Notes from Aggressive conservative investor by MARTIN J. WHITMAN MARTIN SHUBIK

Book value indicates resources available to mgt to create future earnings: 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. Low ROE not always bad: 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. Very few will buy if near term prospects are bad, irrespective of its Net Present Value: Most people who trade common stocks (as opposed to those who hold common stocks) seem to be more interested in the near-term outlook than in anything else. They will not purchase a security if the near-term outlook seems bad or uncertain, regardless of the price at which it is selling. An investor who is able to take positions based on other factors increases his chances of finding outstanding longterm bargains, since there is a relative lack of competition in the market in which he is buying. Thus, by placing primary weight on present asset value rather than on past earnings, an investor should be able to realize higher appreciation potential and lower risk of loss in the long term. If you buy below book value, you are in minority: 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. Do not buy all equities with low price to book value ratio: This is only the starting point of anlaysis. There are certain other condition which stock needs to satisfy. 1) No outstanding obligations eg. Gurantees, to operate loss making routes, contingent liabilities, pension plan liabilities, heavy capex requirements going forward. 2) Check whether company will qualify for loan from bank on its capability to service debt on a long term basis. 3) Assets must be available for sale apart from the operations of the

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going concern. Eg Ship which a company requires for its operations has no value from outside shareholders perspective, because the ships will not sold until company is winding up. 4) assets must have a value that is readily measurable. Generally, it is our view that if a company has little or no outstanding obligations, it is in a strong financial position, unless operating losses seem to have some prospect of being so large that the company’s strength will be impaired. No primacy of earnings other than for traders who like to speculate on short term movement of share prices. Private companies want to minimize reporting of income to reduce taxes whereas public corporations want to maximize it, so that they are able to sell their options or make additional issue of shares at higher prices. Industry classification plays role in valuation: Valuation also depend on the industry classification and the multiple for that industry. A company with lumpy earnings but in growth industry may get a higher multiple compared to a company with consistent earnings record but with no industry classification or in a not so attractive industry. High dividend payout not necessarily good: We believe this argument has elements of validity. Its applicability, however, is limited, since dividend policy does not appear to us to be a particularly good measure of either management ability or management interests. Cash carry: When the dividends are very attractive and the security appears to be safe, like preference shares or debentures, it might make sense to borrow to make investment in these securities. High dividend paying stocks where free float is less than 10% might be a good idea, as holding company which requires dividend, will tend to push for liberal dividend policies. Loss making companies, with no debt and possible turnaround possibility can be good investment option. But never invest in small companies incurring losses: In the years of the new-issue bull markets, 1962 and 1968, there was a theory that the best small companies to invest in were those that were suffering losses, so that when they “turned the corner” their growth records would look so much the better. Because of the tremendous uncertainties involved with predicting outlooks for small companies with no records of profits, and because new issues are normally not priced on bargain bases relative to corporate reality, we think such an approach will not prove especially profitable for most outside investors. Such securities virtually never qualify as attractive as a result of any judgments made using the financial-integrity approach. Macro data abandoned: Macro data, such as predictions about general stock market averages, interest rates, GDP, and consumer spending, have been abandoned as irrelevant as long as such investments are undertaken in countries marked by political stability and an absence of violence in the streets. Paper trail gives information about management: Proxy statements for annual meetings at which directors are elected contain disclosures about management remuneration, about borrowings by insiders from the company, and about certain

