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. (An earlier article on Whitman's talk can be read here: Marty Whitman's "Cowardly" Safe-and-Cheap Way to Invest.)
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?
Brian Zen, CFA, PhD, is the founder of Zenway.com Inc., an investment research firm that publishes Superinvestor Digest and provides training and advisory services to investors and analysts. Complete notes of Martin Whitman's talk at NYSSA can be requested from Brian at: firstname.lastname@example.org