Keep looking in garbage cans and sometimes you will find hidden jewels.

That's the philosophy of Third Avenue Management, whose flagship is the Third Avenue Value Fund run by legendary value investor Marty Whitman, a bankruptcy specialist. The veteran money manager advocates a "safe and cheap" approach to investing in troubled companies. These could be companies close to or about to go through bankruptcy reorganization.

But Third Avenue also wants its companies to have sound balance sheet. Selecting from the entire universe of fallen securities, Third Avenue distills a universe of about 3,000 portfolio candidates down to about 400 securities, according to Tom Lapointe, senior research analyst.

"On those 400 securities, we look to not only our potential return, but more importantly the potential downside of any one of those securities," according to Lapointe.

Several rounds of further vetting will get this candidate group down to a portfolio of 50 to 60 securities. The key is to find a stock out of favor or a distressed debt with a margin of safety. "If we're wrong, we'll have limited downside, which is the most important way to construct a portfolio from our view," Lapointe says.

"We tend to look down before we look up. Our philosophy is capital preservation first," adds David M. Barse, president and chief executive officer of Third Avenue Management.

The four funds of the family, which also include the Third Avenue International Value, Third Avenue Small Cap Value and Third Avenue Real Estate Value funds, pick through financial landfills looking for formerly successful companies that are now shunned by most investors.  

"These funds generally have been very good performers," says Bridget Hughes, an analyst with Morningstar.

The funds buy lots of distressed securities, including senior obligations and what fund officials call "fulcrum securities." These are securities that could give the fund equity participation or control of the company if it continues into bankruptcy.

An example of what Third Avenue finds picking through Wall Street's dumpsters is privately owned Vought Aircraft Industries, an aircraft supplier that has been one of Third Avenue's success stories. Its debt obligations were bought earlier this year at a time of maximum pessimism.

Vought Aircraft was working on a big project with Boeing. Vought Aircraft executives, however, spooked investors by admitting they were financially overwhelmed by the contractual obligation. But Third Avenue saw potential gold in discounted notes.

"There was an opportunity when we looked into it when the first lien bank debt was trading at 82 cents on the dollar and the senior unsecured notes were trading at 66 cents," says Michael Fineman, a Third Avenue senior research analyst.

Both, he adds, represented fat yields to maturity. Third Avenue was also drawn to Vought Aircraft because it had a virtual franchise. It was the sole supplier of many aircraft parts, unlike the auto industry, where there is competition among parts suppliers.

Vought Aircraft was the supplier of  structures and systems in the Boeing 787 Dreamliner's aft fuselage section. "Vought Aircraft was in a very strong position," Fineman says.

So why didn't others see that?  

Investors were scared. They questioned whether the Boeing 787 Dreamliner project, which has been beset with delays,  would take off. But Third Avenue officials insisted there was a good reason to buy. They were convinced the company's fundamentals, especially its debt profile, were good.

"Its bank debt was covered over 200% and we found the senior unsecured notes were probably worth 90% of their par amount outstanding," Fineman says. The optimistic outlook was not just based on the 787 Dreamliner, he adds.

"To the extent that the 787 platform became something real and significant for Boeing and Vought Aircraft, there would be significant upside," Fineman says.

The upside became a reality on July 7, when Boeing agreed to pay Vought Aircraft $580 million for its North Charleston, S.C., plant.

Using the fulcrum security or senior debt, Barse explains, meant shareholders got the maximum shot at Vought's upside and the minimum exposure to things going wrong.

This philosophy dates back to the founding of Third Avenue by Marty Whitman. "He has believed in investing in that fulcrum security as a way to gain control of the business," Barse adds.

Whitman's strategy is to "use his control, and a reorganization process, to exchange that security for the stock of a newly created and equity capitalized business so he would only own company stock in a debt free business that was newly reorganized," Barse says.

The firm originally began its life as a brokerage in 1972 called MJ Whitman & Co. It later evolved into Third Avenue Management. Whitman has stated that he looks for distressed securities because he believes many people misunderstand them.
"The amount of money invested in credit instruments of all types," Whitman writes, "dwarfs the amount of funds invested in equities."

Third Avenue funds buy not only based on a company's numbers, but also on the quality of its leadership. It wants management that "has a good track record as both owners and operators and shares a common interest with outside, passive minority investors," according to a statement of principles at the company's Web site.

Recent history has shown, however, no investment strategy is without downside risk. Last year, for example, Third Avenue Value lost 45.6%, trailing its index by 2.2% and getting beat by about 75% of the funds in its category, according to Morningstar, which puts the fund in the world stock/large cap category.

Third Avenue, which has large foreign real estate holdings, was brought down in 2008 along with almost everyone else due to the world subprime loan crisis. It was also hurt by the fact that it had 35% of the portfolio in just three securities, and a 58% weighting in the financials sector.

"Since this is a highly concentrated portfolio, the portfolio can have problems from time to time," Morningstar's Hughes explains. "So these are really funds for the long-term investor, for someone who has a lot of faith in Marty Whitman. But he has had a lot of success."

The 2008 numbers were also a jolt because of Third Avenue's exemplary performance over the past decade. Even with the losses of 2008, the flagship fund's 10-year annualized return stood at 7.25% as of August 5, which beat its index by five percentage points and put it in the top 9% of its category.

Nevertheless, garbage-picking can be risky business, particularly when it comes to assessing a corporate management team.
In a newsletter earlier this year, Whitman conceded that evaluating management is an area in which the company "screws up more than any other." For instance, there is Third Avenue's legal battle with MBIA, which has huge municipal insurance and structured finance operations.

MBIA was once one of Whitman's favorites, but it is now being sued by Third Avenue, among others. Third Avenue had been a holder of MBIA stock for a decade. Last year, it also participated in the firm's capital-raising process by buying the notes of an MBIA subsidiary.

This happened just after mark-to-market accounting severely reduced the company's capital base. The parent company had decided to separate its structured finance and municipal insurance operations and transferred some assets, which Third Avenue officials believed undermined their investment. Whitman called it a "fraudulent transfer" from one part of the company to the MBIA Illinois subsidiary.

The lawsuit is pending. Third Avenue officials cite its status for not commenting. However, Whitman, in a letter to shareholders, charged that MBIA management has "sullied" its reputation.

Nevertheless, MBIA is "vigorously" defending the lawsuit.

"We have complied with all of the terms of their [Third Avenue] investment," MBIA CEO Jay Brown wrote in a public comment.

Still, despite the traumas of MBIA and last year's subprime meltdown, Third Avenue Value so far this year is bouncing back, outdistancing the indexes. The flagship fund was up some 29.5% for the year through August 5.

Once again it was easily beating its benchmarks, the S&P 500 and MSCI AC World Index, by between 3% and 6% and doing better than most of the funds in its category.

Two of the other funds were also outdistancing the indexes this year by a country mile, although International Value was slightly lagging its index in the first half of the year.   

The prospect of a protracted bear market, say Third Avenue officials, should mean myriad opportunities to invest in historically good companies that are available for a discount.

These will be companies that are temporarily going through hard times or may be in bankruptcy. Who are they? Third Avenue Management officials won't say. However, they are watching them closely.

"We are licking our chops about this market," Barse says.