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transactions—dealings and participations between the company and its insiders. In addition, the long-term record of management is revealed, and this is helpful to analysts who tend to believe that behavior patterns probably do not change much, if at all. Information about who owns the company’s stock, who is acquiring it and what resources the company has may tell whether or not it is a likely candidate for a takeover, or for a liquidation or recapitalization. The paper trail does not provide full disclosure, and never can. Like any other analytical tool, it has its limitations. But for the investor who concentrates on our approach, the paper trail is going to be the essential starting point for his analysis almost all of the time. In some instances, the paper trail is all he will ever need. Corporate analysis better than stock market analysis: In most corporate situations, earnings emphasis is based on looking at results over a number of years to obtain an understanding of how a business operates under a variety of conditions. In stock market analysis, on the other hand, long-term earnings tend to be significant only if there can be an extrapolation of a growth trend. Short term market analysis: Thus, short-run market analysis becomes supreme. In stock market analysis the maxim is, Don’t try to buy at the bottom. Yet almost everybody tries to. In part, this is because each stock purchaser feels that he has special luck and limited exposure; the laws of chance do not apply to him. Furthermore, even if things turn sour, he will be able to sell out at only a small loss if the security declines a small amount. Four characteristics to be present before buying any stock: The company ought to have a strong financial position 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. 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 outside security holders. There ought to be available to the investor a reasonable amount of relevant information that is akin to full disclosure, though this will always be something that falls somewhat short of the mark. The price at which the equity security can be bought ought to be below the investor’s reasonable estimate of net asset value. The second attribute of a strong financial position is the existence of high quality assets, i.e., either cash or assets convertible into cash. Such assets are not measured by the accounting classification of an asset as a current asset, but rather the definition of a high quality asset depends on the economic characteristic of the asset. For example, we would tend to think a well-maintained Class A office building rented on long term leases to AAA tenants is a high quality asset. For accounting classification purposes, this asset would be called a fixed asset rather than a current asset, even though it probably is readily salable for cash.

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Consistency is not relevant: Efficient market theorists will carp that the funds have not outperformed relevant indexes consistently. Consistently is really a dirty word meaning all the time. In investing, consistently should have relevance only for day traders, not long-term buy-and-hold investors. The secret to success in safe and cheap investing is not to obtain superior (or earlier) information, but rather to use the available information in a superior manner. Risk: The idea of general risk is not helpful in a safe and cheap analysis. When financial academics and sell-side analysts refer to risk they almost always mean only market risk and usually very short-run market risk. All GAAP figures are important in a safe and cheap analysis. There is no primacy of the income account. Primacy of the income account means that corporate wealth is created only by flows (i.e., having positive earnings or cash flows for a period). In addition, we believe that corporate wealth is also created by resource conversion activities (e.g., mergers and acquisitions) as well as access to capital markets on a superattractive basis. While income statement and balance sheets are integrally related in safe and cheap investing, there usually is no basis for assuming that income account data are more important than balance sheet data. Review of management: We 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). Our ability to choose reasonably good managements most of the time seems to be due in large measure to the improved disclosure environment that has been created in the last 26 years. Most sell side analyst analyse wrong things: Second, the army is mostly analyzing the wrong things: They primarily believe in 1) Primacy of the income account 2) Short-run outlooks 3) 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) 4) What the numbers are rather than what the numbers mean. Creditworthy more important: A safe and cheap investor sells common stocks immediately when the businesses no longer appear to be creditworthy. This spells a permanent impairment. Bank stocks only if significant discount to book value: Under safe and cheap, Third Avenue Value Fund has never invested in a bank common stock unless the company was extremely well financed and the common stock was available at a substantial discount from book value. Audit by big 4 must for cheap and safe investing: It is our thesis that minimizing risk does not reduce profit potentials for investors in common stocks; rather, minimizing the downside tends to enhance the realistic upside potential, especially for noncontrol investors in common stocks

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Earnings impact stock prices more than change in financial position, but still short term earnings more relevant to day traders and not to long term investors. 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 perceive 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. Primacyof-earnings concepts therefore appear to be more limited in applicability than is popularly supposed. Avoid investing in untried and untested products and management: Since this book is about “how to” invest (and in a sense, “how to” promote), its emphasis is strictly financial; it becomes less useful as nonfinancial variables become more important. Nonfinancial variables tend to be of greatest importance in emerging security situations—that is, in enterprises based on new technologies, new inventions or ideas, and untried, untested managements. First think of the possibility of loss before calculating your returns: 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? Do not try to buy at the lowest price: First, little or no time is spent attempting to gauge the general market outlook, examining technical positions or making businesscycle 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. Public information more than enough: Obviously, most passive investments will be better investigated if publicly available documents can be supplemented with other information derived from talking to people known to the investigator (know-who) and from using the investigator’s special knowledge about particular companies and industries. Nonetheless, in a wide number of instances the public record alone can be quite sufficient. Financial intergrity approach is tough: It requires huge amounts of work, especially reading and understanding documents. Know who— personal relationships with those who are the shakers and movers—is also helpful, and in certain situations essential. The use of know-who in a financial-integrity approach permits an investor who is personally acquainted with insiders to make intelligent judgments about, say, the character and ability of management, corporate long-range plans or reasons why a business would or would not be vulnerable to competitive inroads. Most securities discovered using financial integrity approach trades in inactive markets

