[00:03:19] Shawn O’Malley: So today we’re doing another case study on an investing great. While I would encourage any serious stock investor to of course, go through the in depth writings of some of the best known investors to ever live, which include names like Warren Buffett, Charlie Munger, and Benjamin Graham. There are so many lesser known titans of finance out there that we can learn from.

[00:03:38] Shawn O’Malley: And that’s exactly what I’ve tried to do lately. In recent months, I’ve researched extensively and produced episodes on Wall Street icons like Howard Marks, Bill Ackman, George Soros, and Bill Miller. And today, I want to add to that list and continue with these industry case studies by taking a look at Marty Whitman, who is probably the least well known of those that I’ve studied closely.

[00:03:57] Shawn O’Malley: Some refer to Whitman as a vulture investor, one who feasts on securities from companies that have been left for dead by other types of investors. That certainly characterizes a portion of his career, but not all of it. Whitman is well known for his criticisms of the accounting principles used across corporate America.

[00:04:14] Shawn O’Malley: And we’ll get into that later in the episode, but Whitman has pretty interesting critiques of how generally accepted accounting principles are structured. Namely, he complains that accounting rules cater more to short term speculators betting on swings in stock prices than they do to creditors, which is problematic because debt markets are far bigger than the stock market.

[00:04:32] Shawn O’Malley: Much of the information in today’s episode comes from Whitman’s books and 30 years of shareholder letters, as well as blog posts and other commentaries on Whitman. An eBook compiling Whitman’s shareholder letters called Dear Fellow Shareholders is available for free online, and I’ll link to it and all the other sources I use in the show notes below.

[00:04:51] Shawn O’Malley: I find it fascinating to research the careers of Wall Street greats, and Whitman’s story is as fascinating as any. It really is a unique breed of person who can carve out a successful, market beating career in investing, and I love to learn about what drives these types of people’s thinking. Typically, the lessons extend well beyond just stock investing, and again, that is true here with Whitman too.

[00:05:12] Shawn O’Malley: To understand Whitman better, I’d like to begin by taking a look at the foreword of Whitman’s book, Dear Fellow Shareholders, which is meant to encapsulate three decades of his career as a professional investor. He outlines four elements of what he thinks constitutes a good method for stock investing.

[00:05:28] Shawn O’Malley: Firstly, a company should be eminently credit worthy, to use his words, which means that as a stock investor, you should have no hesitations about also lending the company money. Companies that are untrustworthy in repaying their debts are hardly worth consideration for serious long term stock investors.

[00:05:43] Shawn O’Malley: Creditworthiness also creates competitive advantages like being able to borrow at lower interest rates and being able to secure financing when needed, even in times of market volatility. Secondly, as he puts it, a stock should be purchased at least a 20 percent discount to its net asset value, which is similar to Warren Buffett’s idea of buying into companies at a discount to your estimate of their intrinsic value to provide a margin of safety.

[00:06:06] Shawn O’Malley: Thirdly, Whitman recommends investing in companies where there are full, meaningful disclosures that include reliably audited financial statements. On top of that, SOX, you’re considering investing in, should be traded in markets where regulators provide meaningful protections for minority shareholders.

[00:06:21] Shawn O’Malley: Generally speaking, investing in publicly traded companies in the U. S. and Europe do fit that criteria, so this is primarily a concern about investing in emerging markets. This fourth element for good investing is that a company should have reasonable prospects to grow its intrinsic value over the next 3 7 years at a rate of at least 10 percent per year after accounting for dividends.

[00:06:40] Shawn O’Malley: This stands out to me because it can be easy to fall into value traps where a company looks extraordinarily cheap on some multiple of its past earnings, but this is because the company isn’t expected to really have any future growth. Combined with 2 on buying at a discount to the underlying value, this might come off as a bit of having your cake and eating it too, where you want cheaply priced stocks but also companies that are compounding returns at double digit rates.

[00:07:02] Shawn O’Malley: The great thing about markets is that 5 days a week, stocks are trading, year in and year out and with enough patience, there will inevitably be opportunities to, as they say, have your cake and eat it too. As I mentioned at the top of the show, and as illustrated by his first rule for sound investing that I just went through, creditworthiness is Whitman’s top concern as a stock investor.

[00:07:21] Shawn O’Malley: Too much emphasis, in his view, is put on the income statement and calculations of net income, which do not perfectly capture a company’s ability to repay its debts. Income is important, but it doesn’t tell you much about how much total debt a company has, when it comes due, or what type of debt it even is.

[00:07:38] Shawn O’Malley: Debt matters to stock investors because if the company goes bankrupt, there’s an order of priority for who gets paid back first as the company is liquidated or restructured. And as a general rule, shareholders are paid out last, while creditors who lent money to the firm are repaid first. So if a company is at a high risk of being unable to repay its creditors in full, then there will be nothing left for stock investors, and any shares you own in the company are at risk of going to zero.

[00:08:03] Shawn O’Malley: Following the 2008 financial crisis, Whitman argues that if there’s anything we should prioritize more, it’s creditworthiness over accounting earnings. It’s a subtle note, but what he’s really getting at is that net income is not necessarily an accurate measure of a company’s financial health. It’s just one part of the picture.

[00:08:20] Shawn O’Malley: While Wall Street analysts and many individual investors love to obsess over quarterly earnings reports, much more can be gleaned about a company’s financial health by taking a more holistic perspective, beginning with also looking at a company’s balance sheet. And even more nuanced conclusion is to realize though that all of the company’s liabilities may not even be perfectly reflected on a balance sheet either.

