As I have noted in the past, diversification is merely a surrogate, and frequently a very poor surrogate, for knowledge and control. However, Third Avenue Value Fund (TAVF, “The Fund”) is required by its fundamental investment policy, and the Internal Revenue Code, to meet certain standards of diversification. Further, the Fund is a passive, non-control investor and, thus, common sense dictates that TAVF pay much more attention to diversification than otherwise would be the case were the Fund involved in control acquisitions, including leveraged buyouts.
Accordingly, TAVF is somewhat diversified. However, TAVF is far less diversified than the vast majority of mutual funds, measured both by the Fund’s willingness to concentrate the bulk of its monies in a relatively few issues, as well as the relatively small number of issues owned. Most other funds seem to be managed by “top-down” asset allocators who bring little, or no, knowledge to the nitty-gritty details that affect the companies and securities in which the typical fund has invested. Thus, “top-down” funds approximating TAVF in size tend to invest in the equities of, maybe, 150 to 250 issuers, compared with 63 for TAVF. Other funds tend to spread their investments over a broad range of industry groups (and the turnover among these 150 to 250 names will be frequent). Rarely will these highly diversified funds put as much as 1.5% of their risk assets (i.e., the portions of the portfolio which are not in cash and cash equivalents) into specific securities. Given the amount of knowledge these fund managers bring to individual situations, their broad diversifications probably are prudent for them. But by no stretch would such broad diversification make sense for TAVF, or for other funds which also concentrate on value. This idea of broad diversification reaches its zenith, of course, in index funds where the fund manager’s admitted raison d’être is that he, or she, knows absolutely nothing about the underlying securities which are either in portfolios or the components of indices.
TAVF, on the other hand, tries to bring detailed, “bottom-up” knowledge about companies and securities to each of its portfolio investments. Inevitably, the Fund is going to be less diversified than “top-down’’ mutual funds. The Fund is likely to invest the same proportion of its assets in one security as more diversified entities invest in one industry. For example, as of August 15, 1994, the Fund owned in excess of 5% of the outstanding common stocks of four different issuers. Except for mutual funds in the over $1 billion asset size class, it does not seem usual practice for individual mutual funds to accumulate greater than 5% positions in the equities of individual issuers.
The bulk of the monies invested by TAVF during the quarter ended July 31, 1994, were in expanding existing positions.
In terms of the quality of knowledge that goes into investment decisions, it seems to me that it is infinitely easier for TAVF to get comfortable with concentration in a few situations, than is the case for asset allocators. The knowledge the Fund seeks is a lot more tangible, and capable of analysis, than is the case for many others. TAVF, in seeking knowledge, concentrates on acquiring equities in companies which enjoy strong financial positions, as well as promising long-term outlooks; and to acquire those common stocks at prices which represent substantial discounts from private business values. In acquiring credit instruments, the Fund concentrates on strong covenant protections combined with high yields. Unlike others, the Fund has virtually no interest in gathering knowledge about “soft stuff” which might aid in predicting things like the direction of the general market, interest rates, quarterly earnings, dividends, P/E ratios, business cycles, or Wall Street sponsorship. Nor is TAVF interested in anything that smacks of a technical or chartist approach. Indeed, the TAVF emphasis is much more on ascertaining long-term corporate values, rather than trying to estimate the near-term performance of securities prices. It seems relatively easy to use knowledge if one is striving, as TAVF is striving, to do “good enough,” defining “good enough” as, say, earning 20% annually compounded on a long-term basis. It seems difficult to use knowledge if a fund manager has to strive to consistently or continuously outperform the market and/or a peer group. Admittedly, if the Fund was required to be managed using the variables and goals of other funds, it probably would be prudent for TAVF to emulate the other diversification strategies (and I would find something else to do as an occupation).
An Additional Thought: Research
I’ve spent a fair amount of time and effort criticizing the plaintiffs’ bar and academic finance. A third group very low on my totem pole: research departments at broker-dealers. TAVF has been making a conscious effort to direct more business, consistent with best execution requirements, to a variety of broker-dealers who give usable research ideas to the Fund. I’ve asked a number of broker-dealers to send TAVF copies of their research department’s written recommendations. At least 80% of such writings, while they may be terrific for market players, are unfit for consumption by value analysts who have a long-term, buy-and-hold, investment orientation. Some years ago, I had decided that I would essentially restrict my limited time for research reading to company documents, Securities and Exchange Commission and other agency filings, as well as things like litigation files. After spending some time now with broker-dealer research reports, I appreciate anew the wisdom of my earlier decision. In a real sense, this is not so much overt criticism of broker-dealer research departments, as it is another way of reiterating what ought to be self-evident: TAVF’s investment practices and investment philosophy are quite different from the practices and policies of most other funds.