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Conversation: Jean-Marie Eveillard and Marty Whitman

These famed investors go where they please in search of value.

Morningstar Advisor, 12/11/2007

This article originally appeared in the fall 2007 issue of Morningstar Advisor magazine. Subscribe today. We also value your comments. E-mail us with your viewpoints, ideas, and other feedback.

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Jean-Marie Eveillard and Marty Whitman met in 1990 shortly after Whitman launched what would become his signature fund, Third Avenue Value TAVFX. They were two kindred spirits on a conference panel with a third portfolio manager, who was speaking about financial theories and hypotheses.

"He was talking in a language that was completely different from ours," Eveillard says. "Martin and I chatted afterwards about the fact that it was good that the other was there, because we simply didn't speak the same language as the third guy."

To Eveillard and Whitman, such academic speak only applied to conventional money managers, whose goal was to keep up with a benchmark in the short term. Eveillard and Whitman, on the other hand, didn't give a whit about benchmarks nor the short term; they were buy-and-hold investors who bought companies they knew from the bottom up at ridiculously cheap prices.

"I was very impressed, from that day to this, on what Jean-Marie had to say," Whitman says. "He was very, very value-oriented. Very interested in not taking investment risk, and willing to go all places in the world, and very skilled at doing things that I am particularly unskilled at, such as investing in gold--which is a talent all unto itself."

Nearly two decades later, this mutual respect remains. We asked Eveillard, 67, and Whitman, 82, to sit down together to talk about investing. The following conversation took place Aug. 22 at the offices of First Eagle Funds in New York; they had just returned from having lunch together. Their conversation has been edited for clarity and length.

Marty Whitman: Talking about not speaking the same language, I'd put it this way, in academic terms: modern capital theory, the efficient market theory of the efficient portfolio hypothesis. It's all only extremely tangential. It's really not relevant to what you do, Jean-Marie. It's certainly not relevant to what I do.

Jean-Marie Eveillard: No, I think the consultants, the specialized magazines, they all talk the academic language, and it's an instance where the academics are simply wrong.

MW: Well, I don't think they're wrong, except they're a special case. That's what you really ought to do if you really don't know anything about what the security you're investing in, or you're dealing with borrowed money, or for some reason you're very interested in day-to-day and even hour-to-hour price fluctuations. In that special case, I think you and I agree, it's got validity. But it's got nothing to do with what Jean-Marie Eveillard does for a living.PAGEBREAK

JME: That's right. I think that where the theories apply is to conventional money management-where there is an attempt to keep up with the benchmark and with peers on a short-term basis.

Now, conventional money management, between the spring of 2000 and the spring of 2003, got hurt to the tune of 30% to 40%, because the markets went down as much. And even though conventional money management has recovered a bit over the past four or five years, because markets have been up, I think, over time, it will be squeezed between the Vanguard-style index funds, on the one hand, and the absolute return investors on the other.

MW: Agreed. But I think a big point is, that is really irrelevant to us. We buy and hold long term. Markets go down, we take advantage. We sort of operate under the implicit assumption that if we don't know more about the situation than the market, we wouldn't be there. They operate under the assumption that the market is sending me messages; the market knows more than any individual. It's just the opposite.

JME: That's right. I think it's Seth Klarman who said, "The biggest edge that value investors have is their long-term orientation," which I think jives as well with Ben Graham saying, "Short term, the market's a voting machine; long term, it's a weighing machine."

MW: We like to say at Third Avenue that we do rather well, but when it comes to information, we're always the last to know. [laughs] But it's just not important. It's not that we get superior information, but rather, that we use the available information in a superior manner.

JME: That's right.

MW: That's where we come from, you and I.

JME: So many investors are always looking for the information that the others don't have. And as you said, we have the same information, which is readily available. We try to use it better than the others. It's in the interpretation, in a sense, and the reading of the available information.

MW: Absolutely. For conventional people, there is a primacy of the income account. In what we do, there is no primacy of the income account. If there is a primacy of anything, it's the quality of the financial position. That governs what we do. I think it governs what you do. It's a matter of weight to information. If somebody else is going to emphasize earnings per share, and we're going to emphasize quality of the balance sheet, we're going to weigh the information very differently.

As a matter of fact, on this primacy of the income account, I know from what you did in Bank for International Settlements that our basic emphasis is on wealth creation, not earnings from operations, knowing that earnings from operations and cash flow from operations is just one method of creating wealth. And usually, it's the least desirable method of creating wealth. We have alternatives.

