Marty Whitman — “Business Skill Critical to Investment Success”

Fall 2011

Mr. Whitman founded the predecessor to the Third Avenue Funds in 1986 and M.J. Whitman, a full service broker-dealer affiliated with Third Avenue in 1974. He has managed the flagship Third Avenue Value Fund since its inception in 1990 and was Third Avenue’s Chief Investment Officer from its founding through January 2010. Mr. Whitman graduated from Syracuse University and holds a masters degree in Economics from The New School For Social Research. Mr. Whitman is Adjunct Professor of Distressed Value Investing at Columbia Business School.

G&D: Can you talk about your approach and how it compares to the classic G&D approach?

MW: Graham and Dodd, in my mind, had three great contributions to investing. The first is the focus on distinguishing between market price and intrinsic value. This is very important since modern capital theory assumes a price efficiency and ignores intrinsic value. Second, they preached the importance of basing decisions on solid facts. They did this in the 1960s, which was before companies were forced to disclose every- thing they have to disclose today. Everything about an investment decision should be based on the facts you know and how reliable the facts are. It is much easier to do this type of work to- day than it was when they were doing it. The third great contribution of Graham and Dodd, in my mind, was their idea of investing with a margin of safety. Everything we do at Third Avenue is based around these tenets of the Graham and Dodd method.

G&D: What about any differences?

MW: I don‘t think we can identify high quality securities at discount prices unless we look at things not only as passive investors, but also from the point of view of the corporations, managements, and creditors. So instead of primacy of the income account, we appraise companies and managements in terms of their capabilities as operators. We look at management teams as investors and we look at management as financiers. Between those things we have a balanced approach. Graham and Dodd placed great emphasis on dividends. In general, companies have three uses of cash. They can expand assets, reduce liabilities, or distribute funds to shareholders. The distribution of funds to share- holders, with one exception, always has to be a residual from the company‘s point of view. This distribution can either take the form of stock buybacks or dividends. Both have their advantages and disadvantages. Graham and Dodd had a preference for dividends; we think buy-backs can be a much more judicious use of cash some of the time. The one exception to dividends to stockholders being the residual is where a regular increase in dividends improves the company‘s access to capital markets compared to the access they would otherwise have. This avails itself to certain types of institutions — a good ex- ample is integrated electric utilities companies.

G&D: How do you think about valuation? What metrics do you tend to focus on?

MW: Earnings are very, very overrated. We can look at the four ways corporate value is created. One is cash flow from operations available for security holders, which is relatively rare. The second is earnings, with earnings being defined as creating wealth while consuming cash. Believe it or not, it‘s what most corporations and governments do. In order to have earnings in the long term, you have to remain credit worthy and you have to have access to capital markets to meet cash short- falls. The third element of creating corporate value is resource conversion, which can be massive changes in assets, massive changes in liabilities, and changes of control. This includes mergers and acquisitions, take-privates, LBOs, MBOs, spinoffs. This is a very important element. The fourth element is having super attractive access to capital markets. Let‘s say you own some income-producing real estate. Having access to long-term non- recourse debt to finance 70% or more of your project, that‘s a value creator.

We look at hurdle rates in most of our common stock investments. We want to get in at a substantial dis- count to readily ascertain- able net asset value. We want at least a 25% dis- count. We don‘t go into these types of situations unless we think there are very good prospects that, over the next 3–7 years, the company can increase its net asset value by no less than 10% per annum com- pounded. We are more conscious of growth in readily ascertainable net asset value than we are in earnings per share. This is unlike Graham and Dodd who said value is created by operations. I don‘t think that‘s real in today‘s world, in the 21st century.

G&D: What about some other differences between the Graham & Dodd approach and your approach?

MW: Graham and Dodd loved net-nets. When they invested in them, all they did was look at classified balance sheets. In my opinion, there are real limits to looking at companies like these so far as there are no catalysts. Graham and Dodd wrote about the unimportance of the balance sheet. From our point of view, if you want to predict future earnings, one of the tools you will use is ROE. We don‘t believe that you can just pay attention to past earnings trends. Unlike Graham and Dodd, we are not as concerned with past earnings growth. Taking the balance sheet at face value is often misleading. For example, let‘s take a mutual fund management company. Assets under management, where persistent, have a ready market value even through they are not a balance sheet asset. There are a lot of liabilities that have equity characteristics. Take deferred income taxes for a going concern. Since the company is going to reinvest cash savings when they aren‘t paying taxes in assets which give rise to tax deductions, this account is really more like equity than a liability.

G&D: In the past you have criticized how people use GAAP. Could you explain these criticisms to our readers?

