterprise is truly a sick company. In that situation, the outsider may tend to be the one with the SOTT; the control should carry a discount. Thus, like anything else, control that is a plus in one context may turn out to be a minus in another.
In any economic activity, the relationship among various economic groups and individuals will be marked by areas where there are conflicts of interest and areas where there are communities of interest. SOTT is an area where conflicts of interest seem dominant, as a general rule. More specifically, there tends to be an inherent conflict between management SOTT on the one hand and stockholder well-being on the other.
Most managements undoubtedly feel a responsibility to their securities holders most of the time, even if improving returns to these holders results in reducing management SOTT. The woods seem to be full of corporate “milkers” , however, for whom the realization of personal benefits off the top is a sole goal, and who believe that giving benefits to outside stockholders will detract from the realization of this goal.
Even aside from these milkers, the inherent conflict between management SOTT and investor well-being poses a problem for the outsider. Admittedly, SOTT is generally created at someone else’s expense. The obvious target is an amorphous outside group with whom management has no personal acquaintanceship or dealings. Thus, we have observed that a corporation or a corporate insider tends to create SOTT at the expense of public stockholders and the IRS, rather than at the expense of groups such as labor unions, vendors or customers with whom they have daily relationships.
This inherent conflict becomes especially important when looking at small companies. It is of real concern to every outside security holder – even such a one as a commercial bank whose holding is a senior loan. After all, no matter how senior the loan, interest and amortization payments on that loan will be made at any given point in time only after management salaries have been paid.
An important caveat for public investors is to try to avoid ownership of shares in companies where the insiders have a basic disdain for public stockholders and are in a position to create SOTT at their expense. This is, of course, an essential element of the financial integrity approach.
Charpter 10 Securities Analysis and Securities Markets
It has been said, What goes up must come down. Both in modern rocketry and finance, this is no longer always true. If a stock goes up far enough and its management is astute, it may use the Chinese dollar, or puffed value, to buy economic value elsewhere at a discount. Many of the late 1960’s “conglomerateurs” – for example, Gulf and Western, Walter Kidde, Teledyne, and City Investing – succeeded in doing just that. Real values were built into their stocks and the company by issuing common stocks that were overpriced relative to corporate reality to acquire real corporate values.
The standard of investment behavior for passivists as well as activists should be, Don’t worry about the investments you did not make. Rather, concentrate your worries on the ones you made, but which you should not have made. The only people who logically ought to worry about investments they did not make are total-return traders who are attempting to maximize or beat the market.
One problem with companies in sponsored industries is that capital-raising opportunities are so attractive that inordinate amounts of new competition are attracted to the industry. Witness the tremendous amount of overcapacity visited on the computer components, computer leasing, electronics, food franchises and nursing-home industries during the 1960’s. The very sponsorship of these industries assured that over the long term most companies would fare poorly, if for no other reason than that too much competition would be attracted.
Buying poorly sponsored or unsponsored equity securities has advantages in that they are where the bargains lie for long-term investors, especially for those adhering to the financial-integrity approach. Unsponsored securities, especially during bear markets, frequently sell below unencumbered asset values at, say, two to four times increasing (?) earnings, or on a basis where the cash return to maturity may be 15 percent to 20 percent per annum with reasonable safety. The principal problem with unsponsored securities is that they require know-how to be analyzed so that their true bargain status can be estimated in an always uncertain environment. Also, the timing is indeterminate. There usually is no basis for making judgments that the market price for the securities will react favorably over the near term. If there were, the security would probably already be sponsored, because even in bear markets, there are any number of dedicated, hard-working individuals concentrating on finding securities they believe will perform well over the near term.
Charpter 11 Finance and Business
A high debt load can be an asset in a business sense as well as in a stock market sense. This occurs where the indebtedness had been incurred on an attractive basis that could not be duplicated under present conditions, no matter what the quality of the deal. (cgx: Chinese SOEs?)