[00:08:40] Shawn O’Malley: Still, the balance sheet is where you’d see roughly how much debt the company has outstanding. Whitman loved the balance sheet and he went to uncommon lengths to convert every possible corporate activity into assets and liabilities on company’s balance sheets, which in accounting is called capitalizing.

[00:08:57] Shawn O’Malley: A common example of this is with the leases that companies pay to rent out office space. If a company signs a five year lease where it’s paying a million dollars a year to rent out all of its office space and facilities, then that is essentially a form of debt that should be reflected on the balance sheet.

[00:09:12] Shawn O’Malley: It’s a contractually defined liability with set payments. In the past, though, the cost of lease payments would have been expensed on the income statement, which reduces net income, but you wouldn’t have a complete picture of the company’s financial obligations without including those future lease payments in the balance sheet.

[00:09:28] Shawn O’Malley: The solution, which in this case has become much more mainstream than it used to be, is to create an asset and a liability on the balance sheet reflecting the leases. The liability represents the present value of future lease payments, which gets reduced over time as payments are made. And the asset reflects the value from being able to use the rented office space.

[00:09:45] Shawn O’Malley: And this correspondingly gets reduced over time too. Nothing has changed operationally for the company. It’s still leasing office space and paying the same price to do so. But the way that’s reflected on financial statements like the income statement and balance sheet changes considerably if you choose to capitalize or expense the leases.

[00:10:02] Shawn O’Malley: Capitalizing them increases the assets and liabilities that a company is shown to have, which gives a more accurate view of its long term financial commitments. I don’t want to turn this into too much of an accounting lesson, but the takeaway is that Whitman vastly preferred to look at the balance sheet when examining companies, especially since the income statement gets so much attention already.

[00:10:21] Shawn O’Malley: And, as a result, he typically wanted to capitalize as much as he possibly could on the balance sheet to truly understand the picture of a company’s assets and liabilities. He wanted nothing to be hidden, to my comment earlier on how liabilities like future lease payments can be hidden off balance sheet.

[00:10:37] Shawn O’Malley: It wasn’t just liabilities that he wanted to be fully captured on the balance sheet though. He would even capitalize recurring revenues that were virtually guaranteed to occur as assets of the business. If a company had a contract with a trusted partner where it earned 10 million dollars per year from some royalty arrangement, he’d convert that into an asset on the balance sheet to reflect the present value of those future revenues.

[00:10:57] Shawn O’Malley: This is a step further than most investors usually go, especially since accounting norms require revenue to only be recognized when it’s earned, so you can’t count future revenue, but this really just shows how thoroughly Whitman liked to track everything through the balance sheet. Capitalizing unearned future revenues can be a dubious and misleading practice, but I’m sure he had very careful rules about doing it.

[00:11:19] Shawn O’Malley: Turning back to the conversation on creditworthiness and using the balance sheet to determine creditworthiness, companies with higher debt loads relative to their operating income are much less creditworthy because all it takes is a brief downturn in their business or a crisis in credit markets to potentially leave them in bankruptcy court.

[00:11:35] Shawn O’Malley: Even worse is that both of these things tend to happen at the same time. In 2008, for example, as the economy was slowing down and companies saw their sales fall off, a corresponding panic in financial markets made it very difficult for companies to refinance their debts coming due since banks and other lenders were no longer confident about making new loans.

[00:11:53] Shawn O’Malley: This ties into another very subtle point that the vast majority of governments and corporations never actually pay back most of the debt they issue. They just refinance it, which means they get a new loan to pay back the old loans when it comes due. It’d be like refinancing your house every few years with a new mortgage.

[00:12:08] Shawn O’Malley: It typically makes financial sense to keep rolling the debt forward into new borrowings, but that only works in times when the financial system is functioning normally and lenders are willing to help with that refinancing. Therefore, Whitman claims to only invest in companies that, over a 5 year period, control their destiny regarding when they raise money from capital markets.

[00:12:26] Shawn O’Malley: These companies are financially conservative enough to determine the timing of when and how to access fresh capital. I don’t want to stray too far from the original idea, but Whitman’s commenting on how we have to both look at the entire picture of a company’s financial health, not just its accounting earnings, while also being aware of the fact that many companies are more vulnerable than they might seem at first because they’re too reliant on refinancing their borrowings, which works well until suddenly it doesn’t in a crisis.

[00:12:51] Shawn O’Malley: Creditworthiness then, even in times of crisis, is critical to a company’s ability to continue functioning, earning profits, and creating wealth for shareholders. His criticism of investors obsession with earnings and the income statement also stems from his view that the wealth corporations create includes all of their assets and resources, not just their ability to manufacture recurring earnings.

[00:13:12] Shawn O’Malley: In The Aggressive Conservative Investor, he writes, quote, In referring to earnings power, the stress is on wealth creation. There is no need to equate a past earnings record with earnings power. There is no prior reason to view accounting earnings as the best indicator of earning power. Among other things, the amount of resources in the business at a given moment may be as good or a better indicator of earning power.

[00:13:33] Shawn O’Malley: In other words, this is sort of a veiled criticism of the validity of companies earnings as calculated by standard accounting practices. For example, Amazon stock was undervalued for years because the company’s net income was negative on paper since it was reinvesting so much money into building its business.

