Weight to Performance
The Third Avenue Value Fund (TAVF) had essentially a break-even year in fiscal 1998. What kind of consideration should mutual fund investors give to performance, especially sub-par performance? For buy-and-hold, long-term growth investors such as TAVF, its annual performance ought to be a symptom of one of two things.
- Poor performance could be a measure of a money manager’s incompetence. The investment in LTCB Common would seem to point in that direction. Or,
- Poor performance could be a measure indicating that terrific values in the portfolio became even more terrific as the common stocks of strong businesses with large long-term potentials became even more attractively priced than when they were acquired initially. I believe that this is the case for the twenty-nine common stock positions which were increased during the just-ended quarter. Pricing for the particular issues seemed more like 1974 or 1982 to me than they did like 1998.
Hopefully, the stockholders of TAVF will give much more weight to the quality of the existing portfolio — and the prices paid to establish these positions — than they will to LTCB. LTCBs do go with the territory. After all, Peter Lynch had Crazy Eddie and Warren Buffett had U.S. Air.
Further, there are other ways to measure performance that may be more meaningful than one-year results overall. For example, our investments in Japanese non-life insurance companies have far outperformed relevant indexes. At October 31, the market value of the Fund’s investments in Japanese non-life insurance companies virtually equaled TAVF’s cost. Third Avenue had initially invested in these issues in January 1997 when the Nikkei Index stood at 19,446. At October 31, 1998, the Nikkei Index closed at 13,564, for a decline in the January 1997 to October 1998 period of a little over 30%. The experience for the Fund’s investments in semiconductor equipment common stocks seems to have been similar — the Fund’s investments in semis outperformed easily the semi index.
This is the way it should be. First, the companies in which the Fund has invested enjoy exceptional financial strength. As such, they are unlikely to be victimized by dramatic, adverse, unpredictable business changes. Second, if there is no evidence of permanent impairment of capital, Third Avenue averages down by increasing its positions in the common stocks of solid companies at lower and lower prices. If we do the analysis right, long-term performance for TAVF ought to continue to be satisfactory. I remain optimistic about the issues currently in the Fund’s portfolio, both in terms of quality and in terms of appreciation potential.
A Balanced Approach to Value Investing
Third Avenue uses a Balanced Approach in assessing investments. In this regard TAVF is quite different from the vast majority of other mutual funds where, instead of a Balanced Approach, money managers emphasize a Primacy of the Income Account Approach. These other money managers focus on forecasts of future flows – either earnings or cash flows.
It may be helpful to Fund shareholders if they can gain an understanding of how TAVF differs from most others. I try to provide such understanding in the following paragraphs, most of which are excerpted from my new book scheduled to be published by John Wiley & Sons next spring. The title of the book is Value Investing — A Balanced Approach.
Wall Street analysts employed in the research departments of broker/dealers and as money managers running mutual funds seem out of step with the rest of the world when it comes to corporate valuations. Wall Street analysts in their valuations emphasize, sometimes to the exclusion of all other considerations, forecasts of future flows — either earning or cash flows. This emphasis does not exist when it comes to the valuation of private businesses, or in the vast majority of Merger and Acquisition (M&A) analyses undertaken by control investors.
Benjamin Graham and David Dodd in the 1962 edition of their classic, Security Analysis, describe this difference in analytical approaches. On page 551 it is stated, “Security analysts — should reflect fully on the rather startling truth that as long as a business remains a private corporation or partnership the net asset value appearing on the balance sheet is likely to constitute the point of departure for determining what the enterprise is ‘worth.’ But once it makes its appearance as a publicly held company — even though the shares distributed to the public constitute only a small part of the total — the net worth figure seems to lose virtually all its significance. ‘Value’ then becomes dependent almost exclusively on the expected future earnings.”
