Advisor Perspectives interviews Martin Whitman

Thanks to GuruFocus, I came across a Martin Whitman interview conducted by Advisor Perspectives. Here are some answers I found interesting (as usual, any edits/bold/italics/etc are mine):



Senior Creditor vs Junior

Robert Huebscher: You say that distress investing appeals because it involves analyzing the contractual and legal aspects of an opportunity, rather than macroeconomic factors. Is this still true in the current environment?

Martin Whitman: We really haven’t had to do much on the macroeconomic front. If you are an adequately secured creditor, the general economic environment doesn’t figure in too much. Macroeconomics becomes more important as you go down the capital structure. It is crucial in most common stock investing.

The macroeconomic environment is the worst I have seen in my adult lifetime, which is why we have tended to invest in more senior securities than would otherwise be the case.

Pretty well understood by most... the economic environment matters more as you go down the capital structure. Since many newbies, including me, invest almost solely in equities, which are generally the most junior security of a firm, the econic outcome can significantly impact results.

I find it interesting that Whitman says that he is investing in senior securities due to the poor macroeconomic environment. My feeling was that many were investing in senior securities because returns were attractive. Or is it sort of the same thing? I could be completely wrong but my feeling is that the economy is going to be weak and, although corporate profits will increase from the bottom, stock prices will likely do poorly. So, it'll be interesting to see if investors like Whitman keep buying senior securities or if he will move into stocks at some point.

Debt or Equity?

RH: Are you currently seeing more attractive opportunities in the credit or equity markets?

MW: In the equity markets, the Third Avenue Value fund has a little more than half of its assets in eastern Asia, including a huge presence in mainland China. These investments offer a much higher beta. Credit investing is different in two important respects. First, you get a cash return, and, second, a very attractive benefit is that you are insulated from crazy price fluctuations in the stock market. We can hold securities with a 30% yield to maturity, and if we are right we get 30% no matter what happens in the securities markets. This is a source of great comfort.

Academics fail to recognize the difference between cash return and total return investing. The only place we do cash return investing is in the credit markets. We don’t invest in common stocks seeking a dividend return.

Credit investing doesn’t have anywhere near as high a beta as eastern Asian common stocks. With those stocks we seem to have reasonable prospects for a 10-bagger at some point over the next five to seven years. We won’t do that well in the credit markets.

For US-based taxpayers there is another important difference. In credit investing, any profits are taxed as ordinary income, whereas profitable equity investing almost always results in capital gains.

As I have said many times, Whitman's portfolio is highly vulnerable to a real estate bust in China and Hong Kong. Although it's hard to say with much confidence, I do suspect that Chinese real estate is a bubble*. However, the government has made it a policy of propping up the real estate market so prices may remain stable for a long time. Of course, at a price, anything is worth considering so, if prices are really low, one may want to consider some of those East Asian investments.

The point Whitman makes about cash return is the key reason I was considering debt late last year and early this year. I would really love to invest in something that pumps out a ton of cash (say 15% yield on original investment) so that I can re-deploy it into something else. This allows one to re-deploy cash into new investments. I feel this can be helpful to investors like me who have small portfolios and are more nimble (i.e. can invest at a moment's notice into anything.) Some people attempt to do this with dividend-paying stocks but, like Whitman, I don't think this is desirable or meaningful. The dividend yield, at best, might be 5% and if one's portfolio is small then this is almost meaningless. The transaction costs alone might make it unattractive to re-deploy the 5% cash return.

Of course, as Whitman points out, debt-like securities are taxed at a higher rate (marginal tax rate rather than capital gains rate) so don't forget to factor that into your calculations. I roughly assume that a 30% yield on a medium-term bond is equivalent to a 20% earnings yield on a stock (p/e of 5), but this depends on your jurisdiction, tax rate, etc.

GM & Chrysler Bankruptcies

Contrary to what some, especially on the right, think, the Obama administration hasn't really done anything illegal with the GM and Chrysler bankruptcies. The bondholders got shafted to some extent but it went through the courts and, although I'm somewhat critical of the hardball being played by the Obama administration, it was expected. Whitman clarifies the situation below:

RH: Has the government changed the game for bankruptcy investors through its handling of the Chrysler and GM bankruptcies? Have they set precedents that will permanently impair bondholder interests?

