Third Avenue 2nd Quarter 2008 Commentary by Martin Whitman

Martin Whitman's Third Avenue commentary for the 2nd quarter was just published and let me comment on this thoughts. I'll by quoting most of the letter but I urge anyone that is interested to read the full letter.


(source: Third Avenue Funds 2nd Quarter Shareholder Commentary, April 30, 2008. All quoted material is by Martin Whitman except as noted.)

Martin Whitman isn't shy about venturing into (what seems like) extremely risky stocks. Of course, he is extremely skilled at distress investing and views these investments as safe (whereas the market thinks they are risky).

Of interest to me is the fact that Martin Whitman significantly increased his stake in MBIA and Ambac. Based on his prior letter, I wasn't sure if he was committed to Ambac since he only took a small position. But now I am confident that he views Ambac as being similar to MBIA. It is also interesting to note that he took a position in GMAC unsecured bonds. The important thing in my eyes is that these are due in 2011. I would love to buy distressed bonds if their maturity is short but I don't think small investors have access to these.

Primer On Distress Investing Asset Types

Distress Investing, as far as Fund management is concerned, seems to encompass four different businesses:

1) Issues that are to remain performing loans; are to be reinstated in the event of Chapter 11 filings; or, are to become the equivalent of zero coupon bonds. These credit issues are deemed by TAVF management to have at least a 90% probability of never missing a contracted for payment for interest, principal or premium; or, if they are to miss payments, to become the equivalent of zero coupon bonds where the pay-off at maturity would equal the principal amount plus interest and interest on interest. Third Avenue holds a number of these issues, which were acquired at yields to maturity of between 14% and 20%. Such issues are CIT Senior Unsecureds, GMAC Senior Unsecureds, MBIA Insurance Corp. Surplus Notes, and Standard Pacific Senior Unsecureds.

I don't understand what he means when he says we may end up with something equivalent to a zero coupon bond (any readers have any thoughts?). Would that be similar to a trade claim that needs to be paid first? Anyway, I think this first asset type is almost always out of the reach of most small investors. These are generally credit instruments that not traded on an exchange and require big lum-sum investments (just like the general bond).

2) Small reorganization (or liquidation) cases. These are cases where the administrative expenses incurred in reorganizing (or liquidating) the company far exceed any cash savings for the company arising out of not making interest payments on unsecured debt and undersecured debt to the amount of undersecurity. In small cases, a reorganization (or liquidation) has to take place in a hurry if there are to be any values left for pre-petition unsecured creditors. Such cases with which the Fund has been involved in recent years include Home Products International and Haynes International.

Small investors probably have a shot at this. Without knowing much about these investments, and simply based on what Whitman is saying here, the problem I see is that if you are wrong with the timing, you can get screwed. I mean, if the re-org has to happen quickly for pre-petition unsecured creditors to realize any value, and if the process takes too long, the original investors may end up with nothing.

3) Large reorganization (or liquidation) cases. These are Chapter 11 cases where the cash savings from not paying interest and principal on unsecured debt and undersecured debt to the amount of undersecurity, exceeds the administrative expenses of reorganization (or liquidation). Here, unlike small cases, speed is not necessarily of the essence. The most important large case with which the Fund has been involved in recent years is Kmart.

This the type that most of us can get involved in. These things can take a long time to unfold, stories may be all over the media, and small investors may have a shot at acquiring some of the fulcrum securities that will have value post-bankruptcy or post-liquidation.

4) Making capital infusions directly into issuers to financially strengthen them or, put in other words, to make them feasible. This has become an important new business for Third Avenue. During calendar 2008, the Fund has made capital infusions into MBIA Insurance Corp. through purchasing Surplus Notes; and has also acquired the common stocks of MBIA (Parent), Ambac and St. Joe. Fund management is currently looking at one other possible common stock deal.

Small investors have a good chance to participate in these opportunities--especially if the capital infusion happens through a public means such as a stock exchange or a public offering of some sort. Martin Whitman clearly believes that the capital infusion into the monoline insurers and St. Joe, a land bank/real estate company, is to keep them viable and financially strengthen them. One of the big risks with the monoline insurers is that they are heavily regulated so if you inject capital into the insurance company, you may never get it back for a long time. Fortunately, my impression is that the insurance regulators aren't as prone to mismanaging resources as other government officials (government regulators in industries such as utilities seem to be far worse, with companies deploying billions to build power plants sometimes not really knowing what's in store for them).


