Introduction By Maj Soueidan, Co-Founder GeoInvesting
Marty Whitman holds a special place in the hearts of many deep value investors. As you may know, Marty Whitman passed away on April 16, 2018, but leaves behind a legacy that includes market beating returns and 4 books.
“Martin J. Whitman, often said that March 31, 1946, the day he was discharged from the Navy, was the happiest day of his life. After that date he never obeyed an order from anyone. Fiercely independent-minded, he was a brilliant intellectual; a methodical, patient investor; and a man of profound generosity and integrity. Obituary at Legacy.com”
Thinking outside the box is what makes value investing fun, especially if you are a microcap investor. When it comes to investing, we are often told to follow set rules like “GAAP is more accurate than non-GAAP” or “avoid stocks with high P/Es, buy stock with low P/Es”, and that “a stock with a low book value per share is cheap”. This is not always the case. The places that some ignore are where we can find opportunities. A stock that looks expensive today might be cheap tomorrow. For example, investing in the debt of companies entering Chapter 11, or their stocks upon an exit from bankruptcy, can be incredibly rewarding.
Furthermore, understanding the true earning power of a company and what its assets are worth, beyond what GAAP EPS numbers or the carrying value of assets on a balance sheet are telling you, is how you can find some diamonds in the rough. Whitman coined the acronym, GADCP, Growth at Dirt Cheap Prices, and when it came to investing in stocks, he was generally looking to buy companies trading at a 30% discount from readily ascertainable net asset value that could grow at an annual compounded growth rate of 10%. When he invested in distressed securities, he invested in the “Fulcrum Security”, the most senior security that was going to participate in the reorganization.
If you have ever had the chance to listen to Marty Whitman speak then you will quickly find out that he has no problem challenging the status quo when it comes to value investing. After hearing of his passing, I immediately searched for videos of Marty Whitman that reminded me of why I respect his work. In 2013, Consuelo Mack interviewed Marty Whitman as part of her “Wealth Track” Series. (Ms. Mack offers the most recent transcripts of her Wealth Track episodes for free viewing. Older episodes require additional access credentials.)
Like the presentation that Professor Lo recently gave about behavior and investing that we highlighted in last month’s newsletter, this video was shot at the Museum of American Finance.
What follows is the full transcription from the Wealth Track episode, where Whitman explains how old school thinking might not always be appropriate. At one point, he mentions that he will invest in low ROE companies at the right price and that talk about the U.S. “defaulting” on its debt is basically gibberish.
You may not agree with everything Whitman says, but there are some great lessons to be learned between the lines.
Hello and welcome to this edition of “WealthTrack”. I am Consuelo Mack. We are delighted to be taping at the Museum of American Finance, a must visit destination in the heart of Wall Street. It is the only museum devoted to the history of finance, the foundation of our capitalist system.
“Be fearful when others are greedy and be greedy when others are fearful”, is the famous investment maxim of great investor Warren Buffett. We recently learned how phenomenal returns can be when that advice is followed. As the Wall Street journal reported in its story, “Buffet’s Crisis Lending Hall Reaches Ten Billion Dollars, Buffett and Berkshire Hathaway Inc. (NYSE:BRK.A) tossed financial lifelines to a number of blue chip companies during the financial crisis. From 2008 to 2009, he invested a total of $25.2 billion dollars in six companies – candy maker $MARS and it’s Wrigley subsidiary, Goldman Sachs Group, Inc. (the) (NYSE:GS), Bank of America Corporation (NYSE:BAC), General Electric Company (NYSE:GE), Dow chemical and reinsurance giant Swiss Re (VTX:SREN).
According to the Wall Street Journal, Buffets bonanza, the total dividend and premium return he has gotten so far is nearly $10 billion dollars which is about a 40% pre-tax return. Mr. Buffett says an average investor could have done just as well if they bought during the market panic. Well that is debatable. Few have his resources or ability to obtain terms as favorable. But other great investors were also buying at the lows including this week’s guest. He is legendary deep value investor Marty Whitman. In the throes of the financial crisis five years ago he told us on WealthTrack that investors were in a once in a lifetime opportunity to get very rich. He and his shareholders at the Third Avenue Funds have certainly done extremely well over the years by sticking to his mantra to buy safe and cheap. Whitman is the founder and chairman of the Third Avenue Management. Until March of 2012, he was portfolio manager of the flagship Third Avenue Value Fund which he started in 1990. And during his tenure the fund outperformed the markets by a wide margin.
