Consistent Performance and Averaging Down
As part of my day-to-day chores, I’ve now read a fair amount of the mountains of literature, both books and articles, published by people involved in Academic Finance. Almost all of those materials are, in my opinion, badly flawed insofar as they purport to describe and analyze buy-and-hold, or control, investing. One source of badly flawed analysis revolves around the establishment of a comparative analysis “strawman,” to wit, the thesis that all investors should be judged solely by the extent to which their results outperform, or equal, the performance of a related market or index consistently. “Consistently” means short run, whether daily, weekly, monthly or quarterly. Whatever the merits of such a standard for traders without much, if any, fundamental knowledge of what they are investing in, this consistency standard is totally inapplicable to The Third Avenue Value Fund (TAVF), and other buy-and-hold investors who rely on fundamentals. Academic Finance is a technical-chartist approach to investing which focuses only on the study of prices and markets as they relate to Outside, Passive, Minority Investors (OPMIs).
There is no way that TAVF will outperform any market consistently, nor does the Fund try to do so. Rather, TAVF tries to acquire equities in companies that have good long-term growth prospects, are well-financed, are reasonably well-managed, and whose equities are available at prices that are cheap relative to a long-term, or indeterminate-term, valuation of the enterprise as a private business or takeover candidate. Put otherwise, TAVF tries to avoid investment risk. Avoiding investment risk involves a very meaningful trade-off, in that the Fund seems to take huge market risks, at least as measured against trying to attain superior levels of near-term market performance. Indeed, as to almost all of TAVF’s investments since the Fund started investing four and a half years ago, either the issuer’s recent earnings performance was poor, or the near-term outlook was clouded at the time TAVF invested in the equities –hardly prescriptions for outperforming the market consistently. The TAVF record is replete with examples of this. The Fund’s principal real estate investments were made in 1991 and 1992 when the near-term outlook could hardly have been more dismal. The same was true for the Fund’s acquisition of bank equities in 1991 and 1992; the common stocks of financial insurers and title insurers in 1993 and 1994; regional broker-dealer equities in 1994; Inverse Floaters in 1994 and 1995; and Destec Common in 1995.
Given that the companies in which TAVF invests have tremendous staying power, and that I try to be quite knowledgeable about each issue, it is relatively easy to average down when specific issues are poor market performers. My underlying investment thesis for TAVF is 180 degrees opposite to that of Academic Finance, which assumes that there is universal price efficiency in OPMI markets for control of companies. My view, in contrast, is that if I did not know more than the OPMI market about the companies in which the Fund has invested, or at least about those characteristics of the portfolio company and its securities that are of greatest interest to the Fund, then TAVF ought not to have been in those securities in the first place. Furthermore, these characteristics that most interest the Fund, e.g., strong financial position, tend to be quite different from the characteristics on which OPMIs trying to outperform the market consistently focus, e.g., recent reported or currently forecasted quarterly earnings. The TAVF approach just does not lend itself to consistent outperformance of the market. However, the TAVF approach should allow an investor to average down with far greater comfort than exists for most other investment “styles” in instances where there has been poor OPMI market performance for an issue unaccompanied by evidence of deterioration in the long-term fundamentals of the business.
TAVF’s goal is to try to earn 20% compounded on a long-term basis, whether or not the Fund outperforms specific markets or indices. There is nothing magical about 20%. Most non-investment company issuers have target returns on equity (ROE), without particular reference to the ROEs being earned by other businesses which may, or may not, be comparable. A pre-tax 20% ROE goal for TAVF seems reasonable as is the case for many other businesses in many other industries. For its 4 1/2 years of existence, TAVF’s average annual rate of return has been 21.39%.
My principal reason for writing about this topic is to share with you my thoughts about how corporate takeovers are likely to affect the TAVF portfolio, or at least the equity portion of the portfolio, in the years just ahead.
In the TAVF scheme of things, the ultimate bail-out for equity investments comes from either improvement in going concern operations over the long-term, or from what I call Asset Conversion activities; i.e., the realization of substantial premiums over OPMI market prices in merger and acquisition transactions, hostile takeovers, leveraged buyouts, restructurings or capitalizations, sales of assets and liquidations. In the period ahead, it seems likely to me that there will be an explosion in Asset Conversion activities if present general economic and financial conditions persist.
As I have noted in previous quarterly reports, the environment for Asset Conversion activities became buoyant after 1993, as secured financings from commercial banks became plentiful and access to capital markets, especially for junk bonds and junk preferreds, improved. Now an additional factor has been added — the weak dollar.
