Most people are not investors.

For the true investor, market prices are just that — market prices. They are not well-reasoned appraisals of business value. They are the product of opinion and emotion and can be way off base. They are there to be taken advantage of or ignored, as the case may be.

These true investors don’t try to time the market. They don’t trade stocks. They don’t look for insights from chart patterns or recent market action. Stop-losses (where traders mechanically look to sell if stocks fall to certain levels) are not even part of their language.

The investors who understand this live a good life. Not only is their investment performance better over the long term, they just don’t worry as much. They are secure in their knowledge and their research. They are calm and reflective, even when the market is turbulent and pulsing with fear. They spend time away from their computer screens. They sleep well at night, as the old saying goes.

One investor who has proven the value of this philosophy is Marty Whitman, the skipper of the Third Avenue Value Fund. His own track record over the last 15 years is better than all but a handful of mutual funds. Whitman, over 80 years-old, is a treasure. Smart, iconoclastic, coldly rational and fiercely independent — he seems to embody all the best traits of a long-term investor. And he also articulates his style in an inimitable way.

In his latest letter to shareholders, Whitman talks about risk. I’ve heard and read his thoughts on this matter many times — and in fact, I’ve tried my best to absorb them and make them part of my own investment fiber.

One of the things Whitman believes is that the word “risk” is meaningless without an adjective in front of it. There is market risk and there is investment risk, to focus on just two. Market risk is the risk inherent in the unpredictability of market prices. Investment risk focuses on something going wrong in the business itself.

Whitman basically ignores market risk; his entire focus is on investment risk. Getting a handle on investment risk means acquiring stocks that are “safe and cheap.” Safe means companies with strong financial conditions, in understandable businesses with competent management. Cheap means acquiring a stock below what a private buyer might pay for the whole company.

Ignoring market risk often means looking at companies with poor earnings outlooks or short-term problems. As Whitman says, if you are worried about market risk, you often would pass on these types of stocks — even though these stocks are the ones that offer the biggest upside with less risk. So Whitman doesn’t try to guess at market prices. He aims to buy the stocks of “well-financed companies when the underlying values, measured over the long term, appear to be good enough.”

Who worries about market risk? “Portfolios financed with borrowed money; portfolios run by managers with a trading mentality, portfolios run by managers who do not study individual securities in depth; and managers who believe that the market knows more than they do about any individual security.”

Whitman often gets paid on his ideas through “asset conversion events such as mergers and acquisitions, massive share repurchases and going privates.” And his portfolio has had a number of these events unleash value in his stocks. We’ve had our share of these events as well. Since the start of Capital & Crisis, I estimate that one of three investment ideas underwent some sort of significant corporate event that unlocked values in the shares.

Selling stocks then becomes solely an exercise in looking at the fundamentals of the business and balancing probabilities. You sell when stocks are no longer safe and cheap. Or, as Whitman puts it, you are conscious of “odds and consequences.” You look at not only how much you can make, but also the consequence of being wrong.

So far in Capital & Crisis, we have a good track record of selling stocks. Of the stocks that I recommended in this letter, I’ve sold off eight. Of these eight, many are down a lot since I’ve sold them. Chiquita Brands (CQB:NYSE) is off 55%, Scottish Re (SCT:NYSE) down 21%, Companhia Paranaense de Energia (ELP:NYSE) down 18%. The average of the other five is only about a point or two in the positive. The biggest winner of the stocks I’ve sold is Orient-Express Hotels (OEH:NYSE), which is up all of 6%.

The selling I do is solely based on considering the fundamentals and trying to balance those against the possible gain or loss. No magic chart reading and no automatic stops. We do it the old-fashioned way: We use our brains.

Whitman finishes up his letter by telling his shareholders this: “Ignoring market risk will mean, from time to time [the fund's] performance will be lumpy; the fund is unlikely to outperform benchmarks consistently. Rather, the goal is to outperform on average, most of the time and over the long run.”

That’s well put, and it should be your goal, too.

Sincerely,

Chris Mayer
July 27, 2006

Market Risk vs. Investment Risk was originally featured in the Penny Sleuth.