by Lawrence C. Strauss
MARTY WHITMAN has had a long and storied career as a value investor. The 86-year-old is the founder and chairman of Third Avenue Management, where he also serves as a portfolio manager. He has written several books on value investing and has taught for many years at Yale and Syracuse. The latter is his alma mater, and its business school is named after him. In his view, a company's balance sheet is as an invaluable analytical tool, and he and his staff at Third Avenue Management spend many hours poring over them. The firm's flagship mutual fund, Third Avenue Value /zigman2/quotes/207225650/realtime TAVFX +0.21% (ticker: TAVFX), which Whitman co-manages with Ian Lapey, is 20 years old this week. Although it had a tough 2008, losing about 45% of its value, it has rebounded. What's more, its long-term record is very solid: Its 15-year annual return of 9.82% beats 89% of its Morningstar peers. Barron'sspoke with Whitman recently at his midtown New York office.
What investing lessons did you learn from the financial meltdown?
Whitman : A couple of things. One is the great importance of the quality of the balance sheet and having a strong balance sheet, which gives you safety and it gives the company the ability to be opportunistic. The other lesson I learned is the importance of management. We try to avoid permanent impairments. The only permanent impairments we suffered was with the bond insurers, and that was basically my fault because I put more faith in the management at MBIA /zigman2/quotes/205815173/composite MBI +0.97% [ticker: MBI] than I should have. The toughest thing we do is the appraisal of management. But when I look back on the last couple of years, I'm surprised about what a good job we did. So many of the managements we invested in are terrific.
As I said, we mostly avoided permanent impairments. During that period, a lot of other value guys just looked and they thought cheap was a sufficient condition, whether it was Fannie Mae or Countrywide or Lehman or Bear Stearns. None of that happened to us.
The Third Avenue Value Fund has hit its 20th anniversary. What's the biggest change since you launched it?
Twenty years ago, our investments were strictly in North America, and now we are over 60% in Asia . Our emphasis is on safety; we need and want full disclosure and tremendous regulatory protections. Considering what we do, I wouldn't have dreamed 20 years ago that the largest area where we would be invested is Hong Kong, not the United States and Canada. It's a big change.
Is it harder to find opportunities in the East than in North America?
No. In looking for full disclosure and well-regulated markets, there is not a lot of difference.
There have been a lot of investment ideas, such as modern portfolio theory, that started in the academic world. How important are they to what you do?
They may be of some use to day traders and high-frequency traders. But as far as value investing, control investing, distress investing and credit analysis is concerned, that stuff is absolute garbage.
What about the notion that a portfolio should have some diversification to provide downside protection?
Again, in terms of value investing, control investing – though we are not control investors; we are a mutual fund—distress investing, credit analysis, this stuff is worse than useless.
So what do you emphasize as a value investor?
You have to be gestaltist . Every accounting number is important, and is derived from other accounting numbers. So you have to understand the whole accounting cycle. If I want to estimate earnings, and I only have one tool, I would pick the current balance sheet. As a value investor, what you are interested in is whether the company is creating wealth. There are four ways to create wealth; it is not just cash flow.
They are, one, having cash flow from operations available to security holders. A company can use that cash to expand its asset base, reduce liabilities or distribute the money to shareholders, either by paying dividends or buying back stock. Two, and probably much more important, is having earnings, which we define as creating wealth while consuming cash. Remember, though, that earnings for most companies do not have a long-term value unless the company also has access to capital markets because if it doesn't, sooner or later, it will to run out of cash. The third—and very, very important—value-creation method is resource conversion.
Mergers and acquisitions, changes in control, massive recapitalizations, spinoffs, etc. The fourth wealth-creation method, which I touched on previously, is having extremely attractive access to capital markets.
Why do you prefer to run funds that are concentrated, rather than diversified? And how do you protect against risk when you do this?
We get protection by being price-conscious and by being extremely knowledgeable about our holdings. And diversification is a surrogate—and a damn poor surrogate—for knowledge, elements of control [of a company] and price-consciousness. If you are really a value investor and do deep research, how many investments can you be involved in at the same time? If you are a high-frequency trader, you could trade 100 securities today. The real value investors are lucky if they can do 10 investments at a time.
You mentioned the importance of knowledge. As an investor, is it harder to get an edge today?
Oh, no. There are many bargains around, based on our criteria and what we look for.
What is the state of value investing today?
A lot of the value managers are very good and very skilled. The thing that troubles me, though, is that some of the best value investors are on the short side. In the history of man, the markets have never been better than they are now for shorts. But some of these fellows are out to destroy businesses, such as when a business needs continuous access to capital markets—whether it is Bear Stearns or Lehman or, believe it or not, Goldman Sachs /zigman2/quotes/209237603/composite GS -1.10% [GS] in 2009, and General Electric /zigman2/quotes/208495069/composite GE +0.19% [GE]. Shorts, with present methods of communication that include blogs and cable television, might be able to bring any of them down. Because some of these value people are so good and so powerful, we at Third Avenue don't invest in companies that need relatively continuous access to the capital markets.
What about the argument that short sellers make valuable contributions to price discovery and make markets more efficient?
They don't make markets more efficient. I think they could serve a real function. I am very concerned about their influence, particularly when they try to take a company down.
Turning to another subject, what are your thoughts on the mutual-fund industry and how it has evolved?