A longtime professor of securities analysis at his Alma Mater, Syracuse University as well as Yale school of management, Whitman is the author of several books. His most recent is “Modern Security Analysis” , co-authored with value investor Fernando Diz, which takes on two pillars of Wall Street thought – Modern capital theory, the theory that markets are efficient and Graham & Dodd’s classic approach to analyzing stocks. Whitman maintains both were shown to have short comings during the financial crisis including Wall Street’s focus on earnings. As part of a special program in front of a live audience for the museum of American Finance I asked Whitman what’s wrong with earnings.
If you are just a trader and you are dealing in securities sudden death, like options, warrants, it is perfectly valid. However, if you want to understand the business and the securities they issue, the emphasis on earnings is of no use. It is not what companies do.
They are more interested in wealth creation. Modern capital theory is really tremendously wasteful in the broad scheme of things and tremendously wasteful in terms of most of what goes on Wall Street.
MACK: Why is it wasteful?
WHITMAN: They focus on two things. Markets and securities prices, and they are in no position at all, and they are absolutely ignorant of analyzing companies and analyzing the securities issued by companies. So, while it may be useful for traders, it has got nothing to do with value investing, control investing, distress investing, credit analysis or first and second-stage venture capital.
MACK: So I know one of the shortcomings that you mentioned, which is short-termism, so what does that mean?
WHITMAN: There are four things. You look at the immediate prices. If you’re just going to study markets, you are per say going to be short term because that is what you do with prices. Okay, in the conventional approach, they over emphasize four things – earnings, short term, top down analysis like the economy rather than really understanding businesses.
MACK: Right, the macro, which everyone talks about.
WHITMAN: And Fourth is based on a belief in equilibrium pricing, that the price is efficient, and any change in price will just be impacted by new news on the market. They are utterly oblivious to the companies we mentioned in chapter six which trade as much as an 80% discount from readily ascertainable net asset values and abundantly solvent businesses. So, they are oblivious of that.
As for Graham and Dodd, it was a pretty good book for its time. The last edition I think was 1962 or 1963. Since then, there has been a tremendous explosion in disclosure. I trace it mostly from the Securities Act Amendments in 1964. So, unlike the Graham and Dodd days, now it is absolutely feasible to know tremendous amounts about most companies most of the time. It just was not on their radar screen.
MACK: That’s a great advantage for investors now.
WHITMAN: Yeah, I mean, the problem is one in securities now. They knew tidily-squat about credit analysis.
MACK: So let’s talk about credit analysis. This is what I love about you, Marty Whitman, is that you tell it as you see them. So, you think we should be focused on looking at creditworthiness, that is the most important.
WHITMAN: For our investments, a company had better be creditworthy if we’re going to invest in it. It will only be as a creditor, normally as a senior creditor. To invest in the common stocks of poorly capitalized companies has been and will continue to be a dangerous game. It is not something we do. Our investment criteria, again, cover four facets.
MACK: Right, and I just want to interrupt you for one second, because you call it the safe and cheap is your approach, but there’s one of my favorite acronyms. You know, there’s GAAP which is the generally accepted accounting practices, but you have GADCP which is growth at dirt cheap prices. That’s your approach.
WHITMAN: Okay, there are four elements to getting growth at dirt cheap prices. Three are easy now. One, we don’t acquire common stocks unless the company has a super strong financial position, which is pretty easy to ascertain from documents. Two, we only buy into those companies when they are selling at very, very substantial discounts.
MACK: So, 20%?
WHITMAN: Usually 30%.
MACK: Oh, 30?
WHITMAN: 20% or 30% of readily ascertainable net asset value, where readily ascertainable is not rocket science, like income-producing real estate, like investment companies. We’re owning marketable securities. Third, is we are not going to be involved in common stock investments unless the company involved provides full comprehensive disclosure, including audited statements and is traded on markets where regulations are very, very protective of minority shareholders.
MACK: So, the regulatory environment is really critical.
WHITMAN: Really important, yeah, and it’s really good in places like the United
States, Canada, England, Hong Kong, Japan. That is the only analytics we bring to it. I would like these companies to grow at least 10% per year compounded. That overcomes a lot of the shortcomings of the approach I have just mentioned.
