Whitman Throws Down the Gauntlet

The latest shareholder letter from The Third Avenue Fund has Marty Whitman firing back at William Ackman, a hedge fund manager I have written about previously, over MBIA:

"...invested in MBIA Surplus Notes at a yield to call of slightly over 14% per annum. The MBIA Surplus Notes appear to carry very small, or non-existent, credit risk, and thus are considered by management to be a near-cash investment (albeit the MBIA Surplus Notes, unlike cash equivalents, are subject to market price fluctuations)."

"On February 11th, TAVF acquired from MBIA, 10,610,425 shares of MBIA Common at $12.15 per share. This brought the Fund’s holding to 23,148,845 shares of MBIA Common, or about 10% of the issue outstanding.MBIA is now strongly capitalized. It ought to qualify easily for an AAA rating with a $17 billion claims paying ability. If so qualified, MBIA would be in a position to underwrite a large amount of profitable new business."

And then Whitman gets the knives out:

"Ackman does not seem to understand the Property and Casualty (“P&C”) Insurance business and its sources of profitability. Ackman believes that the Bond Insurer Model does not work because the insureds are able to buy an AAA credit rating so cheaply. The facts are that Bond Insurance is one of the more profitable P&C businesses."

"(Ackman) argues that prices, as determined by marks to market, or mark to model, always deserve 100% weight. This is arrant nonsense. Market prices do deserve dominant weight in an analysis where the portfolio consists wholly of common stocks and non-performing loans held in trading accounts. Market prices deserve little or no weight, when the portfolio consists of performing loans, and in force policies, to be held to maturity."

"(Ackman) pays little attention to the rules of seniority and priority of payment in evaluating, or understanding, senior tranches of debt. The argument that if an entity is in trouble, every liability on the balance sheet of that entity is also in trouble is strictly “amateur hour”. Frequently, senior issues sail through troubles unscathed."

Here is my post on MBIA from February 2008.

MBIA vs. Ackman

During its mammoth fourth quarter conference call that lasted 4 hours, MBIA took a shot at William Ackman:

"One other side benefit from our decision to accept questions only in writing. We clearly acknowledge we are taking the microphone as it were out of the hands of those inclined to ask questions of us. In the recent past, several such people have abused the privilege and used it as a soap box to raise criticisms, complaints, ramped or failed to ask coherent questions. Many of these people have effectively become adversaries of our Company, our employees, our clients and our business relationships. Many of them have demonstrated no problems finding media outlets to proselytize their messages against our Company. We see no reason to provide them with another forum to do so."

What is Value Investing? – Part II

I think that it is safe to say that when William Ackman, the renowned Hedge Fund Manager that runs Pershing Square Capital, says that Target is “undervalued,” and when Warren Buffett, the equally renowned value investor says that Burlington Northern is “undervalued,” they mean two very different things. And yet both are very successful at what they do and very rich. So who is right?

Ackman is not your typical stereotyped “value investor,” and Target is not your typical stereotyped value stock. Target’s enterprise value is 9.5 times its trailing 12 month EBITDA. Its forward price to earnings is 15.5 times, while it trades at 3.5 times tangible book value. It is not cash rich, holding $550 million in cash, or about $ 0.55 per share according to Yahoo Finance. The performance has been great as well. Target is up 12.3% year to date and has beaten the S & P 500 by 700 basis points.

So what’s going on here? Why is the stock “undervalued?” according to Ackman. Well, in a sense there is the effect of what is known as “cult investing.” When a well-known and successful investor announces that he is buying a stock, the herd moves onto it en masse pushing up the price. Ackman enjoyed that effect as rumors hit the market a week before his filing was done on 7/16/2007.

Buffet and other traditional value investors look for a “great business selling at a great price” in his words. He doesn’t seek to change anything at the company he buys. In fact he wants nothing to change, that’s the entire point. Management usually stays in place.

Ackman wants the company to change, to restructure in some way. Not because it will help the company long term, but because the market will pay more for your company if it looks the way I tell you it should look. For Target, that means sell or spin off your credit card division and try to unlock the value of your real estate somehow. For other companies that are being targeted it might mean something else - sell the entire company, split in two, issue debt and use the money to buy back stock. He doesn’t really care if 2 or 3 years down the road Target is a weaker or stronger company because he probably won’t be a shareholder by then.

I hesitate to say that Ackman is price indifferent to what he pays, because everyone cares about what they pay for something but in a sense he is price indifferent. He creates value at the companies he owns not by making its business stronger or better, but by shuffling parts of the puzzle around. Call it financial engineering if you like. If earnings grow faster than they did before he got there, its not because he helped them become better at retailing, its probably because its share count will decline due to some huge buyback that the company announces. When Ackman sits down with Target management is he going to say that they should work on their merchandising or that they should cut back on the number of SKU’s at their stores?

The Ackman strategy then is this simply put –

1. Find a large cap stock where the market is valuing the stock exactly at what it should be valued at based on the company’s profile.

2. Quietly accumulate a large stake in the company over a period of several months.

3. Leak word on the street that you are building a stake in the company and receive the cult effect.

4. Make your public filing of ownership and send letter to management.

5. Meet with and pressure management to do what you tell them to do to get the stock price up.

6. Wait for management to cave in and see the stock rise even more.

7. Sell quietly in a few months after the general public piles into the stock.

8. Give part of profit to charity but only in years when Hedge Fund manager wealth is getting really bad press.

Now I am not criticizing Ackman for what he does. Everyone has to create value for their investors and if it can be done this way then so be it. I was only trying to demonstrate how two investors who are very different can utter the same word and do it with a straight face.