MW: I have criticized how people use GAAP, including Graham and Dodd, who thought it was so important to find true earnings. GAAP is essential, but it misleads you as an analyst in some respects. Cash accounting, which is not GAAP, also misleads because it doesn‘t give you any measure of wealth creation. GAAP misleads because it focuses on wealth creation and bur- ies cash accounting. It is rules based, not principles based. However, GAAP is critical in the USA because it is the only objective benchmark you have. Our portfolio has a lot of financials, income-producing real estate, and a lot of private equity. With these investments IFRS tends to be more useful than GAAP. Under IFRS, income producing real estate assets are carried at appraised value.

G&D: Can you talk about one of your favorite new investment ideas?

MW: Cheung Kong Hold- ings, an enormously successful private equity and real estate development company, has a net asset value of around HK$140 per share. It is the world‘s largest container port operator with facilities throughout the world, other than the United States. Its real estate operations are centered in Hong Kong and mainland China. Cheung Kong, through its 50%- owned subsidiary Hutchison Whampoa, has interests in a leading integrated oil company in Canada; is one of the largest retail store operators in Europe and mainland China; and also has extensive interests in telephonic communication in various countries; as well as utility operations in the United Kingdom. The stock cratered recently due to fears in Hong Kong regarding the company‘s huge presence in Europe in ports and retail. There has been a lot of panic selling. One of the things about the Hong Kong stock market is that it is dominated by ―short term-ism. I like to say that Hong Kong traders ―don‘t like to buy green bananas.

G&D: Can you go through a few other holdings?

MW: Sure thing. Applied Materials, near $11, sells around 10x earnings. It has an extremely strong financial position. It is the world‘s leading producer of chip manufacturing equipment and, through a China-located subsidiary, a leading manufacturer of solar panels.

Capital Southwest trades at $84, yet has a net asset value around $140. Investor AB, which trades at 125 Swedish Krona on the Swedish Stock Exchange, has a net asset value of around 189. Both are investment companies with extremely favorable long-term records for grow- ing net asset value and dividends.

Last, I want to mention Hang Lung Group and Wheelock & Company. Hang Lung is the holding company for the leading developer of shop- ping centers in secondary cities in mainland China, following its huge success in building and operating two shopping centers in Shanghai. Wheelock is a holding company for a huge private equity and real estate developer. Both common stocks sell at substantial discounts from net asset value. Third Avenue has been invested in Cheung Kong, Hang Lung and Wheelock since 2005. During that period, net asset values, after adding back dividends, have increased by more than 15% per year compounded. Results for 2011 will be very strong. 2012 may be a year of moderate recession.

G&D: Can you talk about the characteristics of some of your most successful investments?

MW: Some of my best investments have been in companies that were going through Chapter 11. K- mart was a good example,back in 2003. The first thing we did was buy out a lot of trade claims from creditors. Then we kept averaging down and we went on the official creditors committee. It was there that we met Eddie Lampert, who asked if we would join him in the reorganization, which we did. Eddie ran everything. To find these types of homeruns we really need good partners. We are good investors, but not great managers. Unfortunately he‘s tied up with troubles at Sears now. I think Sears is toast. Eddie is very skilled, but I think it will be very hard to turn this thing around. The company has a nice cash position now from realizing the value of the company‘s real estate. I don‘t know what‘s left. I have the greatest respect for Eddie, and if anyone can pull this off, it‘s he. I‘m not as close to the situation as I used to be, as we sold our position a while ago and I don‘t really follow the company anymore.

G&D: Can you talk about your investment in Brook- field Asset Management (BAM)?

MW: Brookfield has a net asset value of around $40, through it trades near $29 per share. It has ownership in a large number of Class A office buildings in Manhattan, Toronto, Calgary and Washington, D.C. Equally important are its hydroelectric investments in Canada, the U.S. and Brazil. Brook- field controls General Growth Properties and has huge infrastructure, real estate and agricultural in- vestments in Brazil and Australia. Finally, Brookfield is the general partner in highly successful hedge fund in- vestments.

G&D: How do you think about the macro when you invest?

MW: I think the reason that such a high percentage of our holdings are in the Far East is that the region has better prospects for NAV growth than any other part of the world. For us, the key investment criteria are a super strong financial position, buying at a dis- count, and getting comprehensive disclosure so we can understand the business. I think these things are relatively easy to find, but figuring out the macro is very hard. The real thing investors should be thinking about is creditworthiness. Credit- worthiness, for any economic entity that has to borrow, is a function of three things — the amount of debt, the interest rate on the debt, and how productive is the use of proceeds. I don‘t know why everyone doesn‘t wake up to the fact that in the aggregate, debt is almost never repaid, and doesn‘t have to be. Provided the entity can remain creditworthy, it can refinance, expand the amount of debt and continue the process forever. As long as the assets are used productively, you can‘t call it a Ponzi scheme.

G&D: Would you shy away from the equity market given what‘s going on in Europe right now?

MW: First off, it‘s not going on in Europe, its going on in parts of Europe. They are very happy in Scandinavia. I‘m not smart enough to figure out if I can buy things cheaper than I have. If I can buy these well capitalized businesses at big discounts, I‘m not worried about the market. I just think there are fantastic opportunities in 363s (emergency sale of a company in bankruptcy) and in capital infusions. You could do very well making capital infusions like Warren Buffett has in recent years.

