Corporate reporting of “the numbers” has become so important, and so publicized, it might be helpful to Third Avenue Value Fund (TAVF) stockholders if I commented briefly about how the Fund’s management uses, and thinks, about financial statements prepared in accordance with Generally Accepted Accounting Principles, or GAAP. TAVF is quite different from most others in how the Fund makes use of financial information.
First, financial statements are always of utmost importance in the TAVF scheme of things. This, perhaps, may be the most significant reason why Third Avenue has never been involved with pure play Internet issues. Here, corporate numbers don’t seem to count at all. The only important thing seems to be to gauge short-term investor psychology — something to which TAVF management pays scant attention.
GAAP figures can serve two different roles for outside passive minority investors. First, an accounting number — usually earnings per share — is a tool to be used to help predict the price at which a common stock will sell in markets just ahead. Alternatively, all accounting numbers — the whole bookkeeping cycle — are tools to be used to give an investor objective benchmarks, clues to aid him, or her, in understanding a business and its dynamics.
The vast majority of analysts seem to view GAAP only in its first role, as a tool to be used to help predict the price at which a common stock will sell in the period just ahead. The regulators, whether governmental as embodied in the Securities and Exchange Commission, or private as embodied in the Financial Accounting Standards Board, seem to share the same view wholeheartedly. Estimating the market impact of accounting numbers is what counts for them. Thus, there is a primacy of the income account. There has to be as accurate a statement as possible of quarterly reports of income from operations; Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA); and Earnings Per Share (EPS). The focus is on an income account, or flow, number with full attention paid to what the numbers are, as reported, rather than what the numbers mean.
Third Avenue belongs to the second school in its use of GAAP. TAVF believes that financial accounts are essential tools giving analysts objective benchmarks, clues that will aid in understanding a business and its dynamics. In equity analysis, accounting cannot, and should not, be expected to tell real world Truths. Rather, the limiting assumptions of GAAP — for example, depreciation is based on original cost rather than current value — means that what the numbers are, are not what economic truth is. Additionally, if one wants to understand a business and its dynamics, one has to focus on a considerably greater number of factors than merely flows — whether income from operations, EBITDA or EPS. Equally important, and usually more important than flows, in a TAVF analysis is the quality of resources existing in a business and the quantity of resources (relative to the price being paid for a common stock) existing in a business. Quality of resources and quantity of resources are essentially balance sheet, rather than flow, considerations.
Further, in a TAVF analysis, there is no primacy of anything such as earnings, but rather a realization that any number within the whole “ball of wax” can be important. Every accounting number is a function of, derived from, and modified by other accounting numbers. The analytical techniques used by Third Avenue, while different from those that seem to be used by most money managers, seem to be quite similar to those used by most investors in control, or interested in obtaining control, of companies.
Against this background, it seems productive to examine a couple of controversies existing in the accounting profession today: 1) how to expense the issuance of common stocks in acquisitions or the issuance of common stock equivalents, such as options to executive and employees; and 2) how to account for corporate acquisitions — purchase accounting vs. pooling of interest accounting.
In a TAVF analysis, a company is a stand-alone for accounting purposes and its books and records affect what exists in the company and what is happening to the company. As far as the Fund is concerned, corporate accounting, per se, should not, in any way, be related to common stock prices of particular corporations. There is a great hue and cry in the financial world stating that companies ought to charge as an expense against the income account the market value of securities, such as executive stock options, issued as management compensation. This charge against the income account should equal charges for cash payments to management, such as for salaries and bonuses.
This point of view seems to be arrant nonsense for the purpose of any fundamental analysis, especially because the company ought to be viewed as a stand-alone separate and apart from its shareholders. Obviously, the effects on a company are quite different when the company has to make a cash payment (or distribute other assets) compared with when a company issues new common stock or common stock equivalents. The payment of cash by a company diminishes the company’s assets quantitatively and perhaps qualitatively as well. In contrast, the issuance of new common stock, where a company pays no dividends, does not affect the company directly but, rather, results in a dilution of ownership. Dilution of ownership is a stockholder problem, not a company problem. Ownership dilution can only have a cost to the company if it results in the issuer having less attractive access to capital markets than would otherwise be the case. Potentially less attractive access to capital markets is a difficult thing to measure for a company.
