Buy Now, Get Paid Later

By RUSS WILES

Jan. 27, 1998 12 AM PT

Russ Wiles is a Mutual Fund Columnist For The Times

Martin Whitman can be described as three investors in one: a contrarian with a long-term focus who strives for tax efficiency.

He has guided the Third Avenue Value Fund to a 142% total return over the last five years, compared with 121% for the typical small-company value portfolio tracked by Morningstar Inc. of Chicago. Morningstar recognized Whitman’s talents early on, naming him fund manager of the year in 1990.

Whitman, a New York native who still lives in the city, entered the industry after college in 1950, and for the next two decades moved from research to investment banking to investing in bankrupt companies, all at different firms.

He entered the mutual fund business in 1984 and started Third Avenue Value in 1990. A successor fund, Third Avenue Small Cap Value, was unveiled last year, with Whitman as co-manager. With both funds, his hallmark is to buy stocks as if he were purchasing individual businesses.

Whitman, 73, also teaches a class in investing at Yale University’s school of management. He recently spoke to Russ Wiles, a mutual fund columnist for The Times.

Times: What’s your basic approach?

Whitman: All of our equity investments have three characteristics in common.

One, the companies we select have extremely strong financials, meaning a high-quality balance sheet and, in particular, an absence of liabilities.

Two, they are reasonably well-managed.

Three, they’re in businesses I can understand. In short, I’m looking for very strong businesses.

Times: You also want businesses that you can invest in cheaply?

Whitman: Yes. We don’t like to pay more than 50 cents for every dollar that we think a company is worth.

Times: Can you still find such screaming bargains after three years of abnormally large gains in the stock market?

Whitman: Oh, sure. The general market doesn’t count much. It’s really specific markets that matter. Over the last 20 years, during this fantastic bull market, virtually every industry has gone through its own bear market as severe as anything that was seen during the 1930s.

You people in California know what happened to real estate. We’ve also had problems in energy, autos, steel, banking and a lot more. Such industry declines are ongoing and they create opportunities. Almost all of the common stocks we buy are facing terrible near-term outlooks. But that’s how we get attractive pricing.

When we buy bonds, we often face an interruption in debt service. Other bond investors do a credit analysis to gauge whether there might be a money default, meaning a company can’t pay either interest or principal when due. With our type of analysis, we assume there will be a money default, and we want to see how we would come out in that situation. We buy senior securities [which would be entitled to a top claim on assets in the event of a bankruptcy]. I like to call them distressed bonds.

Times: How much do bonds account for in the Third Avenue fund?

Whitman: At the moment, almost nothing, but that could change if we found attractive opportunities.

Times: Let’s focus on stocks, then. Your relative performance against other small-company value funds has been impressive--Morningstar ranks you in the top quarter or so in terms of performance over the last five years. But that said, you lagged a bit in 1997. How come?

Whitman: We spent 1997 with about 40% of the portfolio in cash [which dampens returns in a rising market]. Now the cash position is around 36% and it’s heading south. Part of the problem is that so much money came into the fund from investors during the year.

Times: The fund nearly tripled in size during 1997. Given your value-oriented approach, it probably takes awhile for you to put new cash to work.

Whitman: We have ongoing orders to buy various stocks, but we have to buy them at the prices we want. During some recent, unsettling days in the market, I was able to invest $100 million pretty fast. In a matter of two or three weeks, cash dropped to 36% from 40%.

Times: Do you think your cash position will come down further?

Whitman: I think it will come down dramatically.

Times: Looking at your top holdings, it’s safe to say you have a large stake in financial companies.

Whitman: Financial and semiconductor equipment manufacturers account for the bulk of our portfolio.

I should add that we’re not a very diversified fund. Our 10 largest holdings account for maybe 45% of the equity portion of the portfolio. But your comment also is an unfair one. The reason I say that is there are various types of financial companies. Among our U.S. investments, our largest stake is in companies that have a large presence in money management.

We also own property/casualty companies whose results are driven by their expense ratio rather than their loss ratio. These are title insurers, mortgage insurers and surety companies. The third category we own are regional and community banks. All three groups are very distinct businesses.

Times: What do you mean by property/casualty companies whose results are driven by their expense ratios?

Whitman: Profits for plainvanilla property/casualty companies are determined by the amount of losses they sustain--auto insurers are a good example. But for other companies--the types we like--profits are determined by their expense structures rather than claims.

Title companies are a good example, such as First American Financial of Santa Ana, our largest holding. The results of these companies are driven by the expenses sustained by their research efforts--what they have to do before they write a policy. If they do the research right, they never face any losses.

Times: So how does your portfolio break down in terms of industry groups?

Whitman: Of our equity holdings, 19% of assets are in semiconductor equipment stocks; Japanese non-life insurers account for 16%; money management firms account for 15%; real estate stocks are at 13%; financial insurers are at 13%; and title insurers constitute 12%.

