This letter seems an opportune place to discuss three issues very much in the news nowadays: The Role of Financial Accounting in Security Analysis; Security Analysts and Conflicts of Interest; and SEC Regulation FD — Fair Disclosure. Needless to say, my positions tend to differ from the conventional wisdom on the three issues by about 180 degrees in each case. The issues seem important, not so much because they might affect Third Avenue Value Fund (TAVF) on a day-to-day basis (they won’t), but rather because of possible impacts on the integrity of U.S. Capital Markets — the best of mankind.
The Role of Financial Accounting in Security Analysis
In the TAVF scheme of things, financial accounting is useful, indeed essential, because it is the only tool which provides the objective benchmarks that a security analyst can use in trying to determine corporate values and corporate dynamics. For the Fund there is no belief that accounting should be expected to describe Truth: rather, financial accounting gives results derived in accordance with a relatively rigid system: Generally Accepted Accounting Principles (GAAP). Many of the underlying assumptions of GAAP have to be unrealistic, as for example, property values are based on historic cost less periodic depreciation charges, rather than estimated market values for properties. For TAVF, there is no a priori reason why any one accounting number, say earnings per share, has to be more important than any other accounting number, say book value. Indeed, every accounting number is derived from, modified by, and a function of, all other accounting numbers. For the Fund, what the numbers mean tends to be much more important than what the numbers are.
In contrast, conventional security analysis, at least equity analysis, looks to have financial accounting reflect Truth, i.e., describe some sort of economic reality. Moreover, just one set of accounting figures is deemed to be important: earnings from operations or its derivatives; EBITDA, cash flow from operations, or earnings per share. In conventional security analysis what the numbers are tends to be far more important than what the numbers mean. Insofar as one labors under the assumption that the goal of security analysis ought to be predicting what the price performance of a publicly-traded common stock will be in the immediate future, conventional security analysis seems to be applying an appropriate emphasis to a primacy of the income account approach, as reported for GAAP purposes. It seems obvious that earnings as reported tends to be a key factor influencing short-term fluctuations in the prices of publicly-traded common stocks, even though those reported earnings give little, or no, clues as to what underlying values may be.
Most analysts, whether money managers or employed in research departments of broker-dealers, seem to believe that their primary job is to forecast near-term earnings results as reported, say for the next 3 months to 12 months. These analysts tend to put “buy” or “strong buy” recommendations on the common stocks of companies likely to report improved earnings soon. If the immediate profits outlook is glum, conventional analysts would rather not take a position in the security, not at least until they perceive that a bottom is near. In contrast, at TAVF, we are striving to identify underlying long-term values for companies and the securities they issue. For most of the common stocks the Fund acquires, the near-term earnings outlook at the time of acquisition is poor. The Fund buys at the time the near-term outlook is poor provided the company is well capitalized, if our analysis indicates that the common shares are available at a low price earnings ratio relative to long-term future earning power and/or are selling at a substantial discount from an adjusted, and measurable, net asset value. Thus, the difference between the ways TAVF uses financial accounting and the way most conventional equity analysts use financial accounting, seems understandable. It’s the difference between a long-term balanced approach with emphasis on what the numbers mean (the Fund) vs. a short term, primacy of earnings approach with emphasis on what the numbers are (conventional analysts).
The stock option controversy serves as a good example of how conventional security analysts are unable to use GAAP to determine the Truth. On one side, the granting of stock options to executives are not a charge against the GAAP income account at the time of grant, albeit details of the options are fully described in footnotes to financials. Many conventional analysts want to alter GAAP so that the income account is charged with the market value of stock options granted to executives. Thus, assuming an executive received options on 2,000,000 shares of common stock with a value as determined by the Black-Scholes formula, of $2 per option, then GAAP should be altered so that operating income would be charged with a $4 million expense, the same as would be the case if, in lieu of options, the executive were paid $4 million cash.
The conventional proposals to alter the GAAP treatment of stock options tend to be ludicrous. First, there is no necessary correlation between the value of a benefit to a recipient — the executive — and the cost to an issuer — the company — to grant that benefit. What is the proper charge against income when a retail sales employee acquires a sweater with a retail price tag of $100 which cost the company $20 at a 60% employee discount, or for $40? The value of the sweater to the recipient is $100; no one would argue that the cost to the company is anything other than $20.
In fact, the cost to the company from issuing the executive stock option, which has a value to the executive of about $4 million, is the present value of the diminution, if any, in the company’s future ability to access capital markets for new equity. This is something hard to measure. There may be other company costs, but I haven’t figured out what they might be.
Issuing executive options often results in diluting the common capitalization outstanding. But common stock dilution in those instances where no cash dividends are paid is a stockholder problem, not a company problem insofar as it does not detract from a company’s ability to access capital markets.