Large cash holdings can sometimes be a sign of unattractiveness in a company and its common stock, either where entrenched and nonraidable managements refuse to make productive use of the funds, or where management has refused to use the funds to undertake necessary expenditures. A classic example of cash holdings being unattractive for investors is Montgomery Ward’s huge cash hoard after World War II. As an operation, Montgomery Ward fell steadily and dramatically behind its arch rival, Sears Roebuck, as Sears continued to expand by opening new stores and by entering new businesses.
In the same manner, in the late 1950’s and early 1960’s labor costs had risen so sharply in the cement industry that in order to remain competitive, it was essential for companies in the industry to undertake relatively massive capital-expenditures programs, especially for large automated kilns. In the mid-60’s, it was almost axiomatic that cement companies with strong financial positions were companies with obsolete, noncompetitive plants, whereas companies that were competitive operationally had heavy debt loads.
This problem is brought home if one addresses the question of when a common stock is really a senior security. Take the case of Mountain States Telephone common, 88 percent of which is owned by American Telephone. For the parent company to obtain cash to service its debt and pay dividends on its common, it has to receive dividends from the operating subsidiaries, of which Mountain States is one of the more important. Thus, in economic fact Mountain States common has most of the key attributes of being an American Telephone senior security, though it does lack one attribute – there is no legally enforceable right of Mountain States stockholders to receive dividends. Accounting recognizes this senior position of the non-American Telephone stockholders of Mountain States. In American Telephone’s consolidated accounts, this minority interest is separated out and is carried as senior to American Telephone’s capital and surplus. In economic fact the Mountain States common can, in a sense, be viewed as senior to the most senior parentcompany obligations, simply because the minority shareholders have to receive dividends before such cash dividends to its other shareholder, American Telephone, can be used by American Telephone to pay interest and principal on its debt.
This same feature can be brought home even more forcefully in the case of Schenley Industries when it was 86 percent owned by Glen Alden between 1968 and 1971. Without distributions from Schenley, Glen Alden, the parent, would have been insolvent and probably could not have been made solvent by obtaining distributions from other subsidiaries; it was improbable that enough cash could be generated in short order from their other subsidiaries, either from operations or through the sale of businesses or parts of businesses. As such, the Schenley common represented by the minority interest was senior Glen Alden debt. Glen Alden had to cause Schenley to pay dividends, and the minority interest had to share in these payments on a pro-rata basis. The Glen Alden debentures, of which some $700 million were outstanding, could be properly viewed as Glen Alden’s equity. The Glen Alden common, which was under water (that is, had no tangible net worth attributable to it), might best be viewed as a voting warrant. In any event, the legal and accounting definitions of what these securities were did not necessarily jibe with the realistic economic definitions of what they were.
Charpter 12 Net Asset Values
Even where the past earnings record of a company is a superior indicator of future earning power, we know of no instance in which it has been the sole indicator. The amount of resources a management has available to create future earnings remains an essential indicator of future earning power. And one measure of available resources is book value.
This approach is more commonly used in the context of corporate takeovers (such as mergers and acquisitions) than it is in the context of passive investing by outsiders. Corporate buyers tend to be acutely conscious of how they plan to use the resources over which they gain control in order to maximize earning power. Outside investors, on the other hand, are not in a position to alter the way a corporation’s resources are used, and understandably are thus less likely to use this asset-conversion approach in forecasting future earnings. It does not follow from this, however, that an outside investor should or can safely ignore book value in analyzing a corporate situation. If only because corporate acquirers are using book-value analysis in this fashion, the outside investor may be able to reap a substantial benefit from adopting this kind of approach.
Book value as a measure of resources is also crucial in any kind of return on investment (ROI) or return on equity (ROE) analysis. ROI and ROE analyses are important tools in forecasting future earnings. For example, high ROI may mean that a company has a proprietary position that will allow it to continue to enjoy above-average profitability; alternatively, it may be an invitation for new competition to enter the industry and drive down profits for all. Conversely, low ROI may evidence an overvaluing of assets and inefficient management, or it may be an indication that the business has a large amount of unused resources that give it a margin of safety and the wherewithal to expand earning power.
