Living on Chinese stocks

Whitman: "Over the next five years, growth prospects in East Asia are much better than they are in North America."

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NEW YORK (Fortune) -- Third Ave. Value Fund: (TAVFX)
Manager: Marty Whitman
Return since 12/01/08: 56%

While some investors fear a stock bubble in China, Marty Whitman, manager of the Third Avenue Value fund, still sees value in Hong Kong-based shares. "When I say we're buying equities there at 30 to 50% discounts, I'm not stretching," he says.

Whitman has put his money where his mouth is: Hong Kong-based real estate and private equity companies compose a whopping 40% of Third Avenue Value's portfolio. He says that's why the fund, which has $5.4 billion in assets, is up 39% so far this year, 21 points better than the S&P 500.

Emerging markets took a plunge last year, which is part of the reason why Third Avenue Value, which had about 30% of its holdings in Hong Kong at the time, dropped 46% in 2008.

While Whitman's long-term record is still impressive -- he has beaten the MSCI World Index by 5.3% annually since the fund's 1990 inceptions -- shareholders left the fund in droves, forcing him to sell many of his stocks.

Despite the wave of redemptions, Whitman continued to scan the market for deep values. He told Fortune in December: "I've never seen pricing like this in high-quality, creditworthy companies."

When Whitman goes bargain hunting, he follows a set of long-held investing tenets, looking for companies that are well financed, trade at discounts to "readily ascertainable NAV" of at least 25%, and have long-term growth prospects of at least 10% over the next five to seven years.

After last year's meltdown, he added a new rule: Don't invest in common stocks of companies that need to regularly refinance. "The short sellers, i.e., bear raiders, have become too powerful," he wrote in July.

Those guidelines, says Whitman, are what led him to Hong Kong. "The companies are magnificently financed, they have income producing real estate, and they have huge presences in mainland China," he says.

His top holding is Henderson Land Development, a Hong Kong real estate business (which doesn't trade in U.S. markets). When Whitman increased his stake in Henderson last fall, he told shareholders that he liked its low net debt-to-shareholders equity ratio, as well as its ability to increase ownership of local subsidiaries.

"Over the next five years, growth prospects in East Asia are much better than they are in North America," says Whitman. Analysts expect the average stock in his fund to boost earnings by 15.2% annually over the next 5-7 years, compared with the fund category average of 13.8%.

Because he owns so many Hong Kong real estate stocks right now, Whitman admits he's unlikely to add more to his portfolio. Instead, he's looking for opportunities in U.S. based distressed companies.

"There's an awful lot of them out there," he says.

Last quarter, the fund added 2.4 million shares of Forest City Enterprises (FCY), a real estate company that needed a capital infusion (It's more than doubled in value since Whitman bought it). Third Avenue Value has also participated in 363 sales, which are auctions of assets by bankrupt companies. Recently the fund placed a winning bid on the housing assets of FleetWood Enterprises (FLTWQ), a bankrupt maker of manufactured housing and RVs.

Another area that Whitman likes is energy. "The long-term outlook is still good," he says. "I'm one of those peak oil people -- I believe the world is running out of fossil fuels."

Whitman prefers natural gas stocks, especially Nabors Industries (NBR), where he's on the board. "They're the leading driller, and they have the technology to drill through shale," he says. "If we get back to $13 gas, it would be a bonanza for them."

--Over the course of this week, we're checking in on five funds we recommended last December: Osterweis, Fairholme, Vanguard Primecap Core, Longleaf Partners and Third Avenue Value. All five are beating the market by big margins.