[00:13:49] Shawn O’Malley: Those negative profits on paper hardly reflected Amazon’s true profitability, and it certainly didn’t reflect how the company was setting itself up for decades of competitive advantages as it has since grown to become a company with a market capitalization of over $2 trillion. For context, from 2000 to 2024, Amazon has grown its market value 180 times.

[00:14:10] Shawn O’Malley: Earnings power, which reflects the true potential profits that a business can generate going forward is better assessed in Whitman’s opinion by evaluating a company’s underlying assets and not necessarily by looking at just the accounting profits it’s generated in the past because accounting figures can be manipulated and can be misleading.

[00:14:28] Shawn O’Malley: Another example of what he means is that when trying to value, say, Chipotle, rather than simply looking at Chipotle’s reported net income on its accounting statements from last year and extrapolating them forward, you might look at how many locations it has opened and how many it plans to open or close as an indicator of how much the company can earn going forward.

[00:14:45] Shawn O’Malley: To what extent companies are investing in productive assets or disinvesting from less productive ones will determine their future earnings power. I’m just making up numbers, but if Chipotle earned a billion dollars in revenue last year yet closed 50 locations, then you’d probably conclude that the company can’t earn as much going forward with fewer locations unless it raises prices dramatically at its remaining restaurants.

[00:15:05] Shawn O’Malley: So Whitman begins with understanding the resources invested in the business at the current moment, which may or may not align with past financial statements to determine earnings power. To summarize Whitman’s views on accounting generally and his preference for the balance sheet and the resources that companies have available to them, Hunter Hopcroft, a REIT investor and writer of the Lewis Enterprises blog, adds, quote, The essence of Marty Whitman’s contributions to investment philosophy is that firms, even if they appear asset light, are simply collections of productive assets with both disclosed and lurking liabilities.

[00:15:37] Shawn O’Malley: Whitman would have surely balked at price to sales ratios or discussions of total addressable markets as meaningful inputs to an investment process. A company’s ability to generate sales says nothing of its ability to generate corporate wealth. To build on what Hunter wrote there, I’d mention that as we’ve discussed the flaws with measuring earnings power through the income statement, Whitman would not be particularly impressed by companies like Zoom, which saw sudden surges in sales and profits during an abnormal period like the pandemic.

[00:16:05] Shawn O’Malley: As a rule, he’d be skeptical of companies being able to sustain spikes in sales or earnings without having had invested heavily over time to build up the assets on their balance sheet, both intangible and tangible. And as we’ve seen with Zoom, this is a biased example by me, but still, the company has not ultimately sustained those spikes.

[00:16:22] Shawn O’Malley: Zoom’s usage dropped off, and anyone who read into the jump in sales it earned during the pandemic too much would have overestimated the company’s results in the ensuing years. I’ll read another passage from Whitman’s book, which again, I think is really interesting. The aggressive conservative investor to further illustrate why Whitman is so weary of mainstream accounting and valuation metrics.

[00:16:41] Shawn O’Malley: I’ll read it here in full. It goes, quote, the achievement of earnings as defined by generally accepted accounting principles does not even necessarily contribute to solvency. For example, in the early 1950s, a cigarette called parliament, the original filter cigarette was introduced by Benson and hedges, then a very small cigarette company.

[00:17:00] Shawn O’Malley: Parliaments were inordinately successful, and Benson Hedges expanded by leaps and bounds. Unfortunately for Benson Hedges, working capital requirements ballooned, since in its industry it was, and is, necessary that cigarette tobacco be aged for an average of three years. The faster the business expanded, the more difficult it was to finance its requirements for larger inventories.

[00:17:22] Shawn O’Malley: The more Benson Hedges expanded as a small independent company, the greater its accounting earnings were, and the closer the company came to insolvency. Benson Hedges earnings were not real, they could be made real only by selling out to an entity that could finance Parliament’s expansion. Eventually, Benson Hedges merged into Philip Morris, for whom Parliament’s earnings were, of course, completely real, because Philip Morris had sufficient financial resources to benefit fully from the expansion that was taking place.

[00:17:50] Shawn O’Malley: That was a decent bit of information to digest, but the overly simplified version is that sometimes what looks good on paper and in accounting statements not only doesn’t reflect reality but can actually lead a company toward insolvency. The small cigarette company could not afford to finance its inventory as its products surged in popularity since its tobacco had to be aged for 3 years before being sold.

[00:18:12] Shawn O’Malley: As the company tried to scale up its operations and invest more in tobacco that would be sitting around idly for years to make its products, it was actually putting the company on worse and worse financial footing until it was saved by Philip Morris, who could actually afford to finance its popular Parliament cigarettes.

[00:18:27] Shawn O’Malley: As Whitman continues in his writings to shareholders, the mark of a good long term investor is not one who fixates on short term changes in market prices or just top down analysis based only on the income statement. Instead, a good long term investor is one who, even if they own just a single share in a company, tends to think like they own the entire company or like venture capitalists actively investing in a private business.

[00:18:49] Shawn O’Malley: Diversification is only a substitute for intimate knowledge about a company and a quote damn poor one according to Whitman. He adds quote, for us markets are taken as given, something investors take advantage of because they understand a business. In Whitman’s view diversification is far less necessary despite the teachings of mainstream business schools when someone is truly an expert on a company and has learned to think as if they own the entire business.

[00:19:14] Shawn O’Malley: While that has become something of a cliché, it really is a profound point. The vast majority of investors do not think about their stocks as companies that they literally own. We’ve all seen the way local business owners pour love, sweat, and tears into their businesses, and a good long term stock investor does the same thing with the fractional shares of ownership they hold.