A Comment About Japan

The Fund has now been invested in Toyota Industries for 11 years. During that period, the company has performed brilliantly, while the market performance of Toyota Industries Common has been at best, so-so. As a consequence, TAVF was able to acquire Toyota Industries common during the quarter at 3 under six times flow-through earnings. Flow-through earnings reflect Toyota Industries’ equity in the undistributed earnings of portfolio companies; Toyota Motor Common is the principal portfolio issue held by Toyota Industries.

I cherry-picked his comment about Toyota Industries to illustrate something that worries me about Japan in the grand scheme of things. Whitman says Toyota Industries has been performing exceptionally well on the business front but its stock price hasn't been doing well. This doesn't generally matter if you are a long-term investor. The market misprices assets for various reasons and if the business is doing well, then you can distribute the profits to the shareholders. However, Japanese firms are unique in that they are not shareholder-friendly. I don't know how well Toyota Industries treats its shareholders but most Japanese companies will not initiate tactics to improve shareholder returns. Many companies, even if their business is doing well, simply sit on large piles of cash--or even worse: waste it on some useless new venture.

Even if I find a good company in Japan, I often wonder if the market will reward the pick. Given that companies themselves don't do much to unlock shareholder value, you are relying almost solely on the market price.

One other risk with Japan is the risk of valuation compression. Japanese stock market was so wildly overvalued that valuations of exceptionally well-performing companies haven't gone anywhere (you are talking about world-leaders). I think the valuation problem is less of an issue these days, given that half the stocks on the TSE trade below book value. But nevertheless, it is possible that valuations can still compress further. On a P/E basis, valuations still look high (however I believe this is because earnings are depressed and many of the top Japanese companies are cyclical industrial companies).

Bear Raids

Martin Whitman has been quite outspoken about the prevalence of bear raids these days. I have no idea what is happening out there but my view is that bears improve market efficiency. The question is what happens when speculations lead to a collapse in the business. This is particularly problematic for Wall Street investment banks, who generally depend on reputation to retain customers, and have a highly-leveraged balance sheet. A run on the bank can bring down anyone on the Street. Even the vaunted Goldman Sachs can potentially collapse within a week. Whitman comments on the Bear Stearns collapse:

The analysis of Bear Stearns Common Stock is simple. Assuming that Bear Stearns was credit-worthy, Bear Stearns Common was worth well over $100 per share, even assuming that there had been a material amount of permanent impairments, e.g., the asset management business was a disaster area. However, assuming that Bear Stearns was not credit-worthy, Bear Stearns Common was valueless.

It turned out that Bear Stearns was not credit-worthy...

There probably were a number of financial reasons for the Bear Stearns collapse. However, it appears as if the most important reason, by far, was a concerted bear raid designed to persuade principal customers, i.e., counterparties and principal creditors, that Bear Stearns was no longer credit-worthy. Further, the bears argued, it was easy, and cost-free, to transfer accounts from Bear Stearns to Bear Stearns’ competitors. Why take credit risks with Bear Stearns? Thus, a run on the bank.

Whitman places the primary reason for the collapse of Bear Stearns due to a bear raid. No one will know what really caused the collapse of Bear Stearns. It collapsed due to liquidity problems within a week without any material change in the business environment. Early in the week that it collapsed, it had ample liquidity (SEC and FedRes checked their books) but it collapsed by Friday due to lack of liquidity (when customers pulled their business).

Lehman Brothers is facing a similar problem as Bear Stearns. Everything looks fine but if customers pull their business then the run-on-the-bank will collapse Lehman regardless of how much money it has. This is one reason that I don't buy the reasoning by some that Lehman Brothers can't collapse now that it has access to the Federal Reserve lending window. My layperson view is that money means nothing in these situations. If customers lose confidence, that's the end of you. Period. Dick Fuld has navigated Lehman through treacherous waters in the past (1998 crisis for example) and he really needs to earn his paycheck here.

The monoline bond insurers have been facing similar problems in the sense that customers, rating agencies, and regulators don't want to do business with them (or in the case of rating agencies, downgrade ratings without any qualitative reasoning.) Fortunately, though, the monolines can't face liquidity problems due to the way the insurance contracts are structured. Even the CDS-type insurance contracts that are signed are nothing like the CDS contracts signed by hedge funds, investment banks, pension funds, and others, who dabble in the CDS market.

