The 'Safe and Cheap' Approach
The first step in the safe and cheap approach is to theorize what you could lose. If there isn't a safety net--a high-quality asset, in most cases--to keep the shares from going to zero, then there is absolutely no reason to waste time hypothesizing about the upside potential. The safe and cheap investor tends to focus on companies that own rock-solid assets: The balance sheet takes precedence over the income statement.
The safety net is key, but the company must also have several other qualities. It must be well capitalized, possess solid long-term prospects, have a savvy management team at the helm, provide excellent financial disclosure, and be available for purchase at a discount to its fair value. The "safe" component is satisfied by the first four attributes, while the "cheap" component is fulfilled by the last.
Well-capitalized businesses with solid long-term prospects tend to fall into three buckets under this approach. The first bucket is a strong operating company enjoying an economic moat and a balance sheet with no significant burdens. One of Third Avenue Value's largest holdings, Legg Mason LM, qualifies here. The company generates a great deal of free cash flow from its moaty asset management business and can use its underutilized balance sheet to acquire assets. We tend to prefer companies of this type since their proven economic moat allows them to earn excess profits for sustainable periods of time.
The second bucket includes companies that also lack significant liabilities, but own tremendous underutilized resources. These assets can be put to use in more efficient ways to create wealth over time. St. Joe JOE falls into this camp. The company is the largest raw land owner in Florida and strategically develops its land into master planned communities.
The third bucket consists of companies that own well-positioned assets that throw off solid cash flows and are partially secured with non-recourse debt. This type of debt, which only allows lenders to rely upon the asset for repayment (as opposed to the parent company), lowers the risk profile while enhancing cash returns on equity and providing tax-efficient ways to realize appreciation. Third Avenue Value's longtime holding Forest City FCE.A, a real estate developer, fits this description.
Savvy management teams are important and typically include a group of insiders who own a sizable equity stake in the company. For instance, longtime Third Avenue Value holding White Mountains Insurance WTM insiders own more than 10% of the company. The safe and cheap approach also holds in high regard management teams dedicated to creating wealth in the most tax-efficient manner, as well as management that takes advantage of inefficiencies in the capital markets.
The safe and cheap approach also favors companies that provide excellent disclosure. This disclosure typically supplements required filings and provides non-GAAP measures, and is often critical in assessing the true health of a business and its balance sheet. Such disclosure is also especially important since the safe and cheap investor may be taking advantage of depressed stock prices created by short-term concerns to acquire stakes in blue-chip companies. Great examples of this include Third Avenue Value loading up on MBIA MBI following concerns stemming from reported accounting irregularities, as well as recently establishing a position in Pfizer PFE.
Finally, the approach favors buying at a meaningful discount to fair value. Whitman seems to have rules of thumb for buying in different business lines. He favors buying financial-services companies below book value, real estate companies below private market value, asset managers below book value plus 2%-3% of assets under management, and operating companies below 10 times peak earnings. All of these measures revert to the company's fair value, or what Whitman terms "net asset value." While we prefer to value a company and its moat by estimating the present value of future cash flows, we couldn't agree more with Whitman's stipulation that buy orders only be placed at discounts to intrinsic value.
