MI378: The Aggressive Conservative Investor: Lessons From Martin Whitman w/ Shawn O'Malley

24:24I can still appreciate though the unique perspective that Whitman brings here. A related pitfall is in trying to wait for the perfect moment to buy a stock, either through some form of technical analysis or market timing using macroeconomic indicators. This is a pitfall because as Whitman writes, as an investor, the goal is to concentrate on acquiring reasonable values rather than on getting the best possible values. The dreams of roulette player, the horse player, 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.

25:02In other words, not getting the best price is okay, because a good enough price will be more than good in the long term, and the act of trying to wait for the perfect price is a problematic premise unto itself. Another topic that I enjoyed from reading through Whitman's books and shareholder letters is that investing requires both quantitative and qualitative considerations. Quantitatively, we obviously want to judge companies by their returns and the health of their balance sheet, but we also want to judge the management teams running the company on behalf of shareholders. This is much more subjective, but Whitman offers three factors to consider.

25:37As shareholders and long-term investors intending to think like owners of the companies we invest in, we should evaluate management based on their ability to act as operators, investors, and financiers. That is to say, not only must management teams be operationally excellent in terms of managing logistics efficiently and managing employees well with a healthy corporate culture, but they also must be investors, determining the best ways to allocate corporate resources to create value for shareholders, as well as financiers, determining when and how to raise funds to support the business. Plenty of executive teams excel in one or two of these areas, but being able to do all three well on behalf of shareholders is rare.

26:15If you've read the book, The Outsiders, you'll know this well, but most people really think of management as only being there to oversee the daily operations and strategy of a company, not to act as investors or financiers, but an ability to wear all three hats is a telltale sign of a wonderful management team that investors should want to invest in. All these takeaways so far have been pretty high level, so let's get in the weeds a bit and actually look over some of Whitman's letters to investors and his funds through Third Avenue. Let's begin with his 1989 letter. Despite his later warnings on the importance of credit worthiness, Whitman wrote much of his 1989 letter to shareholders focused on the opposite in discussing opportunities in troubled companies that have either already defaulted or seem likely to soon.

26:58And this is, of course, where he gets his reputation for being a vulture investor, which I mentioned earlier. He clarifies that he doesn't do this, though, as an equity investor, but instead as a creditor buying up the company's bonds on the cheap. This was certainly truer than it is today, but he says that there wasn't much competition in making these types of investments, leaving his team able to earn returns that averaged 20 % per year. In part, that may have been because investing in the securities of bankrupt companies was an even more niche domain in the 80s than it is today, where investors tended to be more concerned with defensively buying stocks and bonds of companies that were unlikely to ever go into bankruptcy, rather than trying to anticipate what would happen if and when a company came out on the other side of a bankruptcy restructuring.

27:40Doing this well obviously takes not only investing expertise, but also considerable familiarity with bankruptcy law. Much of what Whitman was doing at this time was intensive and expensive, ranging from working with lawyers to unified creditors and negotiating restructurings in bankruptcy court to consulting with investment bankers and accountants. So it's not particularly replicable for everyday investors, but it is an illustration of the links to which some on Wall Street go to earn above average returns. You can imagine just how dense a lot of the legal paperwork is that they would be scouring through to try and figure out if they could buy a bankrupt company's bonds for 25 cents on the dollar and get repaid 40 cents on the dollar from the liquidation of the company's assets.

28:18In that example, paying 25 cents to get repaid 40 cents is a 60 % return, even though the company is not repaying more than half the debt they owe. But bankruptcy can be extremely messy and complicated, and you can just as easily lose nearly everything. Plenty of investors would rather be done with it and maybe willing to sell their bankruptcy claims at steep discounts just to get some cash back. So as I said, certain investment firms may own bonds that entitle them to be repaid, say$1 ,000 per bond, and they might be trying to just take their losses and move on. In doing so, they'd sell their distressed bonds for$250 to someone like Martin Whitman, who would write out the pains and uncertainty of the bankruptcy process and earn considerable returns if even just half the bond's value is recouped.

29:00I want to reiterate again that this is a form of bond investing, not stock investing. In this same letter, Whitman notes that when investing in equity as a shareholder, he only considers companies in extremely strong financial positions with effective or at least honest management and where the price of the stock is available at a discount to its intrinsic value. My takeaway from this 1989 letter is that there are, of course, a variety of different ways to make money as an investor and even as what you might call a value investor. And depending on what type of assets you're investing in, you would prioritize very different things.

