CFA Institute

Value Investing: A Balanced Approach by Martin J. WhitmanReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 55, No. 5 (Sep. - Oct., 1999), pp. 92-93Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480199 .

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Financial Analysts Journal

Value Investing: A Balanced Approach. By Martin J. Whit- man. John Wiley & Sons, 605 Third Avenue, New York, NY 10158-0012, 1-800-225-5945. 274 pages, $49.95.

Reviewed by Martin S. Fridson, CFA.

In Value Investing: A Balanced Approach, Martin Whitman poses an intriguing riddle: Intense com- petition among fundamental analysts, who benefit from rigor- ous disclosure requirements, min- imizes the likelihood of any investor lawfully obtaining a material informational edge in the U.S. equity market. Therefore, Whitman says, to earn excess returns through conventional security analysis is nearly impos- sible. Nevertheless, such value investors as Warren Buffett, Ted Forstmann, Henry Kravis, Ron Perelman, and Richard Rainwater have gotten rich through their activities in the securities markets. How can these two observations be reconciled?

Whitman answers his own riddle by explaining that these "su- perior investors are all basically control activists." He then enumer- ates the advantages of investing with an eye toward obtaining con- trol of corporations and corporate processes, rather than being an outside, passive minority investor. Among these advantages are ben- efits beyond those that arise direct- ly from security ownership-for example, salaries, travel, and entertainment perks; the ability to finance on attractive terms with other people's money; and the lat- itude to take the company private, then go public again, whenever market conditions make doing so attractive.

Investors who do not hope to acquire control positions, Whit-

man asserts, can potentially earn superior returns by anticipating the actions of the takeover artists, asset strippers, and leveraged buyout specialists. Underlying Whitman's strategy of passive value investing is an assumption that sooner or later an LBO or merger will close the gap between a company's public and private market value. In contrast, he argues, both Graham and Dodd fundamentalists and efficient market hypothesis proponents generally assume that the com- pany "will continue indefinitely to be a going concern, engaged in the operations in which it has always been engaged, managed the way it has always been man- aged, owned pretty much the way it has always been owned, and financed the way it has always been financed."

As chair of the Third Avenue Value Fund and a fellow at the Yale University School of Man- agement, Whitman speaks with considerable authority on portfo- lio management. The evidence with which he supports his hypothesis about passive value investing is wholly anecdotal, but he provides a number of valuable case studies. Particularly edifying is his critique of contemporary practice in securities analysis.

In particular, Whitman decries the nearly exclusive focus of most published research reports on the forecasting of earn- ings and determination of appro- priate multiples. By extrapolating from past income statement fig- ures, he says, analysts neglect bal- ance sheet data that may provide better insight into future earnings- generation capability. The valid- ity of sell-side research reports, adds Whitman, is sometimes com- promised by investment banking relationships. Buy-side analysts,

by the same token, often feel pres- sured by their marketing counter- parts to recommend in-favor (and thus fully priced) stocks.

Whitman also sheds light on conflicts of interest between man- agement and shareholders; indeed, he suggests that academ- ics' concerns about "agency costs" do not go far enough. He describes another classic conflict with sardonic humor: "There is a saying that a limited partnership is defined as a business associa- tion in which in the beginning the GP [general partner] brings to the association experience and the LP [limited partner] brings to the association money. At the termi- nation of the association, the GP has the money and the LP has the experience."

Whitman notes that every passive investment has some- thing wrong with it. The value investor buys a stock when what is right with it appears to out- weigh what is wrong with it by a comfortable margin. Similarly, investors should strongly con- sider purchasing Whitman's Value Investing on the grounds that its strengths far outweigh its weaknesses.

For example, Whitman's authoritative discussion of invest- ing in distressed companies off- sets his use of a straw man. The conventional wisdom, he asserts, is that when companies default on their debt, they invariably liqui- date. In reality, most high-yield corporate bond managers are fully aware that under the U.S. Bankruptcy Code, reorganization is the more usual resolution of defaults by major corporations.

Neither do the copyediting failures in Value Investing out- weigh its insightful analysis. Readers might wish that the edi- tors had properly differentiated

92 ?Association for Investment Management and Research

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Book Reviews

"affect" from "effect" and distin- guished between "principle" and "principal." More assertive watchdogs of style would have corrected the author's misuse of

"impinge" and "afortiori" and dis- suaded him from using "how- ever" as a conjunction. These small flaws do not detract, how- ever, from the valuable message

that corporate control, rather than skill in forecasting earnings, is the key to exceptional personal wealth accumulation.

September/October 1999 93

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