If there is any efficiency to markets, it seems all but inevitable that companies and other strategic buyers located in countries with strong currencies will be buying up significant pieces of corporate America. Even at premiums of 75% to 150% over OPMI market prices, companies which are well-financed, reasonably well-managed, and have strong franchises, such as, for example, MBIA, Forest City Enterprises, First American Financial and Alex. Brown, must appear to be unusual bargains for buyers who would acquire such businesses for prices measured by these buyers in Japanese Yen, German Marks, or Swiss Francs. The parts of corporate America that will be bought up ought to be those companies which have the same characteristics that made them attractive investments for TAVF.
In Asset Conversion analysis the key factor to consider is not so much whether a particular security is attractively priced in the OPMI market but, rather, whether a particular deal is doable. Whether a particular deal is doable depends primarily on whether or not management wants the transactions; and if not, management’s ability to resist. For reasons discussed below, many, if not most, attractively priced securities probably will not turn out to be doable deals.
TAVF is quite specifically in the pre-deal business, acquiring securities which are attractively priced, but where no evidence may exist indicating that the attractive security might be converted into a doable deal. Insofar as a portion of the Fund’s portfolio of attractive equity securities becomes converted into doable deals, TAVF’s overall long-term performance is likely to be better than it otherwise would have been. To identify whether any appreciable portion of the Fund’s portfolio might be subject to Asset Conversion activities in the years just ahead, it is instructive to gain insights not only into the current takeover climate in the U.S., but also the relationships that seem to exist between corporate managements and OPMI shareholders, as well as the pricing parameters that seem to apply to Asset Conversion activities.
In trying to understand the Asset Conversion climate, it is essential to be attuned to three fundamental economic and sociological factors. First, all relationships between incumbent managements and OPMI shareholders combine both communities of interest and conflicts of interest. Whether communities of interest will tend to be predominant, or the conflicts of interest will tend to predominate, will vary with the particular situation.
Second, in almost any Asset Conversion situation the justified pricing covers a very broad range. At the minimum, OPMI investors, as willing sellers, are happy to receive premiums over recent OPMI market prices. At the maximum, a strategic control acquirer, as a willing buyer, can be satisfied with those prices and terms which represent a modest discount from what the willing buyer believes the acquisition is worth to him, her, or it. The variables dominant in determining OPMI market prices such as reported earnings (especially near-term forecasted earnings), industry identification, dividends, sponsorship, stock promotion activity, market liquidity for the particular security, chartist-technical approaches, views about general levels of credit and equity markets, short-term macro economic outlooks, and comparative analysis are either different or weighted differently than the variables dominant for the control buyer — namely, ability to finance the transaction, strategic fit, and long-term outlook.
Third, any financial practice that is not subject to the imposition of meaningful disciplines is going to be characterized by excesses and abuses. These disciplines are imposed by the operation of competitive markets, by law and regulation, and by other means, such as the operation of the Internal Revenue Code or the hard work of informed, involved, independent members of Boards of Directors. By and large, there are very few, if any, meaningful disciplines imposed on the top managements of public corporations in terms of limits on management compensation, whether such compensation arises out of strict going concern activities, Asset Conversion activities, or terminations of employment. Top management compensation is an area that has been characterized by gross abuses. Here, there are inherent conflicts of interest between top managements and OPMI shareholders. The almost universal existence of management entrenchment devices, such as those discussed below, contribute to the continuation of these gross abuses by top management.
Since the passage by the Federal Government of the Williams Act in 1968, regulating the purchase for cash of 5% or more of a class of a public company’s voting securities, there has been a strong trend, especially by the States and State courts, with Delaware chief among them, toward removing from OPMI stockholders the power to decide about Asset Conversion activities and giving it, instead, to Boards of Directors. In most cases, it appears as if the principal constituencies of these Boards have been incumbent managements. The outside directors serving on these Boards seem mostly to have been inattentive and compliant, rubber stamping management proposals.
If management entrenchment devices, i.e., “shark repellents” did not exist, then acquirers could gain control of companies by: a) buying for cash 50% or more of the outstanding common stock in the open market, in private transactions, and/or via a tender offer; b) by acquiring control through the use of a voluntary exchange of securities to acquire 50% or more of the outstanding voting stock; or c) by soliciting proxies where a majority vote would deliver control. There never has existed a level playing field in contests for control of companies, especially where voluntary exchanges and proxy solicitations have been involved; incumbent managements always have had a big edge. However, the acceptance of “shark repellents” during the last 25 years increasingly has tipped the playing field toward incumbent managements irrespective of which playing field — whether, cash purchases, voluntary exchanges or proxy solicitations – although certain proxy solicitation rules promulgated in 1992 have made vote solicitations a trifle easier for outsiders.
From the TAVF point of view, this abdication of shareholder rights to Boards of Directors has had mixed results even in cases where the communities of interest between managements and OPMI shareholders are predominant, such as would tend to be the case in a negotiated merger with an independent third party. On the one hand, in the case of Asset Conversion deals, Boards of Directors, insofar as they engage in arm’s length dealings, (i.e., the control buyers are not insiders), are likely to obtain better prices and terms than would the OPMI investor groups which could not negotiate and would settle for only a premium over OPMI market prices. On the other hand, there are likely to be fewer transactions than would occur were the decision making process to be left solely in the hands of shareowners, because managements and Boards of Directors are likely to cause difficulties for non-management control buyers, whether friendly or hostile.