In contrast — the cost of cash outlays is easy to measure for a company. Measurement of the true cost of stock options is not something that ought to be part of GAAP, in part because measurement is so difficult. The true cost to a company of stock options ought to be estimated by security analysts, not determined by accountants. In connection with the issuance of stock options, their cost probably ought not to be measured by the imputed market value of the stock option, whether the one who measures such cost is an analyst or an accountant. The market value of the stock option to the recipient may well reflect the value of that option to the recipient. The value of a benefit to an optionee, however, has no necessary relationship to the cost to the company to bestow that benefit. It’s as if an employee receives an item of inventory from the company which cost the company $10 and has a retail selling price of $50; and, therefore, the company’s income account is charged $50, the value of the inventory item to the recipient rather than the company’s $10 cost.
In purchase accounting, the acquiring company is deemed, for valuation purposes, to have paid a cash consideration for the acquired entity even though the consideration paid can consist of cash, debt securities and equity securities. The premium, as so measured paid over an adjusted book value of the net assets acquired, is deemed to be purchase goodwill. Purchase goodwill is amortized in not over 40 years (soon to be reduced to 20 years) by periodic charges to the acquiring company’s income account. Pooling can take place when certain requirements are met, among which are that an acquisition include only exchanges of common stocks for common stocks between, or among, merging companies. In a pooling, old accounts are consolidated as they appear on each entity’s books and no purchase goodwill is created. Pooling accounting is soon to be banned.
From a TAVF point of view, both purchase accounting and pooling accounting have merit. If the analyst wants clues only as to how to appraise an entity as a strict going concern engaged in day-to-day operations, pooling tends to fill the bill. On the other hand, if managements are to be appraised as investors as well as operators, purchase accounting gives additional clues, to wit, the amount of premium paid over an adjusted book value. Either approach to an analysis can be legitimate. Neither purchase nor pooling ought to be expected to tell economic Truth. That is for the analyst to determine for himself or herself using the clues provided by purchase or pooling, as well as financial accounting in general. It seems as if the accounting profession has now got it right in solving the purchase vs. pooling controversy. Commencing next year, only purchase accounting will be used, but companies will report two results — one with a periodic charge for goodwill deducted as an expense and one without any expense deduction for goodwill. The authorities, in connection with this issue, and other pronouncements as well, seem to be waking up to the GAAP fact of life that there is no “holy grail,” i.e., that there never can exist just one number, presumably EPS, that reflects a universal Truth.
It is not that quarterly earnings or EPS are ever unimportant for TAVF. They are important when they provide clues that a permanent impairment of capital may be taking place. Permanent impairments are much more likely to occur for companies which are poorly financed. These are just the sorts of companies in whose equities Third Avenue does not invest.
In terms of what the numbers mean rather than what the numbers are, it may be constructive to examine what the numbers may mean for Tejon and Toyoda. Basically what Tejon management seems to be creating in its real estate activities is unrealized appreciation. Unrealized appreciation for assets, other than marketable securities, is never reflected in financial statements. Therefore, the reported earnings figures for Tejon, which is well-financed, do not mean a lot. One has to look well beyond them to understand the Tejon business and its dynamics.
A number of brokerage house analyses of Toyoda focus on the fact that Toyoda Common sells at over 50 times reported earnings; none seem to focus on the Toyoda net asset value as measured by market prices for its huge securities portfolio. In these brokerage house analyses, what the earnings number is, and is projected to be in the period ahead seem to be key. Not one of these analyses picked up the fact that the Toyoda income account and EPS reflects only dividends received from the common stocks of portfolio companies, including Toyota Common. If Toyoda used “look through” accounting where, besides dividends, the Toyoda income account also included Toyoda’s equity in the undistributed earnings attributable to the common stocks of portfolio companies, then the PE ratio would be materially more modest than 50 times earnings. Also, Toyoda reflects in its income account its share of losses being incurred in the Sony LCD venture. Assuming that the Sony LCD venture is promising, a reasonable analyst might conclude that it makes better business sense to capitalize, rather than expense, those losses for purposes of a valuation analysis.