MACK: When I read in your book, it was net asset value can grow at least 10%
WHITMAN: It is a total return. One of the problems with the approach is the markets efficient enough so that when you get these huge discounts, there are usually no catalysts. They are not going to be changes in control. They are not going to be massive mergers and acquisitions. So, the way you profit is unlike other companies.
MACK: Right, so a lot of your value investor competitors look at companies, and they say, “You know, we want a catalyst. We want a company to be in trouble.”
WHITMAN: Many of the best people won’t invest in common stocks unless they see a
catalyst, understandable. Us, we get pricing that is unbelievable, much better. I mean, if there’s a catalyst, how many common stocks are you going to buy at a 50% discount from readily ascertainable net asset value?
MACK: You made your reputation, you’re Mr. Distressed investing, and you’re buying distressed debt, and one of your most successful the early trade that you made was buying Penn Central bonds when it went bankrupt in, whatever it was, 1974. But now looking at the portfolios and Third Avenue Funds, the vast majority of them are common stocks, so what happened to distressed debt?
WHITMAN: Let me tell you a war story. In the early ’70s when I had my business for
myself, had three kids and no money, but I wanted to do corporate finance, there were
two areas that no respectable investment banker would touch in those days. One was stockholder litigation, and the other was bankruptcy. So, I was pretty good at that business, but I woke up to the fact, I couldn’t charge like Goldman Sachs or Kuhn Loeb in those days, so I better become an investor. And investing in distress. I invested in what I figured out hopefully rightfully the Fulcrum Security, the most senior security that was going to participate in the reorganization, thus the Penn Central mortgage bonds.
MACK: Right, and that’s where you really learned the creditworthiness.
WHITMAN: If a company has an extremely strong financial position, what’s the most senior security to participate in the reorganization? Believe it or not, it’s called the common stock, so that its safe and cheap which we talked about. I think is just a natural, natural outgrowth of what I was doing as a distress investor.
MACK: The last time you and I talked on WealthTrack was in 2008, believe it or not. We were in the throes of the financial crisis, and you said, you know, this is really a once-in-a-lifetime opportunity to get really rich with certain caveats if you knew how to do it.
WHITMAN: That was true.
MACK: Right. So, what’s your view of the market now? I mean, how would you describe the opportunities to get rich in today’s market?
WHITMAN: I think they’re super. We have some type of concentration in east Asia.
MACK: You sure do.
WHITMAN: Yeah, particularly presence in mainland China, and that’s the macro assumption that over the next five to seven years east Asia is more likely to grow than North America or Europe, you know, as a simple macro decision, but we’re getting into these companies that have been growing like weeds, and I would say discounts anywhere from 30% to 80%.
MACK: And let’s talk about that a little bit more in detail, because we just talked about how important the regulatory environment is, but you are buying Hong Kong-based Companies only.
WHITMAN: With a big presence in China.
MACK: In China, exactly.
WHITMAN: Only because I don’t want to go into stock markets where the regulators are not very protective of minority shareholders. In so far as I would want to be a control investor, that might be different. But for an outside minority person, I really have a strong need for strongly regulated markets.
MACK: And you’re also buying real estate holding companies and development companies based in Hong Kong, and so when I look at your top holdings, I mean, it’s Wheelock and Company and Henderson Land and Development, Cheung Kong Holdings, Hang Lung Group. These are all Chinese.
WHITMAN: And Lai Sun Development, yeah.
MACK: So, why real estate?
WHITMAN: It is very easy to analyze. Like I said, this readily ascertainable net asset value is not rocket science.
MACK: So, when you’re looking at your real estate holdings of these big companies that you’ve invested in Hong Kong, these real estate development companies, so, are they selling at major discounts to what you think their ascertainable net asset value is?
WHITMAN: Oh, yeah. What they report their net asset, and all of them, we’ve restricted all of them to companies which have a huge, huge presence in mainland China. You know, I keep saying if we’re wrong about China, it’s not going to be for economic reasons. It’s going to be because of social unrest, political unrest, violence in the streets, especially out of western China. We live in a probability world. It’s probably going to be okay, but my problems with China are not economic.
MACK: Yeah, they are political.
WHITMAN: They’re political and social.
MACK: For a guy who avoids risk and wants to buy safe and cheap …
WHITMAN: Well, wait a minute. If I am buying at a 50, 60% discount, say Wheelock, and suppose I am wrong about China, I might not lose a lot of money. I might not lose any. Price is very, very important in safe and cheap.
