45 Reconciling Modern Capital Theory and Value Investing

APRIL 2003

Huge amounts of the moneys invested in mutual funds have been placed in Index Funds. The raison d’etre for Index Funds arise out of the underlying assumptions of Modern Capital Theory (MCT). For MCT, it is fruitless to hope to outperform benchmarks, e.g., the general market, because trading on the New York Stock Exchange and NASDAQ results in efficient, or correct, prices (the Efficient Market Hypothesis or EMH). Rather, investors should eschew any fundamental analysis but rather allocate assets to an appropriately diversified portfolio (Efficient Portfolio Theory or EPT). MCT is summarized by William F. Sharpe, a Nobel laureate and typical efficient-market believer, when he stated in the third edition of his book, Investments, that if you assume an efficient market, “every security’s price equals its investment value at all times” (page 67).

Value Investing, on the other hand, bottoms on the assumption that through sound fundamental analysis based on knowledge of companies and the securities they issue, as well as price consciousness, a passive investor can usually outperform an index over most periods of one year or more. I remain convinced that over the long term, an investment in TAVF will combine both greater upside potential, and much less downside risk, than would an investment in an Index Fund such as the Vanguard 500 Index Fund. I believe that my conviction is supported by the long-term performance of TAVF. The remainder of this letter explains why I believe this is so by examining some of the underlying assumptions of MCT.

For MCT, the proof of the existence of an efficient market centers on the observation that no individual investor, or institution, has ever outperformed a market, or a benchmark, consistently. Consistently is, of course, a dirty word: It means “All The Time.” Academics seem to be absolutely right in their observation that no one outperforms any market consistently. However, it seems asinine to offer this as evidence that fundamental analysis is useless or nearly useless. Lots of investors, especially value investors, outperform markets or benchmarks on average, or usually, even if no one from Warren Buffet on down can outperform a market or a benchmark consistently. Further, many, if not most, MCT acolytes seem sloppy in their observations in that a good deal of the time they conveniently ignore the “consistently” condition in describing the uselessness of fundamental research.

EMH seems to be absolutely valid in a special case. The basic problem with MCT believers is that they assume wrongly that this special case is a general law. EMH describes the investment scene accurately only when two conditions exist in tandem:

  1. The solitary goal of a passive, non­-control investor is to maximize a risk­-adjusted total return consistently.
  2. The security, or commodity, being analyzed can be best analyzed by reference to a limited number of computer programmable variables. In the securities field, these instruments seem limited to three types of securities:

EMH seems to be the most appropriate approach for participants in the securities markets who combine one or more of the following characteristics, none of which are applicable to Third Avenue Funds, and, hopefully, to the vast majority of Third Avenue Stockholders:

  1. The security holder is playing with borrowed money and might be subject to margin calls if market prices decline. Such a person, or institution, has to be vitally interested in day-­to-­day market prices.
  2. A securities trader with a technical, or chartist, approach. The underlying belief of such people is that the market knows more than I do and that to perform well one needs only study securities prices, not corporate fundamentals. TAVF would not invest in any security except in the belief that Fund management understands the situation better and more completely than the market; and that the Fund understands the business in which it invests as well as the securities issued by that business. In a very meaningful sense, academics who subscribe to the MCT approach are nothing more than technician-chartists with PhDs. In a leading text, Principles of Corporate Finance by Brealey and Myers, Seventh Edition (“Brealey and Myers”), it is stated on page 365 under the heading “The Six Lessons of Market Efficiency” that one ought to “Read the Entrails. If the market is efficient, prices impound all available information. Therefore, if we can only learn to read the entrails, security prices can tell us a lot about the future.”
  3. The person’s livelihood depends on being mostly right about near-­term stock price movements. This group includes many analysts in broker-­dealer research departments, many securities salespeople, and many financial advisers.
  4. People with no training whatsoever in fundamental corporate analysis.

There are many underlying assumptions of MCT and Index Funds that are just plain wrong from a TAVF point of view. Among the most important are the following:

For MCT, there is a risk-reward ratio, i.e., the more (market) risk one takes, the more the possible rewards. This view traces to a belief in price equilibrium. At any moment of time, a security’s price is the correct price for all valuation purposes. For TAVF, the risk-reward ratio trade-off is non-existent; the lower the price in a given situation, the less the risk and the greater potential for reward. For Third Avenue, there does exist a risk-reward ratio insofar as the quality of the company, and the terms of the securities issued by the company, are concerned (e.g., typically a first mortgage obligation of an issuer has a lesser risk element than that company’s common stock issue, other things being equal). However, for TAVF, the existence of a risk-reward ratio implicit in the quality of the issuer, and the terms of issue, are more than counterbalanced by the fact that most of the time securities prices represent a material disequilibrium. There is a huge safety factor inherent in buying in at a bargain price.

MCT misdefines risk. For MCT, the word risk means only market risk, i.e., fluctuations in prices of securities. In fact, one can’t really use the word “risk” without putting an adjective in front of it. There is market risk, investment risk (i.e., something going wrong with the company), credit risk, commodity risk, failure to match maturities risk, terrorism risk, etc. At TAVF, we try to avoid investment risk. We pay less attention to market risk.