29:32Investing in distressed bonds, as Whitman has, is just as valid a strategy as investing in the stocks of well-run companies, though the timeframes and criteria you use are very different. Whitman uses vastly different frameworks depending on what are essentially the legal protections afforded to him. As a senior creditor, he not only gets paid back in bankruptcy before shareholders, but also before other types of lenders. So Whitman has a substantial degree of legal protection that gives him the confidence to buy up the debt securities of even bankrupt companies because he knows that if he can buy them for cheap enough, he can still earn a handsome profit once the messy bankruptcy process has been completed.

30:07This just takes a ton of legwork since you're quite literally estimating what a company can sell its assets for. With a retailer like, say, JCPenney, you'd be trying to figure out after selling its inventory of clothes and properties, how much money is left over to repay outstanding debts, and if there's not enough, how much different groups of creditors are likely to recover. So it's just a tough game to play. However, as a stock investor, his risk tolerance is completely different because his legal protections are far less. Shareholders own everything that's left over in a company after all debts have been repaid.

30:39That's why as a stock investor, it's so important to focus on a business's financial health because the risk that you'll incur a 100 % loss is possible in a way that would be very unlikely for creditors. Creditors are likely to at least get back pennies on the dollar. As Whitman puts it, separately in The Aggressive Conservative Investor, quote, 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.

31:11The 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. This just hammers in the message that bond investing and stock investing are very different, and those differences become particularly apparent in bankruptcy. Yet what's unique about Whitman is that he brings a bond investor's perspective to stock investing. Here's another passage from him. Quote, It has been our observation that the most successful activists have had much the same approach to investing that the most sophisticated creditors have had toward lending.

31:48Essentially, these people approach a transaction with two attitudes. The first having to do with their order of priorities. In looking at a transaction, the single most important question seems to be, what have I got to lose? Only when it seems that risk can be controlled or minimized, does the second question come up, how much can I make? He adds, the second attitude has to do with a basic feeling that risk, how much one can lose, is essentially measured internally, not externally. The possibilities of unsatisfactory results from an investment or loan are to be found internally in the performance of the underlying business and the resources in the business, not externally in market prices at which a company's securities might trade.

32:24Successful activists and creditors, while not unmindful of the value messages that are delivered by markets, tend not to be overly influenced by such messages. As far as my objectives are concerned, I know much more about the situations in which I invest or in which I lend than the stock market does. So Whitman categorizes distress investing as a form of what he refers to as performance investing, where you're looking for a defined catalyst, like the end of bankruptcy, to drive price appreciation in the short term. He writes, quote, I'm not against performance investing, but it tends to be a lot harder to do successfully than value investing.

32:58He continues by saying, quote, value investing has its problems. The biggest single one seems to be that companies invested in frequently are run by conservative, deeply entrenched managements who care a lot less than shareholders do about when good stock market price performance will occur. Even given this, he says, I believe that a portfolio of well-selected value stocks ought to earn reasonably satisfactory returns and ought to entail reasonably small investment risks. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you.

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36:41That's theinvestorspodcast.com slash TIP-finance. All right, back to the show. So in 1989, Whitman saw opportunities in the distressed debt of companies in or near bankruptcy that he couldn't pass up because he could purchase bonds and earn 20 % returns or more by holding them through the bankruptcy process. Yet, even with those sorts of attractive opportunities, he remained partial to classic buy and hold stock investing, particularly when he could take advantage of Mr. Market's mood swings to buy up shares at a hefty discount. Still, he didn't have any illusions about what it means to be a shareholder in a public company.

37:18Throughout his writings, you'll see the acronym OPMI, which stands for Outside Passive Minority Interest. That is to say, when you buy a stock in your brokerage account, you do own shares in the company, but unless you're a high-ranking employee who can make key business decisions, then you're an outsider. And without being a management insider or wielding a large enough stake to affect shareholder votes, your relationship with the company is more passive than active. Outside minority shareholders ride the bus, while insiders or investors with controlling stakes drive it. While having an owner's mindset will help an OPMI investor tremendously in deciding what companies to invest in and at what prices, this shouldn't be confused with OPMI investors actually having sway over their portfolio companies.

