A Bout of Irrational Pessimism?

Fund manager Marty Whitman says investor panic – and not declining businesses – have sunk current market valuations. Is he right?

Legendary fund manager Marty Whitman is pinning the blame squarely on an “irrational” stock market meltdown for this year’s hefty losses at his Third Avenue Value fund.

“As far as we are concerned,” Mr. Whitman declares in his latest shareholder letter to investors, “the fund’s poor 2008 performance is attributable to an irrational stock market, not any fundamental deterioration in the businesses in which [Third Avenue Funds] has invested.”

It’s a pretty bold claim, in the face of a 50% loss over the past year. But is it wrong?

What triumphant bears are apt to forget is that a stock market which is capable of “irrational exuberance” – and the jury on this is surely now in – is just as capable of irrational panic, worry and gloom.

If stock market valuations were wrong when they were soaring last year, who is to say that they are correct now?

Mr. Whitman’s colleague Curtis Jensen, co-chief investment manager at Third Avenue, reinforced the view in an interview last week.

Some current valuations, Mr. Jensen said, are “ridiculous” and anticipate virtual “armageddon.”

[Martin Whitman]

Mr. Whitman and Mr. Jensen see some of the best opportunities in high-yield bonds. “There are unprecedented opportunities in the distressed debt market,” Mr. Jensen said. “You are able to buy very senior securities today (offering) equity-like returns.” That means bonds backed by collateral or strong covenants, with priority claims in the event of insolvency, that in some cases still offer likely yields to maturity “in the high teens” or higher, in Mr. Jensen’s view.

Examples include certain bonds issued by General Motors Acceptance Corp and by the trucking company Swift Transportation. Mr. Jensen’s Third Avenue Small Cap Value bought the Swift bonds at about 60% of par value, and he expects either a yield to maturity of 19% — or a valuable slice of equity in the firm if Swift is forced into a financial restructuring.

The last time Third Avenue saw such opportunities was in the early 1990s, he adds.

Mr. Whitman, writing to shareholders, said some of the distressed loans bought recently might offer yields to maturity as high as 54%

Third Avenue disclosures show that in the past few months the firm’s funds have been aggressively buying certain bonds issued by General Motors Acceptance Corp., among others. Mr. Jensen, in his Third Avenue Small Cap Value, has bought IOUs issued by the trucking company Swift Transportation at about 60% of par value. He expects a yield to maturity of 19% — or a valuable slice of equity in the firm if it is forced into a financial restructuring.

By contrast to this “off-piste” skiing in the debt markets, Third Avenue is sticking to the gentlest runs in the matter of equities. Managers are looking for cash generators with solid balance sheets that won’t need to tap the markets for extra cash any time soon. No one knows how or when this market will turn. The indices may languish for years. But bottom-up value managers, like those at Third Avenue, claim they’re now seeing the best opportunities in generations.

Marty Whitman, for his part, has been through market panics for over 50 years. In his letter, he argues “today the opportunity of a lifetime seems to be present for passive investors who follow a few simple caveats.” Among Mr. Whitman’s caveats: Be a buy and hold investor; avoid investing with borrowed funds; and avoid shares of any companies which need, in his words, “relatively continual access to capital markets if they are to remain going concerns.” Acconding to Mr. Whitman, those companies include financials such as Goldman Sachs and even companies like General Electric. “Deep value and high quality alone are not sufficient conditions for investing in common stocks,” writes Mr. Whitman. “Deep value pricing and high quality assets must be accompanied by creditworthiness.”

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