After reading the latest Third Avenue Value Funds shareholder report, I decided to go back a read Marty Whitman’s book, The Aggressive Conservative Investor. I first read the book when I was in college. I admit that I was intrigued by the juxtaposed  adjectives in the title. How could one be both aggressive and conservative at the same time? Isn’t that what everyone wants? Conservative implies low risk, while aggressive implies potentially huge rewards. Who could resist?

So what is aggressive conservative investing? The opening paragraph of chapter one explains:

“This book is directed toward investor and creditors who hold, purchase or sell all types of securities and evidences of indebtedness, and who are aggressive because with their own contexts the expect a well-above-average return over the long term. For these investors, this book presents conservative methods of investment, especially equity investment, that the authors believe minimize the risk for securities holders. It is our thesis that minimizing risk does not reduce profit potentials for investors in commons stocks; rather, minimizing the downside tends to enhance the realistic upside potential, especially for noncontrol investors in common stocks.”

The book takes a different approach from most investment books. Up front, Marty points out that most investors are simply outside passive minority investors. This is very important because it emphasizes the point that most investors must rely on management and/or a true control investor to realize investment returns. However, Marty stresses that even though an investor is not a “control” investor, they should still “think like an owner” when it comes to evaluating the company. For example, Marty dissuades everyone but the day trader from focusing on near-term GAAP earnings reports and instead, use SEC documents to perform most substantive analysis of the company’s prospects.

Marty spends a few chapters discussing SEC documents and the limitations of GAAP accounting. There are numerous books devoted solely to the limitations of GAAP accounting and how it can be manipulated to show a company’s financial situation in a more favorable light. We will discuss some of those books over time.

We believe the main points that readers of The Aggressive Conservative Investor should come away with are:

1. Do your own work and read the SEC filings.
2. Think long-term like an owner and ignore the daily noise created by those only focused on short-term trading and GAAP earnings estimates.
3. Above average returns can be found in less than “high quality” companies.

Other Takeaways

Marty is not much of a fan of Modern Portfolio Theory (MPT).

His main disagreement with it seems to be that the realities of institutional money management and human emotion provide a long-term investor with opportunities to invest in stocks that are in short-term “disequilibrium” to their long-term intrinsic value. Most value investors have some variation on this idea that the valuation of a company based on the current stock price can be influenced by transitory factors (macro, technical, fundamental or other) which cause a divergence between “market value” and “intrinsic value”. Successful investors take a long-term view of a company’s prospects and  use “time arbitrage” to create “aggressive” returns.

Marty discusses how his approach differs from the traditional “Graham and Dodd” approach.

He states that, “we depart from Graham and Dodd in two respects. First, we think that public disclosures have become increasingly better in the years following the passage of the securities acts of 1964. (editor note: we believe that disclosures today are significantly better than when this book was written in 1979). We believe that disclosures are so good that diligent investors can, in increasing numbers of instances, analyze well enough to obtain reasonable results when they do not restrict their equity investments to securities that are generally recognized as high quality by others.”

“We also differ from Graham and Dodd in that their advice seems directed to the outside investor who reacts to an environment where such things as general market levels and earnings per share are all-important.

The lengthy appendix of the book is Marty’s attempt to use examples to show how his techniques can be used. We did not find this section to be of much help in today’s investment world.

Valuable Quotes

Finally, we would like to leave the reader with a few quotes from the book. We think that these are as valuable as almost anything else you will find in it.

“It is a fool’s errand to think that GAAP ought to be designed to meet the perceived needs of stock market speculators. A stock market speculator is defined as anyone or any institution that believes, for whatever reason, that its income and fortunes are vitally affected by day-to-day securities price fluctuations. “

“Book value, unlike reported accounting earnings, seems to play little to no apparent role in influencing day-to-day stock market prices. This is probably the principal reason why nearly all writers about financial accounting and security analysis have denigrated the importance of book value as a tool of valuation. We, on the other hand, believe that in almost all analysis outside of the day-to-day stock trading environment, book value is a highly useful tool of analysis for a variety of purposes, including predictions of future accounting earnings.”

“Diversification is a surrogate, and usually a damn poor surrogate, for knowledge, control and price consciousness.”

“in contrast to our emphasis on the financial position, conventional fundamental analysis rest 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. for those Common stock trades whose  one consuming interest is day-to-day stock price fluctuations.”

“Anyone who does not understand the business in which he holds securities will have to be highly interested in market fluctuations if he owns any securities other than the highest-quality senior obligations.”

“This book. offers no arithmetical formulas to noncontrol investors. Our “magic formula”  for investment success-understanding a business- has to grow out of experience, insight and maturity of judgement.”

“Market performance as a gauge of how an investor is doing deserves 100% weight when the particular investor does  not know anything about the company in which he is investing other than the most superficial stock market statistics.”

“We agree with the modern capital theorists that it is a losing exercise for almost all outside investors to try and beat the market by forecasting price movements over any particular length of time, say within a year.”

“In considering the weight that should be given to stock market prices, it is important to remember that a stock market price is not the business or corporate value, but a realization value based on the price at which a common stock could be sold.”

“Accounting appears to be an exact science: it just reports a set of numbers, occasionally showing a footnote or textual exposition how the numbers would look different if another method of calculation had been used. Yet in reporting business events- which is part of what accounting does- there is no “right” way of describing anything: it depends on the angle from which you are viewing the transaction.

“The whole truth is, Assets are only useful if they can be used to create earnings, and earnings are only useful if they can be used to create assets, some of which may be distributed to stockholders  and others of which will be retained in the business.”