[00:19:32] Shawn O’Malley: Imagine if you woke up every day and treated your steak in Microsoft the same way that some local entrepreneur treats their bakery business. You’d be constantly thinking about what the competition is doing, trying to understand what you do well, what customers think, and how your products could be improved, among dozens of other things you’d probably be thinking about as an owner.

[00:19:50] Shawn O’Malley: I’m confident that anyone who brings that type of mindset and passion to owning shares in publicly traded companies will have a superior understanding of a stock’s value than anyone on Wall Street, since Wall Street analysts are ultimately just paid to research a company. They’re not truly behaving as owners in it.

[00:20:05] Shawn O’Malley: Whitman takes this view even further by suggesting that at any given moment, it doesn’t put a lot of weight into market prices. In fact, the more one deeply and meaningfully understands a company, the less inclined one should be to look to fluctuations in market prices as a guide to how well their investment has performed.

[00:20:20] Shawn O’Malley: In Whitman’s words, only those with a superficial understanding of a business judge its performance based on short to intermediate term swings in its share prices. He writes, quote, market performance as a gauge of how an investor is doing deserves 100 percent weight when the particular investor does not know anything about the company in which he is investing other than the most superficial stock market statistics, such as market price history, recent earnings, dividend rate, stock ticker symbol, and the latest popular story about the company.

[00:20:49] Shawn O’Malley: This can be a dangerous mindset to have because I’ve seen plenty of investors who thought they understood a company better than the market did, so they rationalized ad nauseum why the stock’s share price continued to underperform, and they ended up spending years longer than they should have betting on an inferior company.

[00:21:05] Shawn O’Malley: So it cuts both ways. The most brilliant and enlightened investors among us are unfazed by whether the market agrees with their assessment of a company over narrow periods of time. Maybe a few months or even years, but eventually when their thesis plays out, they look like geniuses. Yet, I’d say it’s far likelier typically that an investor doesn’t have some superior understanding and are instead trapped by confirmation bias, which leaves them holding the bag indefinitely.

[00:21:29] Shawn O’Malley: I can still appreciate though, the unique perspective that Whitman brings here. A related pitfall is in trying to wait for the perfect moment to buy a stock, either through some form of technical analysis or market timing using macroeconomic indicators. This is a pitfall because as Whitman writes, as an investor, the goal is to concentrate on acquiring reasonable values rather than on getting the best possible values.

[00:21:51] Shawn O’Malley: The dreams of the roulette player, the horse player, and the technical market analyst are all variants of the same belief that just by studying the previous spin of the wheel, the form sheet, or the action of the market. A magic mathematical formula will enable the market player to use a scientific system to beat the game.

[00:22:07] Shawn O’Malley: In other words, not getting the best price is okay because a good enough price will be more than good in the long term. And the act of trying to wait for the perfect price is a problematic premise unto itself. Another topic that I enjoyed from reading through Whitman’s books and shareholder letters is that investing requires both quantitative and qualitative considerations.

[00:22:28] Shawn O’Malley: Quantitatively, we obviously want to judge companies by their returns and the health of their balance sheet, but we also want to judge the management teams running the company on behalf of shareholders. This is much more subjective, but Whitman offers three factors to consider. As shareholders and long term investors intending to think like owners of the companies we invest in, we should evaluate management based on their ability to act as operators, investors, and financiers.

[00:22:52] Shawn O’Malley: That is to say, not only must management teams be operationally excellent in terms of managing logistics efficiently and managing employees well with a healthy corporate culture, but they also must be investors, determining the best ways to allocate corporate resources to create value for shareholders, as well as financiers, determining when and how to raise funds to support the business.

[00:23:12] Shawn O’Malley: Plenty of executive teams excel in one or two of these areas but being able to do all three well on behalf of shareholders is rare. If you’ve read the book, The Outsiders, you’ll know this well, but most people really think of management as only being there to oversee the daily operations and strategy of a company.

[00:23:28] Shawn O’Malley: Not to act as investors or financiers, but an ability to wear all three hats is a telltale sign of a wonderful management team that investors should want to invest in. All these takeaways so far have been pretty high level, so let’s get in the weeds a bit and actually look over some of Whitman’s letters to investors and his funds through 3rd Avenue.

[00:23:47] Shawn O’Malley: Let’s begin with his 1989 letter. Despite his later warnings on the importance of creditworthiness, Whitman wrote much of his 1989 letter to shareholders focused on the opposite and discussing opportunities in troubled companies that have either already defaulted or seem likely to soon. And this is of course where he gets his reputation for being a vulture investor, which I mentioned earlier.

[00:24:08] Shawn O’Malley: He clarifies that he doesn’t do this, though, as an equity investor, but instead as a creditor buying up the company’s bonds on the cheap. This was certainly truer than it is today, but he says that there wasn’t much competition in making these types of investments, leaving his team able to earn returns that averaged 20 percent per year.

[00:24:24] Shawn O’Malley: In part, that may have been because investing in the securities of bankrupt companies was an even more niche domain in the 80s than it is today, where investors tended to be more concerned with defensively buying stocks and bonds of companies that were unlikely to ever go into bankruptcy, rather than trying to anticipate what would happen if and when a company came out on the other side of a bankruptcy restructuring.

[00:24:44] Shawn O’Malley: Doing this well obviously takes not only investing expertise, but also considerable familiarity with bankruptcy law. Much of what Whitman was doing at this time was intensive and expensive, ranging from working with lawyers to unified creditors and negotiating restructurings in bankruptcy court to consulting with investment bankers and accountants.

[00:25:02] Shawn O’Malley: So it’s not particularly replicable for everyday investors, but it is an illustration of the links to which some on Wall Street go to earn above average returns. You can imagine just how dense a lot of the legal paperwork is that they would be scouring through to try and figure out if they could buy a bankrupt company’s bonds for 25 cents on the dollar and get repaid 40 cents on the dollar from the liquidation of the company’s assets.

[00:25:23] Shawn O’Malley: In that example, paying 25 cents to get repaid 40 cents is a 60 percent return even though the company is not repaying more than half the debt they owe. But bankruptcy can be extremely messy and complicated and you can just as easily lose nearly everything. Plenty of investors would rather be done with it and maybe willing to sell their bankruptcy claims at steep discounts just to get some cash back.

[00:25:43] Shawn O’Malley: So, as I said, certain investment firms may own bonds that entitle them to be repaid, say 1, 000 per bond, and they might be trying to just take their losses and move on. In doing so, they’d sell their distressed bonds for 250 to someone like Martin Whitman, who would ride out the pains and uncertainty of the bankruptcy process and earn considerable returns if even just half the bond’s value is recouped.

[00:26:05] Shawn O’Malley: I want to reiterate again that this is a form of bond investing, not stock investing. In this same letter, Whitman notes that when investing in equity as a shareholder, he only considers companies in extremely strong financial positions with effective or at least honest management and where the price of the stock is available at a discount to its intrinsic value.

[00:26:23] Shawn O’Malley: My takeaway from this 1989 letter is that there are, of course, a variety of different ways to make money as an investor, and even as what you might call a value investor. And depending on what type of assets you’re investing in, you would prioritize very different things. Investing in distressed bonds, as Whitman has, is just as valid a strategy as investing in the stocks of well-run companies, though the timeframes and criteria you use are very different.

[00:26:47] Shawn O’Malley: Whitman uses vastly different frameworks depending on what are essentially the legal protections afforded to him. As a senior creditor, he not only gets paid back in bankruptcy before shareholders, but also before other types of lenders. So Whitman has a substantial degree of legal protection that gives him the confidence to buy up the debt securities of even bankrupt companies because he knows that if he can buy them for cheap enough, he can still earn a handsome profit once the messy bankruptcy process has been completed.

[00:27:12] Shawn O’Malley: This just takes a ton of legwork since you’re quite literally estimating what a company can sell its assets for. With a retailer like, say, JCPenney, you’d be trying to figure out after selling its inventory of clothes and properties how much money is left over to repay outstanding debts, and if there’s not enough, how much different groups of creditors are likely to recover.

[00:27:31] Shawn O’Malley: So it’s just a tough game to play. However, as a stock investor, his risk tolerance is completely different because his legal protections are far less. Shareholders own everything that’s left over in a company after all debts have been repaid. That’s why, as a stock investor, it’s so important to focus on a business’s financial health because the risk that you’ll incur a 100 percent loss is possible in a way that would be very unlikely for creditors.

[00:27:54] Shawn O’Malley: Creditors are likely to at least get back pennies on the dollar. As Whitman puts it, separately in The Aggressive Conservative Investor, quote, The biggest misconception is that the company will go out of business. That is typically not the case. Companies survive bankruptcy. Stockholders very often don’t.

[00:28:09] Shawn O’Malley: Another great misconception is that companies are too big to fail. That is a wrong way to analyze these problems. The right question to ask is whether companies have become too big not to be reorganized. Failure can be defined as what happened in the cases of AIG and Lehman Brothers when the common stockholders got wiped out.

[00:28:26] Shawn O’Malley: But these companies survived and their assets were put to other uses or other ownership. This just hammers in the message that bond investing and stock investing are very different and those differences become particularly apparent in bankruptcy. Yet what’s unique about Whitman is that he brings a bond investor’s perspective to stock investing.

[00:28:43] Shawn O’Malley: Here’s another passage from him, quote, it has been our observation that the most successful activists have had much the same approach to investing that the most sophisticated creditors have had toward lending. Essentially, these people approach a transaction with two attitudes. The first having to do with their order of priorities.

[00:28:58] Shawn O’Malley: In looking at a transaction, the single most important question seems to be, what have I got to lose? Only when it seems that risk can be controlled or minimized, does the second question come up, how much can I make? He adds, the second attitude has to do with a basic feeling that risk, how much one can lose is essentially measured internally, not externally.

[00:29:17] Shawn O’Malley: The possibilities of unsatisfactory results from an investment or loan are to be found internally in the performance of the underlying business and the resources in the business, not externally in market prices at which a company’s securities might trade. Successful activists and creditors, while not unmindful of the value messages that are delivered by markets, tend not to be overly influenced by such messages.

[00:29:37] Shawn O’Malley: As far as my objectives are concerned, I know much more about the situations in which I invest or in which I lend than the stock market does. So, Whitman categorizes distress investing as a form of what he refers to as performance investing, where you’re looking for a defined catalyst, like the end of bankruptcy, to drive price appreciation in the short term.

[00:29:56] Shawn O’Malley: He writes, quote, I’m not against performance investing, but it tends to be a lot harder to do successfully than value investing. He continues by saying, quote value investing has its problems. The biggest single one seems to be that companies invested in frequently are run by conservative deeply entrenched Managements who care a lot less than shareholders do about when good stock market price performance will occur Even given this, he says, I believe that a portfolio of well selected value stocks ought to earn reasonably satisfactory returns and ought to entail reasonably small investment risks.

[00:30:28] Shawn O’Malley: So, in 1989, Whitman saw opportunities and the distressed debt of companies in or near bankruptcy that he couldn’t pass up because he could purchase bonds and earn 20 percent returns or more by holding them through the bankruptcy process. Yet, even with those sorts of attractive opportunities, he remained partial to classic buy and hold stock investing, particularly when he could take advantage of Mr. Market’s mood swings to buy up shares at a hefty discount. Still, he didn’t have any illusions about what it means to be a shareholder in a public company. Throughout his writings, you’ll see the acronym O. P. M. I., which stands for Outside Passive Minority Interest. That is to say, when you buy a stock in your brokerage account, you do own shares in the company, but unless you’re a high ranking employee who can make key business decisions, then you’re an outsider.

[00:31:12] Shawn O’Malley: And without being a management insider or wielding a large enough stake to affect shareholder votes, your relationship with the company is more passive than active. Outside minority shareholders ride the bus while insiders or investors with controlling stakes drive it. While having an owner’s mindset will help an OPMI investor tremendously in deciding what companies to invest in and at what prices, this shouldn’t be confused with OPMI investors actually having sway over their portfolio companies.

[00:31:38] Shawn O’Malley: And while I know that many of the listeners of the show are not the types of people who are engaging in short term, highly speculative trading, the reality is that most OPMI investors are. Whitman argues that regulators like the Securities and Exchange Commission and industry groups like the Financial Accounting Standards Boards, which set the generally accepted accounting principles, also known as GAAP, that public companies in the U.

[00:31:58] Shawn O’Malley: S. adhere to, pressure companies to tailor their disclosures to OPMI investors, which drives them to focus more on short term developments. In his view, financial statements should be created narrowly with creditors in mind, not the sort of financial speculators who are likely to buy shares on an OPMI basis based on, for example, whether the company beat earnings projections in a given quarter.

[00:32:20] Shawn O’Malley: This has led to infamous examples of companies creating their own non GAAP adjusted measurements of performance that served only to misinform and exploit OPMI investors. EBITDA has become one such metric that is particularly mainstream, but there are far more egregious examples where companies disregard costs associated with stock based compensation, depreciation, or capital expenditures to create an adjusted measure of profitability for their industry that makes their business look artificially better than it is.

[00:32:46] Shawn O’Malley: Whitman writes, quote, The goal of reality for all through GAP is a mirage. Corporate life is too complicated to expect any system of measurement to reflect more than a few pertinent objective benchmarks. It cannot accurately, that is, realistically, report on all events and positions, especially since what is realistic frequently depends on subjective interpretation.

[00:33:06] Shawn O’Malley: The determination being that when statements cater to OPMI stock investors, the focus is on pitching them some optimistic version of the company. Whitman. Creditors, however, do not care about the optimistic visions for the future, because they do not stand to benefit from them. All they need is for the company to be able to repay its debts, so creditors tend to be far more conservative in their assumptions.

[00:33:27] Shawn O’Malley: There is no upside for them in buying into the hype, only downside if it works out poorly. When lending to companies, creditors are more inclined to consider everything that could go wrong, rather than to dream about what might go right. Again, in Whitman’s view, this conservatism from companies and their statements and disclosures, where they try to be as modest as possible about the future and honestly communicate the risks they’re facing, would be far better for financial markets than allowing companies to cater to equity investors who inherently are telling an optimistic story about the company where its share price appreciates in value.

[00:33:58] Shawn O’Malley: For the record, I do not necessarily agree or disagree with this view, but I can at least appreciate the argument he’s making. I can also see the value in bringing this conservative creditor mindset to making stock investments too. On top of this, Whitman discusses in his various writings that valuation depends on perspective.

[00:34:15] Shawn O’Malley: How the government values a company and determines its tax liabilities differs from GAAP accounting and how companies report their financial results to the public or how different stakeholders may focus on different things. One company looking to acquire another might focus on in the weeds details like balance sheet assets and liabilities, tax loss carry forwards, access to financing, and how asset values are carried on the target’s balance sheet, which are relevant to how a merger would directly affect their own financial standing, whereas the typical Wall Street analyst is looking at a company in a vacuum and valuing it primarily off its earnings results.

[00:34:47] Shawn O’Malley: Valuation then is somewhat a question of what angle you’re coming at an investment from, whether as the management of a competitor company, as the government, as an institutional investor in wall street, or as a retail investor. I’m going to go on a brief tangent here, but related to this, which I’ll link to in the show notes, is Whitman’s thoughts on whether markets are efficient and reflect all available information.

[00:35:09] Shawn O’Malley: In an article for the Yale School of Management, he discusses how markets made up of different types of participants will trend more or less toward efficiency. Similar to how approaches to valuation can differ depending on who you are, the same is essentially true for market efficiency. Not all markets are equally efficient, and participants in different markets will face different degrees of efficiency.

[00:35:29] Shawn O’Malley: In public stock markets with OPMI investors, as he calls them, where barriers to participation are low, and there’s a lack of control over the company, as well as a lack of inside information among those who are trading back and forth, then there will be a trend toward efficiency. In more esoteric markets, like the market for distressed bonds of companies going through bankruptcy where complexity rules the day, the market is less likely to be efficient, meaning there are opportunities for abnormal profits to be earned by skilled investors.

