Methodologies, Value Investing

Martin Whitman’s “safe and cheap” approach

Another good article on Gurufocus.
According to Marty Whitman, the “safe and cheap” investor looks for four things in an investment:

  • High quality balance sheet;
  • Competent and shareholder-oriented management;
  • Understandable and honest disclosure documents;
  • Priced at 50 to 60 cents on a dollar.

Whitman is similar in many respects to Graham. Whitman concentrates more on the value of the company’s assets rather than the earnings that could be generated. Key quotes from the article:

  • “It’s a lot easier to look at the quantity and quality of the assets and resources that a company has than to forecast its earnings. Assets can appreciate in value, can be enhanced, sold, or converted into something more productive.”
  • “To Whitman, high quality means low debt, acreage of raw land, assets under management, fully paid rent, and other assets that can be easily valued.”
  • “Marty Whitman thinks like a LBO control buyer. He asks: “How can I finance the transaction?” It is a balance sheet question regarding what can be put up as collateral to secure lending from the bankers.”
  • “No more than 50 or 60 cents on the dollar for what a business would be worth to a private takeover buyer. It is absolutely crazy to pay more than 60 cents on a dollar for non-controlling interests in businesses. The outsiders always face agency problems.”

Rules of thumb for calculating his buying prices for various types of businesses:

  • Financial-services companies and depositories: Stated book value.
  • Small banks: 80% of book value.
  • Mortgage portfolio: Calculate yield to maturity and perform credit analysis.
  • Financial-guaranty insurers: Adjusted book value – a publicly disclosed number that is book value plus the equity in the present value of certain future premiums.
  • Insurance companies: Adjusted book value.
  • Real estate companies: Private appraisal value or market value.
  • Real Estate (REITs): Appraisal value or discounted present value of cash flow from operations.
  • Broker/dealer and asset managers: Tangible book value plus 2% of AUM.
  • Operating companies: 10 times peak earnings or below “net asset value.”
  • Tech companies: 2 times book value, less than 10 times peak earnings, 2 times revenue and cash larger than the book value of all liabilities.

I’ve also recently came across this video on The Ben Graham Centre for Value Investing (link here). There is also a nice interview here. Some more good takeaways follows:

Problems with his “safe and cheap” approach:

  • In order to get a cheap enough price, typically the near-term outlook of the business has to suck. End up buying stocks that are 30 – 40 times earnings (i.e. earnings are really low, hence P/Es are high).
  • In order to get businesses with huge balance sheets, you typically end up with ultra-conservative management. These companies don’t need access to capital markets due to their big strong balance sheets, hence they are non-promotional to Wall Street.
  • Positions tend to suffer on marketability and liquidity.

Sell Discipline

  • When we make a mistake, e.g. something happens that results in a threat of permanent impairment, competitive forces make the business not feasible.
  • When securities become grossly overpriced.
  • To meet redemptions (e.g. in 1998, 1998, value funds faced alot of redemptions)

Difference between Graham’s Net-Net and Third Avenue Funds’ Net-Net (from Third Avenue Funds’ 06Q1 Shareholder Letter):- Graham defines “net current assets”, “net working capital value”, “net net asset value” as (Working Capital – All Liabilities – Preferred Stock), which is equivalent to (Current Assets – Current Liabilities – All Liabilities – Preferred Stock). The value is a conservative measure of liquidation value, which makes the conservative assumption that at least enough can be realized from the plant account and miscellaneous assets to offset any shrinkage sustained in the process of turning current assets into cash. Graham noted that the purchase of a diversified group of companies on this bargain basis (i.e. below net-net value) is almost certain to result profitably within a reasonable period of time.

Martin Whitman uses the Net-Net concept with the following caveats:

  • Whitman will only look at the Net-Net value if the company is extremely well financed, i.e. it can definitely meet its obligations to its creditors [Note: going-concern]. This is because the current asset value might be boosted up alot by stuff such as inventory, costs in excess of billings, receivables from less than credit-worthy customers, which would not help the company meet its obligations.
  • Appropriate re-classification needs to be made on a case-by-case basis. Some current assets such as department store merchandise inventories, are actually lousy fixed assets. They will fetch much less than book value when sold in a Going Out of Business sale, and even as a going-concern, factors such as markdowns, obsolescence, seasonality, mislocation will significantly impact what you can sell them for. On the other hand, some marketable securities are not considered current assets in GAAP when they should be. If you have a fully-leased, Class A office building with credit-worthy tenants on long-term leases, that should be classified as a current asset (in fact, near cash), since you can sell the building very easily.
  • Off-balance-sheet liabilities (e.g. may be disclosed in footnotes) need to be subtracted in the net-net calculation.
  • Excessive expenses and losses need to be capitalized and included in the liabilities.
  • Certain fixed assets, e.g. PP&E can sometimes create cash. E.g. sales of PP&E at a loss can generate tax benefits / cash refunds.


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