20 Risk from a Third Avenue Point of View

APRIL 2006

Fund management views risk quite differently from the conventional views as embodied in literature such as Against the Gods— The Remarkable Story of Risk by Peter L. Bernstein or Principals of Corporate Finance by Richard A. Brealey and Stewart C. Meyers. Put simply, at Third Avenue, the word “risk” is meaningless unless an adjective describing the particular uncertainty is placed in front of the word “risk”.

For Third Avenue Value Fund (TAVF), there is, inter alia, market risk, investment risk, credit risk, failure to match maturities risk, commodity risk, hurricane risk, terrorism risk, etc., etc. There just is no such thing as general risk.

In particular, market risk refers to fluctuations in the prices of securities mostly traded in public markets. Investment risk, on the other hand, refers to probabilities of things going wrong fundamentally with businesses or with the securities issued by those businesses. TAVF strives hard to minimize investment risk. It rather completely ignores market risk. In contrast, Modern Capital Theory (MCT), typified by the writings of Brealey and Meyers, is focused solely on market risk; MCT seems to misdefine “market risk” as all “risk”, or to use their underlying concept, they believe that markets are efficient; and all risks that exist are reflected in the market prices of common stocks traded on markets populated by Outside Passive Minority Investors (OPMIs).

The Fund’s “Safe and Cheap[1]” approach to common stock investment encompasses consideration of four factors: super strong financial positions; reasonable managements; understandable businesses; and a price that represents a meaningful discount from our estimate of what the security would be worth were the business a private company, or a take­over candidate. Very frequently, and probably most of the time, the near­term earnings outlook for the common stocks Third Avenue is acquiring is anywhere from clouded to very poor.

If Fund management tried to pay attention to market risk, it would eschew investments in those securities where the near-term earnings outlook was clouded or poor. Rather, management acquires the common stock of well-financed companies when the underlying values, measured over a long term, appear to be good enough. Unlike MCT acolytes, TAVF does not try to estimate what near-term stock price performance might be, nor does TAVF try to predict stock market lows. Given a perception in the general market that there exists a Primacy of the Income Account, it seems to me to be impossible to follow a “safe and cheap” investment approach and at the same time to give any weight at all to attempts to gauge market risk. Market risk for Third Avenue is merely a “random walk”, best ignored altogether. The investment in Intel Common during the quarter seems a good example of a situation where the near-term outlook is clouded but the underlying values seem sound.

Thus far, over the fifteen plus years of life of TAVF, ignoring market risks altogether has not been a major problem. While market risk has been a factor for individual securities held by the Fund, it has not been important for the TAVF portfolio as a whole, even though the Third Avenue portfolio seems to be far more concentrated than are the portfolios of other mutual funds of comparable size.

Ignoring market risk can be worrisome for portfolios financed with borrowed money; for portfolios run by managers with a trading mentality; for portfolios run by managers who do not study individual securities in depth; and by managers who believe that the market knows more than they do about any individual security, e.g., believers in MCT. These factors are just not a Third Avenue problem.

There is a view that over the long run, market prices in markets populated by OPMIs will reflect “true value” and, thus, market risk will be equated with investment risk. This is, by and large, an irrelevancy for TAVF. As long as there exists mispricing between OPMI market prices and underlying corporate values, a long-term arbitrage will take place. Insofar as OPMI prices are too low, asset conversion events such as mergers and acquisitions, massive share repurchases, and going-privates will occur. Indeed, over the years, most of Third Avenue’s exits from portfolio positions in common stocks have occurred because the companies were taken over or taken private, not because TAVF sold to the OPMI market. In other words, OPMI mispricing is usually a capital gains creating factor in and of itself; and something more significant in the Fund’s investment experience than is any long-term tendency for OPMI market prices to approximate underlying investment values.

TAVF tries to deal in probabilities. The principal way that the Fund attempts to put the odds in its favor is by acquiring the common stocks of well-financed companies at prices that represent meaningful discounts from readily ascertainable net asset values. However, favorable odds alone should not trigger an investment if the consequences of a mistake might be draconian for Fund shareholders. Thus, Third Avenue will forego investing, even where the probability of success seems great, if the loss from being wrong might be truly harmful. This approach I call being conscious of odds and consequences. Specifically, in all Fund investments which account for more than 3% of portfolio net assets, e.g., Toyota Industries Common, USG Debentures, Cheung Kong Holdings Common and Brookfield Asset Management Common, I believe that on a reasonable worst case basis, each of these investments will always have material value. If I did not feel this way, the prospects of adverse consequences would make any one of these investments unsuitable for the Fund.

Ignoring market risk will mean that, from time to time, TAVF’s performance will be lumpy; the Fund is unlikely to outperform benchmarks consistently. Rather, the goal is to outperform on average, most of the time and over the long run. Measuring investment risk involves the consideration of three factors:

  1. Quality of the Issuer
  2. Terms of the Issue
  3. Price of the Issue

In MCT, only quality of the issuer and terms of the issue are considered because price is assumed to be in equilibrium. Therefore, in MCT there exists a risk/reward ratio — i.e., the more the risk of loss, the greater the possibilities for reward. In the TAVF case, the assumption is that the price is wrong and the Fund tries to acquire common stocks at prices below underlying value. In the Third Avenue scheme of things, there is no risk/reward ratio. For us, the lower the price, the less the risk of loss and the greater the prospects of gain.

[1] “Safe” means the companies have strong finances, competent management, and an understandable business. “Cheap” means that we can buy the securities for significantly less than what a private buyer might pay for control of the business.


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

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