Over the weekend Third Avenue Funds released their quarterly commentary, which always includes wonderful commentaries from their fund managers let by their Chairman Martin Whitman, whose investment philosophy as articulated by his shareholder letters and books, have become a key component to our core value investing philosophy at T&T. Whitman is unique in that he focuses much more on the balance sheet than the income statement. This the opposite of most modern investment analysis which is based on analyzing and predicting earnings. Whitman rationalizes this approach by emphasizing that value creation doesn’t always pass through the income statement as earnings, but instead can be created from more effective utilization of the balance sheet.
Wealth creation is defined as growth in net asset value which for many companies such as banks, insurance companies, and investment management companies, is defined by book value. Warren Buffett has always defined his success as an investor through the compounding of book value as opposed to earnings on any one year. Because of the limitation of General Accepted Accounting Principles, an analyst must make adjustments to the balance sheet and to earnings, to measure true intrinsic value. A perfect example of this is represented by the income statement and balance sheet of AIG in the last decade. AIG constantly had to increase their reserves for various insurance exposures which showed that their book value had almost always been overstated, and their prior quarters earnings were inflated due to lower reserve estimates. Management’s might be incentivized to juice short term earnings by improper reserving of future losses, because of bonus structures, or short term pressure to meet earnings estimates.
Whitman has always stated that intrinsic value can be created by super attractive access to capital, such as non-recourse mortgages that provide low cost financing without risk to the holding company. He also acknowledges that many times companies have assets such as real estate, patents, equipment, etc, that is not core to the operating activities of a business, that might be better utilized in a sale, spin off, sale lease-back, or other optimal resource allocation.
One of the biggest difficulties in investing is understanding management. Often times management has a short track record that makes it difficult to have a great deal of confidence that they will do what they say they will. Because of the short term focus on Wall Street, many CEO’s feel that need to meet next quarter’s earnings estimates instead of taking the steps to maximize shareholder value over the long term. When you have a management that can be trusted to act in the shareholder’s best interests, the value of the business is significantly greater. Activities such as share buybacks at discounts to intrinsic value can be extremely accretive, while value destroying mergers such as HPQ’s $10 billion acquisition of Autonomy can kill an investment. Whitman protects against risk by buying companies that have super strong financial positions, and that are trading at substantial discounts to NAV or “intrinsic value.” Ideally he’d like to also buy companies that can grow NAV by 10% annually over the next 3-7 years.
When we talk about a company such as Bank of America with a book value around $20 per share that should be able to grow that over time by about 10% a year, we believe we are meeting the requirements that Whitman looks for. The key issues are whether Bank of America is financially strong, which we believe they are now after substantial reserving and capital injections, and whether management is acting in shareholder’s best interests, which we do have confidence now after seeing the progress Brain Moynihan is making. Assuming the company is a survivor which seems very likely, the company should trade at tangible book value around $12.50, and we believe they should be able to grow that by 10-15% a year moving forward. Whitman’s checklist is one which we use on each security that we select and I felt it very much worthwhile to introduce him to those of you that aren’t familiar. Below you can find a link to his most recent letter: