Marty Whitman's 'Safe and Cheap' Approach

One of our favorite value investors is Marty Whitman, manager of the  Third Avenue Value Fund (TAVFX). The fund has racked up a heady 16.9% annualized average return since its 1990 inception by adhering to Whitman's self-described "safe and cheap" approach, leaving efficient market aficionados scratching their heads.

Whitman has also been deemed "one of the keener minds in the investment world" by Morningstar fund analyst Kerry O'Boyle, so when Whitman speaks, we listen. Whitman has authored The Aggressive Conservative Investor and Value Investing: A Balanced Approach. Both of these books shed light on his approach. Additionally, Whitman publishes thoughtful quarterly letters that outline recent transactions and provide commentary on timely topics.

To generate some investment ideas from this approach, we'd like to provide our interpretation of the safe and cheap framework. We'll then highlight eight companies currently held by Third Avenue Value that we have published reports for--and that can be acquired at discounts to our fair value estimates.

The 'Safe and Cheap' Approach
The first step in the safe and cheap approach is to theorize what you could lose. If there isn't a safety net--a high-quality asset, in most cases--to keep the shares from going to zero, then there is absolutely no reason to waste time hypothesizing about the upside potential. The safe and cheap investor tends to focus on companies that own rock-solid assets: The balance sheet takes precedence over the income statement.

The safety net is key, but the company must also have several other qualities. It must be well capitalized, possess solid long-term prospects, have a savvy management team at the helm, provide excellent financial disclosure, and be available for purchase at a discount to its fair value. The "safe" component is satisfied by the first four attributes, while the "cheap" component is fulfilled by the last.

Well-capitalized businesses with solid long-term prospects tend to fall into three buckets under this approach. The first bucket is a strong operating company enjoying an economic moat and a balance sheet with no significant burdens. One of Third Avenue Value's largest holdings,  Legg Mason , qualifies here. The company generates a great deal of free cash flow from its moaty asset management business and can use its underutilized balance sheet to acquire assets. We tend to prefer companies of this type since their proven economic moat allows them to earn excess profits for sustainable periods of time.

The second bucket includes companies that also lack significant liabilities, but own tremendous underutilized resources. These assets can be put to use in more efficient ways to create wealth over time. St. Joe (JOE) falls into this camp. The company is the largest raw land owner in Florida and strategically develops its land into master planned communities.

The third bucket consists of companies that own well-positioned assets that throw off solid cash flows and are partially secured with non-recourse debt. This type of debt, which only allows lenders to rely upon the asset for repayment (as opposed to the parent company), lowers the risk profile while enhancing cash returns on equity and providing tax-efficient ways to realize appreciation. Third Avenue Value's longtime holding  Forest City , a real estate developer, fits this description.

Savvy management teams are important and typically include a group of insiders who own a sizable equity stake in the company. For instance, longtime Third Avenue Value holding  White Mountains Insurance  (WTM) insiders own more than 10% of the company. The safe and cheap approach also holds in high regard management teams dedicated to creating wealth in the most tax-efficient manner, as well as management that takes advantage of inefficiencies in the capital markets.

The safe and cheap approach also favors companies that provide excellent disclosure. This disclosure typically supplements required filings and provides non-GAAP measures, and is often critical in assessing the true health of a business and its balance sheet. Such disclosure is also especially important since the safe and cheap investor may be taking advantage of depressed stock prices created by short-term concerns to acquire stakes in blue-chip companies. Great examples of this include Third Avenue Value loading up on  MBIA (MBI) following concerns stemming from reported accounting irregularities, as well as recently establishing a position in  Pfizer (PFE).

Finally, the approach favors buying at a meaningful discount to fair value. Whitman seems to have rules of thumb for buying in different business lines. He favors buying financial-services companies below book value, real estate companies below private market value, asset managers below book value plus 2%-3% of assets under management, and operating companies below 10 times peak earnings. All of these measures revert to the company's fair value, or what Whitman terms "net asset value." While we prefer to value a company and its moat by estimating the present value of future cash flows, we couldn't agree more with Whitman's stipulation that buy orders only be placed at discounts to intrinsic value.

We have turned up eight companies that fit these stringent criteria and that we would classify as cheap (below our estimates of fair value). Whitman has bought all eight before, and each one remains in Third Avenue Value as of the Oct. 31 report date. At a 5-star price, we'd be happy to join one of our favorite value investors as an owner of the following businesses:

 Pfizer  (PFE)
The world's largest pharmaceutical company's share price was rocked by a number of near-term concerns. However, strong cash flow, a fortresslike balance sheet, and a wide economic moat provide tremendous promise. Third Avenue Value initiated its position in the quarter that ended on Oct. 31, 2005.

 Brookfield Asset Management (BAM)
Formerly Brascan Corp, the company's highly regarded management team is redeploying its high-quality assets into numerous funds, which it will manage on the behalf of institutional investors for fees. The company consistently earns 20%-plus cash returns on equity. Third Avenue Value last added to its position in the quarter that ended on Oct. 31, 2005.

 Posco ADR (PKX)
As one of the world's largest steel producers, Posco generates a ton of free cash flow and owns some of the most technologically advanced mills around. The company has a squeaky-clean balance sheet and above-average disclosure. Third Avenue Value last added to its position in the quarter that ended on July 31, 2005.

 MBIA (MBI)
This financial guarantor provides insurance for municipal bonds and asset backed securities. The company enjoys a AAA credit rating, long-term contracts, and a gifted management team. Third Avenue Value last added to its position in the quarter that ended on July 31, 2005.

 Forest City Enterprises 
As one of the United States' top developers, this company works with municipalities to take on large-scale projects in high-barrier-to-entry markets while obtaining tax-favorable financing and uses secured debt to its advantage. Third Avenue Funds own more than 20% of the company. Third Avenue Value last added to its position in the quarter that ended on July 31, 2005.

 American Power Conversion 
APC is the dominant manufacturer of conditioning devices that provide uninterruptible power supplies to microprocessor-based hardware. The company has about $4 per share of cash on the balance sheet, no debt, high insider ownership, and management runs the company for long-term value creation. Third Avenue Value last added to its position in the quarter that ended on July 31, 2002.

 Alexander & Baldwin, Inc. (ALEX)
A&B runs a decent shipping business that serves as the predominant shipper between the United States and Hawaii. The company also happens to own about 90,000 acres of land on the Hawaiian Islands. Third Avenue Value last added to its position in the quarter that ended on July 31, 2002.

 White Mountains Insurance Group (WTM)
White Mountains' savvy management team has amassed a diversified collection of insurance companies that all share something in common: They were acquired at attractive prices. Insiders own more than 10% of the holding company, which boasts high solvency. Third Avenue Value last added to its position in the quarter that ended on July 31, 2000.

This article originally appeared on Jan. 27, 2006.