37:59And while I know that many of the listeners of the show are not the types of people who are engaging in short-term, highly speculative trading, the reality is that most OPMI investors are. Whitman argues that regulators like the Securities and Exchange Commission and industry groups like the Financial Accounting Standards Boards, which set the generally accepted accounting principles, also known as GAAP, that public companies in the US adhere to, pressure companies to tailor their disclosures to OPMI investors, which drives them to focus more on short-term developments. In his view, financial statements should be created narrowly with creditors in mind, not the sort of financial speculators who are likely to buy shares on an OPMI basis based on, for example, whether the company beat earnings projections in a given quarter.

38:41This has led to infamous examples of companies creating their own non-GAAP adjusted measurements of performance that served only to misinform and exploit OPMI investors. EBITDA has become one such metric that is particularly mainstream, but there are far more egregious examples where companies disregard costs associated with stock-based compensation, depreciation, or capital expenditures to create an adjusted measure of profitability for their industry that makes their business look artificially better than it is. Whitman writes, quote, 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.

39:19It cannot accurately, that is realistically, report on all events and positions, especially since what is realistic frequently depends on subjective interpretation. The determination being that when statements catered to OPMI stock investors, the focus is on pitching them some optimistic version of the company. Creditors, however, do not care about the optimistic visions for the future because they do not stand to benefit from them. All they need is for the company to be able to repay its debts, so creditors tend to be far more conservative in their assumptions. There is no upside for them in buying into the hype, only downside if it works out poorly.

39:53When lending to companies, creditors are more inclined to consider everything that could go wrong rather than to dream about what might go right. Again, in Whitman's view, this conservatism from companies and their statements and disclosures, where they try to be as modest as possible about the future and honestly communicate the risks they're facing, would be far better for financial markets than allowing companies to cater to equity investors who inherently are telling an optimistic story about the company where its share price appreciates in value. For the record, I do not necessarily agree or disagree with this view, but I can at least appreciate the argument he's making.

40:26You can also see the value in bringing this conservative creditor mindset to making stock investments too. On top of this, Whitman discusses in his various writings that valuation depends on perspective. How the government values the company and determines its tax liabilities differs from gap accounting and how companies report their financial results to the public, or how different stakeholders might focus on different things. One company looking to acquire another might focus on in the weeds details like balance sheet assets and liabilities, tax loss carry forwards, access to financing, and how asset values are carried on the target's balance sheet, which are relevant to how a merger would directly affect their own financial standing, whereas the typical Wall Street analyst is looking at a company in a vacuum and valuing it primarily off its earnings results.

41:09Valuation then is somewhat a question of what angle you're coming at an investment from, whether as the management of a competitor company, as the government, as an institutional investor on Wall Street, or as a retail investor. I'm going to go on a brief tangent here, but related to this, which I'll link to in the show notes is Whitman's thoughts on whether markets are efficient and reflect all available information. In an article for the Yale School of Management, he discusses how markets made up of different types of participants will trend more or less toward efficiency. Similar to how approaches to valuation can differ depending on who you are, the same is essentially true for market efficiency.

41:45Not all markets are equally efficient, and participants in different markets will face different degrees of efficiency. In public stock markets with OPMI investors, as he calls them, where barriers to participation are low and there's a lack of control over the company, as well as a lack of inside information among those who are trading back and forth, then there will be a trend toward efficiency. In more esoteric markets, like the market for distressed bonds of companies going through bankruptcy, where complexity rules the day, the market is less likely to be efficient, meaning there are opportunities for abnormal profits to be earned by skilled investors.

42:19It is also a question of time horizon too. The investor trading on very short time horizons is likely going against a highly efficient market where there's little opportunity to reliably exploit edges for profit. On longer time horizons, there are just fewer people with that kind of patience to compete against, so a long-term focused investor will go up against less efficient markets to their potential advantage. And lastly, he uses the term external forces to describe the effects of competition and regulation on market efficiency. A market where there is a central exchange, where a great number of people can express their opinion on a price, like the New York Stock Exchange, leads to more efficiency, while less centralized and transparent markets tend to be less efficient.

43:01Real estate, for example, is generally far less efficient than the stock market. There are only a few people bidding on the price of any one house up for sale, and there are intermediaries in the way, and as a result, you're far likelier to find a mispriced house at a discount to its value then you are to find a mispriced stock. Regulators that work to define and enforce the rules of a market, like punishing insider trading, help ensure that the market is more efficient. A country with weak regulatory institutions or a weak legal system is more likely to also have an inefficient stock market that misprices assets.

