CHAPTER 15
Safe and Cheap Investing*
Benefits of the Safe and Cheap Approach for the OPMI
Restrictions and Demands of the Safe and Cheap Approach
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 investment 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 investment 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.
THE SAFE AND CHEAP APPROACH
A basic premise of this book is that many noncontrol investors ought to adopt the same standards of valuation that are used by successful activists, creditors, insiders, and owners of nonpublic businesses.
First and foremost, they must gauge the investment risk. Key variables for doing this are the financial position of the business being analyzed and/or the financial position of the securities holder. Businesses with strong financial positions are those that have access to enough liquid funds so that they can pay for whatever reasonable requirements they might have and still have access to a comfortable amount of surplus liquidity. Earnings, even accounting earnings, are, of course, frequently an important element in determining financial strength or creditworthiness, but this is a far cry from the position usually expounded—that for unaffiliated securities holders, earnings are the primary factor and, in fact, determine value.
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 resource 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 passive minority investors (OPMIs) ought to have the following four essential characteristics:1
These four elements are the sine qua non for an investment commitment using the safe and cheap 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.
The environment within which an investor can search meaningfully for these four characteristics is a good one. The required disclosures under the securities laws give investors good insights into the first three characteristics. Audited financial statements, including footnotes, are particularly useful in describing and enumerating many of a concern’s encumbrances, albeit some potential encumbrances, such as necessary or desirable capital expenditures, may not be disclosed. Proxy-statement disclosures about management compensation and “certain transactions” with insiders, as well as narrative from Form 10-K and financial-statement footnote disclosures about litigation, aid in determining the degree of consideration insiders are likely to have for the interests of security holders. Business descriptions in annual reports, merger proxy statements, prospectuses, and 10-Ks have never been better in enabling investors to understand an enterprise.
In addition to the four essential characteristics, supplementary factors that can make an equity security attractive can be so varied as to defy anyone’s imagination. In fact, most of these factors in most analyses will exist in various combinations. To give the reader some insight into what these can consist of, we merely enumerate possible factors under three subheadings:
Any one or combination of these factors could serve as a trigger to buy securities that the investor has already determined are attractive, based on safe and cheap standards.
Primarily going concern factors are those that relate to the operations of a business. They encompass things ranging from investor beliefs that profitability in the immediate future will increase dramatically, to tenets about dividend increases; from views that current high dividends are safe, to beliefs in the potential of new developments or new research; from optimism about an industry outlook to faith in management abilities.
Primarily resource conversion factors that can serve as a trigger to buy can be more precisely enumerated than can factors that relate primarily to the going concern or to the stock market. Such resource conversion factors encompass possibilities or probabilities of major refinancings, mergers and acquisitions, liquidations, certain common stock repurchases or other large-scale distributions to common stockholders, changes in control, reorganizations, and recapitalizations.
Primarily stock market factors encompass variables ranging from beliefs that a common stock based on existing price-earnings (P/E) ratios is priced below comparable issues, to views that the common stock looks good technically, and to ideas that the company or industry may obtain Wall Street sponsorship. Under primarily stock market factors, we would also include the myriad macro variables that encompass investor perceptions about the economy, about interest-rate levels and about predicted movements in the general stock market or major segments of it.
BENEFITS OF THE SAFE AND CHEAP APPROACH FOR THE OPMI
Investment-Risk-Resistant Commitments
Outside investors using this approach buy and hold securities because issues appear at the time of purchase, and continue to appear while held, to be investment-risk resistant, based on the four essential elements. In contrast to other investment approaches, little or no attention is paid to stock market price fluctuations or to predictions about the immediate outlook for equity prices.
When purchasing equity securities, an OPMI 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 safe and cheap will tend to be emphasized less than it would be if the investor were 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 OPMIs is to concentrate on acquiring reasonable values rather than on getting the best possible values.
