Our series on profiling investors continues. In December I finished reading Martin J. Whitman’s “The Aggressive Conservative Investor” originally published in 1979. The book is considered a classic, and the version I have is from 2006.
Martin J. Whitman (September 30, 1924 – April 16, 2018) was an American investor and founder of Third Avenue Value Fund. He’s the author of many books on value investing, and has cornered an investing style of “safe and cheap”. Third Avenues returns between 1990 – 2004 were a compounded 15.94% compared to the S&P 500 of 11.84%; a handsome difference.
This post will examine key lessons from Marty and provide commentary on the book itself.
The Financial Integrity Approach
The key to sound investment decisions is to look at the balance sheet first. You want the company to operate under what Marty calls “The Financial Integrity Approach”.
As a rule of thumb, you need to look for three elements:
1. Absence of Liabilities
The first attribute of a strong financial position is a relative absence of liabilities, whether on the balance sheet itself or in disclosed footnotes. In layman’s terms, this means low or no debt.
2. Existence of High Quality Assets
High quality assets are either cash or assets that are easily convertible to cash. This is not specific to accounting definitions of current or non-current assets. Quality is measured on the economic characteristics of the assets. For example, top grade real estate can be quite “liquid” despite being listed as a non-current asset.
3. Free Cash Flow From Operations
Free Cash Flow as a result from operating activities is the oxygen firms need in order to remain viable. The key words here are: “From operating activities”. Free cash flow must result from regular, ongoing business activity, rather than creative accounting or one-time events. Unfortunately, most companies seem to focus on earnings rather than free cash flow.
Quality Evaluation
Many companies can tell great stories on what they’re going to achieve and what the future holds for them. The future always looks bright and rosy. This may or may not come to fruition, but the quality of the balance sheet will determine what the company is actually capable of delivering.
Intelligent investors must first answer the question: “What can I loose?”. Only after determining this should you look into what you can gain. The Financial Integrity Approach determines investment quality, not the price at which a security is selling for in the market.
Margins & Management
It is logical to conclude that a company with high profit margins is a good business. However, existing high profit margins by nature leave only little room to expand. Even if margins do slightly expand, its impact on earnings may be underwhelming. It is also known that high margins can become low margins very suddenly due to competitive forces and disruptive technologies.
Lower profit margins should not be shunned, especially if there are signs that improvements are coming. Usually even modest improvements from low margins can have a drastic impact on earnings, and thus the stock price.
Evaluating management is more difficult. Due to the difficulty of the task, it’s much easier to identify bad management. Bad management is usually characterized by them looking out for one interest: their own. You will be hard pressed to find bad management in firms that pass the Financial Integrity Approach.
Track record is another clue into management integrity. Consistent, long-term profitability with consideration to the balance sheet under the same management is usually a great sign.
Conclusion and Commentary
I don’t recommend Marty’s book “The Aggressive Conservative Investor” to a beginner or someone who is not an enthusiast. The book’s language is more “professionally oriented” and its content might not open up to someone at the start of their investing journey. A big part of the book is dedicated to analyzing GAAP (Generally Accepted Accounting Principals) rules, its benefits and shortcomings.
If you’re comfortable with professional financial lingo, the book is excellent. As you can see from the picture above, my copy ended up with plenty of sticky notes and writing in the margins. The book reminds me of my college days reading research papers and studies. Academic literature tends to have a leaning of making simple concepts more difficult than necessary and it’s clear that Whitman has a background in academia. This blog is about investing and business. In simple, easy to understand terms. I’d never want alienate my readers by changing the tone of my writing into “authoritative” academic jargon. There’s enough of that out there anyway.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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