MW: I don’t think so. You have section 363 and the rule of absolute priority. But when there is more than one class of claimants participating in a reorganization under section 1129, you can abrogate the rule of absolute priority with the requisite vote by holders of a class of senior claim. Senior lenders can be forced to compromise their rights pursuant to a vote of two-thirds of the amount of the secured class and over half of the number of class member. Clearly, in Chrysler’s case, when the TARP banks voted for the reorganization, these tests (of two-thirds of the claims and 50% of the number of creditors) were met, whether or not they were forced to sacrifice because of a section 363 sale.

[Ed. Note: Section 363 of the bankruptcy code controls the use, sale, or lease of property and what constitutes cash collateral. The rule of absolute priority states that, in a bankruptcy, the claims of senior classes of creditors must be settled before those of more junior creditors. Section 1129 of the bankruptcy code controls the treatment of impaired classes of claims – claims that are not going to be paid completely or where some contractual right is altered.]

The problem you have is the plan has to be proposed in good faith. In the case of Chrysler, answering the question of whether or not it was proposed in good faith is up to the judge, and he decided it was. Creditors have to be assured of getting more from the plan on the table than if the assets were liquidated. There was no valuation hearing but, if the assets were put under the hammer, the claim was that they would certainly be worth no more than $1 billion. But the senior creditors got $2 billion, so they were better off with the deal they got.

The risks borne by Chrysler’s creditors are the kind of risks creditors have always taken.

Inflation Hedges

RH: Are you positioning your portfolio in anticipation of increased inflation? Do any classes of distressed securities (e.g., bank loans or junk bonds) become more appealing if inflation becomes a greater threat?

MW: Buying assets at a big discount to their net asset values is the best way to guard against inflation.

...when I lived through that era [late 70's and early 80's] I found that companies with a lot of sunk costs were very well protected against inflation. New entrants couldn’t come in and build new plants...

As to buying performing loans with 25% yields – for that not to be a good hedge against inflation we need Weimar Republic-type inflation, not just 1970s-type inflation.

It's amazing how almost every week I read about the possibility of high inflation. This doesn't mean it won't happen but the contrarian in me thinks that this makes deflation even more likely. Anyway...

For inflation hedges, Warren Buffett suggests companies that can raise prices in a highly inflationary time. Martin Whitman prefers companies that have a lot of sunk costs. The challenge with the sunk cost idea is that it is difficult to tell when plant & equipment really needs to be replaced. Sure, you can go and invest in an equity of a manufacturer or a mining company but how do you know if half the equipment on the balance sheet are obsolete and need replacing? (In contrast, the difficulty with the Warren Buffett suggestion is that there are very few true inflation hedges out there. Even if you find one, it is unlikely that the market will be pricing it cheaply enough for it to be a safe buy. A lot of what people take to be pricing power will evaporate if inflation was high.)

Whitman also suggests that debt with very high yields are suitable even if inflation is high, unless we get hyperinflation. Your real returns may not be as good as you initially thought but if you have a yield of 20% and inflation is 10%, you are still earning 10%. This is one reason I think high yield debt is ok regardless of whether you are in the inflation camp or the deflation camp.

International Accounting Standards

RH: Your Third Avenue Value Fund has a large stake in Hong Kong real estate companies. Do these fit with your distress investing discipline? As a value investor, are you able to get the level of disclosure that you require, at least of your US-based investments?

MW: ...For our purposes, international accounting standards are a lot better than U.S. GAAP, especially when it comes to income-producing real estate. Under international standards, income-producing properties are carried at appraised values, which are a lot more helpful than GAAP, where they are carried at historical cost less depreciation, less any impairments.

I wanted to highlight this point because a lot of newbies don't know this (certainly I didn't until a few years ago.) Real estate values in many Asian countries, possibly Europe too (not sure—anyone confirm?), are carried at appraised values. In contrast, American real estate is carried at cost, plus some adjustments as Whitman remarks.


FOOTNOTE:

(* One data point that suggests Chinese real estate is a bubble comes from various stories one hears of real estate owners leaving apartment buildings unoccupied or how brand new shopping malls or commercial buildings are partly empty. This means that owners are pursuing an uneconomic goal i.e. buying simply on the hope that prices will go up. Of course, prices have been going up for many years so this seems like a rational decision...until the bubble pops. Any real estate bust is likely to be small in China because the bubbly areas seem limited to the coastal areas and cities; and majority of transactions involve large amounts of cash (i.e. little debt). The latter point basically means that a debt deflation cycle won't develop, unlike America/Britain/Ireland/Spain/etc. My big concern with China, apart from the totalitarian government, is the potential fixed asset and manufacturing bubbles. Unlike real estate, these can do serious harm.)