G&D: What industries are you inclined to invest in and why?

MW: We like to go where there are readily ascertain- able asset values at a huge discount. Readily ascertain- able‘ is not rocket science — it includes income- producing real estate, securities and private equity. I like technology companies. Microsoft (MSFT), Intel (INTC) and AVX (AVX) are companies that have cash well in excess of book liabilities. These are very profitable businesses generating a lot of cash, and they have large cash balances. As such, I feel confident that they will not burn the cash that serves as a sizeable portion of the asset value. I think retail is often very prone to distress. Between the banks, the landlords, the bondholders, and the trade, companies are very dangerously financed. It‘s often hard to call a bottom on retailers. I remember what one of my college professors used to say ―Everything is unpredictable, especially the future.

G&D: What is the best approach to find new ideas that finding companies trading at a substantial discount to NAV, but also have a quality business, a quality management team, and growth prospects for NAV?

MW: We usually tend to be in bed with managements who don‘t really need the capital markets. In 2010 and 2011 these managements were willing to sacrifice return on equity for the safety and opportunism of a strong financial position. We really lucked out. We‘ve dealt with terrific managements throughout the world. These discounts would never exist if there were catalysts, especially prospects for change of control. Once that existed, they wouldn't sell at these dis- counts. If there are no prospects for change of control, there is no reason security prices ever have to be rational. What we do is Graham and Dodd on steroids. We are looking for growth in NAV if there are no readily apparent catalysts. One of the reasons for the huge discounts for securities on the Hong Kong stock exchange is because the rules for change-of-control that make it almost impossible for companies to go private or do a cash merger. You need a shareholder vote of 90% of the outside share- holders to approve a going private transaction. We've gone to the Hong Kong Stock Exchange to try to get them to change the rule so that companies can go private with a simple majority. If something like this were to happen, the discounts would not be as ludicrous as they are right now. Meanwhile, the companies we are invested in have insiders who continue to make open market purchases of their stock, despite not being able to do a full transaction. The absence of potential changes in control really hurts an economy. It breeds management teams that don‘t use resources well. Japan seems a good example of this.

On a different note, a good example of our being disciplined in finding bargains, was not chasing things during the dotcom boom. We never really suffered during the period. We had criteria when looking at tech companies in those days. Cash had to be well in excess of book liabilities. We would never pay more than 2x annual revenue and never pay more than 10x peak earnings. We could meet these criteria with large blue chips, such as Intel (INTC), AVX (AVX), and Applied Materials (AMAT).

G&D: How do you get comfortable investing in Japan and Hong Kong when the catalyst may never actualize?

MW: I‘m absolutely comfortable in most things when I can find discounts to NAV of 40%. I was a limited partner in Jim Grant‘s Nippon Partners. They went out and bought 20 net-nets in Japan in 1999. On this stuff, I have to hope they have the growth in NAV and that the discount doesn‘t widen. A real shortcoming of what we are doing now, and what we doing then, is a lack of a catalyst.

G&D: How do you get comfortable that there is a sufficient margin of safety an investment?

MW: You can be wrong about anything. One of the things that is very important to understand is that diversification is only a surrogate, and usually a poor surrogate, for knowledge, control, and price consciousness. As a non-control investor you have to have a moderate amount of diversification, which is not true as much for control investors. It is very hard to make guarantees. A margin of safety usually comes from buying high quality securities at a discount. Secondarily, if you are a passive investor you need a moderate amount of diversification. This is really a probability business, not a certainty business. As an outside passive investor, you can be wrong about anything.

G&D: If an analyst comes into your office with a new idea, what are the first few things you would want to know?

MW: What I want to do is understand the business. I want to know the estimate of NAV, and can we buy it at a sizeable discount from this. We guard against in- vestment risk, but we pretty much ignore market risk, which is different from Graham and Dodd, who were very conscious of how much you suffer when the price goes down. We try and train our people that to be successful, you need to guard against investment risk. Market risk is just a random walk. Without catalysts, any near-term market prices are a random walk.

G&D: Who else in the industry do you have a lot of respect for?

MW: There is a great tendency for the best people in value investing to graduate and to do control investing and distressed investing. There are a lot of very successful people who will never make a passive investment. Take my friend Sam Zell for example – he never makes an investment where he doesn‘t have control. Warren Buffett is a control investor and also is very much a distressed investor. Bill Ackman, David Einhorn, and Mario Gabelli come from the Graham and Dodd school of passive investing and are all investors I respect.

G&D: What do you think has made you a successful investor?

MW: I can spell that out. L…U…C…K. It‘s been more business skill than investment skill that has helped me throughout my career.

G&D: We appreciate you sharing your thoughts with us, Mr. Whitman. Thank you.