“We’re such cowards!” said Martin Whitman, the 82-year-old legendary superinvestor, at a seminar organized by New York Society of Security Analysts (www.NYSSA.org) on February 16, 2006, “We only want to be the senior-most creditors in distressed situations. We only want to be the adequately secured lenders in Europe and overseas. We don’t want to be subordinate to any of the asbestos or tobacco liabilities…” And he brilliantly calls himself the “safe and cheap” investor.
Marty Whitman’s “License To Steal”
The man brave enough to call himself a “coward” is never short of shocking and jaw-opening statements though. Marty Whitman says that he started as one of the “grossly overpaid bankruptcy professionals” in the 1970’s. Seeing that a mutual fund business is “a license to steal”, he entered the money management business in 1990 through the backdoor via a “hostile” takeover of a close end fund and then opening it. He confesses that he “goes to bed” with competent managers who kiss minority owners. And when Whitman got upset at his investors who exited his underperforming value funds in droves during 1989 and 1999, he told a reporter with undisguised relish, “As for dealing with the public, and you may quote me, screw ’em!”
With first-hand knowledge about the mutual fund business, Marty Whitman made large investments in asset management companies like Legg Mason. To Whitman, money management is a great business, better than the toll booth on George Washington Bridge. “Fund managers are prosperous ?C no credit risk, no inventory, no fixed asssets, no liabilities, you are talking to the overhead,” laughed Marty Whitman.
There are occasional tough times though. Third Avenue Fund’s asset under management dropped from $50 billion to $38 billion during 1998 and 1999, which prompted Whitman to echo William Vanderbilt’s famous line “The public be damned!”
And that’s vintage Marty Whitman, someone who’s honest and forthright to the core. He arrives for work on Manhattan’s Third Avenue often dressed in an open-collared plaid work shirt, baggy blue cotton pants, worn sneakers, and white socks. One reporter claimed that he observed some sizable holes on Whitman’s socks when he was already a multimillionaire. This author personally saw Marty Whitman carried an old and saggy polyester school bag to his talk at NYSSA. (On my lucky day, I could perhaps pick up a similar bag from a neighbor’s garbage yard, and I am not exaggerating.) You could mistake this superinvestor for a street person. But Marty Whitman is a legend at picking over the balance sheets of troubled companies in search of hidden treasures. And his track record of approximately 17% per year since 1990 speaks for itself.
According to Marty Whitman, the “safe and cheap” investor looks for four things in an investment:
* High quality balance sheet;
* Competent and shareholder-oriented management;
* Understandable and honest disclosure documents;
* Priced at 50 to 60 cents on a dollar.
The first three is related to how safe an investment is. The fourth relates to how cheap the stock is. And “safe” is more important than “cheap”.
Assets Over Earnings
The first thing Marty Whitman wants is a “safe” balance sheet featuring high-quality assets, the absence of liability and the presence of cash. Without these, he doesn’t even consider the common stock.
Whitman believes that scrutinizing the balance sheet is easier than trying to forecast earnings and predict stock market gyrations. Most investors are outlook-conscious. He is price-conscious. He hones his easy way of measuring price, quantity and quality. Everything is in the balance sheet – the only way you know whether you’ve covered all the bases is to look at the lists of assets and liabilities.
To Marty Whitman, balance sheets are much more important than the income statement. He believes that security analysis would be simpler if one focuses on the balance sheet while placing no emphasis on the income statement and earnings estimates.
Marty Whitman thinks that earnings and earnings power are vastly overrated. In his book, Value Investing: A Balanced Approach, he advises businessmen not to treat one accounting number, such as the bottom line, as more important than another. They are all part of the whole picture. Besides, profits are may be viewed as the least desirable way to create wealth because of the income-tax disadvantage. It’s a lot easier to look at the quantity and quality of the assets and resources that a company has than to forecast its earnings. Assets can appreciate in value, can be enhanced, sold, or converted into something more productive.
Graham & Dodd stressed the importance of balance sheet also. But Marty Whitman feels that Graham & Dodd talked more about quantitative instead of qualitative issues about the balance sheet. To Whitman, high quality means low debt, acreage of raw land, assets under management, fully paid rent, and other assets that can be easily valued. For example, some of his companies have huge investments in real estate, which may be classified as fixed assets disliked and ignored by Graham & Dodd. But Marty knows he can sell class “A” buildings with long-term creditworthy tenants easily by picking up the phone.
Marty Whitman thinks like a LBO control buyer. He asks: “How can I finance the transaction?” It is a balance sheet question regarding what can be put up as collateral to secure lending from the bankers.
Marty also has a special eye for well-positioned assets throwing off solid cash flows and using non-recourse debt. Unlike traditional debt, non-recourse debt holders or creditors lack the legal power to bring the debtors to the court or force a reorganization. So non-recourse debt is not a threat to the safety of the stockholders’ position. For example, Forest City has a lot of debt but it is nonrecourse. In other words, the debt is taken on individual properties. The lender can’t force the parent company into a reorganization if there’s a default on a loan taken on a particular piece of property.
In terms of appraising the intangibles, Marty Whitman sticks to the easy ones, like the asset under management of a mutual fund. The intangible media assets are too hard for him. He recently took a look at Tribune Co. (TRB) and turned it down.
Marty Whitman watches out for the so-called-earnings that create “wealth” while consuming cash. If you have earnings that consume cash, sooner or later, you’ve got to have access to capital markets which may not be there when you need them.
Go To Bed With Competent Management
Marty Whitman looks for reasonably competent managing or controlling groups that care about minority shareholders. Community vs. conflict of interests is always the problem facing investors. Sole proprietorship is the only place where there is no conflict of interest.
Marty Whitman thinks that Warren Buffett’s greatest talent is in his ability to judge people and appraise the management. And this special area is exactly where Whitman had the most of his screw-ups. Buffett is a control buyer, too.
Marty Whitman does spend a lot of time talking to the management, but he is much more document-driven than other money managers. “Evaluating the management is the toughest thing I do. By comparison, everything else is easy,” said Marty Whitman. He had been impressionable when executives of semi-conductor equipment manufacturers visited him, feeling that each guy is more impressive than the next. He saw these really great managements that have a sense of urgency – great engineers trying to do good things. He also visited Japan, where they invested in some property-and-casualty insurers, where he thought he was dealing with deadheads who are not driven to create shareholder value.
Understandable and Honest Disclosures
Marty Whitman is very document-intensive. He feels that a company’s documentary disclosures must be understandable so that someone with an I.Q. of 70 should be able to interpret the disclosures. He only invests in businesses where he can appreciate the excellent documentary disclosures from the company. If he can’t understand the disclosure statements, he doesn’t bother to meet the management.
Whitman doesn’t meet the management before he studies the proxy statement, understand the compensation arrangements, analyze past transactions of the management, and scrutinize the accounting choices.
Whitman looks for the kind of company that provides excellent disclosure that supplements required filings and provides non-GAAP measures that is often critical in assessing the true health of a business and its balance sheet.
What Is Cheap?
After scrutinizing the assets, the management, and the disclosures, Martin Whitman makes sure that he places his buy orders at a big discount to the private market values of those quality assets – that is, to the net asset value per share. For example, his second largest position is Forest City Enterprises (FCE-A). When they were buyers, in the early 1990s, its income-producing properties were appraised at $80 to $90 per share. But you could buy all the shares you wanted for $17. The net asset value that Whitman talks about is what a company could sell for in a takeover or a private market auction.
What kind of a discount to net asset value is viewed as cheap by Marty Whitman? “No more than 50 or 60 cents on the dollar for what a business would be worth to a private takeover buyer,” said Martin Whitman. Over 80% of his portfolio companies were acquired at a substantial discount to “readily ascertainable net asset values”. This is not rocket science. A lot of real estate, marketable securities, mutual fund management companies which can be bought at intrinsic values of 3 to 4 % of assets under management (UAM). Toyota Industries is a way of buying Toyota Motors at a meaningful discount.
“It is absolutely crazy to pay more than 60 cents on a dollar for non-controlling interests in businesses. The outsiders always face agency problems,” said Marty Whitman.
Valuation Rules Of Thumb
Marty Whitman has developed his own rules of thumb for calculating his buying prices for various types of businesses:
- Financial-services companies and depositories: Stated book value.
- Small banks: 80% of book value.
- Mortgage portfolio: Calculate yield to maturity and perform credit analysis.
- Financial-guaranty insurers: Adjusted book value – a publicly disclosed number that is book value plus the equity in the present value of certain future premiums.
- Insurance companies: Adjusted book value.
- Real estate companies: Private appraisal value or market value.
- Real Estate (REITs): Appraisal value or discounted present value of cash flow from operations.
- Broker/dealer and asset managers: Tangible book value plus 2% of AUM.
- Operating companies: 10 times peak earnings or below “net asset value.”
- Tech companies: 2 times book value, less than 10 times peak earnings, 2 times revenue and cash larger than the book value of all liabilities.
Marty Whitman tries not to buy property and casualty insurers. He wants an underwriting loss of zero, but even the managers themselves don’t know what the loss will be. He does invest in other type of financial institutions. He is currently using a 6% discount rate to capitalize cash flow from Hong Kong rental properties whereas those properties could be readily sold at 5% capitalization rate.
“We Are Growth Investors”
According to Marty Whitman, traditional growth investing is essentially paying up for widely recognized growth with the hope that the growth will continue.
“We are growth investors, too,” declared Martin Whitman, “We buy into the kind of growth that is not generally recognized while most other growth investors buy into generally recognized growth and they have to pay up for that.” The key here is to figure out the value of future growth. “Many people on Wall Street know the price of everything but the value of nothing,” said Marty Whitman.
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