It seems as if it is now easier, and more economical, to conduct bear raids than has ever been the case heretofore – even before 1929.
1) There is no longer an uptick rule. Prior to July 2007 and since the early 1930’s, a common stock listed on the New York Stock Exchange (as was Bear Stearns Common) could be shorted only at a price that was higher than the last price or change of price.
2) There are now well-developed options markets, where one can go short without incurring any material cash outlays – say, buy put options and offset the cost of
put options, by selling call options.
3) It is now feasible to sell short specific indices, e.g., the Markit ABX.HE, the indices that track prices of residential mortgages.
4) Perhaps most important, the means are more available, and more effective than they have ever been, to spread rumors through new communications devices – the Internet and business television stations.

I think Whitman is a bit harsh with the bears and I think the first two reasons are weak. My opinion is that the uptick rule probably didn't alter the playing field much. I also don't know if the options market really does anything.

The last two points are bang on. The Markit home equity index is the biggest joke out there. The problem isn't so much that you can short the index. Rather, the problem is that accountants and risk management outfits are using the index to project losses far into the future. The index is thinly traded (it isn't like a major stock index), does not represent the true nature of the housing market, and has too-low of a sample of constitutents.

As for the media, well, that is always manipulated by the bulls and the bears. Bulls always hype their stocks and I guess the bears are learning to play that game now too. When you have William Ackman saying that all the monolines are going to go bankrupt within the first three months of the year, it clearly has an impact on the clueless investors and, not to mention, regulators. Or when you have Jim Cramer screaming for nationalization of the monolines, well, it certainly doesn't help matters. Overall, I am in favour of free speech and I think the media is fine.

Net-net, the bear raids seem beneficial for the Fund. The raids are beneficial if all they do is depress the prices of common stocks by propagandizing faulty analysis, e.g., Ambac and MBIA. TAVF can acquire securities at true bargain prices. However, insofar as bear raiders can actually reduce corporate values, e.g., Bear Stearns, where important customers and creditor constituencies were convinced that Bear Stearns was not credit-worthy, bear raiders can be a real problem. Since TAVF is not going to become a bear raider, Fund management’s job is to avoid those situations where bear raiders actually harm companies;

Bears likely help contrarian investors because they force stock prices to overshoot on the downside. The problem is when they cause a collapse in the company.

If you are long the monolines, you need to keep the following playbook being used by the bears:

Bear raids will continue unabated unless those people leading shortselling forays can be shown some downside, whether economic, legal or
both. For example, there appears to be a four-pronged approach toward
trying to destabilize MBIA as a going concern. First, there are efforts to strip the holding company of assets so that the holding company might become insolvent. Second, there is pressure brought on the ratings agencies to remove the AAA ratings from MBIA’s insurance subsidiaries. Third, there are pleas to regulators suggesting that they restrict the insurance subsidiaries’ ability to write policies. Finally, and as part of the other three, the bear raiders are trying to discourage clients from doing business with MBIA. None of these actions seem to have any merit at all. But from the bear raiders point of view, why not press these approaches? After all, there is no downside.

The 2nd event has already unfolded: MBIA has lost its AAA rating. The third bear tactic is the most dangerous to MBIA and Ambac right now. There is strong pressure on the regulators to do something--even though Ambac cannot be shown to be insolvent or has missed any payments for any claims. Elliot Spitzer barged into town with guns blazing, not because of the bears but likely because of political pressure, and, well, fell off a cliff due to some, hmm, personal problems. Eric Dinallo seems to be cool-headed but it remains to be seen what comes out of any of this.


Most Important Lesson I Learned This Year

Martin Whitman summed up earlier in his letter a lesson for investors:

One of the important lessons from the Bear Stearns debacle for TAVF is to avoid owning common stocks of companies where the businesses need to have relatively continuous access to capital markets in order to survive as going concerns. It is also important to avoid common stocks of companies where the customer base can be lost because of a rumor campaign and where Third Avenue would suffer losses were there to be a run-off of the business.

I never understood what it means to own a company that depends on the capital markets. After owning Ambac and following the Bear Stearns case, I now know. Although Ambac doesn't really rely on the capital markets (only time was with its dubious tactic of trying to raise capital to preserve its AAA rating), it is very close to the description above.

Contrast Bear Stearns with Buffett's American Express in the 60's. Even though American Express was supposedly on the verge of bankruptcy and the media was all over it, the customers never fled the company. In contrast, Bear Stearns collapsed without even missing a single payment simply because its customers fled.