Third Avenue Management Founder Marty Whitman died Monday at the age of 93.
Many Third Avenue investors will probably remember Whitman as much for his insightful and witty letters to shareholders as for his successful stock-picking approach. Whitman has authored The Aggressive Conservative Investor and Value Investing: A Balanced Approach. Both of these books shed light on his approach. But Whitman's record speaks for itself: He won Morningstar's Fund Manager of the Year Award in 1990 for his work running Third Avenue Value.
A vulture of a value investor, Whitman would often rummage through the rubble of distressed stocks--those of beaten-down companies, some on the brink of insolvency. But many of Whitman's depressed stock plays eventually turned around for the better.
The key to Whitman's stock-picking success was buying companies that were cheap and safe, and holding onto them.
Whitman was a value investor after Benjamin Graham's own heart. Like Graham, Whitman would look for stocks that were dirt cheap, but instead of using a company's price/book ratio (Graham's preferred valuation measure) Whitman would focus on a company's takeover value, or how much he believed a buyer would pay for the whole company.
A shrewd analyst of business accounting, Whitman would comb through a company's financial statements to figure out what he thought the business was worth. He then would determine whether the company’s balance sheet had remained strong in spite of setbacks in the business. He would generally pay no more than 50% of what he thought a buyer would pay to acquire the whole firm.
In addition to a having a very cheap share price, Whitman also favoured firms that met the following three criteria:
- Companies with very little debt on the books.
Whitman looked for debt on the balance sheet and in the footnotes of the company's financial statements; he had seen companies downplay hefty liabilities by burying items in notes. Because he often invested in troubled companies, Whitman didn't like firms overburdened by debt: Debt can make a company’s troubles even worse.
- Companies with high-quality assets.
Whitman defined high-quality assets as cash or real estate. He looked for assets with value.
- Companies that don't require a huge overhead to generate cash.
Whitman liked companies that could make money without spending a lot of money. A money-management firm, for example, can conduct its business online, via telephone, or in a face-to-face meeting, which doesn't cost a lot.
An analyst in Morningstar Chicago interpreted the safe and cheap framework.
- The first step in the safe and cheap approach is to theorize what you could lose.
If there isn't a safety net--a high-quality asset, in most cases--to keep the shares from going to zero, then there is absolutely no reason to waste time hypothesizing about the upside potential. The safe and cheap investor tends to focus on companies that own rock-solid assets: The balance sheet takes precedence over the income statement.
The safe and cheap approach also holds in high regard management teams dedicated to creating wealth in the most tax-efficient manner, as well as management that takes advantage of inefficiencies in the capital markets. A savvy management team is important and typically includes a group of insiders who own a sizable equity stake in the company.
- Well-capitalized business.
It must be well capitalized, possess solid long-term prospects, provide excellent financial disclosure, and be available for purchase at a discount to its fair value. The "safe" component is satisfied by the first four attributes, while the "cheap" component is fulfilled by the last.
Well-capitalized businesses with solid long-term prospects tend to fall into three buckets under this approach.
1. The first bucket is a strong operating company enjoying an economic moat and a balance sheet with no significant burdens.
2. The second bucket includes companies that also lack significant liabilities, but own tremendous underutilized resources. These assets can be put to use in more efficient ways to create wealth over time.
3. The third bucket consists of companies that own well-positioned assets that throw off solid cash flows and are partially secured with non-recourse debt. This type of debt, which only allows lenders to rely upon the asset for repayment (as opposed to the parent company), lowers the risk profile while enhancing cash returns on equity and providing tax-efficient ways to realize appreciation.
The safe and cheap approach also favors companies that provide excellent disclosure. This disclosure typically supplements required filings and provides non-GAAP measures, and is often critical in assessing the true health of a business and its balance sheet. Such disclosure is also especially important since the safe and cheap investor may be taking advantage of depressed stock prices created by short-term concerns to acquire stakes in blue-chip companies.
- Buy at a meaningful discount to fair value.
Whitman seems to have rules of thumb for buying in different business lines. He favors buying financial-services companies below book value, real estate companies below private market value, asset managers below book value plus 2%-3% of assets under management, and operating companies below 10 times peak earnings. All of these measures revert to the company's fair value, or what Whitman terms "net asset value." While we prefer to value a company and its moat by estimating the present value of future cash flows, we couldn't agree more with Whitman's stipulation that buy orders only be placed at discounts to intrinsic value.
The above information was taken from Remembering famed investor Marty Whitman and Marty Whitman's 'Safe and Cheap' approach
