Martin Whitman On “Wealth Creation Stocks”

Over the years, Martin Whitman has gained a reputation for his contrarian investment strategy and devotion to the school of value investing. For more than 50 years, Martin Whitman has shown that active management strategies with a value slant can outperform the market.

Martin Whitman founded the predecessor to the Third Avenue Funds in 1986 and managed the flagship Third Avenue Value Fund since inception in 1990 through March 1, 2012. Throughout the years he was running the Third Avenue Value Fund, Martin Whitman's quarterly letters to investors became an invaluable source of information for investors. In one such letter, sent out to investors at the end of Q2 2001 Martin Whitman outlined the importance of including "wealth creation common stocks" in a value-orientated portfolio.

Martin Whitman: Third Avenue Value

Martin Whitman: Wealth creation common stocks

"Much of Wall Street, and much of academia, seem out of touch with the real world because of their emphasis on forecasting recurring future earnings and/or cash flows from operations as the tool of choice for common stock valuations." -- Martin Whitman Third Avenue Value Fund second quarter 2001 letter to investors.

In the early 2000s, Martin Whitman's Third Avenue Value Fund placed an emphasis on "wealth creation common stocks". These companies were, in the words of Whitman, focused on wealth creation, not by increasing quarterly income figures but by increasing net asset values. These wealth creation stocks acted like an investment company rather than an "earnings common stock".

Whitman disliked Wall Street's exclusive focus on a corporation's income account. He called this focus the, “primacy of the income account” approach.

"Primacy of the income account, in plain English, means that corporate values are determined by earnings from recurring operations and/or discounted cash flows from recurring operations."

However, primacy of the income account does not reflect real-world economics:

"In the real world, in contrast, the value goal of almost all corporations revolves, not around earnings or cash flow, perse, but rather around wealth creation by the best available methods. In most, but far from all, cases, the real world goal is to create wealth for the corporation itself rather than for outside, minority shareholders."-- Martin Whitman Third Avenue Value Fund second quarter 2001 letter to investors.

There are several different methods of creating wealth from operations. Enjoying earnings from operations, having free cash flow from operations, capital appreciation, financings, and asset redeployments are ways for corporations to create wealth. But the key difference between the real world and Wall Street, is that real world companies would, when given the choice, rather create wealth by means other than having recurring earnings from operations. Operating earnings are taxed at maximum rates under circumstances where the taxpayer has little, or no, control over the timing of the tax.

 

"Most corporations probably do not have alternative methods for creating most of their wealth other than through the creation of recurring earnings or cash flows...However, there are a vast number of issuers which appear more like non-registered investment companies masquerading as operating companies. These companies do not strive for operating earnings but rather look to the creation of realized and unrealized appreciation. These are essentially wealth creation companies even under conditions where controlled operations enjoy operating earnings. However, unlike earnings companies, it is not particularly helpful to value wealth creation common stocks by reference to price-earnings ratios, the primary valuation metric on Wall Street. Rather the crucial quantitative valuation technique here is premium or discount from reliable measures of net asset value. The Fund has very substantial investments in the common stocks of wealth creation companies, almost as large as its investments in the common stocks of earnings companies." -- Martin Whitman Third Avenue Value Fund second quarter 2001 letter to investors.

Third Avenue Value Fund's pricing criteria for wealth creation common stocks was a discount of at least 25% from readily ascertainable net asset values. For most of the wealth creation stocks actually acquired for the Value Fund, the pricing was closer to a 40% discount than a 25% discount. Some of the wealth creation stocks Martin Whitman's Value Fund owned at the time were, Japanese non-life insurers, White Mountains, Hutchison Whampoa, Capital Southwest, Tejon Ranch and Koger -- all of which still exist today.

Martin Whitman: A word on earnings common stocks

The vast majority of the Third Avenue Value Fund's holdings were earnings common stocks, which unlike the wealth creation common stocks, were purchased based on earnings multiples, not discounts to net asset values.

Martin Whitman liked to look for earnings common stocks trading at well under ten times peak earnings of the recent past.

"...common stocks were acquired only where it was felt, based on analysis, that the prospects were bright that the next earnings peak, to occur, say, three to five years hence, would be materially better than the last peak."

The key analytical question for Martin Whitman and his analysts at Third Avenue Value was, "will the next earnings peak be materially better than the last one?" Indeed, as long-term value investors Third Avenue wasn't interested in the immediate outlook of any distressed company. More often than not, Martin Whitman found himself buying companies entering a difficult period. However, if the long-term growth potential of the company seemed attractive, and there was a reasonable chance that future earnings would exceed a previous peak, Third Avenue was prepared to weather the storm until the business in question returned to growth.

"...those concentrating on the near-term outlook rather than the long-term growth potential seem to me to have their eye on the hole and not on the doughnut. Most of Wall Street seems to have their eyes only on the hole."

"...[If] the immediate earnings outlook seems mediocre to poor. TAVF is prepared to live through that. The key analytic question for the Fund as a buy and hold investor, is not the immediate outlook, but will the next peak be materially better than the last one. Insofar as that proves to be the case, the specific common stock issues should have huge, long-term appreciation potentials. It is silly for the Fund to try and pick market bottoms for securities...Rather, buying at 4 times peak earnings seems 'good enough'."-- Martin Whitman Third Avenue Value Fund second quarter 2001 letter to investors.