A good part of the problem for conventional security analysts, and virtually all academics, is that they fail to view the company as a stand-alone. Rather, they implicitly assume that there exists a substantive consolidation between the interests of the company and the interests of its stockholders. Most of the time, substantive consolidation is an unrealistic economic assumption. Indeed, in credit analysis, whether for performing loans or distressed credits, the company is almost always analyzed as either a stand-alone, or a stand-alone with parent-subsidiary relationships. The stockholder just doesn’t figure in most of the time.
There are macro problems involved with designing GAAP to meet the perceived needs of conventional equity analysts for Truth determined on a short run basis with emphasis on the primacy of the income account. To begin with filling those perceived needs probably is an impossible task. More importantly though, trying to fulfill those needs has unnecessarily made GAAP just about as complex as the Internal Revenue Code. The Internal Revenue Code has to be complex because it leads to just one number — a taxpayer’s tax bill. GAAP on the other hand need only give the analysts objective benchmarks. From the available information, I can figure out for my analytic purposes, what the true costs of executive stock options to a company might be. I don’t need a Certified Public Accountant to do it for me, even assuming the CPA could.
Security Analysts and Conflicts of Interest
There is now a general sense of rebellion against security analysts, who during the period prior to April 2000, were putting out strong buy recommendations for dot com common stocks, telecom common stocks, and other issues of companies whose only apparent real asset was an ability to sell new issues to the public at ridiculous prices. Many analysts are perceived to have had conflicts of interest because, among other things, the investment banking departments of the broker-dealers employing these analysts, benefited because the recommendations were essential if the investment bankers were to keep, or develop, relationships with present or potential issuers. There is validity to this view of conflicts of interest. However, it overlooks the main point of what went on during this period of speculative excess. The main point is that many, if not most, analysts, by and large, were incompetent. They drank the Kool-Aid. Put otherwise, I bet the same trillion of dollars would have been lost by the investing public even if there had been no conflicts of interest.
Many analysts are very smart and also very well informed. However, except for the extremely rare genius and skilled risk arbitrageurs (risk arbitrage exists where there are relatively determinate workouts in relatively determinate periods of time — e.g., announced merger transactions), it seems as if no one person, or group, can outperform a market, or index, by trying to predict short-term swings in security prices. It seems apparent that you can’t beat the market by trying to beat the market consistently.
During the period of speculative excess, it was very hard for conventional analysts to not recommend dot com, telecom and similar common stocks, no matter what the price. If the analyst failed to outperform his peers, or benchmarks consistently, not only might his or her compensation level been in question but even his or her job. These analysts were in no position to pay attention to “safe and cheap” even if it was on their radar screens. It had little, or nothing, to do with conflicts of interest.
At present the major broker-dealers are implementing programs to assure that security analysts give out advice that is objective. Who do you want your investment advice from? Someone who is objective or someone who has their money where their mouth is? At Third Avenue, you don’t get objectivity; you get managers who are investing on the same terms as any other TAVF stockholder.
The macro issue here is that so much ought to be done to raise the standards of security analysis practice so that in equity analysis, there is a de-emphasis on the importance of outperforming benchmarks consistently in the stock market. There’s much to be learned from credit analysis where the analyst has to look mostly to the resources in the business and the performance of the business in order to gauge the quality of the security being analyzed. In credit analysis there tends to be little attention paid to market psychology, i.e., what will a bigger fool pay me for the security I hold regardless of that security’s underlying merit or the security’s price.
SEC Regulation FC — Fair Disclosure
Regulation FD is now under attack. FD requires issuers to make disclosures available to everyone in the market at the same time, rather than leaking disclosures to a select few. Many people want FD repealed. The issue really does not have anything to do with the Fund. Ever since TAVF has been in existence, Third Avenue has almost always been the last to know. TAVF does not operate with needs to obtain superior, i.e., early, disclosure. Rather, Fund operations revolve around using the available disclosures in a superior manner.
Yet, I think Regulation FD, which has been in existence only since October 2000, is very important as one guarantor of market integrity from a macro point of view. One of the United States’ most valuable assets is that its capital markets are perceived as the best, deepest, most informed, most honest capital markets that have ever existed. This is a perception that should be nurtured carefully. Trading markets have to be viewed as fair. It can be said today that the U.S. does not really have a trade deficit but rather that the U.S. is exporting participations in its magnificent capital markets.
That confidence in U.S. markets might cease to exist if trading markets came to be viewed as unfair and disorderly. Regulation of securities, especially by the SEC, covers three principal functions:
- The maintenance of fair and orderly markets
- Providing disclosure
- Oversight of fiduciaries, and quasifiduciaries.
Of the three, the first seems to be most important. Regulation FD goes a long way toward preserving the perception that the public trading markets are fair and orderly. Regulation FD should not be repealed.