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Modern Security Analysis: Understanding Wall Street Fundamentals


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Modern Security Analysis: Understanding Wall Street Fundamentals

Martin J. Whitman, Fernando Diz

ISBN: 978-1-118-39004-7 May 2013 496 Pages

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A legendary value investor on security analysis for a modern era

This book outlines Whitman's approach to business and security analysis that departs from most conventional security analysts. This approach has more in common with corporate finance than it does with the conventional approach. The key factors in appraising a company and its securities: 1) Credit worthiness, 2) Flows—both cash and earnings, 3) Long-term outlook, 4) Salable assets which can be disposed of without compromising the going concern, dynamics, 5) Resource conversions such as changes in control, mergers and acquisitions, going private, and major changes in assets or in liabilities, and 6) Access to capital.

  • Offers the security analysis value approach Martin Whitman has used successfully since 1986
  • Details Whitman's unconventional approach to security analysis and offers information on the six key factors for appraising a company
  • Contains the three most overemphasized factors used in conventional securities investing

Written by Martin J. Whitman and Fernando Diz, Modern Security Analysis meets the challenge of today's marketplace by taking into account changes to regulation, market structures, instruments, and the speed and volume of trading.

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Acknowledgments xv

Introduction 1

PART ONE The Foundations of Modern Business and Security Analysis 9

CHAPTER 1 The Scope of Fundamental Finance, Investing, and the Investor Landscape 11

Investing versus Speculating 12

The OPMI Defined 17

Activists 18

Summary 18

CHAPTER 2 A Short Introduction to the Going Concern and Resource Conversion Views of Businesses 19

Methods of Wealth Creation 20

The Pure Going Concern View 21

The Resource Conversion View 23

Summary 25

CHAPTER 3 Substantive Consolidation and Structural Subordination 27

Substantive Consolidation Not of Prime Importance 29

The Accounting for Stock Options Controversy in Light of the Substantive Consolidation Doctrine 32

Structural Subordination Not a Signifi cant Factor 37

Lack of Progress in Eurozone Crisis Resolution: The Failure to Use Substantive Consolidation 40

Summary 41

CHAPTER 4 The Substantive Characteristics of Securities 43

Types of Securities for Analytic Purposes 44

Control versus Non-Control Securities 44

Control and Non-Control Pricing and Arbitrage 45

Terms of Securities as Options 49

What a Security Is Depends on Where You Sit 50

Summary 55

CHAPTER 5 Primacy of the Income Account or Wealth Creation? What Are Earnings, Anyway? 57

Wealth or Earnings? 59

Infl uence of Reported Earnings on Common Stock Prices 61

The Long-Term Earnings Record 63

Parsing the Income Account 64

Summary 68

CHAPTER 6 Net Asset Value: The Static and Dynamic Views 69

The Graham and Dodd View on NAV 71

The Financial Accounting View on NAV 72

Our View on NAV 73

The Usefulness of NAV in Security Analysis 75

The Importance of NAV Dynamics 78

NAV as One Measure of Resources 83

NAV as One Measure of Potential Liquidity 84

Limitations of NAV in Security Analyses 89

Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE 93

Net Nets Redefined 94

OPMI Investing in Companies with Growing NAVs 96

Summary 101

CHAPTER 7 Creditworthiness 103

Creditworthiness from the Borrowing Entity Point of View 105

Capital Structure 107

Capital Structure from the Corporate Perspective 107

Factors Affecting Capital Structure 112

Conservative Capital Structures 117

Summary 118

CHAPTER 8 What Matters Is Investment Risk 119

There Is No General Risk—Only Specific Risk 120

The Components of Investment Risk 122

Successful People Avoid Investment Risk 123

Methods to Avoid Investment Risk 125

Safe and Cheap Investing and Minimizing Investment Risk 127

Summary 130

CHAPTER 9 Shareholder Distributions from the Company Point of View 131

Cash Dividends or Retained Earnings 132

Stock Dividends 135

Stock Repurchases 138

Distribution of Assets Other than Cash 141

Liquidation 141

Summary 142

CHAPTER 10 Roles of Cash Dividends in Security Analysis and Portfolio Management 143