Confidence in Investment Commitments
Such investors tend to have a degree of confidence in their commitments that just cannot exist for those who are significantly affected by day-to-day or even month-to-month stock market fluctuations, or who believe that values are determined by elements based on soft, or always shifting, factors, such as earnings estimates, P/E ratios, and technical market conditions. This confidence factor can afford significant rewards in the usual (though far from universal) investment instance where there has been no fundamental deterioration in the position of companies with strong finances whose common stocks are part of the investor’s portfolio. The rewards come because:
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 which ended in 2000) price performance for securities attractive by safe and cheap 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.
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.
Availability of Multiple Exits
One of the huge advantages that safe and cheap has over other investment styles is that, on a long-term basis, the investor can look confidently to a multiplicity of exit strategies. In contrast, in other investment styles the only exit on which to concentrate is the sale in the open market to other passive minority investors. Safe and cheap investors ought to benefit not only from open market price improvements, but if their basic analysis is close to right and open market prices remain depressed, values for stockholders would still get created because companies will continue to grow over time, increasing NAV year over year; will be taken over at prices that represent a premium over market; will refinance and restructure; and companies with strong financial positions will make acquisitions that enhance future earning power.
The safe and cheap approach calls for the holding of securities for a permanent or quasi-permanent basis. Exits from positions are made (a) through resource conversion events (tender offer, merger, liquidation, etc.); (b) when the price of the security trades at a substantial premium over and above NAV; (c) when a permanent impairment of capital occurs (something goes wrong with either the company or the security); and (d) when the analysis supporting the commitment is found to be wrong.
RESTRICTIONS AND DEMANDS OF THE SAFE AND CHEAP APPROACH
Activists and Safe and Cheap
For activists and certain aggressive non-control investors using this approach, finding securities that are attractively priced based on the standards we have discussed is not as difficult as finding doable deals, situations where resource conversions can be made to take place, or where there seem to be probabilities that resource conversions will take place, in the context of cash tenders for control, mergers and acquisitions, going private, and liquidations. Thus, for activists in particular, the emphasis may be on spotting attractively priced doable deals where a resource conversion event may be made to occur. For these people, safe and cheap may be only a secondary consideration; they are more willing to balance the risk-reward equation. In that sense, they differ from us in that they do not necessarily make potential risk a more important measurement than potential reward. Doability, which most often entails obtaining control of a business, may become the most important consideration.
Safe and Cheap and Know-Who
The safe and cheap approach to investing is but one approach. It is not a magic formula suitable for all outside investors or even all activists. There are trade-offs, and the approach has disadvantages, especially for OPMIs. 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.
Using know-who does not connote using inside information. Those who use inside information for the purpose of buying and selling securities are violating both specific securities laws and more generalized antifraud provisions of law. Inside information embodies factors that are not generally known but that, if known, would be likely to have a material effect on immediate market prices. This type of information might include forthcoming earnings reports, disclosures of natural resource discoveries, or a pending takeover at a price well above current markets.
The use of know-who in a safe and cheap 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.
Missing of Attractive Opportunities
The standards used to minimize investment risk limit the selection of attractive securities. Adherence to the approach results in missing many investment opportunities where securities are attractively priced by standards other than those used by fundamental finance investors. In following the approach, an investor, whether activist or outsider, will forgo many equity investments regardless of price if they do not meet all four essential conditions. For example, an emphasis on financial position could prevent one from investing in airline equities, because of a belief that the industry is dangerously financed (an example of on-balance-sheet liabilities) and would be even if re-equipment 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.
Avoidance of Predatory Control Groups
Under our approach, securities of issuers controlled by those believed to be predators, should be avoided regardless of price by both activists and OPMIs. The securities avoided are both equities and debt instruments. Significant clues as to who the predators might be are publicly available from documents filed with the SEC. Some of these clues are discussed in Chapter 20 on company disclosures and information. Especially pertinent in these documents are disclosures about management remuneration, insider borrowings from the company, and transactions between the company and insiders. These disclosures are contained either in the annual-meeting proxy statement or in Part II of the 10-K Annual Report. Disclosures about “litigation” in Part I of the 10-K Annual Report, Part II of the 10-Q Quarterly Report and in footnotes to audited financial statements can also give valuable clues to the caliber of management and control groups. Disclosure of grievances by creditors or securities holders that culminate in lawsuits brought against companies and insiders should serve as warnings that a particular company may not be a satisfactory investment using an investment risk minimization approach.