Insofar as MCT theory is concerned, the only source of corporate value is Discounted Cash Flows from operations (DCF) and the only source of value for stockholders is the present worth of future dividend flows. These MCT views are utterly naive. In focusing on DCF, the academics confuse project finance (where any project has to have a positive net present value as measured by cash flows in order to make sense) with corporate finance. This can be seen in Brealey & Myers’ statement on page 119, “Only Cash Flow Is Relevant.” In fact, the vast majority of prosperous corporations consume cash; they do not generate positive DCF. Rather, the prosperous corporations have earnings, not DCF. Earnings are defined as creating wealth while consuming cash.

For TAVF purposes, corporations can create value in four different ways:

The MCT view of common stock value is summarized on page 118 of the text Corporate Finance by Ross, Westerfield and Jaffe, Fourth Edition (“Ross, Westerfield”): Investors “only get two things out of a stock: dividends and the ultimate sales price, which is determined by what future investors expect to receive in dividends.”

For TAVF, in contrast, the value of a common stock is the estimated present worth of any future cash bailout whatever the source. The cash bailout can come from one of three sources:

  1. Cash payments by the company for dividends or to repurchase outstanding common stock.
  2. Sale to a market, with the market price determined by any number of factors: e.g., estimated future dividends; increases in corporate wealth for businesses which will never pay dividends; or speculative enthusiasm for a particular group of common stocks.
  3. Control, or elements of control, of a company.

For MCT, diversification is a must; EPT governs. For TAVF, diversification is only a surrogate, and usually a damn poor surrogate, for knowledge, control and price consciousness. Because the Fund is a non-control investor, a certain amount of diversification is essential, but Third Avenue is far more concentrated in its investments than are Index Funds.

Much of MCT is based on utterly unrealistic views of the real world. For example, Ross, Westerfield state on page 17, “Shareholders determine the membership of the board of directors by voting.” The fact in the real world is that, in 99%-plus of the cases, membership of the board of directors is determined by those people who control the corporate proxy machinery — management and/or people friendly to management. Shareholder votes almost all the time are equivalent to what elections used to be like in the U.S.S.R., where incumbent Communists received from 99% to 100% of the vote.

Ross, Westerfield also state on page 17, “Fear of a takeover gives managers an incentive to take actions that will maximize stock prices.” The universal fact is that fears of takeovers have caused almost all managements to put in place “shark repellents” such as poison pills, staggered boards, blank check preferreds, fair price provisions, and friendly state laws, in order to insulate themselves in office. These entrenchment provisions tend to depress, not enhance, common stock prices.

While not wholly free from doubt, MCT seems to say that except for agency costs, managements do work in the best interests of stockholders. For TAVF, a much more productive approach is to understand that all participants, in all financial processes, including the relationships between managements and stockholders, combine communities of interest and conflicts of interest. For the vast majority of companies in the TAVF portfolio, the managements seem quite cognizant of the interests of Third Avenue and other outside stockholders. Nonetheless, the only situation of which I am aware where one might expect management to work exclusively in the interests of stockholders to the exclusion of other constituencies, is the one where the CEO and his family own all the outstanding common stock.

MCT and Index Funds are based on two premises. First, there is only one securities market, the places where Outside Passive Minority Investors (OPMIs) trade, e.g., the New York Stock Exchange and NASDAQ; and second, the market is efficient, or to put it otherwise, securities prices almost always reflect an instantaneous efficiency. TAVF, on the other hand, believes there exist myriad markets, and that all markets tend toward efficiency, but that few actually achieve instantaneous efficiency except in the special cases previously cited. A market is an arena in which participants arrive at agreements as to price, and other terms, which each participant believes is good enough under the circumstances. Disparate markets include OPMI Markets, leveraged buyout Markets, Merger and Acquisition Markets, Managerial Compensation Markets, and Markets for Reaching Agreements about Consensual Plans of Reorganization in Chapter 11. Sometimes price efficiency is attained slowly.  I’ve noticed that it took the better part of 10 years for the pricing of first mortgage bonds of troubled regulated electric utilities to become priced efficiently. An efficient price in one market, say the OPMI Market, is, per se, an inefficient price in another market, say, the Leveraged Buy-Out Market.

MCT — and Index Funds — operate under the assumption that OPMIs cannot outperform a market, or index, because all relevant information gets impacted into common stock prices instantaneously. At Third Avenue, we do not rely on receiving superior information but rather we strive to use the available information in a superior manner. For example, most practitioners, from MCT theorists to Graham and Dodd, believe that there is a primacy of the income account; the balance sheet is virtually ignored by these analysts, who instead concentrate on the past earnings record or forecasts of future flows, whether earnings flows or cash flows. In contrast, a majority of the common stocks held in the TAVF portfolio are issues of companies with ultra-strong balance sheets where the issue was acquired at prices that represent a substantial discount from readily ascertainable net asset values; e.g., Toyota Industries, Tejon Ranch, MBIA, Millea Holdings, Forest City Enterprises, Radian Group, St. Joe, and Brascan. These common stocks will have substantial appreciation potential if managements can keep growing net asset values, even if such growth comes from sources other than having operating income or cash flow, such as appreciating land values.

The goal of MCT seems to be to find general laws which will explain market price fluctuations and securities price fluctuations. At TAVF, in contrast, we focus on individual differences. The tools and variables involved in analyzing securities vary case by case. Our standards for investing in the common stocks of high-tech companies are quite different than our standards for investing in the common stocks of real estate companies or banks; and the criteria we use in investing in distress credits are quite different than our common stock criteria because in the case of common stocks, we restrict investments to companies with strong financial positions while in the case of distress credits, corporate balance sheets are almost always very weak.


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

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