Marty Whitman is a legend in value investing circles, and yet he still continues to surprise. In his most recent letter to shareholders, a must read for value investors, he laid out his case for both MBIA (MBI) and Radian (RDN):
THE RESIDENTIAL MORTGAGE MELTDOWN AND HOUSING COLLAPSE
TAVF is investing heavily in the common stocks of companies suffering through the current housing crisis. These companies include financial institutions, a homebuilder, a building supplier, land banks and investment builders. The Fund’s reasons for this investment program provide a good case study as to how Third Avenue’s “safe and cheap” approach works in practice:
First, the bad side of these investments:
1) The stock market pricing for these equity issues is chaotic. There is no way Fund management is able to pick a bottom for securities prices, or a near bottom.
2) Fund management has no good idea of how deep the crisis will become, or how long it will last. Our best guess is two to four years.
Second, the good side of these investments:
1) In each instance, TAVF is acquiring common stocks at meaningful discounts from readily ascertainable NAVs. In the case of certain financial institution common stocks – MGIC Common, MBIA Common and Radian Common, the prices the Fund is paying are no more that 40% of book value, or adjusted book value. For each of these companies, a normalized Return on Equity (equity equals book value) (“ROE”) ranges from 8% to 14%. Assuming a 10% ROE sometime in the future, and no further dramatic deterioration in book value during the interim, probably a realistic assumption; and current pricing at 40% of book value, Third Avenue would be paying only four times future normalized earning power. There seems to be a reasonable probability, too, that TAVF is really paying less than four times normalized earnings, even assuming that future normalized earnings are fully taxed and even assuming some modest dilution of the common stocks.
2) Each common stock acquired, is acquired in a company which enjoys a strong financial position. While there can be no guarantees, the probabilitiesare that each of these companies will survive as solvent going concerns either without requiring major access to capital markets for new funding, or by obtaining new funding from others on terms that are only modestly dilutive for TAVF. On December 10th, MBIA announced that it is obtaining $500 million of equity financing from Warburg Pincus; and another $500 million from a rights offering which Warburg Pincus will backstop, i.e.,underwrite. Assuming that Third Avenue participates in the rights offering and also takes advantage of any oversubscription privileges, the capital infusion should be, at worst, only modestly dilutive for TAVF.
3) Each company seems very well managed.
4) It is possible that the crisis will become increasingly deep, and prolonged; or rating agencies will start to place great weight on soft, qualitative considerations. In those events, the companies might need capital infusions to remain going concerns. TAVF has proposed to MBIA,Radian and USG managements that such infusions be in the form of equity, and that existing stockholders provide the equity via pre-emptive rights offerings. MBIA proposes to raise $500 million via a rights offering. If this were to occur, and if other portfolio companies were to follow the MBIA path, the capital infusions would be, for Third Avenue, mostly nondilutive, or anti–dilutive (if there are oversubscription privileges). In the case of MBIA and Radian, it is crucial if they are to remain going concerns, that the national rating agencies continue to assign AAA and AA ratings, respectively, to each company’s bond insurance subsidiaries. As an aside, given current prices, TAVF would probably not lose money if Radian or MBIA were to go into run-off rather than remain going concerns. Run-off, i.e., liquidation, simply is not a likely outcome, however.
In the past, Whitman has been a master in both distressed equity, and even distressed debt, with a keen ability to determine true value, post crisis. While Marty is one of our heroes, we for one don't have the stomach to go near either of these companies, or most other names in related sectors.
The game has changed since Marty wrote this letter, especially in the case of MBIA, but we are steering clear. Too much risk, we believe, and possibly another shoe or two yet to drop.
While we hope Marty Whitman is right in the end, we are staying on the sidelines.
Disclosure: The author does not have positions in any of the companies mentioned, but does have a position in Third Avenue's Small Cap Value Fund.