Restricting the Investment Universe
Those using the approach restrict investments to situations where considerable knowledge about companies can be obtained. This is true for both control and non-control investors. While reliance on public information only is sufficient—or even more than sufficient for certain types of investments, such as investment companies registered under the Investment Act of 1940 and public utilities—in other areas required public information frequently provides insufficient data for making intelligent decisions, as is usually the case when a company is engaged primarily in mineral exploration activities. There is a close correlation between the usefulness of financial accounting and the usefulness of public disclosures as tools for making investment decisions. As accounting becomes more reliable, so do required public disclosures. We also discuss this correlation in Chapter 19 on the uses and limitations of financial accounting.
Most important, since the control and non-control 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,2 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. It is our observation that attempted force-outs at prices we would consider unconscionably low are relatively infrequent.
Basically, we think most control groups in most situations attempt to treat their stockholders fairly or are forced to do so by circumstances. Nonetheless, outside stockholders are sometimes treated unfairly, and legal recourses available to stockholders are frequently inadequate. First, those who overreach at the expense of stockholders have the independent appraisal weapon in their arsenal. Major or second-tier investment banking houses can be retained either to recommend a force-out price or to approve one chosen by boards of directors. Many independent appraisals seem to be based on a theory that if stockholders are given more than they could realize by sale of the shares on the open market, then the deal is per se fair.3 No real reference is ever made to any standards other than stock-price standards.
Stockholder claims of violations of federal securities law may be of only limited help, since in most instances such suits are controlled by attorneys for stockholders who frequently have to be primarily interested in promoting settlements rather than obtaining full dollar value for stockholders. Federal securities laws are basically concerned with disclosures and with fulfilling fiduciary obligations, not fairness. The Supreme Court decision in Ernst & Ernst v. Hochfelder,4 however, raised some question as to what can be brought to bear by the private bar against professionals such as auditors who fail to fulfill professional obligations insofar as federal antifraud securities laws are concerned. In Hochfelder, the Court said that an auditor was not responsible under antifraud statutes for his own “inexcusable negligence” when conducting an audit, but, rather, he may or may not be responsible where there is “reckless disregard for the truth,” and that the auditor is clearly liable under the antifraud statutes only if he is “an intentional participant in a scheme.”
Resort to appraisal rights under state law where available is of only limited usefulness because in leading states (a) considerable weight in arriving at value is usually given to market prices, and (b) costs of litigation for dissenting stockholders can be enormous.5
State law can be helpful in affording some protection to outside stockholders in force-out situations. This has become true especially since the supreme court of the leading corporate state, Delaware, ruled in 1977 that force-out transactions ought to have “business purposes,” and that stockholders are entitled to “entire fairness.” Nonetheless, overall protection for minority stockholders seems to be limited.
Despite the less than strong legal posture of OPMIs, we think that in general the threat of forcing out stockholders by predatory managements and control groups is not a realistic deterrent to an investment program based on the safe and cheap approach.
We think that a crucial reason why our approach has been largely ignored in the accounting and economic literature is that those writing on the subject tend to attribute the perceived information and analytic needs of traders seeking to maximize total return to all investors. Along with others, we believe that it is futile for OPMIs to strive for the maximization of total return. It is our thesis that by not trading and by concentrating on an investment risk-minimizing approach, outside investors can achieve good-enough results, probably beating the market from time to time and on an overall basis, but never consistently.6 For the vast majority of noncontrol 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.
In order to use our approach well, both activists and passive investors should have practical perspectives about risk and uncertainty. Investors using the approach need patience and fortitude if their investment operations are to succeed. After all, the underlying thesis for the investor is that, given the elements that determine value for him, he knows much more about the particular security he is interested in than the stock market does.
Understanding Motivating Factors
People and companies rarely act unless they expect a resulting benefit, either for themselves or for others with whom they have identities of interest. In making such decisions, the actors aim to take advantage of certain factors that seem to be present in many resource conversion activities. Understanding these factors is helpful for those using our approach. There are three acronyms that serve as a slang shorthand in describing these factors: TS, OPM, and SOTT. TS stands for Tax Shelter, OPM (pronounced “opium”) for Other People’s Money, and SOTT for Something Off The Top. We discuss these factors at length in Chapter 22 on resource conversion activities.
The normal academic assumption is that, managements work in the best interests of stockholders. We believe that relationships between managements and stockholders, between managements and companies, between companies and stockholders and between stockholder groups are best viewed as combinations of conflicts of interests and communities of interests. We provide a framework for appraising managements in Chapter 11.
Dismissal of the Conventional Wisdom
The normal security-analysis assumption is that certain financial factors, such as large returns on investment, are good per se, and such others as intense competition are bad per se; we demur. Appropriate judgments about most analytical factors, including high profit margins or rapid expansion, depend upon context.
In minimizing investment risk, it is important to distinguish among variables, depending upon the types of companies being evaluated. Oil companies are not analyzed in the same way electric utilities are, nor are primarily resource conversion businesses analyzed as going concerns are. As we stated elsewhere in this book much of conventional analysis, such as that of Graham and Dodd, modern capital theory (MCT), and conventional money managers seem to be implicitly based on taking tools especially applicable to a relatively narrow, special case—the equity securities of pure going concerns for example—and then trying to fit those standards to the analysis of almost every type of business and security. Such an approach allows earnings to become a common denominator and point of departure. We, in contrast, consider a strong financial position (safety) to be the more appropriate common denominator and point of departure for most investors.
Financial statements provide the basis for the determination of financial position. In determining financial position, it must be noted that the several financial statements are integrally related to each other: there are necessary relationships between book asset values and accounting earnings as well as between estimated asset values and estimated earning power.
As stated previously, we discount the importance of the concept of primacy of earnings for anyone other than total-return traders and possibly also investors in companies that are special cases, such as public utilities. It is our view that those emphasizing reported earnings are, for a number of reasons, out of step with almost everybody in the United States aiming at wealth creation. First, when primacy of earnings advocates refer to earnings, they tend to mean earnings as reported for accounting purposes, with a view to giving such a number a high degree of precision, precisely reflective of operating results for a past period; investment results, for example, are normally excluded by these people from earnings. Second, these reported earnings tend to be stressed for two purposes: they are thought to be the single best indicator of what future reported earnings are likely to be (here again we do not agree), and earnings as actually reported are deemed to be at any given moment the single most important contributor in determining the market price of a common stock. We also tend to believe that earnings as reported at any time will impact stock prices. We, however, conclude that in general any such impact lacks significant relevance in an investment risk minimizing approach to investments.
Corporate cash and the uses to which it can be put, including distributions to shareholders, are, of course, important to investors. There is an inherent conflict between stockholder needs and benefits from cash distributions, and the needs of companies to retain cash.
There are various methods of distributing cash and property to shareholders, including dividends, share repurchases, liquidation distributions and stock dividends. Stockholders are far from constituting a monolithic group, and among them there are varied and sometimes conflicting interests concerning cash distributions.
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.
A basic point about loss companies is that while such companies are sources of tax benefits, for them to have value they have to be clean shells—companies in which benefits to be derived from the absence of liabilities for income taxes outweigh the encumbrances to be assumed, either already existing or likely to be created by future activities. This caveat, of course, is part and parcel of our approach, and it gives essentially the same advice to activists buying loss businesses as is given to outside, passive investors buying common stocks.
In conventional analyses today, there is almost no understanding of risk. The prime example of this is the conventional belief that long-term U.S. Treasury Notes, selling near par, are safe and free from risk. Not so. The U.S. Treasury Notes, paying say 2 to 3 percent, do not carry any credit risk; but, they are replete with several other types of risk, such as inflation risk and capital depreciation risk, while at the same time there are no prospects for capital appreciation. The huge amounts of realistic risk inherent in owning U.S. Treasuries today is offset greatly if the portfolio holding these instruments is a dollar-averager and will continue to acquire new U.S. Treasuries as interest rates fluctuate. Nonetheless, for most portfolios in 2012, the way to guard against economic risk is to be a total return investor using the safe and cheap criteria rather than to be a cash return investor in U.S. Treasuries.
Short-termism is rampant among market participants. Much of short-termism is appropriate, justifiable, and essential for many market participants. It just happens to be irrelevant largely for safe and cheap investors focused mostly on buy-and-hold, long-term purchases of securities.
One had better be very short-term conscious where the portfolio is highly leveraged; where the market participant doesn’t know much about the company or the securities it issues; where the market participant uses trading systems, or a technical approach to the market; and where the more important variable in an analysis is what is the near-term outlook, rather than what are the underlying values existing in the company and the company’s securities.
Even for the largest institutions, it seems to be impossible to have underlying knowledge about an individual security where the portfolio consists of a huge numbers of securities (say over 500 different common stocks) and those securities are traded frequently. This includes high-frequency trading portfolios. If that’s where one’s interest and attention lies, one should be short term.
Understand Activities and Motivations of Activists
We think that any person involved with fundamental finance can function better if he understands the activities and motivations of activists.
OPMIs following the precepts outlined in this book strive to achieve above-average long-term returns by acquiring the common stocks of strongly capitalized companies at bargain prices. Activists, on the other hand, frequently can achieve super returns in other ways, that is, without necessarily acquiring interests in companies with strong finances or strong operations bought at bargain prices. In Part Five of this book we describe three deals where activists made out extremely well by using finance techniques rather than merely being a buy and hold investor. The three examples are as follows:
Understanding these types of transactions ought to be helpful to OPMIs in gaining insight into how Wall Street operates even though the vast, vast majority of OPMIs will never become activists or promotees of activists.
SUMMARY
Safe and cheap investing is a value investing approach that gives primacy to the avoidance of investment risk. The four main components used in the selection of companies and their equity securities are (1) the company ought to have a strong financial position, something that is measured both by the presence of quality assets and 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; strong financial positions or creditworthiness are a company resource, which provides “insurance” to OPMIs and opportunism to management; (2) the company ought to be run by reasonably honest management and control groups and must operate in markets where regulators provide significant protections for minority investors; (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 short of “full disclosure”; and (4) the price at which the equity security can be bought ought to be significantly (say 20 percent or more) below the investor’s reasonable estimate of net asset value. The benefits and disadvantages of the approach are also discussed.
* This chapter contains original material and parts of the chapter are based on material contained in Chapter 1 of Value Investing by Martin J. Whitman (© 1999 by Martin J. Whitman); and Chapter 2 of The Aggressive Conservative Investor by Martin J. Whitman and Martin Shubik (© 2006 by Martin J. Whitman and Martin Shubik), and ideas contained in the 1999 2Q, 2001 4Q, 2005 3Q, 2008 4Q, 2009 1Q, and 2012 1Q letters to shareholders. This material is reproduced with permission of John Wiley & Sons, Inc.
1 We also discuss these factors in Chapter 8 on investment risk.
2 In a short-form merger, stockholders can be forced out of a company in a merger or reverse stock split, and have no right to vote on the transaction.
3 See our discussion on fair prices in takeovers in Chapter 14.
4 Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
5 Unlike class-action suits in federal court, in appraisal procedures in states such as Delaware and New York dissenting stockholders may be liable not only for their own court costs, including attorneys’ and experts’ fees, but also for similar costs incurred by the company, in the discretion of the court.
6 The reader is reminded that the optimization of performance is dependent not only on security or investment selection but also (and most importantly) on the degree of concentration or diversification of the investor’s portfolio. See Chapter 13.