43:32So when discussing efficiency and the corresponding opportunities to reliably earn market-beating profits, you have to consider the type of market you're talking about, the time horizon, how strong the external forces are, and the complexity of the market. All around us, there are markets defined by these factors with different degrees of efficiency, ranging from the market for sports betting to real estate, to the stock market, credit markets, and the market for companies to acquire competitors. Coming back from that tangent on market efficiency, I want to discuss further Whitman's issues with gap accounting, particularly for the income statement.

44:04He uses some very technical examples to showcase the shortcomings of gap accounting, but in short, the lesson is that accountants are often forced to make trade-offs that really should be left to investors to make. In one example in the 1980s, he talks about how rampant inflation was making everything more expensive, including the barriers to entry to compete in certain industries. Whereas a factory might have cost$10 million to build before, as costs for all the equipment and labor needed rose, building a factory from scratch might have risen to cost$15 million. Companies faced offsetting effects from this, though.

44:34On the one hand, if they build a factory when it only costs$1 million to do so, the depreciation charges on their income statements would not properly reflect the fact that now it's considerably more expensive to build that same factory, which is a cost they would eventually have to incur as they maintain and replace facilities. Yet, on the other hand, these higher costs make it harder for new competition to build factories too, which is an advantage for companies that had made these investments before a surge in inflation. Deciding how to account for the net effects of rampant inflation then, in Whitman's opinion, was better left for financial analysts and investors to determine, not accountants preparing audited financial statements who tried to make what's known as current value supplements to reflect the current market value of company assets after a bout of inflation.

45:18It is more technical than this, but for the sake of brevity, I just wanted to make that very simple outline of Whitman's issues with relying too heavily on accounting standards to accurately reflect the realities businesses are facing. Studying Whitman closely is interesting in part because he really does embrace thinking like a creditor to an extent that he disagrees with great investors like Warren Buffett. You can say pretty safely that Buffett is a master of thinking like a shareholder, and therefore an owner in the business, and finding companies that run themselves accordingly to invest in.

45:48One example of that is avoiding companies that abuse stock-based compensation programs and excessively issue stock options to their management teams. That's because issuing stock in this way increases the number of shares outstanding for a company, which dilutes existing shareholders' ownership stake in the company, which reduces the returns they earn over time. You're splitting up the same pie more ways, and everyone gets a smaller slice to make way for those who receive the stock options. Looking at this issue from the perspective of a shareholder, Buffett concludes that stock options are very much a real expense that must be accounted for since they reduce the wealth of existing shareholders who own the company.

46:21Yet, stock options are not a cost paid in cash, and Whitman, like any true creditor, prioritizes cash flows in and out over anything else. In his Q3 2004 letter to shareholders, Whitman rails against accounting rules moving toward counting stock-based compensation as a real cost. He writes, quote, there seems no rationale whatsoever for equating the value of a non-cash benefit to a recipient from an executive receiving a stock option to the real cost to the company to bestow that benefit. It seems doubtful that the real cost to the company for issuing the stock option benefit is measurable, while the value of the benefit to the recipient of the benefit seems measurable.

46:56For the record, that is a very, very wordy way of saying if a company issues stock options to executives, it gets the benefit of compensating executives for the work they perform while not actually having to pay them in cash. And since cash is the lifeblood of any business, he takes that to be a good thing. He even suggests that from a creditor's perspective, any cash payouts to shareholders, either via dividends or share buybacks are essentially a negative because they reduce the company's cash balance, which effectively makes the company more leverage. I can definitely appreciate this perspective if one were to only invest in corporate bonds, but I really don't agree with this thinking at all on stock-based compensation, at least from the perspective of equity investors.

47:35It's similar to how depreciation is a non-cash item in accounting, but still a real cost to account for over time. Car owners will certainly understand this since they have to pay over time to service their vehicles to keep them operating. That wear and tear on a vehicle is a real cost because relative to a new car, an older car it requires much more maintenance. Like depreciation, stock-based compensation is a real cost to shareholders, even if that cost doesn't show up as cash leaving the business today. It is a longer-term and more indirect form of cost. To wrap things up today, I'll say that, as we've covered, Whitman's investment philosophy is centered on the belief that a company's true value lies in its balance sheet, its collection of assets and liabilities.