The vast majority of transactions are friendly, negotiated deals which result in OPMI shareholders realizing a substantial premium over market. However, the existence of “shark repellents” which enable managements and Boards to discourage any unfriendly “change of control” activities tends to have an importance that far transcends the hostile takeover arena. Purely and simply, the absence of the pressure from hostile transactions causes many managements to prefer the status quo in any case, thereby eliminating desires to become involved in all types of Asset Conversion events, whether friendly or unfriendly.
From TAVF’s perspective as a buy-and-hold investor involved mostly with investments in going concerns that are going to remain going concerns, the mechanism of market price in the OPMI market does nothing to distinguish between good managements, which a buy-and-hold investor would want to remain in office, and bad guys who ought to be kicked out. As a matter of fact, what the Fund defines as “good management” tends to be different from what the OPMI community might define as good management. TAVF tends to dislike managements which are highly promotional and short run conscious; managements which, for example, massage earnings to obtain near-term market performance, or managements which forego attractive long-term investment opportunities, because they might have an immediate negative OPMI market impact. From a corporate point of view, promotional managements deliver very important benefits to companies which need current, or relatively continual access to capital markets, especially through the sale of new issues of equity. However, as a result of the TAVF’s criteria that its portfolio issuers have strong financial positions, most of the companies in which the Fund invests are essentially self-financing businesses without compelling pressures to access capital markets.
Against such a background there is much to be said for requiring outsiders to negotiate with Boards, rather than deal directly with stockholders, since in many instances dealing with Boards of Directors results in shareholders, such as TAVF, receiving materially more consideration than they would if outsiders could appeal directly to shareholders by offering them a premium over market.
All management entrenchment devices are promulgated under the rubric of stockholder (or creditor) protection — whether in the form of supermajority provisions, fair price provisions, freeze-out provisions, cash-out provisions, control share acquisition provisions, poison pills, staggered boards, disgorgement statutes, parachutes, blank check preferreds, or change of control provisions in loan documents. However, despite the lip service paid to stockholder protection, conflicts of interest are almost always present. All too frequently the underlying intent in establishing management entrenchment devices is not to get better pricing for OPMI shareholders, but to insulate management in office. Here, the inherent conflicts of interest predominate.
“Shark repellents” tend to be waived when the acquirer is a friendly. A lot of friendlies are insiders in going private management buyout transactions. The negotiations, here, seem frequently to revolve only around giving the OPMI a premium over market, especially in the case of smaller, less well publicized transactions. Additionally, the insider buyer always controls the timing of transactions. Going private buyout proposals tend to be made by insiders when the OPMI market price for a particular issue is relatively depressed compared with a contemporaneous business value. Here, conflicts of interest predominate, especially for the long-term, buy-and-hold investor, because the willing buyer (the insider) who seeks a low price is also a fiduciary charged with improving returns for OPMIs.
For example, say the common stock of a publicly owned company has a private business value of $10; a TAVF-type investor acquires a position for $5; and a bear market causes the common stock to sell at $2, even though there has been no deterioration in business fundamentals. The insider fiduciary picks that bear market moment to go private at $4. To the outside world, all the stockholders, including the TAVF-type investors, receive a 100% premium over the OPMI market. What is their gripe? Plenty, I think, from a TAVF point of view, even though Academic Finance and arbitrageurs understandably would disagree. This type of pricing phenomena, where insiders absolutely control timing and can choose to force outsiders to sell, is a reality that is going to be present in a portion of any buy-and-hold, long-term investment portfolio, including the TAVF portfolio. It is a built-in long-term disadvantage that TAVF is just going to have to live with.
The Revlon line of cases in Delaware is important because of its general tendencies to encourage better pricing for specific deals but also fewer deals in the aggregate. Revlon defines the duty of a Board to become auctioneers, and get the best price and terms for OPMI shareholders when a company is going to be sold and there will be a change of control. Revlon, therefore, puts companies into play and requires competitive bidding, even though reasonable bust-up fees for an initial bidder are allowed. The result is a relatively level playing field in the auction. Revlon is a godsend in terms of improving prices, even though the Revlon line of cases are far from universal. A notable exception to Revlon was Time Warner where Delaware courts, through tortured and unworldly reasoning, found that the Time, Inc.-Warner Communications merger did not involve a change of control because majority voting remained in the hands of OPMIs. The Delaware Courts failed, in Time Warner, to realize that in voting situations involving OPMIs, control does not belong to OPMI voters, but rather to whomever has meaningful elements of control over corporate proxy machinery and corporate funds used to solicit proxies.
