Valuation of Martin Whitman's Four New Buys

Martin Whitman is in the process of handing the reigns over to his successor at $3.8 billion Third Avenue Management, Ian Lapey, who was promoted to sole portfolio manager on March 1, 2012. Whitman remains as chairman of the board of trustees and mentors the investor team. Year to date, the fund has returned 12.68%, recovering from its 11.68% downturn in the last year.

The investors in the third quarter bought four new stocks: Devon Energy (DVN, Financial), Comerica Inc. (CMA, Financial), Alleghany Corp. (Y, Financial) and White Mountains Insurance Group (WTM, Financial).

In his firm’s third-quarter letter, they reiterated that the firm emphasizes quantity and quality of a company’s resources when choosing stocks, namely, companies with a lot of cash and little to no debt. As long-term, buy-and-hold value investors, in their third quarter they bought conservatively valued holdings, primarily financials.

Third Avenue bought 518,149 shares of Devon Energy Corp. (DVN) in the second quarter at an average price of $63 per share. Devon Energy is an oil and gas exploration, development and production company with U.S. and international operations.

Devon ended the first quarter with $7.1 billion in cash, significantly higher than the $3 billion it had the year prior. It also has approximately $14.4 billion in long-term liabilities and debt, an increase from $9.6 billion the year prior, and has been increasing revenue each year since it met a cliff in 2009.

According to GuruFocus’ Valuations Tab, Devon Energy trades for a Graham Number of $61.15, slightly above its Tuesday share price of $55.24. Tangible book value is $39.3, intrinsic value according to the DCF calculator is $43.22, and it has a negative 0.04% rate of return and 13.8% earnings yield.

Devon began 2012 with a record-breaking quarter. The company averaged 694,000 oil-equivalent barrels (Boe) per day, the highest daily production rate in history in its North American onshore properties, and a 10% increase from the prior year. Its liquids production increased for the sixth consecutive quarter to 256,000 Boe per day, driven by a 26% increase in oil production.

Third Avenue purchased 490,000 shares of Comerica Inc. (CMA) at an average price of $31 in the first quarter. Comerica is a bank holding company with businesses that engage in corporate and consumer lending, mortgage loans, small business and individual banking, and mutual fund and annuity products.

Comerica currently trades for $30 per share, and by comparison has a Graham number of $45.61, tangible book of $35.40, intrinsic DCF value of $62.16, rate of return of negative 2.2% and earnings yield of 10.6%.

The firm commented on this holding in his third-quarter investor letter:

During the quarter, we added to our existing position in Key Common and initiated a new position in Comerica Common (CMA). At quarter end, the two positions accounted for 3.4% of the Fund's net assets. Comerica Common was identified by Vic Cunningham. Comerica Incorporated is a financial holding company based in Dallas with subsidiaries engaged in retail and business banking and wealth management. The management team, led by Chairman and CEO Ralph Babb, has an impressive longterm track record, having avoided many of the consumer related problem areas in 2007 and 2008. As a result, the company's tangible book value is roughly flat compared to five years ago, a considerable accomplishment in light of the financial crises. The current earnings outlook is subdued owing to depressed net interest margins (3.2%, versus 3.6% to 4.0% historically) and tepid loan growth (2% in the first quarter). Nevertheless, the company appears poised to generate improved returns over the next several years, owing to its low cost deposit base, strong business lending franchise in its core markets (Texas, Michigan, California and Florida) and strong capital position (10.3% Tier 1 Capital ratio). The company recently passed the Fed's Comprehensive Capital Analysis and Review ("CCAR") stress test and was approved to repurchase $375 million in stock (about 6% of the company's outstanding shares) over the next year. The Fund's initial position in Comerica Common was acquired at about 13 times earnings and a slight discount to tangible book value.

Third Avenue bought 39,898 shares of Alleghany Corp. (Y) at an average price of $333 in the first quarter. Alleghany Corp. is an insurance and financial services company.

Alleghany in the first quarter of 2012 had $1.1 billion in cash, significantly increased from the $311 million in had the year prior, due primarily to a merger. It has $1.9 billion in long-term liabilities and debt. The company has also produced strong cash flow annually for the last decade.

