I spent the weekend in a cabin in the Catskill Mountains in New York. In between hikes I spent a lot of time by the fire reading old shareholder letters by Martin Whitman of Third Avenue Management. Whitman is a legendary value investor, and his letters are an incredible source of learning about general value investment principles. It’s also a great opportunity (as other fund manager letters are) to see what individual stocks they are invested in, and more importantly, the logic they used in making those investments. Reverse engineering some of the best investors’ ideas is an invaluable way to learn.
I read through a few of his letters over the weekend, and later this year I plan to study each one that is available on his website, and I’ll make short comments about them here on the blog as I go through them.
One of the things I like about Whitman is that he is a balance sheet guy. What I mean by this is he is more focused on a company’s net worth (book value), than he is about earning power. Earning power is extremely important, and Whitman acknowledges that you need to weight both the income statement along with the balance sheet, but he says that most investors would benefit if they focused more attention on the assets and liabilities a company has, along with management’s ability to grow the company’s net asset values.
He mentions how Wall Street values earnings over everything else, but the rest of the business world first looks to net asset values (or other balance sheet metrics). He talks about how the first thing Warren Buffett discusses each year in his shareholder letter is Berkshire’s change in book value. He mentions how most businessmen are concerned with wealth creation, or growing their net worth or the net worth of their businesses. Mutual funds report their change in NAV, etc…
This is very much in the school of classical Graham and Dodd, who were much more concerned with identifying a company’s assets, and using balance sheet analysis to determine whether they had a margin of safety. Their strategy worked incredibly well, providing 20% annual returns over the course of 3 decades. A recent study by Tobias Carlisle (author of the great blog Greenbackd): 75 Years and Outperforming-Graham Strategy analyzes the results of a hypothetical strategy that invests in a portfolio of all the stocks selling for less than 2/3rds of their net current assets (defined as current assets less total liabilities). Basically, Graham was looking for stocks that were selling for 67% of liquidation value.
The results are absolutely stunning: the hypothetical portfolio of these so-called “net-net” stocks, many of which had no earnings at all, produced a shocking 35.2% annual return for the period from 1984-2008. A predecessor study showed similar results (29% annual returns) from 1970-1983.
Whitman mentioned in something I read that he felt individual investors (he calls them Outside Passive Minority Investors, or OPMI’s) could significantly improve their results by focusing more attention on what stocks are truly worth, and worry less about the future earnings potential, which is much more difficult to predict.
Whitman’s thoughts are similar to Ben Graham and Walter Schloss, two of the investors that have had the largest impact on my own investment ideas. I personally place a lot of emphasis on earnings, but the balance sheet is the foundation and is given top priority in my book.
I’ll be talking more about Whitman as I study his letters and ideas. Lots to learn on his site. Here is a quick video (less than 60 seconds) where he summarizes these thoughts):