Sunday, April 09, 2006

A Legend: Marty Whitman from Third Avenue Funds
Explains His Take on “Net Nets” (aka companies trading below their net current asset value)

To me, Marty Whitman is truly a living legend in the world of value investing. Here’s the disclaimer: I’ve owned Third Avenues Small Cap Value Fund for several years. I’ve heard Marty speak, and I’ve spoken with him. So he’s a little cranky from time to time, that’s okay, he’s allowed. To be in this is business at his age (he’ll be 82 in September), as good as he’s been, and as much clarity as he’s brought to the world of value investing, a little crankyness is just fine with me. (Even your Cheap Stocks editor can be a bit of a curmudgeon from time to time. Just ask Mrs. Cheap Stocks editor…)

So I was very pleased upon receiving his latest letter to shareholders (dated January 31, 2006)
to notice his discussion on "net nets", otherwise known as companies trading below net current asset value. Whitman starts the "net net" discussion by disclosing that over 80 % of the Third Avenue Value Funds (the larger cap version of the fund I own) were bought at prices
" which at the time of acquisition, represented meaningful discounts from readily ascertainable net asset values.
After reading this I was astonished, wondering why I’d never discovered the plethora of companies Whitman has? The reason is because Marty is a genius who takes the whole concept of “net nets” to the next level…a level of sophistication, insight, and research that is far beyond the scope of our “Cheap Stocks” research. (Not that we couldn’t take it to that level, mind you, unfortunately our time is limited, and I only wish this was my full-time job).

Later, Whitman explains this better:
"Rarely (except for cash and equivalents) were these readily ascertainable asset values classified as current assets under Generally Accepted Accounting Principles ("GAAP"). The Fund’s definition of “Net-Nets” is taken from Graham and Dodd’s Security Analysis, but with a few twists. Graham and Dodd relied on a GAAP classified balance sheet to define current assets in order to ascertain if a common stock was a Net-Net. TAVF (Third Avenue Value Funds) uses its own judgement rather than GAAP classification to define current assets in order to decide what is a liquid, i.e., current asset." we are getting somewhere. Here at Cheap Stocks, we are using Graham and Dodd’s interpretation, not that that is the only way. In Marty’s world, you can’t manage significant amounts of money looking for net-nets the way we do here at Cheap Stocks. There simply is not a big enough pool of them available and, the large majority are micro caps. That’s where we come in. Since most of the net-nets we research are far too small to have a great deal of institutional interest, they tend to languish, unnoticed by the market. Therein lies the opportunity for the small investor.

Back to Marty Whitman’s interpretation. He goes onto describe the differences between TAVF’s net-net process and Graham and Dodd’s:
"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, costs in excess of billings, 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."
We certainly agree with Marty on these points. We place a much greater degree of value on cash and marketable securities than we do on other current asset accounts, but truth be told, here at Cheap Stocks, we do cover some companies that are not extremely well financed. That is one reason they are so "cheap", and its our charge to try and determine whether there’s any life left in these companies. We are not always right. But we don’t need to be. In this realm of deep value investing, it is not wise to concentrate too much money in too few companies.

Marty continues
"Second, many current assets classified as current assets under 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."
Again, we couldn’t agree more. When current assets are primarily inventory, we are much more skeptical of whether the NCAV calculation reveals true undervaluation. All else being equal, we like our current assets in cash and short-term marketable securities.

Marty continues down the inventory path
:"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 mislocation."

"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."
The takeaway here is that is extremely important to read the footnotes in a companies SEC filing. You need to know what you are buying. Think of the footnotes as the "fine print".

"Fourth, Graham and Dodd only seem to recognize partially that certain fixed assets,e.g.m property, plant and equipment, can sometimes create cash."
Let me handle this one, Mr, Graham, and Mr. Dodd: we at Cheapstocks want to be aware of the non-current assets, we don’t ignore them. We simply don’t include them in the calculation. This creates a safety net of sorts, depending on how valuable these assets may be. Essentially, we value the company as (Current Assts) – (Current Liabilities) – (Other long term liabilities), "ignoring", at least in the calculation, the potential value of property, plant and equipment, and any other long-term assets. (Certainly, we are interested in those assets, and knowing what they are.)

Whitman closes with the following:
"When all is said and done, however, TAVF management owes an enormous debt of gratitude to Graham and Dodd for introducing the concept of Net-Nets. It remains the most important part of the Fund’s common stock portfolio."

Well said, Marty.

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