41 Modern Capital Theory and Fundamental Investing

APRIL 1993

More on The Third Avenue Value Fund’s Investment Philosophy

The Third Avenue Value Fund (TAVF), in its investment processes, is strictly fundamentalist. The analyses used by TAVF for the purpose of making passive securities investments are virtually the same analyses as those used by businessmen to buy and sell businesses, and by Wall Street activists engaged in mergers and acquisitions, leveraged buyouts (LBOs), the restructuring of troubled companies, going private, and venture capital. In particular, technical market factors, and the teachings of technicians, are completely ignored. Technicians are those who reach investment, or more likely trading, conclusions by studying the behavior of securities prices and securities markets. Technicians are of two types: practitioners and academics.

Also, TAVF fundamental analysis is always bottom-up. There is a concentration on factors peculiar to the business, and minimal weight is given to top-down factors such as predicting business cycles or interest rate movements, or the shape of the new tax bill overall, or the level of the general stock market. On the other hand, fundamental securities analysis, as embodied in the classic Graham & Dodd text, Security Analysis, is essentially top-down. Further, Graham & Dodd is not about understanding businesses. Rather, it is about excellent caveats to follow if you can’t, or don’t, understand particular firms.

I thought it might be helpful to the Fund’s shareholders if I briefly contrasted the TAVF approach with the approach that is central to academic finance, to wit, Modern Capital Theory (MCT). This spring, I conducted a seminar at Yale University’s School of Organization and Management entitled “Restructuring Troubled Companies.” The participants in the seminar seemed concerned that most of their work in my seminar was in sharp contrast to what went on in other finance courses. Consequently, I reviewed somewhat systematically the key literature of MCT, and then wrote a paper for my seminar, entitled “Reconciling Modern Capital Theory and Active Investing.”

It seems useful in this letter to share a few thoughts with you about MCT because I believe it has a huge influence on most money managers with whom TAVF ostensibly competes. Further, MCT obviously is becoming highly influential in many financial areas where there are important public policy issues, ranging from reform of the U.S. Bankruptcy Code to accounting for employee stock options under Generally Accepted Accounting Principles (GAAP). MCT, in fact, ought to be applicable, if at all, to a few narrow special cases. It has nothing to do with what TAVF does or, I daresay, with at least 98% of the investment activities in the financial community, excluding mutual fund managers and other strictly passive investors. To the extent one is trained to obtain fundamental knowledge about companies and their securities and to the extent one is an activist investor, promoter, or business buyer, MCT and its practitioners are best described as being straight out of “Looney Tunes.”

In the MCT scheme of things, the entire investment process (including the management of companies) revolves around the needs and desires of Outside, Passive, Minority Investors (OPMIs) who can never have special knowledge of anything, or control of anything, and whose needs and desires are fulfilled by continuously outperforming, in the stock or bond market, similarly situated OPMIs, risk adjusted. MCT might be useful for such OPMI traders. That agenda has nothing to do with TAVF. It may have a little to do with trading. It also has nothing to do with long-term investing. MCT does not involve fundamental analysis. Rather, its practitioners are technicians with PhDs. For MCT to be useful in security analysis, the application of its teachings must be limited to those securities which are readily tradeable and which can be analyzed by reference to a few simple, computer programmable, variables. In my view, those securities are limited to the following: a) credit instruments without credit risk; b) derivative securities, including synthetics, warrants and convertibles; and c) pure risk arbitrage situations, i.e., situations where there are relatively determinant price realization events in relatively determinant periods of time.

As to other precepts of MCT, e.g., diversification theory and measurement of the riskiness of assets, these are merely surrogates, and usually very poor ones, for knowledge and control. From a “money grubbing” point of view, I’d strongly suggest to those who invest on the basis of MCT theories that they, and their clients, would be well served by placing a portion of their portfolios in TAVF as an alternative investment. I’ll bet such an investment would be a lot more productive than would be, say, an investment in an index fund. More importantly from a public policy point of view, now that I’ve read the MCT literature, I can’t fathom why any respectable authority would give any weight to MCT in coming to terms with optimizing the U.S. Bankruptcy Code, U.S. securities law and regulation, Generally Accepted Accounting Principles, and the valuation of businesses. In these areas (indeed most areas) MCT ought to be viewed as irrelevant.


Dear Fellow Shareholders... Copyright © 2016 by Martin J. Whitman. All Rights Reserved.

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