The downside of Revlon is that target companies are discouraged from doing any deals because negotiating a transaction, e.g., Paramount-Viacom, will just put the target company, Paramount, on the auction block. Given the nature of the TAVF portfolio, which I think is chock full of takeover candidates, the Fund’s overall interest might better be served if there were more takeover transactions at lower premiums over OPMI market prices, rather than improved pricing for fewer individual transactions because an auction takes place on a relatively level playing field. This is of decreasing validity, however, insofar as the TAVF portfolio companies become growing going concerns which are increasing in fundamental value over time. This mitigates the need for any Asset Conversion transactions at all. However, where portfolio companies earn unsatisfactory economic returns on the inherent asset values, or where those companies would derive synergistic benefits from corporate combinations rather than remain a stand-alone going concern, there is a need for Asset Conversion activities, especially if the Fund is to earn its 20% bogey. I am sure that there are, and will be, quite a number of issues in TAVF’s equity portfolio with large inherent asset values whose future earnings might be less as stand-alone going concerns than if those companies were combined in whole, or part, with other enterprises. Current examples of such portfolio companies could include St. Joe Paper, Apple Computer, Cray Research, Capital Guaranty, Datascope and Forest City Enterprises.
Delaware is the key corporate state, not only because more than half of the Fortune 500 is incorporated in Delaware but also because other State courts tend to follow the Delaware lead.
It is hard to engage in Asset Conversion activities unless one has a good concept of what a fair price is. A fair price is defined as that price, and such other terms, which would be arrived at in a transaction between a willing buyer and a willing seller, both with knowledge of the relevant facts, dealing at arm’s length, and neither under any compulsion to act. The underlying factor that makes an OPMI a willing seller is a premium over OPMI market price. The underlying factor that makes a control buyer a willing buyer involves paying no more than a moderate discount from the present value of the benefits that the deal might bring strategically to the buyer, especially if the transaction can be financed on attractive terms. Thus, a fair price can, and usually does, encompass quite a broad range. In level playing field auction situations, the price arrived at tends to be close to the value of the willing buyer. In non-contested transactions, especially where the buyer is an insider, say a going private transaction, the price arrived at tends to be the premium over the OPMI market price that the willing seller will go along with. If OPMIs in Delaware perfect rights of appraisal, or in litigation there is a substantive appraisal of “entire fairness,” the courts tend to focus on the willing seller environment, giving considerable weight to what an OPMI could have sold his stock for in the OPMI market.
Finally, given our views that fairness covers a broad range of pricing, the last thing to depend on, as a rule, are “fairness opinions” rendered by investment bankers. Traditionally, investment bankers have been perceived as the tools of the managements who hire them. Also, as a matter of habit, investment bankers tend to focus on OPMI market prices in all instances other than those where the investment bankers are hired by Boards whose managements want to resist change of control proposals. I rarely have found investment bankers to have a strong community of interest with the OPMI stockholders (versus managements) the bankers purport to represent.
Having said all of the above, I come down, net, in favor of moderate management protection provisions for the companies in the TAVF portfolio. Virtually all of the companies whose common stocks are represented in the portfolio have very strong financial positions. Many appear to enjoy valuable franchises. Most seem managed by reasonably competent people with relatively strong interests in the feasibility of the companies they manage. Further, I believe most give genuine weight to taking actions that will benefit the long-term welfare of the OPMI stockholder (and, though I cannot know for sure, I believe that few of the managements are thinking of using their control of timing to engage in Asset Conversion activities like going private at just the wrong time for TAVF). The existence of “shark repellents” ought to result in better terms most of the time than would exist if the purchaser/acquirer dealt directly with the shareholders rather than negotiating through the Board. The obvious trade-off seems to be that the existence of “shark repellents” will mean there will be fewer deals for TAVF overall than otherwise would be the case. Taking, say, a five-year perspective, rather than a one-year perspective, I have a hunch that there ought to be enough Asset Conversion deals done so that TAVF will fare well. If the Fund does not, it probably will be attributable much more to flaws in the Fund’s fundamental analyses, rather than to the existence of a hostile Asset Conversion environment within the portfolio companies.
Incidentally, my views about the benefits of “shark repellents” in the case of the Fund’s equity portfolio do not apply to all managements. It certainly is inapplicable to the many insiders who will seek to use their control of timing to force companies to go private at just the time when the underlying pricing is highly favorable to them and less favorable to OPMIs. Also, I am against using “shark repellents” to insulate in office most managements of financially troubled companies which can’t or won’t meet their obligations to creditors and are restructured either out of court or in Chapter 11. As a group, these managements generally are not entitled to any entrenchment from the point of view of their securities holders. However, the fact is that the vast majority of them enjoy considerable entrenchment.