33 So What Are Earnings, Anyway?

JULY 2006

Put bluntly, and in summary fashion, earnings are one of three things:

  1. The flow numbers – whether cash or accrual – as reported under Generally Accepted Accounting Principles (GAAP). These earnings numbers, as reported, are by far the most important numbers for market participants who are, or believe they are, affected vitally by day-to-day, or short run, price fluctuations for individual securities. For these participants, GAAP are supposed to reflect economic reality. In contrast, as reported GAAP are relevant to Third Avenue Value Fund (TAVF) only as objective benchmarks. For example, book value computed in accordance with GAAP has no necessary equality with net asset value (NAV). NAV is Fund management’s estimate of true net worth. However, GAAP book values frequently are objective benchmarks, enabling an analyst to more accurately estimate NAV.
  2. The flow numbers – whether cash or accrual – as adjusted by the market participant to reflect that market participant’s version of economic reality. For these participants, GAAP is an objective benchmark, not “truth” or “economic reality”.
  3. Wealth creation, or increases in NAV – whether those increases come from flows, realized appreciation, unrealized appreciation or combinations thereof.

The first definition of earnings is largely irrelevant for TAVF. The second and third definitions are what the Fund is involved with. However, the greatest weight and importance lies with the third definition of earnings, i.e., increasing the NAVs of the companies whose common stocks make up the bulk of the Third Avenue equity portfolio after adding back dividends paid during an interim.

Ernest Jones, in his three volume biography of Sigmund Freud, describes Freud’s genius as an abhorrence of looking at other people as irrational or “off the wall”. Rather Freud sought to understand the underlying reasons for why people acted the way they acted, and why they thought the way they did. Were Freud to be describing the 1998 to 2000 high tech bubble, he probably would have described it as “Rational Overexuberance” rather than “Irrational Exuberance”. And so it is with the question of, “So what are earnings anyway?”

Earnings for TAVF purposes are something quite different from what earnings are deemed to be in conventional, plain vanilla, market analysis. Rather, both the Fund and the conventional analysts tend to be rational; they just approach the problem from different places. The fact is that in conventional security analysis, predicting market prices over the very near term is crucially important. In contrast, TAVF ignores near-term market prices for individual securities. Third Avenue tries to buy long-term value safely and cheaply; and allows market prices of individual securities in the portfolio to take care of themselves. The Fund strives to avoid investment risk on a long-term basis, i.e., something going wrong with the business or the securities issued by that business.

Unlike TAVF, many market participants are, in fact, affected vitally by day-to-day price fluctuations in markets for individual securities. For these people, it is important to predict near-term target prices. For them, therefore, there actually does exist a “Primacy of the Income Account” and a need for GAAP to tell them the truth. After all, it seems quite valid to conclude that market prices for most securities will be influenced more by earnings as reported under GAAP than by any other single factor. These market sensitive participants include margin buyers; people and institutions relatively uninformed about the securities and companies in which they are interested; participants holding junior securities – subordinates, preferreds, common stocks and options – in companies that are not well financed; and participants who have to strive to outperform benchmarks consistently (such as many research department analysts who want to keep their jobs and get promoted). There are also market participants involved with both near-term predictions and fundamental analysis — to wit, short sellers and risk arbitrageurs (risk arbitrage is defined as investing in situations where there are reasonably determinate workouts in reasonably determinate periods of time). “The fact is that in conventional security analysis, predicting market prices over the very near term is crucially important. In contrast, TAVF ignores near-term market prices for individual securities. Third Avenue tries to buy long-term value safely and cheaply; and allows market prices of individual securities in the portfolio to take care of themselves.”

The basic problem is that this market-sensitive group seems to be the only group that is studied by academics. This group also seems to be the primary concern of securities regulators. However, this group seems to be a small factor in the overall economy, and may even be a minority on Wall Street. Most value investors, control investors, distress investors and venture capital promoters think, and act, more like TAVF than like market participants affected vitally by near-term securities price fluctuations. Like TAVF, most sophisticated market participants look at market prices not as something you predict, but rather something of which you take advantage.

