Value investors spend considerable time trying to distinguish between temporary and permanent company problems. Few investors are more qualified to provide insight on that particular subject than Third Avenue’s Marty Whitman.
Having figuratively “written the book” on investing in troubled companies, Whitman has now literally done so with the publication of Distress Investing: Principles and Technique, written with colleague Fernando Diz, an associate professor of finance at Syracuse University’s Whitman School of Management.
Key excerpts from Value Investor Insight's recent interview follow:
Has the biggest money in distressed debt already been made?
MW: In my adult life, I’d never seen the kinds of prices and yields that were out there last fall and earlier this year on debt for which we saw minimal default risk. We weren’t buying into performing loans that we thought would remain performing unless we could get an annual yield of at least 25%. That bogey is down a bit today, to 20%, but that’s still high relative to what we’ve been satisfied with in the past. Given what’s going on in the economy, we expect to continue to have plenty to look at for some time.
In addition to still-performing debt, the other area in which we’re most interested today is direct capital infusions into companies that need it to be made, as they say, more feasible. We made such a capital infusion into MBIA, which so far hasn’t turned out well, and we currently have offers out to make similar investments in a few other companies.
Describe a traditional fixed-income idea you find compelling today.
MW: We own the 3.625% senior notes of Forest City Enterprises (FCE), which we consider one of the preeminent real estate developers in the U.S. This is holding-company debt and there’s no debt outstanding that is senior to what we own at that level.
The operations of the company are conducted through myriad subsidiaries, which finance the construction of highquality office buildings, shopping centers and residential properties with long-term, fixed-rate, non-recourse mortgage debt, of which there is about $6.8 billion worth outstanding. In other words, a creditor owning subsidiary-issued debt can look only to the mortgaged individual properties for repayment, not to any assets of Forest City as a parent company. In effect the senior notes we own are a second mortgage, which to remain performing require only a subset of Forest City’s vast empire of prime real estate assets to throw off adequate cash.
Very little in distress investing lends itself to certainty, so as investors we always have to deal in probabilities. Based on our property-by-property analysis, we judge there to be a 90-95% chance that our notes will pay off at par when they mature in 2011. In the event we had to go through a Chapter 11 reorganization, we’d expect to receive in return common stock worth well in excess of the value implied by the current 50 to 55 cents on the dollar at which the notes trade. We’ve been long-term holders of Forest City stock and think the odds are good the company’s excellent long-term growth record will persist.
Since we first bought into this, the company has sold $300 million of common stock, so the credit has been enhanced. But even with that, the yield to maturity today is still around 20%.
How does that type of potential return compare to what you’re seeing in equities today?
MW: One thing I stress in the book is that if a well-financed distress investor is right about a performing loan remaining a performing loan, he doesn’t have to worry about market prices. If our analysis is correct and I bought Forest City debt with a yield to maturity of 30% – what it was when we originally bought – that’s what I’m going to get, regardless of what craziness goes on in the market.
I’m still spooked enough by what’s happened in the stock market that any new money we have to invest is very likely to go into performing loans we expect to stay that way – as long as we can hit the 20% bogey. I hate the tax disadvantage (bond interest and appreciation are typically taxed as ordinary income) but that’s just the way it goes.
Your support of MBIA (NYSE:MBI) has not been well-rewarded. What’s gone wrong?
MW: Management is trying to screw us, which I point out in the book is something that goes with the territory in distress investing. Basically, the company announced in February an asset-stripping transaction under which the MBIA Insurance Corporation – which issued the Surplus Notes we bought to provide them with fresh capital – transferred without any consideration over $5 billion of assets and all the profitable goingconcern activities of MBIA Insurance Corporation to a second-tier subsidiary of MBIA’s parent company. If that transaction stands, our notes will surely have suffered a material permanent impairment, and may be worth nothing. We and many other investors are currently suing them to reverse the transaction. If we’re successful, we’d expect the notes to remain performing.
In retrospect, any lessons to be learned from your MBIA experience?
MW: Probably the toughest thing we do is make judgments on portfolio-company managements. We generally do a decent job, but it’s the area of our “safe and cheap” approach in which we most often mess up. What’s particularly shocking in MBIA’s case is that management has not only materially harmed existing creditors and policyholders, but in my opinion it has made it so no one in the financial community is ever going to want to do business with them again.
More fundamentally, given how worried we were about the health of the housing market in 2007, we should have recognized how a collapse there would impact MBIA. I thought the municipalbond guaranty business was so good that it would overcome any problems elsewhere. That obviously has not turned out to be the case.
Have you been at all involved in the Chrysler or GM bankruptcies?
MW: Our only interest in all that has gone on is as a very large equity holder in Toyota (NYSE:TM). My general feeling is that nothing has happened with General Motors and Chrysler that is very likely to address the biggest problem they have going forward, which is that not enough people want to buy their cars.
You’ve often said that investing in distressed situations is a great training ground for value investors. Why?
MW: Mostly because it forces you to take a balanced approach, which means not just looking at earnings, but also studying the balance sheet and the cashflow statement. Distress investing gets down to the nuts and bolts of understanding exactly when and how money is coming in and going out, which is essential if you want to be a successful value investor. It puts an emphasis on leverage, on readily available cash, on realizable asset value – all of which is critical for surviving shocks like 2008 without permanent impairments.
We had a lousy year last year, but I’d argue we had far fewer permanent impairments than many other large value investors who paid more attention to the upside from very low valuations than to how bad things could get if credit shut down like it did.