I was reading Marty Whitman’s new book Distress Investing. The book is about investing in distressed situations that will involve reorganization, possibly via the bankruptcy process. As the “Principles and Techniques” subhead implies, the book is mainly for practitioners. However, in the course of some rather technical discussions, Whitman makes some general points about investing worth passing on.

One discussion talks about where you are likely to find inefficiencies, or market pricing “errors.” This is useful to think about as an investor, because you want to find those soft spots where markets misprice widely. Some markets are efficient and hard to beat. Some markets are less efficient.

Markets tend toward inefficiency when:

• The situation is complex
• When the time frame for a payoff is longer, rather than shorter
• When participants are unsophisticated or use borrowed money
• When external forces are weak (for instance, when liquidity is low).

We tend to avoid complex situations, but even in simple situations, markets can be very wrong. “Markets for securities can be grossly inefficient,” Whitman writes, “even though the analysis is simple and few variables are involved.”

As for time frame and participants, Whitman maintains that a well-trained and informed analyst — not influenced by short-term price swings — is likely to find these inefficiencies. Someone who is unsophisticated, uses borrowed money and allows short-term price movements to influence his thinking will find the going a lot tougher.

The reason borrowed money is important is because if you borrow money to buy stocks, you put yourself at the mercy of the market to some degree. A stock that is temporarily cut in half on borrowed money becomes a problem for you and may force you out at a bad time.

The other discussion that is worth passing on to you involves risk. First, Whitman lets you in on a little secret that I don’t think most investors believe is true. “The secret to building a great fortune is to avoid, as completely as possible, the taking of any investment risk.” If you study great entrepreneurs, you find that they often took little risks. In his book The Dhandho Investor, Mohnish Pabrai goes through several interesting examples. Richard Branson, for instance, started Virgin Atlantic with little money down.

Most successful investors, too, seek to lower risks as much as possible, while retaining upside potential. So how do investors reduce risk? Whitman has five suggestions.

Buy cheap. As an outside investor, you protect yourself by buying cheap. Whitman points out that Buffett likes to say how he wants to buy great companies at reasonable prices. But Buffett is a control investor — that is, he often has influence over the companies he invests in. As an outside passive minority investor, or OPMI, you do not have such influence. Therefore, the standard of great companies at reasonable prices “is not good enough.”

Whitman writes: “OPMIs pretty much have to leave companies as is, and therefore place particular effort into buying into well-managed businesses with stable, but clearly superior, managements.”

Buying cheap is the best protection you have as an investor in common stocks.

Buy only when you have an excellent financial condition. Whitman writes you should not “knowingly acquire the common stock of any company unless that company enjoys a super strong financial condition.” A great financial condition simply gives you some margin for error. It’s hard to go bankrupt if you have an excellent financial condition. In addition, it should be an understandable business with good disclosures. This helps keep you from being snookered.

Ignore market risk. Whitman believes changes in market prices are not measures of long-term investment risk or potential. This is hardest for most people to get over. But most great investors give little weight to daily, or even annual, price changes. Just look at the price charts of any stock. You see huge price swings even in a year’s time.

Buy growth, but don’t pay for it. Investors are better off betting on companies that can grow over time. Growth, though, is often misused by financial people. “Most market participants do not mean growth,” Whitman says, “but rather mean generally recognized growth.” That kind of growth you have to pay up for. Whitman prefers growth companies that are not generally recognized as such and, therefore, can be great bargains.

It is usually a good idea to be a buy-and-hold investor. If you do all the upfront work well, then you can often continue to hold onto a stock for as long as your initial thesis is intact. The simple idea here is when you have really found a gem, you should be a reluctant seller. Let the idea work for you. That might not seem like good advice after 2008, but good businesses do increase their net asset values over time. Time is an important ingredient to compounding an investment’s value over time.

Good times to sell are when you have made a mistake. Whitman writes that a mistake would include some fundamental impairment — like a loss of credit standing that means the business can no longer do in the future what it did in the past. Sell, also, when a stock becomes grossly overvalued. And finally, sell for portfolio considerations — such as tax reasons.

To sum up, Whitman’s book touches on two important ideas for investors to boost their returns. First, focus on those markets and situations in which you are likely to find inefficiencies. Second, aim to lower your investment risks. We look to do both as often as possible here.

Sincerely,
Chris Mayer

May 28, 2009

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