Graham and Dodd were quite insightful in pointing to the strong tendency to look at businesses quite differently when dealing with private entities rather than publicly-traded common stocks. In my view, though, Graham and Dodd overstated the importance of net asset value in appraising private businesses. Rather, those valuing private businesses, or M&A opportunities, tend to have a balanced approach consisting of three general factors:
- The quality of resources in a business; i.e., the financial strength to be able to either expand, acquire, or refinance, businesses; or to withstand future adversities.
- The quantity of resources in a business relative to the price paid to acquire equity interests. This is akin to Graham and Dodd’s net asset value, or book value, but the accounting figures are almost always adjusted to reflect a more realistic value for assets — e.g., real estate appraisals for income producing properties, or equities in loss reserves for certain property and casualty insurance companies. The quality of resources and the quantity of resources are then translated into another factor.
- The prospects for long-term wealth creation.
Long-term wealth creation for private businesses, or in an M&A context, can come in a number of forms, including improved operating earnings, prospects for Initial Public Offerings, enhanced M&A prospects, abilities to refinance and/or create unrealized appreciation. Except when taking advantage of Wall Street’s focus on reported earnings per share from operations, having such reported earnings tends to be the least desirable method by which to create wealth. Operating earnings usually are characterized by huge income tax disadvantages. Such wealth creation usually is fully taxed (in a situation where it is hard for the corporation to control timing of taxable events) as compared with, say, unrealized appreciation which is not taxed at all.
The best investors on Wall Street — Warren Buffett, Carl Icahn, Richard Rainwater, et al — all seem to use the three-pronged balanced approach described above in their investment activities. All are control, or elements of control, investors who do not try to predict stock market prices but rather take advantage of stock market prices whatever they may happen to be at a moment of time. The goal of these control investors seems to be to determine what a business is worth and what the internal dynamics of the business might be. Then they stop.
Wall Street analysts, on the other hand, carry extra analytic burdens. Their object is not so much to determine the underlying worth of a business, though that is part of their job, but, more importantly to predict the price at which a common stock will sell in stock markets in periods just ahead. In doing this, Wall Street analysts become involved in considering a whole gamut of factors that have little, or nothing, to do with determining underlying business values. These non-business value factors include all technical-chartist considerations, predictions about the direction of the general stock market, gauging investor psychology, looking at corporate dividend policy, and studying the supply-demand calculus inherent in figuring out who is buying a particular security and who is selling.
Most buy-and-hold investors, who are interested in analyzing fundamentals, probably can fare very well by emulating the best investors, such as Warren Buffett and Richard Rainwater. It has never been easier for outside, passive, investors to understand most businesses, without the use of inside information. Since Graham and Dodd wrote, there has been a true disclosure revolution. Trained analysts now can make reasonably good decisions about most common stocks an investor wants to hold for the long term simply by reviewing the public record supplemented by interviews of managements and other knowledgeable parties, something that was not possible when Graham and Dodd were writing.
There is a great deal of comfort in investing using a balanced approach. It seems particularly appropriate for investors with true long-term goals — retirement or a child’s higher education. Here, rewards ought easily to outweigh risk.
Using a balanced approach, though, is not for everyone.
- Do not use a balanced approach if you are untrained in fundamental analysis, something true for many research department analysts and money managers.
- Fundamental investors try to guard against investment risk; i.e., permanent impairment of the capital of the underlying business. In doing this, most fundamental investors end up taking huge market risks, i.e., the price of the common stocks they own may decline. Market risk is particularly pertinent because for most businesses to become attractively priced using a balanced approach, the near-term outlook for the company is poor. If a near-term outlook is poor, near-term stock price performance might be poor also.
- Don’t use a balanced approach where one’s job depends on near-term market performance, or where client redemptions are likely to occur based on near-term common stock price performance.
- Don’t use a balanced approach where the portfolio is financed with borrowed money where collateral is marked-t- market daily. Loans are likely to be called if market prices decline, the underlying fundamental merits of a business notwithstanding.