48:16By capitalizing as many aspects of a company's activities as possible, including assured earnings and fixed expenses, Whitman sought to identify investments that were safe and cheap, in his words, which traded at a discount to their intrinsic value. But for him, safety took priority over cheapness, and safety meant that an investment was one where a long-term investor was unlikely to suffer a loss. Of course, to an extent, the two are interrelated, and cheapness does afford some safety. Whitman emphasized the importance of assessing intrinsic value through the balance sheet over popular metrics like sales or earnings ratios, arguing that the ability to generate corporate wealth, with wealth being defined as the difference between assets and liabilities, is more important than simply generating revenue.

48:59As the investor Hunter Hopcroft puts it, today, Whitman is rarely mentioned among the great investors of the past, but those of a certain disposition will find his work instantly edifying as a reasonable and rational approach to public equity investing. Whitman understands that as a common shareholder, you're buying a levered instrument, typically in a non-controlling 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. In 2015, one of Whitman's colleagues, Peter Lupoff, told the Wall Street Journal that, quote, Marty was an academic at heart who approached every day as if the workplace were a laboratory to test his theory of deep value investing.

49:38While there are aspects of Whitman's career and philosophy that are compelling, his downfall has undoubtedly affected his legacy. From December 2007 through 2015, Whitman's flagship fund fell from managing almost$11 billion to less than$2 billion, as investors pulled their money while Third Avenue delivered paltry returns. Intellectually, it's not controversial to say that Whitman really did contribute to the investing world. Whether you think he is a great investor in his own right, though, is more up for debate. On the one hand, he pioneered novel forms of investing, especially in buying up the securities of bankrupt companies, yet his ethos of buying safe and cheap companies, which was meant to protect him from worst case scenarios, they helped to hold up during the 2008 financial crisis.

50:18While many well-regarded investors were caught up in the once-in-a-generation type of crisis that 2008 was, due to his age, Whitman was unable to find redemption in the same way that other investors like Bill Miller have. My colleague at The Investor's Podcast, William Green of our Richer, Wiser, Happier podcast, knew Marty well. And I'd like to share a clip with you of William reflecting on his conversations with Marty after the financial crisis? I said to Marty, you know, you didn't really handle the financial crisis well. And not only didn't you handle the financial crisis well, but then the rebound afterwards, you didn't really handle that well.

50:52And I said, how come? Like, given the strength of your ideas, given how smart you are, given how robust your ideas are, I don't get why you didn't do better. And it was a question based on the fact that actually I knew a lot about Marty Whitman. And so I was able to ask him this kind of important question that wasn't just important. And it was like I was wrestling with what on earth happened. And he happens to be a very honest and direct guy. And he said to me, you know, as I got older and richer, I became lazier. And he said, I kind of took my eye off the ball. And he said, I owned housing related stocks and insurance related stocks going into the financial crisis in 2008.

51:26He said, I kind of thought about selling and I never got around to it. And it was an incredibly candid, honest admission. And to me, a really powerful reminder of just how difficult this profession is. to be a great investor, you've got to be full on. And he was in his 80s at that point, if I remember rightly. And I think he was slowing down a bit and he had been an extraordinary investor. So Whitman is human, and you might say Whitman was facing more structural challenges. Whitman's balance sheet focused flavor of investing has gone out of sale as tech companies have come to increasingly dominate financial markets where their assets are primarily intangible and much harder to quantify.

52:06I found his approach interesting, but I can also see why it may have been best suited for a period of time like the 1980s and 1990s and hasn't aged well as the structure of the economy and financial system have changed. Still, I'd venture to say we can all learn a thing or two from thinking like an aggressive conservative investor. On that note, I'll leave you all with one last quote from Martin Whitman to wrap things up today. Quote, most people who trade common stocks, as opposed to those who hold common stocks, seem to be more interested in the near-term outlook than in anything else. They will not purchase a security if the near-term outlook looks bad or uncertain, regardless of the price at which it is selling.

52:43An investor who is able to take positions based on other factors increases his chances of finding outstanding long-term bargains since there is a relative lack of competition in the market in which he's buying. I hope then, as Whitman tells us, we can all turn our focus to the longer term, where markets are less efficient and offer better bargains. That's all for today's episode and I hope to see you again next week. Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com.

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