Many analysts recognize the importance of ROI and ROE analyses and place considerable emphasis on them while disclaiming the importance of book value. But you cannot calculate a return on investment unless you know the amount of the investment; nor can you know the amount of the investment unless you know the amount of the net worth. Inasmuch as book value measures common-stock equity, which is a component of net worth, it must necessarily figure in this calculation.
The outside investor who purchases securities regardless of the immediate outlook will probably always be in a distinct minority among securities purchasers. Such an investor must be in a strong financial position. He must also be capable of curbing any tendencies toward greed in his investment: he cannot attempt to buy precisely at the bottom of the market or to maximize capital gains over short periods. Finally, he must be convinced that there are important values in the company whose stocks he holds that are not reflected in the market price and are not likely to be dissipated. Without such conviction, almost any investor can be expected to panic if the market price of the security he holds declines. It tends to be much easier for outsiders to gain some degree of conviction if a cornerstone of their analysis is the financial-integrity approach.
Changes in earnings can be sudden and violent, and changes in price–earnings ratios even more so. Changes in book value, on the other hand, by definition must be more gradual. A large, relatively unencumbered book value may be an anchor to windward, both for the company with honest and reasonably competent management and for the investor who holds its stock.
What do we mean by “quality of assets”? In short, financial integrity. We suggest that quality of assets is determined in a corporate situation by reference to three separate, but related, factors.
First, an asset or mix of assets has high-quality elements insofar as it approaches being owned free and clear of encumbrances. Conversely, the assets of debt-ridden companies tend to be of low quality. Note that though encumbrances that depress the quality of assets (such as long-term indebtedness) may be stated liabilities, they may also be off-balance-sheet items, some of which, of course, will be disclosed in footnotes to the company’s financial statements. These include such items as pension-plan liabilities, and such contingent liabilities as litigation and guaranties of the debts of others. Others may be disclosed elsewhere. For example, a railroad may be obligated to operate unprofitable commuter services, or a steel mill may be required to install antipollution equipment that does not generate revenue. Still other off-balance-sheet encumbrances may not be disclosed in any public document. A common example would be the need to substantially overhaul outdated plants and equipment in order for the business to remain competitive enough to survive. Unless an investor has know-how, and perhaps even know-who, he may be unable to find out that such encumbrances exist.
The second factor to consider in evaluating the quality of assets of a going concern is its operations. Does it have a mix of assets and liabilities that appears likely to produce high levels of operating earnings and cash flows? Good operations are the most important creator of high-quality assets and are likely to contribute to a company’s having a strong financial position. Lenders quite properly prefer to finance businesses whose operations are sound and who are likely to create the wherewithal for continuing debt service on a long-run basis. The most financially attractive going concerns are blue chips and near blue chips, such as IBM, General Motors, DuPont, Kraftco, and R. J. Reynolds.
The third factor the investor must consider is the nature of the assets themselves. An asset or mix of assets tends to have high quality when it appears to be salable at a price that can be estimated with a modicum of accuracy. In most going-concern situations, of course, no values can be assigned to specific assets as a practical matter, because they are useful only as a part of the operations of the company – as part of an overall mix. For example, although it is said that certain proved and readily recoverable domestic oil reserves have a present value of five dollars per barrel, it is not especially useful for a nonmanagement investor analyzing Exxon to value that company’s assets according to this formulation as long as the company is likely to remain a going-concern operation. Exxon’s domestic reserves in that instance are dedicated directly or indirectly to Exxon’s refinery and marketing operations; for practical purposes they have no five-dollar-per-barrel independent value. By contrast, if the same proved reserves were owned instead by, say, General American Oil, the five-dollar-per-barrel valuation would tend to be meaningful as long as there was a likelihood that General American would sell the reserves to others in bulk or in the normal course of business, or that General American would be acquired by others.