Times: What do you like about financial stocks in general?

Whitman: First, we never paid to get in. When we bought our money management stocks [several years ago], we did so by investing in brokerage firms that have money management affiliates. For the prices we paid, we got the money management businesses for nothing. Our holdings in this industry include Raymond James, our largest position, along with Alex. Brown & Sons, Legg Mason, ReliaStar, John Nuveen, SunAmerica and Liberty Financial.

When we bought our bank stocks in 1990 and 1991, we never paid as much as 80% of book value. When we bought the other insurers, we did so at a discount from adjusted book value. The only financial institutions we’re buying at the moment are the Japanese insurance companies. And here we aren’t paying even 50% of the firms’ asset values.

Times: Technology stocks--specifically, semiconductor equipment manufacturers--wouldn’t seem to be typical value investments. What do you like about the companies in this group?

Whitman: Over the long term, meaning three to 10 years out, these companies will see an explosion of growth, driven by the digital revolution.

Times: What stocks do you like in this field?

Whitman: FSI International is our biggest position. Our current favorites are FSI, Silicon Valley Group, Electroglas and KLA-Tencor. We also own Applied Materials, Electro Scientific Industries, Photronics, Speedfam International, Veeco Instruments and Zygo Corp. While I think this industry will have explosive growth, it’s pretty hard to know which companies will succeed or fail. That’s why we have diversified. We own a mix of companies covering the whole production cycle.

Times: Aren’t you concerned about the Asian slump and how it might affect these types of companies?

Whitman: Yes. The midterm outlook is pretty poor. I think these companies generally will have a tough 1998 and maybe 1999. But we never paid more than a 60% premium to book value. Each of these companies has a cash position that exceeds total book value liabilities. Their strong finances will give them staying power. I’m willing to live through it.

Times: Yet a completely different type of stock is your second-largest holding, Tejon Ranch, a big property owner in north Los Angeles County.

Whitman: Yes. In fact, we bought out Times Mirror’s stake in the company last July. [Times Mirror is the corporate parent of the Los Angeles Times.] Tejon is a debt-free company for which we paid less than $650 an acre.

I think they have wonderful development opportunities. . . . Above all, I think the management is solid. It’s the right team to exploit the company’s 270,000 acres. Their holdings include 32 miles of frontage along Interstate 5.

Times: Do you own any other real estate companies?

Whitman: Yes. Real estate weighs in with 13% of the equity portion of our portfolio. Other holdings include Forest City Enterprises and Koger Equity.

Times: Do you spend a lot of time visiting companies?

Whitman: It depends. For example, we’re intimate with the managements of the U.S. financial insurance stocks that we own. But of the Japanese insurers, I wouldn’t know enough to get out of my own way in my relationship with those fellows.

Times: What attracted you to Japanese insurance companies?

Whitman: The companies we’re buying are the only financial institutions that are capital-rich in an economy that is capital-short. The two key types of stocks we’re buying these days are U.S. semiconductor equipment manufacturers and Japanese insurers. We’re also trying hard to make a major commitment to well-capitalized Japanese banks. As yet, we haven’t been able to buy anything at the discounts we want, but we’re working hard at it.

Times: Are you looking at foreign markets other than Japan?

Whitman: No. It’s not our style to be involved in countries that are less industrialized and don’t have high political stability. We probably wouldn’t be too successful in emerging markets.

Times: Your fund has low portfolio turnover, meaning that you don’t sell stocks very often.

Whitman: It’s true. We’ll sell in a flash if we think there’s a permanent impairment of capital--that is, if the fundamentals of the business have deteriorated. But not just in the event of a stock market decline. We treat our holdings like we own these businesses. . . . We try to be tax-efficient, and I think we’ve been extraordinarily successful. I might add that while we invest in some dividend-paying stocks, we don’t pay much attention to dividends. We invest based on the value of a business. The dividend is irrelevant to that.

Times: Do you have an outlook for the U.S. stock market?

Whitman: I don’t have a clue. One of my proudest moments came when a journalist interviewed me and asked if I resented being called a “vulture investor.” I said I’d rather be called a vulture investor than a market strategist. I mean, who knows where the market is going?

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Third Avenue Value Fund

Strategy: The fund seeks long-term capital appreciation by investing in small-capitalization companies with strong balance sheets and good managements, and which are believed to be significantly undervalued.

Vital Statistics:

1997 return: +23.9%

Avg. small-cap value fund, 1997 return: +27.8%

5-year average annual return through 1997: +19.4%

Avg. small-cap value fund, 5-year avg. return: +17.2%

Five biggest holdings as of Dec. 31:

1. First American Financial

2. Tejon Ranch

3. Tokio Marine & Fire Insurance

4. Financial Security Assurance Holdings

5. FSI International

Sales charge: None