JME: That's right. And you have done so much with real estate-related securities. Of course, that's a case where the earnings per share simply do not.

MW: Measure anything.

JME: That's right.PAGEBREAK

Buy and Hold
JME: In your April quarterly, you wrote something that intrigued me. You said the entry point into a stock is important, and the entry point must be at a bargain level. Because once you hold the stock, you're a buy-and-hold investor, and accordingly, you do not sell the stock, even if it's fairly valued; you only sell the stock if you think you've made a mistake, or if you think the stock is grossly overvalued.

MW: Or for portfolio reasons.

JME: Or for portfolio reasons, right.

MW: I think buy-and-hold makes much more sense than people give it credit for. Because one, value is not static. It is very dynamic. If you're in a reasonably good company on a long-term basis, the business continues to create value. And I've had a long career in learning my lesson. I'd own a stock for three years; it would double; and I'd sell it to somebody for whom it would triple in the next six months. We should also talk about shortcomings. I think your discipline and my discipline works an awful lot better on the buy side than the sell side. Therefore, unless you have compelling reasons, why sell?

JME: That's right. Too much money is often left by value investors on the table because the stock is sold too soon. Truly, as value investors and as long-term investors, we should not worry too much about the fact that after the price of the stock has moved up, maybe it will no longer go up, or maybe come down a bit over the next year or two.

MW: I must say one thing. You and me, we like to look at what's wrong with what we're doing. And let me say what's wrong most of the time with what we do in buying into very well financed companies at a discount from readily ascertainable net asset value, which is 90% of our portfolios.

First, most of the time, the near-term earnings outlook sucks. That gives us the price.

Two, we're in bed with highly conservative managements, who most of the time are willing to sacrifice return on assets and return on equity in order to get the insurance policy of a strong financial position.

Saying that, we do get our fair share of deadheads. Obviously, you're dealing with companies with very strong financial position. By definition, we have selected a population that doesn't need access to Wall Street. And many of them just don't give a damn.

It's certainly a shortcoming of what we do. I think we pretty much have overcome it. You pretty much have overcome it.

JME: Yes. Most of the time, in my opinion, management of companies should not listen to Wall Street. It's almost always, "You have to optimize your balance sheet"-by which, of course, they mean to take on a lot of debt.

And I agree with you that if you have cash sitting on the balance sheet, then you can seize opportunities when you see them.PAGEBREAK

MW: Leveraged companies have disadvantages. They can't be opportunistic, and they don't have any insurance policy against the unknown and uncertainty. You and I were talking at lunch about how the current credit crisis is particularly acute for companies who need relatively regular access to capital markets. Of course, what's happened in July and August is a lot of market access has been shut off.

Isn't it nice to have a portfolio of companies which don't need access to capital markets? Capital markets are very capricious. From time to time, credit will be easily available, or it won't be available at all. On the equity end, from time to time, there will be IPO booms, or there will be times when you cannot raise new equity for love or money, either from the public or in a merger-and-acquisition context. It's a very capricious market.

JME: You certainly don't want to be the shareholder of a company that needs to access capital markets at precisely the wrong time.

MW: Yeah, and for some of these people, of course, we would provide the capital-at the right price. [laughter]

Scarcity of Value Investors
JME: We've been talking about the virtues of value investing. I think the late Bill Ruane, of the Sequoia Fund, estimated years ago that only 5% of professional money managers were value investors. How come there are so few value investors? I mean I'm happy there are so few, because if there were more, the field would be more competitive.

I think the answer is psychological. To be a long-term investor means that you have to accept the fact that you're not trying to keep up with the benchmark and with your peers on a short-term basis. So by definition, every now and then, you will lag.

The Berkshire Hathaway annual report shows a record of Buffett over 40 years. It's extraordinary. But you can spot very quickly three or four years where he did worse, sometimes much worse, than the S&P 500, which is his benchmark. But it doesn't matter. We're not talking about a sprint, we're talking about a marathon. Over 40 years, he did extraordinary work.

Both you and I are willing to put up with the slight irritation associated with the fact that we may lag our peers. I mean, it was not so slight in the late 1990s, because we lagged for a few years, and as a result, we suffered from considerable redemptions. But I think the long-term investor, or the value investor, has to be willing to put up with short-term pain to achieve long-term gains.

MW: I'm reminded by my daughter, who is a Broadway producer, that 95% of the people in show business are extraordinarily talented, but only 5% make a living. But you go into finance, 5% may be talented and 95% don't know which end is up, but they all make a very comfortable living. Finance is a much better vocation in general than show business. [laughter]

But I like to try to understand why other people do what they do. And let us say, Jean-Marie, that you and I were younger fellows, employed in a research department in a brokerage firm. I think we would be a lot more market conscious, because we might get fired, and we might not get promoted if we don't have near-term performance.

So we are insulated from what most other analysts face. I have a down year, big deal. It isn't going to bother me.

JME: But we did lose clients in the late 1990s, and it was...

MW: A great experience, because we found out it was manageable.

JME: That's true.PAGEBREAK

MW: You know, it was funny. Going into that redemption period, I was extremely worried, because many of the securities we own are called roach motels. You know, thin markets: Easy to check in, but you can't check out. When we get massive redemptions, we're not going to have stuff in the portfolio to sell. But we managed it. That's very comforting.

JME: Because we had enough cash. We had enough big stocks that were rather easy to sell. With the benefit of hindsight, it's never helpful to have too much money coming out too fast, or too much money coming in too fast.

MW: So much of our portfolios are takeover candidates. So we exit to the takeover market, and not to the public market. Again, '98 and '99 proved not to be a problem.

JME: That's right. But apropos of being taken out, sometimes I think it does not work, except in an immediate sense, to our advantage. Because maybe the business would have continued to create value for another five or 10 years.

Incidentally, the financial planners I run into today, they all tell me, "We never left you." I wonder, who did then? [laughter] But some in the late 1990s came to me and said, "Look, we understand what you are trying to do. We are all for it, but the client rushes into my office, bangs the table, and says, 'Throw the bums out!'--the bums being us, of course. "What can I do?" says the financial planner.

MW: Well, you know, for many of them, the long-term outlook changes day to day as the stock prices fluctuate.

Finding Growth at Value Prices
JME: One thing you say that I've always liked, Martin, is, "Hey, we're value investors, but we have nothing against growth." What we don't want is what you call "generally recognized growth." In a sense, I suppose what you are saying is, "We're all for growth, but we don't want to pay for it."

MW: The second largest holding in the Third Avenue Value Fund is Toyota Industries, which is the founder of Toyota Motor TM and still a 5% or 6% shareholder of Toyota Motor. Under Japanese accounting, on the balance sheet, Toyota Motor and other portfolio companies have to be carried at market. Toyota Industries' common is selling out at 30% discount from net asset value.

However, under Japanese and U.S. accounting, all Toyota Industries picks up in earnings from Toyota Motor is dividends paid by Toyota Motor, not the retained earnings of Toyota Motor.

If you look at GAAP, Toyota Industries is selling around 21 times earnings. However, if you adjust the earnings to pick up Toyota Industries' equity in the undistributed earnings of Toyota Motor, it's selling around 6 or 7 times earnings.

We, over many years, thought Toyota was a growth stock, and we thought we were buying it under 10 times earnings. And I think, essentially, we're right. But that's how I think. You and I, Jean-Marie, both try to buy growth and try not to pay for it.PAGEBREAK

JME: But also what you did, Martin, by buying Toyota Industries as opposed to Toyota Motor, is to look at Toyota Industries in an unconventional way. Looking at just the multiple of earnings is the wrong way. There is a number of securities where you have to be careful how you look at them, and where you may not want to look at them in the conventional manner.

We've been a shareholder in Rayonier RYN, which basically owns timberlands, for more than a decade. Timberland is a bit like real estate. Price to earnings does not apply.

MW: It's wealth creation that applies.

JME: Exactly. And also, the other angle--which neither you nor I care about--is that Toyota Motor, the stock, is in the big index. Toyota Industries, which is the holding company for Toyota Motor, is not in the big index.

So people who pay a great deal of attention to index weightings will sacrifice the 30% discount, which they could get if they bought Toyota Industries as opposed to Toyota Motor, just because Toyota Motor is in the big index.

Buying into 'Safe and Cheap'
JME: Martin, you once wrote that, in essence, all of you on the investment side, portfolio managers as well as analysts, are analysts--which is exactly what we think.

MW: We have a mantra, "safe and cheap." I hope my 21 analysts have signed off on safe and cheap. At the moment, I think 19 of 21 have. [laughter] To my taste, one or two of them in the managed account are a little bit too market conscious, and don't put enough emphasis on the quality of the financial position.

If I've done anything right, I've done a terrific job in having our analysts sign off on safe and cheap. My designated successor, a terrific analyst, Ian Lapey, was at First Boston before we hired him away six years ago. He came to us then and wrote up and recommended four, five, or six telecommunications equipment common stocks, using our criteria, where in each instance, cash alone was substantially in excess of all book liabilities.

After he made the recommendations, the stocks proceeded to go down dramatically. Ian noted that we--I in particular--thought he had done a terrific job. He knew that if he had stayed at First Boston, he'd be fired. And boy, did he sign off. The other analysts have as well. For many years, they have seen that the thing sort of works.

It's awful nice for analysts to do what you and I do, Jean-Marie. I have been an analyst for over 50 years, and I'm still waiting to lose my first night's sleep worrying about the market, worrying about securities. Once you sign off on safe and cheap, it's just a nice, stimulating, non-worry business.

JME: I'm not as positive as you are about the fact that it's easy work [laughter], and that one does not worry too much-although I agree that by not focusing on the day-to-day fluctuations of securities prices, in a sense by ignoring them, we obviously save a lot of aggravation.

But there is a great importance to the team of in-house analysts. Because we look at securities with a long-term orientation, most of Wall Street sell-side work is not truly helpful to us, because their focus is more on what will precipitate an increase in the price of the stock over the next six to 12 months.

In our shop, there is no genuine distinction between portfolio managers and analysts. We're all analysts to begin with. Listening to you, Martin, since we started talking here, I can hear that you talk like an analyst. PAGEBREAK

'License to Steal'
MW: I got in the business in 1984 when I did a hostile takeover of a closed-end, my first fund. It took me a long time--I'm sometimes not too swift--to find out that the business was a license to steal. [laughter] It's better than having a tollbooth on the George Washington Bridge. All cash business, no credit risk, no inventory, you are the principal overhead.

It is a fantastic business, not only fun and interesting, but you make a lot of money. It took me a long time to realize that in the fund business, the value is not in buying at a discount. The value is in having a management contract. In terms of the public, our shareholders, I have a great community of interests with them, in that the majority of my family's fortune is invested in our shares, which is very rare among mutual funds, that people eat their own cooking.

I feel the obligation to the public, despite that greedy speech I made about the George Washington tollbooth. We try to keep fees modest, we don't have any 12b-1 fees, not going to have a load, and the only redemption charge is for short-term money.

Most important, in all my years in business, the public has always been hosed, with the real-estate tax shelters, private equity, two and 20, oil and gas deals, margin buying-they've always been wiped out.

I don't know what genius made it up, but the mutual fund industry is so effectively and strictly regulated; it's the only area, in my experience in business, where the public gets close to an even break. The Investment Act of 1940 gives the public all these benefits and substantive protections. At the same time, it allows promoters like Jean-Marie and myself to get ungodly rich. [laughter]

JME: The mutual fund industry has its flaws, but nothing is perfect. It's the case of an industry that has hurt shareholders much less than other money management schemes.

To begin with, the fees are low--especially in comparison to hedge funds. Number two, mutual funds do not use leverage. The way you can really kill your investors, of course, is when you've used leverage and you're wrong. I was struck to see that some of the Goldman Sachs funds were down 20% in a month, even though the assets they own were down only 3% or 5%, but they were leveraged 5, 6, or 7 times. When you're leveraged 5, 6, or 7 times and your assets are down 3% to 5%, in fact you're down 20% or more.

But, as I've said before, many mutual funds in the end, and it may be a slow death, will be squeezed between the very cheap index funds and absolute return investors.

Incidentally, when institutions and individuals looked at the bear market between the spring of 2000 and 2003 and saw that conventional money managers had lost 30%, 40%, they said, "Oh, we have to find something else." And they came across hedge funds and private equity, which the Harvard and Yale endowments had discovered themselves 15 years before. And so, with the help of consultants, they moved into so-called alternative assets with delight.

I think it's Jeremy Grantham [chairman of Grantham, Mayo, Van Otterloo & Co.] who recently said, "Over the next five years, private equity will provide no returns except the 2% to KKR and other private equity firms." It will truly be a case of "Where are the customers' yachts?" As far as hedge funds are concerned, I suspect that many will not provide the absolute returns they're supposed to provide, and accordingly, as Grantham predicts, maybe half of them will fall by the wayside.

MW: Let me just talk about private equity, limited partnerships and tell an old story.

A limited partnership is a business or investment association where, at its inception, the general partner brings experience to the situation, and the limited partners bring money.

At the end of the limited partnership, the general partner has the money, and the limited partners have the experience. [laughter]

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