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Industries to avoid under this approach: For example, an emphasis on financial position could prevent one from investing in airline because of a belief that the industry is dangerously financed (an example of on balance- sheet liabilities) and would be even if reequipment programs were modified; in integrated steel and aluminum companies; in many electric utilities, because they may be encumbered with inordinately large capital expenditures requirements (an example of encumbrances that are not disclosed in accounting statements); and in labor-intensive companies with large pension-plan obligations (an example of off balance- sheet liabilities that are disclosed in financial-statement footnotes). This does not mean that at certain prices such securities are not very attractive investments for many. They just do not happen to be attractive for adherents to our approach. For the vast majority of non control investors, the best way to wealth is not to try for continuous short-term maximization, but to aim for a performance that is good enough over a long horizon. Outside investor bound to make error of judgement: Aside from the handicap of incomplete knowledge, the outsider (and the insider as well) is always faced with the possibility that his analysis is wrong. This may be due to out-and-out error, such as a failure to account for some crucial factor in an evaluation of a company. Analysis may also fail because of a misappraisal of management. Such appraisals are crucial in many areas of financial analysis and especially in the field of emerging securities. We do not know, however, of any reasonably objective standards by which to judge whether a management is “good,” except for the standard of honesty. Even if the outside investor avoids errors in his analysis or appraisal of management, he may still turn out to be wrong, simply because the future is unpredictable. Finally, even if the outsider is correct in his analysis that a security has large intrinsic values that are not dissipated, there is no certainty that he will ever be able to realize these values. For one thing, the values may not be reflected in the stock market for an indefinite period of time. The uncertainty that results from the outside investor’s incomplete knowledge—and from the possibilities of erroneous analysis, adverse future developments and the preemption of intrinsic value by others—can never be eliminated. Rather, the goal is to tip the risk–profit equation as far in favor of profit as possible, and we believe that intelligent use of our approach achieves this result. Three important factors to consider 1) Quality of the issuer 2) Price of the issue 3) Financial position of the holder Investment in lesser known companies yield higher returns: It follows, then, from this conventional wisdom that the securities of lesser-known issuers, so-called riskier investments, will have greater capital appreciation potential. Thus the cliché, You have to take chances if you want to make money. The third element in the risk–profit equation is the financial position of the holder. The investor who buys a stock of even the best quality at a fraction of its underlying value is engaging in an extremely dangerous speculation if he cannot afford to make the purchase. 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

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dividends and on which the holders realized no profits or paper losses for two, three or even four years. Portfolio concentration: He stands to gain most from concentrating his investment in the area where his knowledge (and perhaps control) tips the risk–reward ratio for the particular security very strongly in his favor. Never trade on margin: Our bias toward the financial-integrity approach prejudices us against playing the stock market on margin for two reasons. First, we think it is nearly impossible for any outsider to predict or influence short-term to intermediateterm stock-price movements. Second, there is a danger of loss where there is a lack of positive cash-carry— that is, a positive cash-carry occurs when the cash interest payments on a loan are exceeded by the cash income from the investment. Low profit margin can be a good reason to buy, if margins are expected to improve: Low profit margins can be a strong reason for purchasing a security if there are grounds for believing that they will improve. Small improvements in low profit margins can result in dramatic increases in earnings, whereas the same improvements for a high-profit margin business would have only a modest impact on earnings. Small size business preferable over large business: Much the same argument can be made for investment decisions that are based on the size of the enterprise. Smaller companies should be The Financial and Investment Environment chosen because of the appreciation potential inherent in their prospects for growing into giant businesses. 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 totalreturn traders who are attempting to maximize or beat the market. Large cash positions: Large cash holdings can sometimes be a sign of unattractiveness in a company and its common stock, either where entrenched and non raidable managements refuse to make productive use of the funds, or where management has refused to use the funds to undertake necessary expenditures.

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