[00:35:57] Shawn O’Malley: It is also a question of time horizon too. The investor trading on very short time horizons is likely going against a highly efficient market where there’s little opportunity to reliably exploit edges for profit. On longer time horizons, there are just fewer people with that kind of patience to compete against, so a long term focused investor will go up against less efficient markets to their potential advantage.

[00:36:20] Shawn O’Malley: And lastly, he uses the term external forces to describe the effects of competition and regulation on market efficiency. A market where there is a central exchange, where a great number of people can express their opinion on a price, like the New York Stock Exchange, leads to more efficiency, while less centralized and transparent markets tend to be less efficient.

[00:36:39] Shawn O’Malley: Real estate, for example, is generally far less efficient than the stock market. There are only a few people bidding on the price of any one house up for sale, and there are intermediaries in the way, and as a result, you’re far likelier to find a mispriced house at a discount to its value than you are to find a mispriced stock.

[00:36:55] Shawn O’Malley: Regulators that work to define and enforce the rules of a market, like punishing insider trading, help ensure that the market is more efficient. A country with weak regulatory institutions or a weak legal system is more likely to also have an inefficient stock market that misprices assets. So, when discussing efficiency and the corresponding opportunities to reliably earn market beating profits, you have to consider the type of market you’re talking about, the time horizon, how strong the external forces are, and the complexity of the market.

[00:37:23] Shawn O’Malley: All around us, there are markets defined by these factors with different degrees of efficiency, ranging from the market for sports betting, to real estate, to the stock market, credit markets, and the market for companies to acquire competitors. Coming back from that tangent on market efficiency, I want to discuss further Whitman’s issues with gap accounting, particularly for the income statement.

[00:37:42] Shawn O’Malley: He uses some very technical examples to showcase the shortcomings of gap accounting. But in short, the lesson is that accountants are often forced to make trade-offs that really should be left to investors to make. In one example in the 1980s, he talks about how rampant inflation was making everything more expensive, including the barriers to entry to compete in certain industries.

[00:38:00] Shawn O’Malley: Whereas a factory might have cost 10 million to build before, as costs for all the equipment and labor needed rose, building a factory from scratch might have risen to cost 15 million. Companies faced offsetting effects from this though. On the one hand, if they build a factory when it only costs 1 million dollars to do so, the depreciation charges on their income statements would not properly reflect the fact that now it’s considerably more expensive to build that same factory, which is a cost they would eventually have to incur as they maintain and replace facilities.

[00:38:29] Shawn O’Malley: Yet, on the other hand, these higher costs make it harder for new competition to build factories too, which is an advantage for companies that had made these investments before a surge in inflation. Deciding how to account for the net effects of rampant inflation then, in Whitman’s opinion, was better left for financial analysts and investors to determine, not accountants preparing audited financial statements who try to make what’s known as current value supplements to reflect the current market value of company assets after a bout of inflation.

[00:38:57] Shawn O’Malley: It is more technical than this, but for the sake of brevity, I just wanted to make that very simple outline of Whitman’s issues with relying too heavily on accounting standards to accurately reflect the realities businesses are facing. Studying Whitman closely is interesting in part because he really does embrace thinking like a creditor to an extent that he disagrees with great investors like Warren Buffett.

[00:39:17] Shawn O’Malley: You can say pretty safely that Buffett is a master of thinking like a shareholder and therefore an owner in the business and finding companies that run themselves accordingly to invest in. One example of that is avoiding companies that abuse stock based compensation programs and excessively issue stock options to their management teams.

[00:39:33] Shawn O’Malley: That’s because issuing stock in this way increases the number of shares outstanding for a company, which dilutes existing shareholders ownership stake in the company, which reduces the returns they earn over time. You’re splitting up the same pie more ways, and everyone gets a smaller slice to make way for those who receive the stock options.

[00:39:49] Shawn O’Malley: Looking at this issue from the perspective of a shareholder, Buffett concludes that stock options are very much a real expense that must be accounted for, since they reduce the wealth of existing shareholders who own the company. Yet, stock options are not a cost paid in cash, and Whitman, like any true creditor, prioritizes cash flows in and out over anything else.

[00:40:07] Shawn O’Malley: In his Q3 2004 letter to shareholders, Whitman rails against accounting rules moving toward counting stock based compensation as a real cost. He writes quote, There seems no rationale whatsoever for equating the value of a noncash benefit to a recipient from an executive receiving a stock option to the real cost to the company to bestow that benefit.

[00:40:26] Shawn O’Malley: It seems doubtful that the real cost to the company for issuing the stock option benefit is measurable, while the value of the benefit to the recipient of the benefit seems measurable. For the record, that is a very, very wordy way of saying, if a company issues stock options to executives, it gets the benefit of compensating executives for the work they perform, while not actually having to pay them in cash.

[00:40:47] Shawn O’Malley: And since cash is the lifeblood of any business, he takes that to be a good thing. He even suggests that from a creditor’s perspective, any cash payouts to shareholders, either via dividends or share buybacks, are essentially a negative because they reduce the company’s cash balance, which effectively makes the company more leveraged.

[00:41:03] Shawn O’Malley: I can definitely appreciate this perspective if one were to only invest in corporate bonds, but I really don’t agree with his thinking at all on stock based compensation, at least from the perspective of equity investors. It’s similar to how depreciation is a noncash item in accounting, but still a real cost to account for over time.

[00:41:19] Shawn O’Malley: Um, Car owners will certainly understand this, since they have to pay overtime to service their vehicles to keep them operating. That wear and tear on a vehicle is a real cost, because relative to a new car, an older car requires much more maintenance. Like depreciation, stock based compensation is a real cost to shareholders, even if that cost doesn’t show up as cash leaving the business today.

