16 Index Funds and the General Market

JANUARY 1999

In terms of my own money, I have invested rather heavily in Third Avenue Value Fund (TAVF, “The Fund”) because I am enthusiastic about the underlying long-term values represented in the Fund’s portfolio. On the other hand, the general market scares me because of the lack of sound, underlying values. This view of mine is reflected in a recent article I wrote. A portion of that article is reprinted here.

Index Funds Seem Unusually Dangerous From a Long-Term Point of View

The appreciation in market prices for the common stocks that make up the leading indexes have, in recent years, so far outstripped the growth in book value and earnings for the companies whose common stocks make up the indexes that these market prices seem now to be grossly out of line with corporate reality. Thus, the possibilities for disaster. Here, excellent past performance seems likely to be a harbinger of future under-performance insofar as one believes that over the long term, market prices for passively owned common stocks will have a relationship to underlying corporate fundamentals.

The managers of Third Avenue Funds do not predict the future but rather deal in probabilities. Probabilities are driven by securities prices as they relate to underlying corporate realities. It is our strong belief that the higher the current market prices relative to corporate fundamentals, the greater the investment risk; and the lower current market prices are relative to corporate fundamentals, the less the investment risk. We also believe that for an index, or almost any general aggregate for that matter, corporate fundamentals can be measured by accounting earnings and accounting net asset value per share, i.e., book value.

A principal reason why Third Avenue Fund deals in probabilities, rather than in predictions, is that predictions are so difficult to make. To predict that the prices represented by the S&P 500 Index will crater at a specific time, one has to visualize what the precipitant for such a scenario might be and when that catastrophic event might occur. Third Avenue is not very good at foreseeing precipitants, especially if timing is involved, and we doubt anyone else is much good at it either. Who could really have forecast the timing of the Asian collapse in 1997? Who could really have forecast the timing of sovereign defaults in Russia in 1998, the Mexican Peso devaluation in 1994, the U.S. Savings and Loan debacle in the mid-to-late 1980’s, or the plunge in oil prices in 1982 and again in 1998?

The Third Avenue Funds use a balanced approach to analysis, initially measuring the quality of resources in a business, as well as the quantity of resources acquired relative to market prices.

Quality and quantity of resources translate into return on equity. In using financial accounting as a tool to analyze individual companies, no particular number is emphasized by Third Avenue, but rather each accounting number is a function of, modified by, and derived from, all other accounting numbers. Thus, book value is intimately related to earnings, and vice versa. Both are joined at the hip so to speak, in the concept of return on equity, or ROE. R is the earnings figure; E is the book value figure.

Financial accounting in the analysis of individual companies is always subject to adjustment. The most GAAP figures can represent in the analysis of an individual company are objective benchmarks which the analyst uses as a tool to reach opinions about economic reality, either in terms of flows, whether cash or earnings; or asset values, or both. However, financial accounting in the aggregate tends to be highly meaningful. It measures changes over time, the amount of resources in existence and flows, whether cash or earnings. For the aggregates, statistical errors that might exist for individual companies tend to even out.

The Statistical Case Demonstrating That Prices for the S&P 500 Industrial Have Outrun Corporate Reality

Period Market Price as a Multiple of Book Value PE Ratio Book Value Per Share ROE*
12/31/1998 6.5x 32.3x $188.11 $38.09 20.00%
12/31/1997 5.1 18.6 190.12 39.72 21.8
12/31/1995 3.5 18.3 174.33 33.6 22.2
12/31/1990 2.2 19.2 153.01 21.73 14.8
12/31/1987 1.8 14.1 126.82 17.5 13.8
12/31/1982 1.3 11.1 112.46 12.64 11.6

* EPS for the year divided by book value at the end of the prior year

The significance of superlative past performance can be attributed to one of three factors. First, in the case of actively managed funds, it can be evidence of superior skills being brought into play by an active manager. Second, in the case of either actively managed funds or index funds, it can be evidence of superlative growth in underlying corporate fundamentals which growth is reflected in common stock prices. Third, in the case of either actively managed funds or index funds, it can be evidence that increases in common stock prices have outpaced increases in underlying corporate values. The third alternative seems to be the root cause for the excellent performance of the S&P 500 in recent years, as is shown in the following table covering growth rates in market prices relative to growth rates in earnings and book values:

At 6X Book Value For the S&P 500 It Is Hard To Make the Numbers Work
It is hard to justify a 6x multiple of book unless one can postulate that either ROE for the index companies will increase to a number greater than 25%, or that companies in general will be able to issue massive new amounts of common stocks, either for cash or in a merger and acquisition transactions, at prices related to 6x book.

From 1982 through 1998, ROE’s for the S&P 500 ranged from a high of 22.2% in 1996, to a low of 10.6% in 1991. The average ROE for the 17-year period was 15.7%. However, for the five years through 1998, the average ROE was 21.0% and in no year was it below 20.0%.

Assuming a market price of 6x Book, PE ratios are as follows based on various ROEs:

Market Price Book ROE EPS PE Ratio
$6 $1 25% 25¢ 24.0x
6 1 20 20 30
6 1 15 15 40
6 1 11 11 54.5

It seems unrealistic to suppose that, on average, the companies making up the S&P 500 would have such attractive access to capital markets that such a large amount of new equity capital could be raised at those prices. Alternatively, it seems questionable that companies in the aggregate would be able to maintain existing ROEs if massive new amounts of capital were injected into their businesses.

It is always possible that securities pricing for the common stocks that make up the S&P 500 have entered into a new era where greater capitalization rates will be given to earnings, and greater premiums will be assigned to book values, than historically has been the case. These enhanced valuations might persist, or even be improved upon, on a permanent or semi-permanent basis. Such a new era pricing scenario seems to be a possibility, rather than a probability.

In contrast to this statistical picture for the S&P 500, many common stocks, especially well-capitalized small caps, currently seem to be priced at bargain prices relative to long-term earnings prospects and current book values. This type of pricing in markets for passive, minority investments seems to occur frequently at times when the immediate earnings outlooks are poor. The semiconductor equipment stocks Third Avenue Funds are currently acquiring seem to meet these criteria. As a long-term investor, Third Avenue is betting that the probabilities are, for most of these companies, that the next peak in earnings will be well in excess of historic peaks.

We recommend to investors that they switch holdings in the S&P 500 to Third Avenue Funds or other funds that concentrate on Value Investing. Value investors, by definition, are conscious of the relationship of securities prices to corporate fundamentals.  In value investing, asset allocation is driven  more  by price considerations and less by predicting outlooks.

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