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The Aggressive Conservative Investor
June 6, 2007, 8:10 am
Filed under: investments/finance/economics

Notes taken off The Aggressive Conservative Investor by Martin J. Whitman and Martin Shubik

In fundamental security analysis, a key element to be emphasised 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, conventional fundament analysis rests on a primacy-of-earnings theory- that is, reported earnings are a principal determinant of common-stock prices.

Attractive equity investments ought to have the following four essential characteristics:

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.

The company ought to be run by reasonably honest management and control groups, especially in terms of how cognizant the insiders are of the interest of creditors and other security holders.

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.

The price at which the equity security can be bought ought 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.

Risk in equity securities has three distinct elements: quality of the issuer, price of the issue and financial position of the holder.

Book value does not measure the value of a company’s asset. Quality of asset refers to financial integrity. Quality of assets is determined in a corporate situation by reference to three separate, but related, factors.

First, an asset or asset mix 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. Some encumbrances may be stated liabilities while some might be off balance sheet items in the footnotes of financial statements. These include items like pension-plan liabilities, and such contingent liabilities as litigation and guaranties of debts of others.

The second factor is its operations. Does the operations have a mix of assets and liabilities that appears likely to produce high levels of operating earnings and cash flow? Good operations are the most important creator of high-quality assets and are likely to contribute to a company’s strong financial position.

The third factor is the nature of the assets themselves. An asset or mix of assets tends to have higher quality when it appears to be saleable at a price that can be estimated with a modicum of accuracy. First and foremost, for an asset to have independent value, it must be available for sale apart from the going concern.

Assets that are more liquid and more marketable tend to be more attractive to lenders. To be marketable, the asset must have a value that is readily measurable. Flexibility and scarcity are factors that tend also to make an asset more valuable.

High quality assets are most commonly used to finance rapid growth.

Frequently the best tool for projecting future earnings is the structure and amount of asset value at a given moment.

In fundamental analysis, special attention should be given to the importance of a favourable long-term earnings record.

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