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Modern Security Analysis
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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

About the Author

Martin J. Whitman is Chairman of the Third Avenue Funds and founder of Third Avenue Management, an investment adviser to private and institutional clients. Mr. Whitman has proven for more than fifty years that active, opportunistic investors can find under-priced securities in companies with strong balance sheets. He is also an adept control investor who was an important participant in the rehabilitation of Nabors Industries and Covanta Energy, among others. He was Third Avenue's Chief Investment Officer from its founding through January 2010. For over thirty years, Mr. Whitman was a Distinguished Management Fellow at the Yale School of Management. He is also an honorary trustee at Syracuse University which is also home to the Whitman School of Management. He is a frequent speaker and commentator within the financial services community. Fernando Diz is the Managing Director of the Orange Value Fund, LLC, the Martin J. Whitman Professor of Finance and the Director of the Ballentine Investment Institute at Syracuse University. He teaches classes in value, control and distress investing and created and directs the two-year Orange Value Fund program. He is the co-author with Martin J. Whitman of Distress Investing: Principles and Technique. Professor Diz received his MSc and PhD degrees from Cornell University.

Reviews

?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

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