Stealing from Sigmund Freud, it is not that some financial participants are irrational and others are rational. Rather, almost all participants tend toward rationality. It is just that what is rational for those affected by immediate market price impacts, tend to be irrational from the point of view of those involved with long-term fundamentals. Those involved with immediate market impact are involved with market risk, i.e., securities price fluctuations, while those focusing on underlying fundamentals are involved with investment risk. For most fundamentalists, like TAVF, market risk, both for individual securities as well as for macro factors affecting general markets, are things that can be ignored safely.

Also, if a company is not well financed, as a general rule it may be rational to emphasize quarterly reported earnings, and other short-term considerations, more than is the case for well-financed companies. Where a company is poorly financed, a poor quarterly report can often contribute to a permanent impairment of capital where the issuers are either denied any access at all to capital markets, or can access such markets only at an ultra-high cost. This is not a problem for the types of companies whose common stocks constitute the TAVF portfolio.

While Fund management attempts to buy deep value based on fundamental analysis and does not have any views as to how individual securities in the portfolio might perform in periods just ahead, TAVF is quite sensitive to how the overall portfolio performs. Fund management’s goal is to have Fund NAV increase more than any benchmarks most of the time, on average, and over the long term. No effort, however, is made to outperform consistently, i.e., all the time. The TAVF idea is that if the portfolio consists of securities that are “safe and cheap[1]” on a value basis, market prices will take care of insuring good performance most of the time. For the NAV investments at discount prices, long-term performance ought to be good enough if the issuer can continue to increase NAV, or if the company engages in resource conversion activities such as getting taken over, liquidating assets, or buying back common stock on a massive scale.

In value investing, common stock assessments are made along a continuum with weights given to appropriate variables. The basic variables revolve around whether principal emphasis in an analysis should be on operating earnings and cash flows and/or whether principal emphasis should be on looking at the company as an investment vehicle where greatest weight is given to NAV. In pure investment vehicles, such as mutual funds striving for total return, most market participants assign 100% weight to NAV and ignore earnings rather completely. Assume Company A is a strict going concern operating in its traditional lines of business, managed as it has been for years and/or financed pretty much the way it has always been financed. Also, Company A is unlikely to be a takeover candidate or to engage in mergers and acquisitions; contests for control; spin-offs or liquidations. Against this background, principal weight for a Company A analysis ought to be given to a Primacy of the Income Account, albeit NAV would never be ignored. On the other hand, assume Company B is realistically an investment vehicle where management’s basic goal is wealth creation frequently attained by means other than having taxable earnings. A large part of Company B’s modus operandi is to engage in massive asset redeployments, including acquisitions and going into new lines of business, massive liability and net worth redeployments (including common stock repurchases), management changes and taking advantage of attractive pricing in capital markets. Against this background, principal weight for a Company B analysis ought to be given to NAV, albeit income and cash flow from operations would never be ignored.

At July 31, 2006, fully 85.4% in market value of the TAVF common stock portfolio were in securities where, at the time of purchase, primary weight was given to NAV. These securities were issues of extremely well-financed companies and were selling at material discounts from readily ascertainable NAVs. Fund management forecasts, in most cases, were that there were good prospects that NAV plus dividend payouts over the long term would increase at a compound annual rate of much better than 10%. For TAVF, in these cases, earnings were clearly defined by looking, not at the income account, but at the prospects for future increases in NAV, whether such increases came from operating profits, realized appreciation or unrealized appreciation. At July 31, 2006, only 14.6% of the TAVF common stock portfolio were in issues, where at the time of purchase, primary emphasis was given to operating income flows – whether income flows, or cash flows. These companies, too, were extremely well financed. In looking at the past flows and prospective future flows, the only reliance on GAAP were as objective benchmarks, not something that would tell Fund management “the truth”. So here, even when there was a Primacy of the Income Account, TAVF was different from most conventional analysis in that in looking at the income account, TAVF management cared about what the numbers meant, rather than believing that GAAP numbers, as reported, reflected some sort of reality.

The Fund’s concentration on investing in the common stocks of financially strong firms based on pricing that represents discounts from NAVs results in material differences from other funds in portfolio management. Fund management, like other market participants, tries to predict the future. Like other market participants though, Fund management is frequently wrong in its predictions. However, in the TAVF case, the consequences of unpleasant surprises tend to be a lot less draconian than had the investments been made in poorly-financed companies based on predictions of future flows from operations. In common stocks, buying “what is” in well-financed companies seems to carry a lot less investment risk than buying based on forecasts of future operating results, where not much attention is paid to present financial strength. Thus, TAVF has considerably less need to diversify broadly than does the average mutual fund. As a consequence, TAVF is able to concentrate its investments much more than other mutual funds. At July 31, 2006, the ten largest common stock positions accounted for slightly over 50% of the Third Avenue equity portfolio. Each of the 10 was an NAV issue. Also, the nature of NAV investing is buy and hold. TAVF will have an annual turnover rate of, say, 10% to 15%. In contrast, the average mutual fund has a turnover rate in excess of 100%.

Concentrating on a NAV approach seems to be much more mainstream than is Wall Street’s obsession with the Primacy of the Income Account. Most investors and most companies are interested in wealth creation rather than ordinary, and therefore, taxable income. Indeed, I never have heard from a TAVF stockholder about the Fund’s net income; I do hear a lot about NAV.Corporations

Corporations have, for analytical purposes, four (often, but not always, interrelated) ways to create wealth:

  1. Cash flow from operations available for common shareholders. This seems to be relatively uncommon since most companies in their overall activities seem to be cash consumers rather than cash generators. Academics write quite correctly about projects needing to have a positive Net Present Value (NPV) in order for a project to make economic sense. The present value of the cash inflows from the project has to exceed the present value of the cash outflows. However, this refers to project finance, not corporate finance.
  2. Earnings, with earnings defined as consuming cash while creating wealth. This is what most corporations do. For most businesses, earnings cannot have a positive value unless also combined with access to capital markets to fund cash shortfalls.
  3. Resource conversion – creating wealth through asset redeployments (including mergers and acquisitions, liquidations); liability redeployments; and management changes.
  4. Have access to capital markets – both credit markets and equity markets – on a super attractive basis. Probably more fortunes have been built because of super-attractive access to capital markets than any other way.

Emphasis on Primacy of the Income Account made more sense in the old days when most businesses were strict going concerns, concentrating on one or two spheres of operations, managed as the business had always been managed, and financed the way the business had always been financed. Nowadays, almost no strict going concerns exist. Over any five-year period, virtually all businesses will undergo massive resource conversions ranging from mergers to major refinancings. NAV is now a lot more important in corporate analysis than it had been in the days of strict going concerns. A strict going concern approach tends to be more important when analyzing old line American manufacturing companies. TAVF tends not to invest in the common stocks of such issuers. All of the Third Avenue NAV holdings are in the common stocks of real estate companies, financial institutions and businesses holding large portfolios of either marketable common stocks or performing loans.

As you might expect, the Fund’s NAV emphasis is not without specific investment risks. Given today’s pricing, the bulk of TAVF’s NAV investments are being made in East Asia – Japan, Hong Kong, South Korea and Singapore, where the various companies also have interests in projects located in the People’s Republic of China. One troubling factor is that in East Asia, outside passive minority investors such as TAVF just do not get close to the same investor protections as are present in the U.S. Also, there probably is less political stability in East Asia than there is in this country. Neither of these disadvantages, however, have been “show stoppers”.

A real problem for TAVF shareholders revolves around the draconian income tax disadvantages for U.S. citizens and residents from owning the common stocks of certain foreign issuers selling at discounts from readily ascertainable NAVs. For U.S. income tax purposes, certain of these issuers are classified as Passive Foreign Investment Companies (PFICs). For practical purposes, this means that each year, