27 Corporate Valuation

JULY 1997

The Third Avenue Value Approach to Corporate Valuation

The Third Avenue investment approach seems quite distinct from that of most other mutual funds; even others who, like the Fund, claim to be buy-and-hold value investors. In a nutshell, TAVF emphasizes the primacy of a Resource Conversion Approach (“Resource Conversion”) in most valuations of equity securities. Almost all other money managers emphasize the primacy of a Going Concern Approach (“Going Concern”) in most corporate and securities valuations. The key factor for Third Avenue in a Resource Conversion analysis is the quality and quantity of resources existing in a business at the time of analysis; i.e., a “what is” approach focusing on an adjusted balance sheet. The key factor for a Going Concern analyst is an estimate of future flows, whether those flows are cash or earnings; i.e., a “what will be” approach focusing on estimated income accounts.

Going Concern is the bedrock for business valuations in just about all literature about finance, including Generally Accepted Accounting Principles (GAAP), academic finance as embodied in the Efficient Market Hypothesis (EMH), and fundamental analysis as embodied in the writings of Benjamin Graham and David Dodd, their predecessors and their successors (collectively, “G&D”). The best analysts embracing Going Concern, for example G&D, do not ignore Resource Conversion (just as TAVF does not ignore Going Concern in its corporate valuations). G&D’s connection to Resource Conversion seem to come mostly in the context of being aware of liquidating values. G&D point to the attraction of acquiring common stocks at prices below liquidating value, especially prices below net, net current assets. Net, net current assets refers to net current asset value after deducting all GAAP liabilities, both short term and long term.

The least sophisticated analysts, e.g., EMH, believe that Resource Conversion is the exclusive value determinant anytime values can be measured by trading prices in markers populated by Outside Passive Minority Investors (OPMIs). In all other cases, Going Concern is the value determinant. Thus, for academics a Resource Conversion emphasis for corporate valuations is adopted by requiring that performing loans held in corporate portfolios be valued at market. In general, EMH operates on the assumption that financial results for all corporations other than investment companies are to be measured strictly by Going Concern standards; while portfolio results for an investor in those corporations’ securities are to be measured strictly by Resource Conversion standards. This academic approach is not helpful at all for a Third Avenue type corporate analysis.

The underlying force driving Going Concern is the strict going concern assumption. Corporations are seen in Going Concern as devoted essentially to the same day-to-day operations they have always conducted within the same industries in which they have always operated; managed and controlled as they always have been managed and controlled; and financed pretty much as they always have been financed. Up until the early 1990’s this strict going concern assumption accurately described the environment existing in the electric utility industry. It never described accurately most U.S. corporations whose securities are publicly traded. The strict going concern assumption no longer seems appropriate even for electric utilities.

Certain conclusions follow logically if one grants the strict going concern assumption. First, among buy-and-hold fundamentalists there is a primacy of the income account, and a consequent denigration of the balance sheet for corporate valuation purposes. (Further, among traders not engaged in risk arbitrage, i.e., situations where there will be relatively determinant workouts in relatively determinant periods of time, the income account is supreme; short-term movements in common stock prices, after all, are likely to be heavily influenced by changes in reported earnings and not influenced at all by changes in book values). Further, G&D point out that the past earnings record of a corporation usually is the best tool for estimating earnings for the years just ahead over a business cycle or growth phase. If one grants the strict going concern assumption, G&D are absolutely right about the relative importance of the past earnings record as a tool for predicting future earnings.

Third Avenue believes that the strict going concern approach is utterly unrealistic. Most companies whose securities are publicly traded will always combine elements of the going concern and elements revolving around the conversion of corporate resources to other uses, other ownership, other control and other financing or refinancing. In the Fund’s view, few U.S. corporations are going to go for as long as five years without being involved in resource conversion activities-mergers and acquisitions; changes of control; management buyouts; massive share repurchases; major financings, refinancings or reorganizations; sales of assets in bulk; spin-offs; investing in new ventures in other industries; and corporate liquidations. G&D describe these resource conversion activities as non-recurring events. For TAVF, there is nothing non-recurring about them.

