Wednesday, January 23, 2008 2 comments ++[ CLICK TO COMMENT ]++

Morningstar Conversation: Martin Whitman and Jean-Marie Eveillard

Thanks to for mentioning this Morningstar Advisor conversation piece between Martin Whitman and Jean-Marie Eveillard. For those not familiar, they are highly successful value investors who run the Third Avenue Value Fund (Whitman) and the First Eagle Fund (Eveillard). It`s an entertaining read, with a humourous Martin Whitman. Here are some things I found insightful:

(MW=Martin Whitman; JME=Jean-Marie Eveillard)

MW: ...We buy and hold long term. Markets go down, we take advantage. We sort of operate under the implicit assumption that if we don't know more about the situation than the market, we wouldn't be there. They operate under the assumption that the market is sending me messages; the market knows more than any individual. It's just the opposite...

JME: That's right. I think it's Seth Klarman who said, "The biggest edge that value investors have is their long-term orientation," which I think jives as well with Ben Graham saying, "Short term, the market's a voting machine; long term, it's a weighing machine"...

JME: So many investors are always looking for the information that the others don't have. And as you said, we have the same information, which is readily available. We try to use it better than the others. It's in the interpretation, in a sense, and the reading of the available information.

There are some big advantages that small investors with a value-orientation have over the street. Many small investors think that we are at a disadvantage to the Street but that's not really true. We don't have to follow the market. We can be long-term whereas everyone on the Street has a narrow focus.

MW: Absolutely. For conventional people, there is a primacy of the income account. In what we do, there is no primacy of the income account. If there is a primacy of anything, it's the quality of the financial position. That governs what we do. I think it governs what you do. It's a matter of weight to information. If somebody else is going to emphasize earnings per share, and we're going to emphasize quality of the balance sheet, we're going to weigh the information very differently.

As a matter of fact, on this primacy of the income account, I know from what you did in Bank for International Settlements that our basic emphasis is on wealth creation, not earnings from operations, knowing that earnings from operations and cash flow from operations is just one method of creating wealth. And usually, it's the least desirable method of creating wealth. We have alternatives.

JME: That's right. And you have done so much with real estate-related securities. Of course, that's a case where the earnings per share simply do not.

MW: Measure anything.

Value-oriented investors tend to value the balance sheet more than the income statement. Investors like Warren Buffett give weight to the income statement, but others like Martin Whitman are on the extreme end where he primarily looks at the balance sheet. If one focuses on the balance sheet, I think they are best off reading the strategies of Martin Whitman, Benjamin Graham, and the like.

From my perspective, if you don't get the balance sheet right, it's hard to have confidence in the value of anything. Who knows if Ambac will turn out to be a disaster but one of the reasons I had confidence in it--with it down 70% within one week of me investing a huge sum--is because it looked clean from a balance sheet point of view. Similarly, one of the reasons I'm willing to venture into Japanese stocks, even though the macro picture is poor and the Street is bearish on it, is because most stocks are trading at a low price-to-book-value.

Overall, you should try to figure out what you are good at: looking at the value via the balance sheet, or the earnings through the income statement. Of course, if you nail both of them, you will become a superinvestor :) A lot of newbies look at the income statement (i.e. earnings) because it looks easier to analyze. After all, you just think about what the growth rate is going to be, and if a product is going to do well in the market. But the earnings are so sensitive to projections. One percent off here and there and it can turn into a disaster.

JME: In your April quarterly, you wrote something that intrigued me. You said the entry point into a stock is important, and the entry point must be at a bargain level. Because once you hold the stock, you're a buy-and-hold investor, and accordingly, you do not sell the stock, even if it's fairly valued; you only sell the stock if you think you've made a mistake, or if you think the stock is grossly overvalued.

MW: Or for portfolio reasons.

Pretty straightforward but thought I would quote it...

MW: I must say one thing. You and me, we like to look at what's wrong with what we're doing. And let me say what's wrong most of the time with what we do in buying into very well financed companies at a discount from readily ascertainable net asset value, which is 90% of our portfolios.

First, most of the time, the near-term earnings outlook sucks. That gives us the price.

Two, we're in bed with highly conservative managements, who most of the time are willing to sacrifice return on assets and return on equity in order to get the insurance policy of a strong financial position.

Martin Whitman tends to favour a super-strong balance sheet at the expense of growth. I'm just a newbie but I personally don't. I usually avoid companies with low ROE, the most important measure for Buffett (it's actually either ROE or ROIC for him).

JME: One thing you say that I've always liked, Martin, is, "Hey, we're value investors, but we have nothing against growth." What we don't want is what you call "generally recognized growth." In a sense, I suppose what you are saying is, "We're all for growth, but we don't want to pay for it."

MW: The second largest holding in the Third Avenue Value Fund is Toyota Industries, which is the founder of Toyota Motor TM and still a 5% or 6% shareholder of Toyota Motor. Under Japanese accounting, on the balance sheet, Toyota Motor and other portfolio companies have to be carried at market. Toyota Industries' common is selling out at 30% discount from net asset value.

However, under Japanese and U.S. accounting, all Toyota Industries picks up in earnings from Toyota Motor is dividends paid by Toyota Motor, not the retained earnings of Toyota Motor.

If you look at GAAP, Toyota Industries is selling around 21 times earnings. However, if you adjust the earnings to pick up Toyota Industries' equity in the undistributed earnings of Toyota Motor, it's selling around 6 or 7 times earnings.

We, over many years, thought Toyota was a growth stock, and we thought we were buying it under 10 times earnings. And I think, essentially, we're right. But that's how I think. You and I, Jean-Marie, both try to buy growth and try not to pay for it.

JME: But also what you did, Martin, by buying Toyota Industries as opposed to Toyota Motor, is to look at Toyota Industries in an unconventional way. Looking at just the multiple of earnings is the wrong way. There is a number of securities where you have to be careful how you look at them, and where you may not want to look at them in the conventional manner.

We've been a shareholder in Rayonier RYN, which basically owns timberlands, for more than a decade. Timberland is a bit like real estate. Price to earnings does not apply.

Two good examples of why these guys are some of the best on the planet... looking at things in an unconventional manner...

JME: Exactly. And also, the other angle--which neither you nor I care about--is that Toyota Motor, the stock, is in the big index. Toyota Industries, which is the holding company for Toyota Motor, is not in the big index.

So people who pay a great deal of attention to index weightings will sacrifice the 30% discount, which they could get if they bought Toyota Industries as opposed to Toyota Motor, just because Toyota Motor is in the big index.

This provides an argument against passive investors (aka indexers). If you can somehow do okay, you'll avoid these problems. I personally don't like passive investing for another reason: if a company totally sucks, you still end up bying it because it's in the index. Having said that, if I figure out I don't know what the hell I'm doing and not cut out to invest on my own (will know within 2 years given my concentrated portfolio strategy), then passive indexing is the way to go.

MW: Let me just talk about private equity, limited partnerships and tell an old story.

A limited partnership is a business or investment association where, at its inception, the general partner brings experience to the situation, and the limited partners bring money.

At the end of the limited partnership, the general partner has the money, and the limited partners have the experience. [laughter]

LOL :)

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2 Response to Morningstar Conversation: Martin Whitman and Jean-Marie Eveillard

January 24, 2008 at 8:16 PM

ABK's balance sheet was and is a disaster.

January 24, 2008 at 8:49 PM

Why do you say that?

All the risk is with unknown events. As far as I'm concerned, there is nothing to indicate that Ambac can't make any payments on its known risks.

You can argue that the balance sheet MAY turn into a disaster but there is nothing to indicate it now.

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