First and foremost, then, for an asset to have independent value from the point of view of the outside securities holder, it must be available for sale apart from the operations of the going concern. It must be something that is not so related to the going-concern operation, or if so dedicated, is separable from it in a manner that will not have an adverse impact on the operating-earnings power of the going concern.
If an asset is one that third-party lenders or guarantors (such as financial institutions and governments) are experienced in lending against, the standards they have developed for lending may also provide a measure of value, and the asset tends to be more valuable than it would otherwise be. Examples of such high-quality assets have included oil and gas, maritime vessels and certain types of real estate.
Flexibility and scarcity are factors that tend also to make an asset more valuable. Thus, multipurpose assets tend to be more valuable than single-purpose assets. Flexibility is especially important in the case of real estate: a factory useful for only one type of assembly-line production tends to be less attractive than, say, a downtown hotel that can be converted economically into efficiency apartments. Assets that are scarce, at least on a long-term basis (such as copper mines or domestic oil), may have special values all their own.
Certain assets that appear to have these characteristics may, of course, not have them because of legal impediments. For example, U.S. margin regulations make common stocks worse collateral than other assets that lack common stocks’ characteristics of liquidity, marketability, flexibility and measurability. Other assets may have special value because they can be used to create tax shelter. Because tax savings allow these assets to throw off more cash, tax-sheltered assets tend to be most attractive in the eyes of creditors. Thus, assets such as real estate, timberlands, to some extent oil and gas as well as other natural resources, and until recently, motion pictures have been outstanding examples of this.
Charpter 13 Earnings
Where businessmen have choices, the generation of reported earnings from operations tends to be the least desirable method for creating wealth, simply because reported earnings from operations are less tax sheltered than are other methods of wealth creation. This is one of the reasons why asset-conversion activities by corporations seem to have grown in importance at the expense of ordinary going-concern activities.
It is well known that privately held corporations, even those that are strict going-concern operations, usually attempt to report earnings in a manner that minimizes income taxes – an important consideration to these businessmen in realizing wealth-creation goals. Publicly held corporations, on the other hand, frequently attempt to report the best earnings possible. This is not because businessmen think that current earnings per se are so all-important, but, rather, because the ability to report favorable current earnings may have the most favorable impact on stock prices and in this instance provides the greatest potential for wealth creation. High commonstock prices provide insiders with opportunities to realize values by selling or borrowing. They also give a company opportunities to issue new equities in public underwritings for cash, or to acquire other companies either for cash or by the direct issuance of common stock or other equity securities. (cgx: incentive changes behavior)
Given the varied economic definitions of earnings, it may be wise to distinguish between earnings and earning power. By “earnings” is meant only reported accounting earnings. On the other hand, in referring to “earning power” the stress is on wealth creation. There is no need to equate a past earnings record with earning power. There is no a priori reason to view accounting earnings as the best indicator of earning power. Among other things, the amount of resources in the business at a given moment may be as good or a better indicator of earning power.
Charpter 14 Roles of Cash Dividends in Securities Analysis and Portfolio Management
It is our experience that the acquisition of a portfolio of minority interests is attractive because of the likelihood that parents will eventually attempt to acquire, through mop-up mergers, 100 percent interests in subsidiaries at prices reflecting substantial premiums above stock market prices (which are depressed in part because such securities are liable to lack marketability). Such securities, which have been acquired in recent years by their parents at substantial premiums above market, include Indian Head, Marcor, and Otis Elevator Company.
In acquiring these types of minority-interest securities, however, it frequently is important to the investor that such securities pay dividends, in part because an investor may need income and in part because the receipt of dividends may be far more certain than cash tender offers or mop-up mergers that may never occur. When situations exist where the parent company finds it essential to receive cash from subsidiaries in the form of dividends on outstanding common stock, cash income may be virtually assured for the outside investor.