Somebody Has to Pay For Lunch

Marty Whitman and the Aggressive Conservative Investor

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In the financial world, it tends to be misleading to state “There is no free lunch.” Rather the more meaningful comment is “Somebody has to pay for lunch.”

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Edge, if an investor has one, can only be revealed in time. Bill Gross, as told in Mary Child’s The Bond King, knew intimately the role “true odds” played when you had an edge, that time above nearly all else would ultimately reveal your advantage.

…[S]uccess relied on time, the “true odds” gamblers talk about—a long enough time span, a big enough data set, to reveal his 51 percent advantage. In the short term, he risked getting a random sample where the market vomited for no reason, or surged for no reason, where relationships between investments went sideways. In the true odds, he wins; without them, he could lose. If his strategies still worked, the only way to get the advantage was time.

Time betrayed Marty Whitman and his flagship Third Avenue Value Fund. The 2008 financial crisis wiped out a 17-year track record of outperformance. Whitman was nearly 84 years old at the time and handed off management to protégé Ian Lapey, whose subsequent five-year under-performance and the resulting 80% redemption of assets proved too yawning a gap for the Fund to ever return to its former glory. In 2015, when Whitman was 91, the firm faced another crisis when its high-yield fund had to freeze withdrawals.

This “random sample” coming at the twilight of Whitman’s career robbed him of the notoriety and reputation some of his less influential, and frankly, less interesting peers. Whitman is sometimes characterized as a deep value or distressed investor; he even wrote a book post-GFC about the subject. To me though, Whitman’s approach is wholly unique in the canon of Value Investing and his views heterodox from what defines asset management today. Whitman’s seminal work, the paradoxically titled “The Aggressive Conservative Investor” lays out a style of investing that is still novel over 40 years after its original publication.

Whitman can be verbose, sometimes leans academic and fans of Graham and Dodd will be repeatedly offended by his mischaracterization of their ideas. Nonetheless, I think the writing has a charm unto its own. Finally, those looking for a process will be disappointed as Whitman’s “Safe and Cheap” approach is more of an ethos than formula for analysis.

The aggressive conservative investor uses a credit-minded approach, focusing on financial integrity which, in close-to Whitman’s words is:

1. The company must have a strong financial position as measured by the absence of liabilities whether or not they are reflected on the Balance Sheet

2. Reasonably honest management

3. Relevant information disclosed with the understanding that it will be somewhat short of that mark

4. The price of the equity security can be bought below the investors reasonable estimate of Net Asset Value

Unlike Graham and Dodd and the financial accountants, we believe that a very large part of American businesses are engaged in asset-conversion activities: that is, they are not strict going concerns involved only in operations that result in recurring accounting earnings. Rather, many companies, in whole or in part, are engaged in asset-conversion activities that give rise to tax shelter, mergers and acquisitions, changes in control, liquidations, investment activities and major refinancings.

Whitman viewed the role of the corporation as generating corporate wealth and doing so required remaining credit worthy. Credit worthiness opened the toolbox of asset conversion and corporate wealth creation. For Whitman this meant most investors’ obsession with the “primacy of the income statement” was misguided.

On the other hand, in referring to “earning power” the stress is on wealth creation. There is no need to equate a past earnings record with earning power. There is no a priori reason to view accounting earnings as the best indicator of earning power. Among other things, the amount of resources in the business at a given moment may be as good or a better indicator of earning power.

Consuming cash to generate earnings, Whitman believed, was not indicative of a company’s ability to generate corporate wealth as it overlooked the resources required to generate those earnings.

The achievement of earnings as defined by GAAP does not even necessarily contribute to solvency. For example, in the early 1950’s a new cigarette called Parliament, the original filter cigarette, was introduced by Benson and Hedges, then a very small cigarette company. Parliaments were inordinately successful, and Benson and Hedges expanded by leaps and bounds. Unfortunately for Benson and Hedges, working capital requirements ballooned, since in its industry it was (and is) necessary that cigarette tobaccos be aged for an average of three years. The faster the Benson and Hedges business expanded, the more difficult it was to finance its requirements for larger inventories. The more Benson and Hedges expanded as a small independent, the greater its accounting earnings were and the closer the company came to insolvency. As a small independent operator, Benson and Hedges’ earnings were not “real.” They could be made real only by selling out to an entity that could finance Parliament’s expansion. Eventually, Benson and Hedges merged into Philip Morris, for whom Parliament’s earnings were, of course, completely real, because Philip Morris had sufficient financial resources to benefit fully from the expansion that was taking place.

Benson & Hedges Cigarettes

O.P.MI.

Whitman took a clear-eyed view of the place of the shareholder in corporate hierarchy and employed the acronym O.P.MI. to convey this concept: Outside, Passive, Minority Interest. He writes extensively about the difference between management and insiders relative to outside, non-control investors. He is a harsh critic of GAAP, GAAP expansion and what he calls the "disclosure explosion."

Whitman believed the best way to maintain financial statement integrity was to have financial statements that were directed narrowly to the company's creditors, not financial speculators. Whitman believed that adjusted numbers and increased disclosures in the form of non-GAAP metrics invite the opportunity for misleading presentation versus the simpler evaluation of credit worthiness. Understanding that nearly all presentation is limited by the "convention of conservatism" that discloses possible losses but not possible gains.

The goal of reality-for-all through GAAP is a mirage. Corporate life is too complicated to expect any system of measurement to reflect more than a few pertinent objective benchmarks; it cannot accurately—that is, realistically—report on all events and positions, especially since what is realistic frequently depends on the subjective interpretation of individual users of GAAP, as, for example, whether the first approach to valuation should be a going-concern approach or an asset-conversion approach.

Timely as ever, Whitman used inflation as an example of excessive disclosure that he felt was beyond the scope of financial statements.

We learned a great lesson from the current value accounting supplements of the early 1980s. Here inflation accounting was supposed to help the analyst appreciate that because of inflation many corporate depreciation charges were woefully insufficient to provide a reserve for replacing aging and obsolescing equipment. The current value supplement, however, could in no way account for the benefits to a company because inflation might make it prohibitively expensive for new entrants to come into the industry to compete with the company that had very modest sunk costs. Deciding what the net effect of rampant inflation might be on a company is a decision best left to a trained analyst, not a preparer of GAAP financial statements, albeit the non-GAAP disclosure of current value was helpful to the safe and cheap analyst trying to make investment judgments.

Whitman was also well ahead of his time in understanding the obscuring effects of the growing influence of intangible assets on GAAP financial statements.

GAAP becomes increasingly less descriptive of phenomena in our economy as intangible become more important as the principal elements of value and the principal sources of income.

Inefficient Markets

Foundational to this view was that much of Wall Street viewed shareholders as a single, monolithic class when in fact their motivations, time horizons and risk tolerances could lead to dramatically different approaches to valuation.

...it is impractical to view finance and investment problems as if there existed monolithic stockholders and monolithic corporations, or as if there was any necessary relationship between the value of a business and the price of its common stock.

Company X had a net worth of $475,000 has a specific meaning. In the world that we live in, virtually any individual who by any measure is worth around half a million is not in a position to calculate his wealth at any point of time with much accuracy unless the purpose for evaluation and conditions for liquidation are all specified. It will be one value for estate planning, another for income taxes and yet another in obtaining a loan.

Related to this view is a healthy agnosticism towards stock prices at any given moment. “Taking a private equity approach to public markets” is somewhere on the spectrum of in vogue to widely-mocked, but Whitman believed in the power of conviction that came from a deep understanding of a business’s fundamentals.

In gauging investment results for the vast majority of people and institutions, market performance at any moment should be given a weight of considerably more than zero and something quite a bit less than 100 percent. The precise weight, assuming that any precision is desirable or necessary, should be determined by the individual investor. Market performance as a gauge of how an investor is doing deserves 100 percent weight when the particular investor does not know anything about the company in which he is investing other than the most superficial stock market statistics, such as market price history, recent earnings, dividend rate, stock-ticker symbol, alleged sponsors and the latest popular ‘story.’

A Damn Poor Surrogate for Knowledge

Perhaps Whitman’s most famous quote is often mistakenly characterized as endorsement of concentration but which is actually an admonition to get into the “nitty gritty” fundamentals which “compensate for many errors that are bound to be made by all general economic crystal-ball gazers…”

We think diversification is only a surrogate, and usually a poor surrogate, for knowledge, control, and price consciousness.

