Sunday, March 8, 2009 0 comments

Martin Whitman 1Q2009 shareholder letter

Thanks to GuruFocus for pointing me to Martin Whitman's latest shareholder letter. Martin Whitman is coming off probably his worst year ever and he seems to be going back to his bread & butter of distressed investing, primarily through senior bonds. If you are following Whitman through his buys/sells, it's difficult to get a handle on anything because he is forced to sell a lot of securities due to mutual fund redemptions.

The current letter also mentions his defintion of a net-net stock versus the Graham & Dodd definition. Here are some of my thoughts on his comments:

Distressed Investing

Whitman is moving heavily into distressed bonds and here is an example of his Nortel bond purchase:

The Nortel Seniors were acquired at around 17¢ on the dollar. Nortel, a giant world-wide provider of telecommunications services and equipment, is now in bankruptcy operating under the Canadian CCAA Bankruptcy Statute and U.S. Chapter 11. It appears as if the sale of the company, or much of its asset base, to a financially strong U.S. telecommunications company is a reasonable prospect.

However, much uncertainty attaches to Nortel. There is comfort, though, in the 17¢ price and in the knowledge that the Nortel Seniors are the most senior issue in the Nortel capitalization.

In my opinion, "safe" distressed investing is difficult for amateurs. The problem is that one generally needs to own bonds in bankruptcy. My impression is that this wasn't the case 50 years ago, when owning shares of bankrupt firms may have sufficient. Distressed bonds are not friendly to small investors at all. It is "easier" and often cheaper for you to buy shares in some foreign country you have never heard of than it is to buy bonds.

One also needs to study all the debt instruments and get a good idea of legal rights afforded to various bondholders. Martin Whitman likes to buy the most senior securities and it may be difficult for small investors to do that. I don't invest in bonds but from some research and queries I have made to several brokers (at least in Canada,) senior bonds are hard to acquire, whereas junior subordinated bonds are easier to acquire.

At times, Whitman also likes to acquire blocking interest so that he can influence the restructuring or bankruptcy proceedings. Clearly small investors can't do that.

Potential Inflation?

The multi-trillion dollar stimulus packages could result in rampant inflation during the next two to three years. The stimulus packages don’t necessarily have to have an inflationary result, but they easily could.

I see many individuals, ranging from Warren Buffett to Jim Rogers to David Einhorn to, now Martin Whitman, warning about the potential for high inflation. I have a dissenting view that inflation is unlikely to be high in the future (unless policymakers purposely pursue that--in this case, we'll get obvious signals ahead of time.) I keep thinking about this and I honestly don't understand why all these great investors warn about inflation. Can I be wrong? It remains to be seen.


Martin Whitman says that most of his stock holdings are in net-nets. I'm not sure if he invested originally into a net-net or if these became net-nets after the price declines. In any case, he comments extensively on how his definition of net-net differs from that of Graham & Dodd:

While Graham and Dodd seem to have invented the idea of Net-Nets, TAVF uses that idea with a number of modifications.

First, the Fund is not interested in Net-Nets unless the company is extremely well financed. A large quantity of current assets, especially if they consist of inventories, billings in excess of costs, or receivables from less than credit-worthy customers, probably cannot help the common stock of a company which cannot meet its obligations to its creditors.

Second, many current assets classified as current assets under Generally Accepted Accounting Principles (“GAAP”) are really fixed assets of the worst sort. Take department store merchandise inventories. If the department store is to be liquidated, merchandise inventories are indeed a current asset, convertible to cash within 12 months at prices that conceivably could be close to book value, although much less than book value may be realized if the merchandise is disposed of in a GOB (Going Out of Business) sale. On the other hand, if the department store is a going concern, merchandise inventories are a fixed asset of the worst sort. The merchandise inventories have to be replaced, are hard to value, and are subject to markdowns, obsolescence, shrinkage, seasonality and misallocation. The Toyota Industries portfolio of marketable securities, the majority of which consists of Toyota Motor Common Stock, seems to be much more of a current asset than department store merchandise inventories even though, for GAAP purposes, Toyota Industries’ marketable securities are not considered a current asset.

Third, the Graham and Dodd formulation does not account for off-balance sheet liabilities which may, or may not, be disclosed in footnotes; nor do Graham and Dodd take into account excessive expenses or losses. At TAVF, such expenses or losses are capitalized and added to liabilities.

Fourth, Graham and Dodd only seem to recognize partially that certain fixed assets, e.g., property, plant and equipment, can sometimes create cash. For example, under Section 1231 of the U.S. Internal Revenue Code, the sale at a loss of such assets used in a trade or business, usually gives rise to an ordinary loss for income tax purposes. Such loss will generally produce cash savings by reducing current year tax liability, or if the business has an overall operating loss, the corporation may be able to get a “quickie” cash refund of certain prior year taxes from the IRS.

I think anyone investing in net-nets should consider the comments by Whitman. Some of the suggestions by Martin Whitman modernizes the Graham & Dodd formulation. For instance, I suspect that off-balance-sheet liabilities weren't a big deal when Graham & Dodd were around but are potentially huge right now. To make matters worse, bad management tries to obfuscate the details so one needs to do some thinking.

The identification of Net-Nets has not proved that difficult for the Fund, even though most of the new investments now are outside the United States. The toughest problem faced by TAVF, by far, is to identify managements and control groups of these Net-Nets who are both able and conscious of the interests of outside, passive, minority investors, such as Third Avenue.

Unlike 50 years ago, when one had to manually run through stock guides and the like to discover net-nets, this job isn't so hard these days. You can find stock filters on websites that allow you to automatically scan for net-nets (this is the case of American exchanges but it's difficult to find free filters for foreign exchanges.) One still needs to double-check the financial statements to make sure the auomated numbers are correct but the job doesn't seem so hard.

As Whitman points out, what is hard, however, is finding a business that will not destroy shareholder value. It's quite easy for management to blow away the excess cash cushion. I would say that you either need a shareholder activist already owning the company or need to own a lot of net-nets (as Graham suggested.)

If you are interested in net-nets, Cheap Stocks is a blog that caters to such companies. I also recently came across Greenbackd, a blog that focuses on investing in (generally) net-nets with some shareholder activism behind it.

My macro-influenced opinion is that net-nets will do well (relatively speaking) if we enter a severe recession or depression-type scenario. If we get an economic recovery then I think buying high quality companies with good future prospects will likely outperform net-nets. This is not to say that net-nets won't make money--in fact they may be quicker to realize a profit--but the long-term returns may be weak.


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