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Looking For Hidden Value With Whitney Tilson

Emma Trincal

Few people are more qualified to discuss hedge funds and value investing than Whitney Tilson. Founder of T2 Partners, which manages three value-oriented hedge funds and two mutual funds, Tilson also co-edits Value Investor Insight, an investment newsletter, and is the co-founder and chairman of the Value Investing Congress. He's also written on value investing for the Motley Fool Web site and for TheStreet.com. Recently, we asked him to explain what differentiates a value investor, and to share some of his best investment ideas.

TheStreet.com: Who influenced your style in value investing?

Whitney Tilson: Warren Buffett has, by far, been the biggest influence on me as an investor. Beyond him, I'd cite Charlie Munger, Ben Graham, Phil Fisher, Joel Greenblatt, Seth Klarman and Bill Miller. Incidentally, one of the reasons I started the newsletter, Value Investor Insight, and the Value Investing Congress is so I could continue to learn from some of the all-time greatest money managers.

You are both a mutual fund and a hedge fund manager. That's rare. What are the advantages of doing both, and do you see this business model as a growing trend looking forward?

Few hedge fund managers have set up mutual funds, in part because of the regulatory burdens of being a registered investment adviser, but now that most hedge funds have to register anyway, I expect that more of them will choose to open mutual funds. We decided to launch mutual funds after years of frustration from turning away hundreds of people who wanted to invest with us [by law, only accredited investors can invest in hedge funds]. We launched the Tilson Focus Fund and Tilson Dividend Fund just over a year ago, and both are off to strong starts.

Your funds have a heavy exposure to large-cap stocks. Does it make sense for you, considering that you've made money on relatively obscure names?

Such a heavy exposure to large-cap stocks is indeed an unusual situation for us, but we are flexible and opportunistic investors. Our job is to scour the entire investment universe and find a handful of cheap stocks to buy, and the occasional overvalued stock to short, regardless of the size of the company, how many analysts follow it, or what industry it's in (as long as we can understand it well). While it is certainly true that bargains are more likely to be found in the obscure corners of the market, on rare occasions, such as right now, we believe, many of the best bargains are lying in plain sight.

Talk about your largest holdings. What is compelling about those stocks as a group?

We much prefer to own great businesses at good prices rather than the reverse, and are delighted that our portfolio has many such positions today. In fact, our seven largest holdings are Wendy's(WEN), Berkshire Hathaway(BRK-A), McDonald's(MCD), Wal-Mart(WMT), Microsoft(MSFT), Anheuser-Busch(BUD) and Costco(COST). The investment thesis is similar for all of them: With the exception of Wendy's, which is a good, but not great, business, we think these are among the world's greatest companies and that they will continue to dominate their industries for the foreseeable future. Such companies have historically traded at a significant premium to the market, as well they should, but today, on average, they trade at a midteens P/E multiple, which is actually lower than the market's. That's crazy!

We think that, on average, these businesses will grow their intrinsic values at about 10% annually and that their P/E multiples are likely to expand as well over time, such that we should earn 15%-20% compounded for the next few years, with low downside risk.

Talk to us about Microsoft, one of your largest positions.

Given how skeptical we are about the tech sector, owning Microsoft is a real leap for us, but this is a fantastic businesses and the stock is attractively priced. Microsoft has a dominant franchise; some of the most jaw-dropping economic characteristics ever achieved; capable, honest, shareholder-friendly management; and, unlike most technology companies, reasonably predictable future prospects. We're optimistic about Microsoft's future prospects for a number of reasons. Most importantly, the company will be releasing in the next year major new upgrades of its two cash cows, Windows and Office. Historically, these events have been big and highly profitable events for Microsoft, and there's no reason to believe otherwise this time. At a recent price around $27, Microsoft, after adjusting for the company's cash hoard, is trading at under 17 times earnings estimates for this calendar year. We don't claim this is screaming cheap, but it's close to the lowest P/E multiple the stock has ever traded at and is, we believe, a very attractive price for a company of its quality and bright future.

Lear(LEA) is your most contrarian play. Describe it.

Lear is one of the largest manufacturers of automotive seats and interior components in the U.S. The stock was the worst performer on the New York Stock Exchange last year, falling 52%, and is down another 38% this year. Lear's entire sector is highly distressed and many fear General Motors(GM), Lear's largest customer, will soon file for bankruptcy [GM has adamantly and repeatedly denied this].

So why do we own Lear's stock? Very simply, we think Lear is a good company -- in a terrible industry, to be sure -- and the stock's selloff is way overdone. Over the past 10 years, Lear has consistently generated returns on tangible capital of more than 25% and earned more than $5 a share in both 2003 and 2004. The stock is trading at three times that level of earnings today. Of course, earnings have been dismal over the past year and many question whether the company will revert to anything close to the prior mean. But even if earnings only rebound to half their historical levels, the stock is likely to double from here. We believe that most, if not all, of the factors that have caused Lear's profits to tumble will go away over time and that our patience will be rewarded. It may not be a smooth ride but no one said uncovering hidden value was easy.

You're still short MBIA(MBI). Why?

We've been short MBIA for years and it hasn't worked out yet, but we're more confident than ever about our investment thesis. We believe that the company is dangerously overlevered and underreserved and has been engaging in questionable accounting for many years to hide the true status of its business. Not long ago, it was forced to restate a $170 million loss that it now admits was not accounted for properly, and we believe that this is the tip of the iceberg. Many regulators, armed with subpoena power, are currently scrutinizing MBIA carefully and we think it is likely that they will find all sorts of other skeletons in MBIA's closet.