"We're such cowards!" said Martin Whitman, the 82-year-old legendary superinvestor, at a seminar organized by New York Society of Security Analysts 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.
Value investors never hesitate when they ask "What's the bad news?" and "What's wrong?" Last year, Seth Klarman talked about the bad news of value investing and complained that the field is getting too crowded. On February 16 th, 2006, Martin Whitman went further to make a list about what's wrong with value investing in his talk at NYSSA.
The Problems with Value Investing
"There are a lot of things wrong with what we do," said Marty Whitman.
1) Compared to people who stare at the charts, value investors have tons of documents to read. Marty Whitman himself hired 17 analysts reading all those documents. It's very labor-intensive.
2) In order to get quality assets on the cheap, the near term outlook often sucks.
3) "Safe and cheap" companies often have the problems of low return on equity (ROE) due to concentration in underutilized assets positioned too conservatively. Management with whom Marty Whitman go to bed are just as conservative or even more conservative than Whitman himself. The management is often non-promotional people who don't need Wall Street. They don't care. One of the things that Whitman found with having competent management is that, the strong balance sheet allows them to be opportunistic. The management's ability to opportunistically take advantage of market inefficiencies has probably accounted for Whitman's 10 baggers more than anything else. When ultra conservative balance sheets meets opportunistic and able managers, a number of low ROE stocks turned into 10 or 20 baggers for Whitman as excess cash was converted into future earnings.
4) The safe and cheap investor is often subject to leverage buy out (LBO), management buy out (MBO), "take-under", or "going private" phenomenon. Most of Marty Whitman's positions were exited via takeovers. A lot of resource conversions, spin-offs, and liquidations happen within Whitman's portfolio.
5) Cheap stocks suffer the problems of poor marketability and liquidity. They are subject to the "roach motel" problem -- easy to check in, but very hard to check out. Thus, the returns are lumpy. Marty Whitman tries to avoid investment risk, or permanent impairment of capital. He pays no attention to market risk, or short-term price fluctuations. "If I recommend something, it soon goes down 20 percent," says Marty Whitman.
6) To be safe and cheap, you have to turn down a lot of ideas also. So you would miss a lot of good stuff that is a little pricy.
The Tao of Selling
Most of Marty Whitman's sellings are a result of resource conversion activity such as mergers, acquisitions, spin-offs, restructurings, etc. He would consider selling a security in the open market if:
1) as a portfolio consideration, the security appreciates and becomes excessively over-weighted in the fund;
2) a security becomes grossly overvalued; (They won't sell if something is moderately overvalued.)
3) a company experiences, or appears to have the potential for, a permanent impairment of capital; or,
4) their analysis was flawed and they made a mistake.
Marty Whitman has no hard-and-fast rules for selling. And he doesn't sell much. Their turnover rate is 16% in an active year. In essence, he doesn't depend on the stock market to deliver profits to him. He relies on the private market. Just like Warren Buffett, if the stock market is closed for five years, Marty Whitman wouldn't care. His investing style doesn't really depend on how the public stock market does. "If I'm right, these very undervalued companies will be taken over, liquidated or refinanced, and that's where you make your money," said Whitman.
According to Whitman, the "Safe and Cheap" approach works a lot better on the buy side than on the sell side. He sold many stocks after a double and then watched them triple in a hurry. So nowadays he tends to hold on to the moderately overvalued issues.
The Art of Distress Investing
In value investing, chapter 11 is the end. In distress investing, Chapter 11 is the beginning.
Marty Whitman looks for the senior-most debt issues and tries to get at least 500 basis points more in yield versus comparable credit. He would like to buy 50% or more of the senior debt of troubled companies at 15 to 20% yield to maturity. If it has to be reorganized, he converts all the senior issues into common stock. In some cases, there are prepackaged deals. He also buys into the debt of larger companies where his ownership percentages would be a lot less. He would be very interested if GM files bankruptcy.