Whitman believed the market and liquidity itself produced opportunities for one with adequate knowledge of business value to acquire stakes at a discount to Net Asset Value.

For us, markets are taken as given, something investors take advantage of because they understand a business.

Regarding the timing of those purchases or relative value considerations Whitman was equally ambivalent:

First, little or no time is spent attempting to gauge the general market outlook, examining technical positions or making business-cycle predictions. Put simply, there is no attempt to hold off buying until the investor believes stock prices are near bottom. Second, comparative analysis, though always a useful tool, tends to be less important than in other forms of fundamental analysis. The reason, of course, is that the investment goal for outside investors is to concentrate on acquiring reasonable values rather than on getting the best possible values.

The dreams of the roulette player, the horseplayer and the technical-market analyst are all variants of the same belief: that just by studying the previous spin of the wheel, the form sheet or the action of the market, a magic mathematical formula will enable the market player to use a ‘scientific system’ to beat the game.

The Balance Sheet and Net Asset Values

If Whitman did not believe in the “primacy of the income statement” he exalted the balance sheet as the crucial gauge of a company’s financial integrity — to the point of capitalizing nearly every corporate activity.

In safe and cheap, one tends to PV everything—asset values, liabilities, earnings, EBITDA, expenses—often converting fixed expenses into liabilities and assured earnings and cash flows into asset values.

The relevance of this approach seems especially appropriate today. As rates come off the lower bound their impact on asset values is amplified. Moreover, while some sectors have over-earned through and following the pandemic, Whitman’s safe-and-cheap approach naturally reduces the weight of those outliers by viewing the Company as a collection of resources and liabilities and seeks to purchase at a discount to Net Asset Value. Credit worthy, shareholder focused enterprises can undertake a variety of “asset conversion activities” that can close the net asset value gap, either through the share price or distributions.

This is really the essence of Marty Whitman’s contribution to investment philosophy — that firms, even if they appear asset-lite, are simply collections of productive assets with both disclosed and lurking liabilities. Whitman would have surely balked at Price-to-Sales ratios or discussions of Total Addressable Markets as meaningful inputs to an investment process. A Company’s ability to generate sales says nothing of its ability to generate corporate wealth.

As bankruptcies and distress across once high-flying growth companies accelerate Whitman’s credit-focused approach may find a new, more attentive audience. Whitman once said Companies survive, shareholders do not:

The biggest misconception is that the company will go out of business. That is typically not the case. Companies survive bankruptcy, stockholders very often don't. Another great misconception is that companies are too big to fail. That is the wrong way to analyze these problems. The right question to ask is whether companies have become too big not to be reorganized. Failure can be defined as what happened in the cases of AIG and Lehman Brothers, when the common stockholders got wiped out. But these companies survived, and their assets were put to other uses or other ownership.

Today, Whitman is rarely mentioned among the great investors of the past, but those of a certain disposition (me) find his work instantly edifying as a reasonable and rational approach to public equity investing. Whitman understood that as a common shareholder you are buying a levered instrument, typically in a non-control position. Viewing that investment from the seat of a creditor and justifying the risk in those terms is the hallmark of the “Aggressive Conservative Investor.”

Marty Whitman, Beyond Investing

Whitman passed away in 2018 and his official obituary is a moving tribute to man who thrived both professionally and personally. Born in Brooklyn in 1924 to Jewish refugees from Poland, Whitman would serve in the Miliary, on the Three-Mile Island Commission and become a “thoughtful philanthropist, a proud supporter of equal opportunity initiatives. His philanthropy was informed, in part, by his wartime observations of the military's ill-treatment of African American sailors.”

The business school at Whitman’s alma mater Syracuse bears his name, and he taught for years at the Yale School of Management. His 62-year marriage to Lois Quick, founder of Human Rights’ Children’s Rights Watch, bore three children: A Yale law professor, a Broadway producer and Swarthmore music professor.

Further…

Are markets always efficient? Read Marty Whitman’s Yale Insights article here about efficient market hypothesis to get a feel for his unique style and view of markets.

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