Alleghany is selling at a substantial discount to several of its valuation numbers. On Tuesday, it is trading for $341.68 per share, and has a Graham number of $667.49, tangible book value of $672.80, and intrinsic DCF value of $924. Its rate of return is 5.63, and earning yield is 24%, the highest of Whitman’s new purchases.

Alleghany just completed a merger with Transatlantic Holdings on March 6, so its first-quarter results include 25 days of operations with Transatlantic. As a result, in the first quarter, shareholders’ equity increased to approximately $6.2 billion, from $2.9 billion at year-end 2011.

The firm made these comments on Alleghany in his investor letter:

We initiated a position in Alleghany Common (Y), which was purchased in TASCX and discussed in last quarter's TASCX shareholder letter. Curtis Jensen and I attended a lunch with a small group of investors and Alleghany's CEO, Weston Hicks, in April. Weston seems to be our type of CEO: he is non-promotional and focused on generating shareholder value by growing book value per share. The company has no dedicated investor relations person and does not do quarterly earnings calls, but instead provides comprehensive financial disclosures aimed at enabling long-term investors, as opposed to short-term speculators, to make informed investment decisions. Weston's presentation to investors consisted of a one page Excel spreadsheet showing the company's performance since 2002, when he joined the company. Over this period, the company's average combined ratio was 90% (i.e., a 10% underwriting profit margin), and book value per share increased at a 9% compounded annual growth rate ("CAGR"). This growth was particularly impressive given the difficult underwriting environment over the period with competitive pricing and an elevated level of insured losses.

Future book value growth should be partially driven by the company's 2012 purchase of Transatlantic, a leading global reinsurer. This transaction appears to have been well timed, as it was completed at a significant discount to tangible book value and reinsurance rates are improving in 2012. Alleghany also recently announced a small acquisition of Bourn & Koch, Inc., an Illinois-based manufacturer of precision machine tools. This company will join several other noninsurance investments in Alleghany's portfolio and is representative of management's opportunistic approach and willingness to look outside the insurance industry to enhance shareholder value. Shares of Alleghany Common were purchased at a discount to tangible book value.

Third Avenue bought 21,628 shares of White Mountains Insurance Group (WTM) at an average price of $517.70 in the second quarter. White Mountains Insurance is a property, casualty insurance and reinsurance company based in Bermuda.

At the end of the first quarter, White Mountains had $1.5 billion in cash, flat from the previous year, and $1 billion in long-term liabilities and debt. For the last three years, revenue has been falling, though it has been improving for the last three quarters.

White Mountains is also inexpensive compared to several of its valuation numbers. Alleghany is trading for $522.63 per share, compared to a Graham number of $909.27, tangible book value of $650 and intrinsic DCF value of $341.48. White Mountains has a negative rate of return of 1.97% and earnings yield of 11%.

In the third-quarter letter, the firm commented on White Mountains:

We also initiated a position in the common stock of White Mountains Insurance Group Ltd. (WTM), a Bermuda-based holding company whose principal businesses are conducted through property and casualty insurance and reinsurance subsidiaries. White Mountains Common was recommended for investment last year by John Mauro, a research analyst on Third Avenue's international team, when the company announced the sale of its Esurance subsidiary at a terrific price (about 2.5 times tangible book value) to the Allstate Corporation. White Mountains Common was subsequently purchased in the Third Avenue International Value Fund and discussed in that fund's July 31, 2011 shareholder letter. Impressively, White Mountains' tangible book value has increased at about 15% per year since 1985, with much of the growth driven by timely resource conversion activity (e.g., buying and selling of businesses), such as the recent Esurance sale.

In recent years, White Mountains' management has also been engaged in precisely the type of resource conversion activity discussed in Martin Whitman's Chairman's letter this quarter, e.g., repurchasing White Mountains Common. Since 2007, White Mountains has repurchased 37% of its outstanding common shares in a combination of open market repurchases, privately negotiated transactions and tender offers. Most recently, the company repurchased about 11% of its outstanding shares in a tender offer at $500 per share in March 2012 (versus a price of $523 per share on April 30, 2012). White Mountains Common was purchased during the quarter in the Fund at a modest discount to the company's March 31, 2012 book value per share of $560.

For more of Martin Whitman’s third-quarter buys and sells, see his portfolio here. Also check out the Undervalued Stocks, Top Growth Companies and High Yield stocks of Martin Whitman.