Both going concern considerations and resource conversion considerations are important in most corporate valuations. Indeed, in most situations going concern considerations and resource conversion considerations are related intimately to each other, derived from, modified by, and a function of, each other. The current sales value of an asset is determined frequently by what it is believed that asset can be caused to earn. Much of the “what is” value for many, if not most corporations probably was created by past going-concern prosperity. Third Avenue, in its valuation approach, does not subscribe to a primacy of Resource Conversion over Going Concern in its evaluation of equity securities because of a view that Resource Conversion is more important or more commonplace necessarily in the overall economic scheme of things. Rather, the Fund subscribes to a primacy of Resource Conversion because it seems to provide the Fund with superior tools of analysis for the types of buy-and-hold investments of interest to Third Avenue. Emphasizing Resource Conversion makes it easier for the Fund to identify publicly-traded securities that meet the Fund’s twin objectives for an investment — “safe” and “cheap.”

People who focus on Going Concern tend to believe that value creation is a function of just one factor — estimated free cash flows appropriately capitalized: EMH; or estimated earnings appropriately capitalized: G&D. For Third Avenue, corporate values are derived from one, or more, of four, separate, but often related, sources:

As I have pointed out in previous letters, each investment the Fund makes has something wrong with it, and we spend a lot of time trying to figure out what is wrong and worrying about it. We make investment commitments when, in our judgment, what is right seems to outweigh strongly, what is wrong. One of the more important areas where there are trade-offs between right and wrong is in the differences that arise when emphasizing Resource Conversion and de-emphasizing Going Concern. Frequently, what is right for Resource Conversion is wrong for Going Concern, and vice versa. Here are a few examples:

While the Fund does not ignore Going Concern in the analysis of securities, there is no question that Third Avenue places primary emphasis on Resource Conversion. This emphasis results in certain advantages and disadvantages. The advantages for the Fund in emphasizing Resource Conversion seem to be about as follows:

  •  It is a relatively non-competitive activity. Most money managers seem to concentrate on forecasting earnings or cash flows.
  • The businesses are easier to analyze. TAVF does not get involved in common stocks, unless the businesses are extremely well financed and we can understand what they do. This is our basic criteria for “safe.” As to “cheap,” TAVF tries not to pay more than 50 cents for each $1 dollar we think the company is worth as a private company or a takeover candidate. The Fund uses certain preliminary “rules of thumb” to ascertain “cheap” when acquiring common stocks:

Insofar as long-term, future earnings are to be forecast, estimating returns that might be earned on a realistic asset base is probably as good, or better, a tool than is a corporation’s past earnings record, albeit one is not a substitute for the other. The analyst ought to use both tools a good deal of the time.Aside from those times when a corporation, or its control shareholders, are seeking access to equity markets, usually an occasional occurrence, American business seems to be run much more with a Resource Conversion emphasis than with a Going Concern emphasis. This is certainly true for virtually all privately owned companies not seeking to go public, and is probably true, also, for most of the better run public companies. Most corporations, where managements do not have their eye wholly on OPMI stock prices, seek to create wealth in the most income tax efficient manner. The most inefficient tax way to create wealth is to have reportable operating earnings, a Going Concern emphasis; while the most efficient tax way to create wealth is to have unrealized (and, therefore mostly unreported) appreciation of asset values, a Resource Conversion emphasis.

Aside from those times when a corporation, or its control shareholders, are seeking access to equity markets, usually an occasional occurrence, American business seems to be run much more with a Resource Conversion emphasis than with a Going Concern emphasis. This is certainly true for virtually all privately owned companies not seeking to go public, and is probably true, also, for most of the better run public companies. Most corporations, where managements do not have their eye wholly on OPMI stock prices, seek to create wealth in the most income tax efficient manner. The most inefficient tax way to create wealth is to have reportable operating earnings, a Going Concern emphasis; while the most efficient tax way to create wealth is to have unrealized (and, therefore mostly unreported) appreciation of asset values, a Resource Conversion emphasis.There is a high level of comfort for a buy-and-hold OPMI investor such as Third Avenue, when investing in the equities of companies which enjoy strong financial positions. Not only does the cushion of a strong balance sheet make buy-and-hold investments feasible, but insofar as these strong financial positions are not dissipated, it makes it relatively easy for Third Avenue to average down when stock prices plummet.

