Despite a snowstorm that caused the absence of several speakers, the Columbia Investment Management Conference in New York today included many interesting presentations and panel discussions. The highlight of the day was the conversation between Columbia Professor Bruce Greenwald and Martin Whitman, Founder and Portfolio Manager of Third Avenue Management.
Mr. Whitman has a sixty year history in the investment management field and represents a distinguished voice of experience we can all learn from. This article includes several topics that were included in the discussion between Prof. Greenwald and Mr. Whitman but it is not a complete transcript and, unless otherwise noted, is based on the authors notes and recollection of the conversation rather than a presentation of direct quotes.
The Evolution of a Value Investor
Most investors who have arrived at a “value oriented” strategy moved toward the approach over a period of time. Many of us know the story of Warren Buffett reading every book on investing in the Omaha library but not reaching the conclusion that value investing represents the best strategy until reading Ben Graham’s The Intelligent Investor in 1950. A similar “evolution” was the case for Mr. Whitman who entered the business as a security analyst at Shearson, Hammil in 1950. For the first four years, Mr. Whitman focused on many of the traditional benchmarks that security analysts today still concentrate on such as earnings per share growth and predicting near term price movements.
In 1955, Mr. Whitman read Between the Sheets by William J. Hudson which is a book (currently out of print) regarding the importance of paying particular attention to the balance sheet. This book combined with several real life examples at the time convinced Mr. Whitman that emphasizing balance sheet quality should be more heavily considered in the field of security analysis. Mr. Whitman also gained a great deal of experience working as a portfolio analyst for William Rosenwald starting in 1956. Experience in stockholder litigation and bankruptcy, fields that were shunned at the time, also provided important lessons regarding analyzing the capital structure of distressed firms.
“Cheap is Not Sufficient”
At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme: It is not sufficient for a security to be “cheap”. It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness. In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”. This might include current year earnings compared to the stock price, current year cash flow, and many others. However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company. A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity.
A New Take on Graham’s “Net-Nets”
Mr. Whitman believes that it is a “myth” that there are no “net-net” opportunities available in the market today. We discussed Graham’s concept of net-nets in a prior article and came up with some examples of such opportunities over the past year (for example, see the articles on Hurco and George Risk Industries). However, such opportunities are very rare and often exist only in the most thinly traded stocks and therefore are rarely actionable.
Rather than adhering to Ben Graham’s original concept of “net-nets”, Mr. Whitman has made a few modifications. Instead of using current assets as the store of value, he looks at “readily ascertainable asset value” and tries to buy at a large discount to that value. Assets that can be readily convertible to cash may include high quality real estate, for example. In certain situations, assets such as real estate may be more valuable in a liquidation than inventories which are part of current assets but often highly impaired in distressed situations.
One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations. The true value of a company may never come out if there is no threat of a change in control. This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business.
When asked if the management of a typical public company is overpaid, Mr. Whitman said “you’d better believe it” due partly to the fact that most Boards of Directors are “a bunch of wimps, including me.” This serves as a reminder that there is one other characteristic that many value investors share: Humility and a willingness to admit errors.