I’ve been a big fan of Marty Whitman’s value investing ideas for quite a while. His emphasis on “resource conversion” instead of income from operations, his insights on distress investing and credit analysis are all invaluable. His recent passing inspired me to re-read some of his books: Distress Investing and Modern Security Analysis. In person, Whitman was highly entertaining and had a brash, no-nonsense demeanour (see https://www.youtube.com/watch?v=Hlj3fMUx73c&t=0s&index=4&list=PLF6090A1CA7D0A577), but his writing style was incredibly stiff. Consequently, his ideas haven’t really spread as widely as they should have.
Whitman on Creditworthiness
Whitman always placed a big focus on creditworthiness, i.e. a company’s ability to remain solvent. He only invested in companies that had a rock-solid financial position and were thus highly creditworthy. Chapter 7 of Modern Security Analysis is entirely focused on the importance of creditworthiness. In the chapter, Whitman essentially argued that:
- In order to measure the creditworthiness of a company, value investors simply need to look at:
- The company’s ability to create liquidity; and
- The relative absence of liabilities on and off the balance sheet.
- A company can create liquidity from:
- Cash and cash equivalents;
- Assets that can be easily be converted into cash (for Whitman this includes marketable securities, assets under management, Class-A real estate);
- Earnings and cash flows from operations; and
- Its ability to raise finance (debt or equity).
Clearly as minority shareholders, we should avoid companies who are creditworthy only by reason of their access to equity capital markets (such as mining or biotech companies). We should rather focus on companies which are creditworthy because of an abundance of high-quality assets or a high-quality stream of future cash flows from operations relative to total liabilities. We also need to be confident that such assets are not going to be depleted or such cash flows aren’t non-existent. I generally focus on companies with high-quality assets because they are far easier to identify than companies with a high-quality stream of future cash flows.
Whitman also thought that companies which need access to debt markets should be avoided. He looked to companies that are very conservatively capitalised which Whitman believed have distinct advantages. They act as an insurance policy for the company itself and junior securities holders. They provide management with the flexibility to engage in opportunistic, wealth-generating capital expenditure at times in the credit cycle when other aggressively capitalised companies cannot so engage. There are also higher prospects for takeovers as well capitalised companies are also more attractive to potential outside investors. A market re-rating can occur when more leverage is taken on. A clear drawback of conservatively capitalised companies is lower levels of ROE during times of favourable economic conditions.
Importance in Deep Value Investing
Applying this simple concept of creditworthiness to net-net or discount-to-NAV investing significantly increases one’s margin of safety. On the whole, most companies trading below net cash or net current assets are highly creditworthy because of high levels of assets that can be easily converted into cash to meet any liabilities. Of course, value investors will want to avoid companies which are only creditworthy because of their ability to access capital markets or which are not actually creditworthy (such as frauds or firms with grossly overvalued balance sheets). Net-nets which will need to raise finance will do so because their assets will be depleted by disastrous operating losses, wasteful capital expenditure, or unforeseen liabilities. Therefore I avoid terminally-unprofitable net-nets with a long history of losses and no clear and obvious prospect of recovery. I always look for off balance sheet liabilities. I look at capex needs and likely capex spending. I look at debt levels and the covenants attaching to that debt. I have an absolute rule against investing in any mining, biotech or commodity exploration net-nets.
Accessing creditworthiness in deep value situations isn’t rocket science. You simply need to look for high quality assets (or cash flows) and a relative absence of liabilities. If there is a sniff that a deep value company is not creditworthy or if it will need access to capital markets to remain creditworthy, then I am usually not interested and will move on to something better.
Side Note – Whitman Wisdom
As I mentioned above, Marty had a rather dull writing style despite his catchy phrases like “sleep-at-night-factor”. There are, however, some passages where he writes rather well. The following from Modern Security Analysis on capitalisation in resource conversion activities is worth re-airing:
“…in the reorganization of troubled companies, recapitalization tends to make sick companies healthy, whereas in leveraged buyouts, recapitalization tends to make healthy companies sick.”