There is a high level of comfort for a buy-and-hold OPMI investor such as Third Avenue, when investing in the equities of companies which enjoy strong financial positions. Not only does the cushion of a strong balance sheet make buy-and-hold investments feasible, but insofar as these strong financial positions are not dissipated, it makes it relatively easy for Third Avenue to average down when stock prices plummet.

We believe that Third Avenue is less likely to be victimized by securities frauds and securities promoters than are other investors. The Fund will have a fair number of unsatisfactory investments because sometimes we misanalyze and because the future is mostly unpredictable. Losses, though, because of management or control group malfeasance or outright fraud are probably a lot less likely for the Fund than for many other institutional investors, who rely on insider forecasts of the future and insider statements unsupported by public records as the principal weapons in their analytical arsenal.

Third Avenue’s emphasis on Resource Conversion carries a number of disadvantages. These seem to be about as follows:

  • While trying to avoid investment risk, Third Avenue, in almost all its purchases, assumes a lot of market risk, i.e., the risk that stock prices in OPMI markets will plunge. In almost all investments by the Fund the immediate earnings outlook is anywhere from poor to uncertain (see the Japanese non-life insurers). Certainly the immediate earnings outlook is almost never good. The OPMI market seems efficient enough so that there exists a trade-off — Third Avenue’s investment criteria are met because the prospects are poor for those factors of the most immediate importance to participants in the OPMI market. The Fund is pretty much stuck with buying what is unpopular when it is unpopular.
  • The managements the Fund deals with tend to be very conservative, non-promotional types, frequently indifferent to what Wall Street thinks or does. There is a certain “efficiency” in this because these management groups, by and large, are not seeking near-term access to equity markets.
  • The Fund ignores factors that are important in the management of many portfolios; e.g., dividend payouts and marketability of individual securities.
  • Resource Conversion seems largely unrelated to, or the antithesis of, certain short-term measures important to other analysts; Return on Assets, ROE, or Economic Value Added (EVA). Indeed, TAVF rejects, as a tool of analysis, any system which assumes that there exists a substantive consolidation between the interests of the corporation, itself, and the interests of those OPMIs who emphasize short run prices in securities markets. EVA bottoms on an assumption of a substantive consolidation between the company and short run OPMIs.
  • Using Resource Conversion there seem to be a much more limited pool of eligible investments than exists under Going Concern.
  • Resource Conversion is unsuitable as an investing technique where the money manager is operating with borrowed money or is otherwise heavily influenced by daily marks to market. Resource Conversion is also unsuitable for traders who treat securities investing as one more casino game.
  • To be successful at Resource Conversion, it seems to take not only a fair amount of training in fundamental corporate valuation but also a fair amount of knowledge about securities law and regulation, financial accounting and income taxation; say, enough knowledge in these areas to be an intelligent client in dealing with full-time securities law, accounting or income tax professionals.
  • Resource Conversion is not particularly relevant for portfolios, or portions of portfolios, investing in credit instruments without credit risk for the purposes of either obtaining assured streams of cash income or speculating on changes in interest rates. As a final comment, it ought to be noted that TAVF does not invest as if it were in competition with other mutual funds. Rather our goal is to minimize investment, but not market, risk while earning, on average, and over the long term, a compound annual rate of return of 20% regardless of what other funds, or the general market, have as rates of return. For TAVF to continue to have this type of long-term return, we are going to have to be both good and lucky. The benefits of Resource Conversion notwithstanding, it won’t be easy.

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