[00:41:39] Shawn O’Malley: It is a longer term and more indirect form of cost. To wrap things up today, I’ll say that as we’ve covered, Whitman’s investment philosophy is centered on the belief that a company’s true value lies in its balance sheet, its collection of assets and liabilities. By capitalizing as many aspects of a company’s activities as possible, including assured earnings and fixed expenses, Whitman sought to identify investments that were safe and cheap in his words, which traded at a discount to their intrinsic value.

[00:42:08] Shawn O’Malley: But for him, safety took priority over cheapness, and safety meant that an investment was one where a long term investor was unlikely to suffer a permanent loss. Of course, to an extent, the two are interrelated, and cheapness does afford some safety. Whitman emphasized the importance of assessing intrinsic value through the balance sheet over popular metrics like sales or earnings ratios, arguing that the ability to generate corporate wealth, with wealth being defined as the difference between assets and liabilities, is more important than simply generating revenue.

[00:42:37] Shawn O’Malley: As the investor Hunter Hopcroft puts it, today, Whitman is rarely mentioned among the great investors of the past, but those of a certain disposition will find his work instantly edifying as a reasonable and rational approach to public equity investing. Whitman understands that as a common shareholder, you’re buying a levered instrument, typically in a non-controlling position.

[00:42:57] Shawn O’Malley: Viewing that investment from the seat of a creditor and justifying the risk in those terms is the hallmark of the aggressive conservative investor. In 2015, one of Whitman’s colleagues, Peter Lupoff, told the Wall Street Journal that quote, Marty was an academic at heart who approached every day as if the workplace were a laboratory to test his theory of deep value investing.

[00:43:16] Shawn O’Malley: While there are aspects of Whitman’s career and philosophy that are compelling, his downfall has undoubtedly affected his legacy. From December 2007 through 2015, Whitman’s flagship fund fell from managing almost 11 billion to less than 2 billion. As investors pulled their money while 3rd Avenue delivered paltry returns.

[00:43:35] Shawn O’Malley: Intellectually, it’s not controversial to say that Whitman really did contribute to the investing world. Whether you think he is a great investor in his own right, though, is more up for debate. On the one hand, he pioneered novel forms of investing, especially in buying up the securities of bankrupt companies.

[00:43:48] Shawn O’Malley: Yet his ethos of buying safe and cheap companies, which was meant to protect him from worst case scenarios, failed to hold up during the 2008 financial crisis. While many well regarded investors were caught up in the once in a generation type of crisis that 2008 was. Due to his age, Whitman was unable to find redemption in the same way that other investors like Bill Miller have my colleague at the investors podcast, William green of our richer, wiser, happier podcast knew Marty well, and I’d like to share a clip with you of William reflecting on his conversations with Marty after the financial crisis.

[00:44:19] William Green: I said to Marty, you know, you didn’t really handle the financial crisis well. Not only didn’t you handle the financial crisis well, but then the rebound afterwards, you didn’t really handle that well. And I said, how come? Like, given the strength of your ideas, given how smart you are, given how robust your ideas are, I don’t get why you didn’t do better.

[00:44:38] William Green: And it was a question based on the fact that I actually, I knew a lot about Marty Whitman and so I was able to ask him this kind of impertinent question that wasn’t just impertinent, it was like I was wrestling with what on earth happened? And he happens to be a very honest and direct guy and he said to me, you know, as I got older and richer, I became lazier.

[00:44:57] William Green: And he said, I kind of took my eye off the ball and he said, I owned housing related stocks and insurance related stocks going into the financial crisis in 2008. And he said, I kind of thought about selling. And I never got around to it. And it was an incredibly candid, honest admission. And to me, a really powerful reminder of just how difficult this profession is.

[00:45:15] William Green: You know, to be a great investor, you’ve got to be full on. And he was in his eighties at that point, if I remember rightly. And I think, you know, he was slowing down a bit and he had been an extraordinary investor.

[00:45:27] Shawn O’Malley: So Whitman is human and you might say Whitman was facing more structural challenges. Whitman’s balance sheet focused flavor of investing has gone out of style as tech companies have come to increasingly dominate financial markets where their assets are primarily intangible and much harder to quantify. I found his approach interesting, but I can also see why it may have been best suited for a period of time like the 1980s and 1990s and hasn’t aged well as the structure of the economy and financial system have changed.

[00:45:57] Shawn O’Malley: Still, I’d venture to say we can all learn a thing or two from thinking like an aggressive conservative investor. On that note, I’ll leave you all with one last quote from Martin Whitman to wrap things up today. Quote, Most people who trade common stocks, as opposed to those who hold common stocks, seem to be more interested in the near term outlook than in anything else.

[00:46:14] Shawn O’Malley: They will not purchase a security if the near term outlook looks bad or uncertain, regardless of the price at which it is selling. An investor who is able to take positions, based on other factors, increases his chances of finding outstanding long term bargains, since there is a relative lack of competition in the market in which he is buying.

[00:46:31] Shawn O’Malley: for listening. I hope then as Whitman tells us, we can all turn our focus to the longer term where markets are less efficient and offer better bargains. That’s all for today’s episode, and I hope to see you again next week.

[00:46:43] Outro: Thank you for listening to TIP. Make sure to follow Millennial Investing on your favorite podcast app and never miss out on our episodes to access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.