Off the Beaten Path with Third Avenue

Forget diversification, says fund manager Martin Whitman, who has turned that and other unconventional views into a winning formula

By James A. Anderson

Times like these make the gruff Martin Whitman smile. The manager of Third Avenue Value Fund (TAVFX ) is a 40-year veteran of the financial markets and an expert at unearthing undervalued investments, and he has to like what he sees these days. In this topsy-turvy market, plenty of out-of-the-way picks can be scooped up at unheard-of prices.

For example, California's energy debacle has allowed Whitman to load up on a number of distressed securities, the kind of investments Wall Street's rank and file normally avoid.


  Whitman's portfolio has certainly posted some impressive numbers. He's a value manager, and these days the markets are rewarding his type of investing. So far this year, his Third Avenue Value Fund is up about 4.0%, beating the Standard & Poor's 500 by nearly 9 percentage points. Last year, Whitman's fund bagged a total return of 20.8%, while the 500 mustered no better than a 9.1% loss.

Scan three-, five-, and 10-year periods, and Third Avenue has bested the market benchmark each time. As a result, Whitman's portfolio has earned a spot on BusinessWeek's A-list of high-return, low-risk funds and a five-star rating from Morningstar.

Whitman likes to stir things up as sure as the New York Stock Exchange closes with a bell at the end of trading. Take his views on diversification, that hallowed principle embraced by virtually every fund manager. Whitman says it's a tactic that's strictly for the lazy. "We feel it's a surrogate for knowledge, and a poor one at that," he explains.

Then there's Japan, where Whitman has parked about 12% of Third Avenue Value's Assets. He thinks the Asian nation's economy "stinks," and that Tokyo bureaucrats and business leaders "might be able to get things together, but they don't know how to get out of their own way." He's quick to point out, however, that his stake in Japan isn't about him losing his mind or his fund holders' money. "We love our investments there," he beams.


  True to his iconoclastic view of the markets, Whitman has divvied up his fund's money in an unconventional manner. As of the end of March, 43% of his assets were positioned in financial shares, including sizable stakes in bond insurer MBIA (MBI ) and brokerage and mutual-fund manager Legg Mason (LM ). Unlike many of his value brethren, Whitman has taken to tech, parking about 32% of the fund's money in small electronic-equipment stocks.

A financial expert in the vagaries of bankruptcy, Whitman also likes to carry distressed securities, positions in troubled companies, or shaky bonds that most investors avoid. Whitman says he'll place anywhere from 20% to 50% of his portfolio in those types of investments.

As an example, Whitman recently took a position in mortgage bonds issued by the troubled utility Pacific Gas & Electric (PCG ), with a yield to maturity of 25%. Though PG&E recently filed for bankruptcy protection, Whitman isn't worried. "There's a chance they might default, but it's very, very slim," he says.

Third Avenue Value has a large stake in what could loosely be described as Japanese blue chips. One large component of that position is a 3% stake in Toyoda Automatic Loom Works, a subsidiary of giant Toyota. For all the vinegar he has to share on the state of the Japanese economy, Whitman thinks the carmaker is special. "Toyota is nothing short of the most efficient, best-run manufacturing enterprise in the history of mankind," he gushes.


  Whitman says holding subsidiary Toyoda Automatic is a great idea for several reasons. For one, the company owns just over 20% of Toyota's common stock. For another, Toyoda is a major supplier of Toyota. And best of all, Toyoda is a cheap way to get in on the main company's assets. Whitman says Toyoda sells for about $19 a share on the Nikkei, while the market value of its Toyota holdings is at least $21.

Another intriguing bet for Third Avenue Value is passive components, parts of the electronic circuitry that make cell phones, PCs, and appliances work. Companies in the business -- such as Vishay Intertechnologies (VSH ), Kemet (KEM ), and AVX (AVX ) -- have seen their stock tumble over the past year in concert with semiconductor shares. But Whitman thinks the retreat was overblown and that passive-component makers' shares are inexpensive, selling at no more than four to six times their projected earnings for this year. "You haven't seen that in Cisco Systems," he chuckles.

"It makes sense that this would be a group to attract value investors right now," says Standard & Poor's equity analyst Tom Smith, who follows the industry. "It's a cyclical business, and if you get in when the stocks are cheap, you stand a good chance of making a healthy profit in an up cycle when the group's shares tend to move to double-digit multiples in the 20 to 30 range."


  Last year, passive-component makers were talked into bringing on a massive amount of capacity by cellular-phone makers, Smith explains. When the mobile-phone business started to slow, passive-component makers saw their orders fall off. Smith says revenues in the industry could drop as much as 20% this year but should pick up to the teens in 2002 as the industry recovers.

Whitman's moves into tech haven't always panned out, however. The money manager says two semiconductor-industry holdings, SpeedFam-IPEC (SFAM ) and C.P. Clare (CPCL ), just never got going in 2000. SpeedFam-IPEC, a chip-equipment maker, has moved from the low 20s to a May 14 close of $5.66, mainly on worries that the semiconductor industry had hit a cyclical peak and would go into hibernation. C.P. Clare, which makes components used in the communications business, has sagged from $9.75 to a May 14 close of $2.65.

Such is the nature of value investing, especially in tech, Whitman says. "We treat the sector as if we're first-stage venture capitalists. We understand we're going to have a pretty high strikeout ratio, so we better cast a wide net."


  For a value investor, Whitman's standards are stringent. He's on the lookout for companies the market has passed over, and he won't pay more than 50 cents for any $1 of underlying value. He won't sniff at a company unless it's in "superstrong financial condition." For Whitman, that means free cash flow and preferably a good deal of money on the books as well. He shies away from liabilities of all sorts and sizes. While he might stomach long-term debt on the books of a real-estate holding, for instance, he'd never tolerate the type of litigation problems that crop up with tobacco shares.

Whitman says he needs to feel that management isn't overreaching. He also likes a straightforward business. "We expect full documentary disclosure from a company and reliable audits," he says. "We don't expect them to tell the truth, but we expect an audit to give enough objective benchmarks to enable us to understand what's going on."

Whitman's modus operandi also requires a good deal of patience. He says he's willing to hold a position for years, and his record bears that out. According to Morningstar's latest tallies, Third Avenue Value's turnover last year was a small 30% of its portfolio. On average, small-cap value funds -- the peer group Morningstar uses to gauge Whitman's results -- shuffle about 72% of their holdings a year.


  A steady hand keeps Whitman's expense ratio low, as well. Third Avenue Value's costs amount to 1.1% of assets. Meanwhile, the average small-cap value fund's expenses hover at about 1.6%, according to Morningstar.

But to hear Whitman tell it, patience is just one part of value investing. "Value is dynamic, and if we're doing our job right, the underlying value of the business should increase over time," he says. "We follow the simple formula, we take our stake, and hold our breath."

Anderson teaches journalism at the City University of New York. Follow his twice-monthly Mutual Fund Maven column, only on BW Online

Edited by Patricia O'Connell