MACK: So, the other thing about looking at your portfolios at Third Avenue now is that they were heavily skewed not just to east Asia which they are, but also to overseas holdings as well as opposed to U.S.
WHITMAN: Yeah, macro what’s going on in the U.S., can you blame me, Consuelo? In light of the last 16 days.
MACK: Right. As a matter of fact, I asked you before October 17th, you know, when the next financial crisis was going to come, and you told me it could come next Thursday which was October 17th. We dodged that bullet, but how do you feel?
WHITMAN: I don’t know that we have. The politicians basically have it wrong, particularly rightwing Republicans in the economic sense. In the history of this republic and any creditworthy entity, you better mark down that debt in the aggregate is almost never repaid. It is refinanced and expanded by businesses and governments and even individuals who become creditworthy and increase their creditworthiness. That’s very important. So, all this business about a debt limit is going to end up in chaos because the truth is, the United States federal government is eminently creditworthy, and if it’s going to get in trouble, it’s at the use of proceeds from borrowing are not wisely spent, not that we’re incurring debt. As a matter of fact, to go to the corporate level, in chapter six I put down a list of recommended stocks in 2012.
MACK: Right, in Modern Security Analysis, your book.
WHITMAN: And we went in them in 2007, 2008, and it’s obviously every company on the list had much, much more borrowing capacity in 2013 than they had in 2008, and it’s just true in any analysis.
MACK: I’m sure individual investors come up to you all the time. You teach at Yale. You teach at Syracuse University. So how do I make money in the market?
WHITMAN: There are a lot of ways to make money.
MACK: What’s the best way to make money in the market?
WHITMAN: Safe and cheap. But safe and cheap has certain shortcomings. One, you can’t do it with borrowed money, very hard. You can’t afford margin calls.
MACK: So, don’t use leverage.
WHITMAN: Don’t use leverage, and buy into well-financed companies at huge, huge discounts. Let me again talk about what’s wrong with well-financed, you know, which is all I do and a way to make money, but you have to understand that a lot of well-financed companies are run by deadhead management. You want to try to avoid that. And the management of all these companies we are in quite willingly sacrifice return on investment and return on equity in 2013 for the safety inherent in a large, strong financial position and also the opportunism it gives them, but in terms of you’re going to legitimately measure ROA and ROE, our guys have lower returns than others, though they have lower P/E ratios. I mean, we’re buying these things, say, at 50% discounts.
MACK: Such as …
WHITMAN: Wheelock, Henderson.
CMACK: Again, Hong Kong-based real estate development companies.
WHITMAN: Maybe Brookfield Asset Management is probably 30% discount.
MACK: Right, Canadian-based.
WHITMAN: But largely U.S. presence. U.S., Brazil, Canada, Australia, but you have to realize that the Dow Jones average is selling three times book. You are buying at 60% of book, and the market itself is 300 times book.
MACK: That’s pretty stunning.
WHITMAN: Yeah, and our price/earnings ratios are equally low. I mean, some of the stuff we’re buying is less than two times earnings.
MACK: We always ask our guests at the end of every WealthTrack, what’s the One Investment we should all own some of in a long-term diversified portfolio? And I think you mentioned that it might be Brookfield. Is that right?
WHITMAN: Yeah, it would be Brookfield.
MACK: And why? What is it about Brookfield that’s…?
WHITMAN: Well, as compared with East Asia, Brookfield I know the culture, I’m intimate with the people and we do much together. While I can’t say the same about Hong Kong and China, though it’s not that bad. One of the things about Hong Kong, all of these companies are controlled by billionaires, and one of the things Hong Kong billionaires insist on doing is coming to New York. We send someone over to Hong Kong once a month, but these companies keep visiting us, so you know you get a good sense, but I can’t get the same comfort that I get with Brookfield and Bruce Flatt and all my friends over there.
MACK: All right. Marty, we’ll leave it there. Thank you so much for being with us on WealthTrack at the Museum of American Finance. We really appreciate your being here.
WHITMAN: Thank you
MACK: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: “Think safe and cheap with your investments.”
Those are Marty Whitman’s simplest golden rules of investing. Safe means a company has the financial wherewithal to weather storms such as the recent financial crisis Cheap means you pay less for the company than it’s worth.
As a deep value investor, Whitman looks for stocks or bonds that are selling at 30% discount or more to what he thinks they are worth. But it’s the combination of the two that makes a good investment.