The Three Conventional Theories 145

Cash Dividends as a Factor in Market Performance 149

The Placebo Effect of Cash Dividends 151

Cash Dividends and Portfolio Management 151

Cash Dividends and Legal Lists 154

Cash Dividends and Bailouts 154

The Goals of Securities Holders 156

Summary 157

CHAPTER 11 The Appraisal of Managements and Growth: GARP versus GADCP 159

New Framework for the Appraisal of Managements 160

Managements Attuned to OPMI Interests 161

Managements as Resource Converters 162

Tradeoffs 165

Growth: GARP versus GADCP 166

Growth at a Reasonable Price (GARP) 167

Growth at Dirt Cheap Prices (GADCP) 168

Summary 170

CHAPTER 12 The Significance (or Lack of Signifi cance) of Market Performance 173

Market Performance and the Character of a Portfolio 176

Market Performance of Portfolios versus Individual Securities 177

Outsiders, Insiders, and Market Price 179

Professional Money Managers and Beating the Market 180

Perspective on Bailouts and the Significance of Market Performance 181

Summary 182

CHAPTER 13 How Much Diversification? 185

Portfolio Diversification versus Securities Concentration 186

Corporate Diversification versus Concentration 190

Summary 191

CHAPTER 14 Toward a General Theory of Market Efficiency 193

The Determinants of Market Efficiency 195

External Forces Influencing Markets Explained 198

Great Economists Can Learn a Lot from Value Investors 199

Markets Where External Disciplines Seem to Be Lacking 206

Market Efficiency and Fair Prices in Takeovers 211

Summary 213

PART TWO Putting It All Together: Safe and Cheap Investing versus Conventional Approaches 215

CHAPTER 15 Safe and Cheap Investing 217

The Safe and Cheap Approach 218

Benefi ts of the Safe and Cheap Approach for the OPMI 220

Restrictions and Demands of the Safe and Cheap Approach 222

Summary 231

CHAPTER 16 Graham and Dodd Placed in Context 233

The OPMI Defined 235

The OPMI Perspective of Analysis 236

The Going Concern and Investment Company Views of Businesses 238

Primacy of the Income Account and Wealth Creation 238

Primacy of the Income Account, Dividends, and Corporate Uses of Cash 240

Primacy of the Income Account and the Appraisal of Managements 240

Primacy of the Income Account and Top-Down versus Bottom-Up Analysis 241

Primacy of the Income Account and Diversification 241

Primacy of the Income Account and Growth Stocks 242

Market Risk versus Investment

Risk and Margin of Safety 242

The Importance of Market Performance 243

Uses and Limitations of Financial Accounting 244

Substantive Consolidation 245

Compensation of Promoters 245

Do Stock Market Prices Reflect Corporate Values? 245

Trade-Offs 247

Modern Capital Theory versus Graham and Dodd 247

Summary 248

CHAPTER 17 Academic Finance: Modern Capital Theory 249

The MCT Point of View 253

Equilibrium Pricing Is Universally Applicable 254

The Outside Passive Minority Investor Is the Only Relevant Market 260

Diversification Is a Necessary Protection against Unsystematic Risk 261

Systematic Risk Exists 262

Value Is Determined by Forecasts of Discounted Cash Flows 262

Companies Are Analyzed Basically as Going Concerns; Investors in Marketable Securities Are Analyzed as Investment Companies 264

Investors Are Monolithic: Their Unitary Goal Is Risk-Adjusted Total Return, Earned Consistently 266

Market Efficiency Means an Absence of Market Participants Who Earn Excess Returns Consistently or Persistently 267

General Laws Are Important 269

Risk Is Defined as Market Risk 271

Macro Considerations Are Important 272

Creditor Control Is a Nonissue 273

Transaction Costs Are a Nonissue 273

Free Markets Are Better than Regulated Markets 273

The Outside Passive Minority Investor Market Is Better Informed than Any Individual Investor 275

Markets Are Efficient or at Least Tend Toward an Instantaneous Efficiency 275

Summary 276

CHAPTER 18 Broker-Dealer Research Departments and Conventional Money Managers 277

How Research Departments and Conventional Money Managers Think 279

Problems Faced by Research Departments and Conventional Money Managers 282

Summary 292

PART THREE Real-World Considerations 295

CHAPTER 19 Uses and Limitations of Financial Accounting 297

The Conventional Approaches 299

Financial Accounting Reports as Objective Benchmarks 302

Generally Accepted Accounting Principles as Defining

Reality for Certain Specifi c Purposes 309

Generally Accepted Accounting Principles as a Road Map for Due Diligence and Less Thorough Investigations 310

Summary 319

CHAPTER 20 Company Disclosures and Information: Following the Paper Trail in the United States 321

Narrative Disclosures in the United States 322

The Documents and How to Read Them 327

What the Paper Trail Does for the Outside Investor 328

What the Paper Trail Doesn’t Do 331

How Good Is the Paper Trail? 334

Summary 335

CHAPTER 21 Buying Securities in Bulk 337

Methods for Acquisition of Common Stocks 338

Acquisition of Voting Equities through Exchanges of Securities 343

Acquisition of Control without Acquiring Securities by Using the Proxy Machinery 345

Summary 346

PART FOUR Understanding Resource Conversion 347

CHAPTER 22 A Short Primer on Resource Conversion 349

Long-Term Arbitrage between OPMI Prices and Control Values 350

More Aggressive Employment of Existing Assets 355

Merger and Acquisition Activity 355

Corporate Contests for Control 356

Going Private and Leveraged Buyouts 359

Summary 368

CHAPTER 23 Restructuring Troubled Companies 369

The Five Basic Truths of Distress Investing 370

Rehabilitation of Troubled Entities 380

Summary 391

CHAPTER 24 The Role of Government in Reorganizations 393

Bailouts or Capital Infusions? 394

Too Big to Fail Is a Phony Concept 395

The Government and Private Sector Are in Partnership Whether They Like It or Not 396

Wall Street Professionals and Corporate Executives Are All in the Business of Creating Moral Hazards 398

Taxpayer Bailouts Are a Phony Concept 398

Reorganizations of General Motors, Chrysler, and CIT Corporation 399

Strict Regulation of Financial Institutions Is Absolutely Necessary 399

Summary 400

PART FIVE Active Investors Buy and Sell Common Stocks on an Advantageous Basis 401

CHAPTER 25 The Economics of Private Equity Leveraged Buyouts 403

The 2005 Acquisition of Hertz Global Holdings and Subsequent Events as a Prime Example 404

Super-Attractive Access to Capital Markets 404

Cash Payments to Sponsors and Sponsor-Controlled Funds 409

Sponsors’ Control of Hertz 410

Sponsors Attuned to the Needs of Bankers and the Wall Street Underwriting Community 411

Questions about LBOs 412

Summary 413

CHAPTER 26 The Use of Creative Finance in a Corporate Takeover 415

The Case 415

The Postscript 427

Investment Lessons 428

The Appraisal of Management 430

Spotting Doable Deals 431

Summary 432

CHAPTER 27 The Use of Creative Finance to Benefit Controlling Stockholders 433

The Problems Faced in the Schaefer Corporation Deal 435

The Background of the Deal 435

Discount Purchases of Restricted Corporate Stock 437

Corporation’s Acquisition of Brewing 440

Problems and Wealth Creation Potentials for the Parties in Interest 449

Summary 467

Glossary of Acronyms 469

About the Authors 471

Index 473

“Modern Security Analysis is full of useful discussions of such standard topics as creditworthiness, market efficiency, diversification, and financial accounting. But it also includes descriptions of more controversial ideas about the overriding importance of tangible net asset value, the shortcomings of the Graham–Dodd approach to value investing, and the irrelevance of both modern capital theory and broker/dealer research.”
CFA Institute Book Review