In distress investing, the play-it-safe Marty Whitman doesn't want to be subordinate to any liabilities ahead of his claim, including off-balance-sheet liabilities. "We never did anything with tobacco stocks. In the history of Third Avenue, we virtually had no investments in old line manufacturing companies. After being investors in John Mansville credits, there is no way we would want to be junior to asbestos liabilities. There is virtually no old line manufacturing company that does not have asbestos liabilities," said Marty Whitman. And he missed the upside in the USG stock, which makes an interesting case study about the flip side of the "safe and cheap" approach.
Marty Whitman looks for debt issues that will never miss a payment, such as those of GMAC and CIT when it was controlled by Tyco. They have made huge amount of money in distressed situations like Nabors and Public Service of New Hampshire. He also buys a lot of trade claims.
But Marty Whitman has his share of blow-ups in distress investing. It's much like venture capital. "We have a high strikeout ratio. It's not easy," said Whitman.
The Huge Cost Of Reorganization
We all know that American CEO's are overpaid. But CEO's pay is nothing compared to the pay of bankruptcy professionals, said Marty Whitman. The cost of Enron's reorganization is $1 billion. And pre-petition creditors are paying for that. The key here is to shorten the process of reorganization. Bankruptcy administrative costs are payable in cash. You pay as you go. So the bankruptcy professionals have all the incentives to prolong the process. Marty Whitman told the following joke about bankruptcy lawyers:
A prominent bankruptcy attorney died young on his way to court, and found himself before the gates of Heaven. When he arrived, a chorus of angels appeared, singing in his honor. St. Peter himself came out to shake his hand. "Mr. Jones," said St. Peter, "it is a great honor to have you here at last. You broke the world record for longevity. You are older than Methuselah!"
"But I am only 40," said the attorney, "You must have made a mistake, Sir."
"No mistake here," said St. Peter confidently. "We have been carefully adding up the hours on your time sheets. You have lived 1,028 years!"
Global Values: Cheaper but Less Safe
Since the "safe and cheap" are becoming more difficult to find in America, Marty Whitman is now shopping in places like Hong Kong, Singapore and Japan. There are real risk of investing in foreign issues even though they are local blue chips, with financials audited by the Big Four because you are investing in jurisdictions where you don't get protection from the U.S. security laws. "Foreign issues are cheaper but less safe. You have communists crawling all over Hong Kong," laughed Marty Whitman, who estimated that foreign issuers are now approaching 50 percent of his portfolio.
"Because of Sarbanes Oxley, no foreign issuer like Toyota Industries will be willing subject to our jurisdiction unless they really need our capital. I think Sarbanes Oxley is screwing up our capital markets for foreign issuers and small companies," said Marty Whitman, who is known for his capacity for critical thinking. "We used to require that they have disclosures published in English, audited by the big four, with ADR trading in the U.S. Now we are dropping the ADR requirement because of Sarbanes Oxley."
For people used to the American culture, it is a lot harder to venture overseas. You need to understand foreign accounting rules also. For example, Hong Kong public companies list their fixed assets at appraisal value.
Top-Down vs. Bottom-Up
Martin Whitman believes that most people on Wall Street are top-down and those guys are still living in the 1930's. For the 70 years after the Great Depression, virtually every industry in the U.S. has gone through some sort of depression with similar magnitude of the 1930's saga. Yet the economy of the whole country never went through a depression ever since. The last time that global events were more important to long-term investors than the company-specific valuation deals in moving the stock market was 1933. "Bottom-up company and industry analysis counts a lot more, and top-down economy analysis is less meaningful nowadays," said Marty Whitman.
When asked how he sees his firm's future 10 years from now? Marty answered: "Well, I am in my 82nd year. (Applause) I assume we would do very well, and they would get rid of me. Or I may [go ga-ga], which may happen in another two weeks."
Don't be so fast, Mr. Whitman. St. Peter told me that your time sheet is not long enough due to your career switch. How about a few more cheap ones with star potential hiding on a safe bed and a few more jaw-opening moments?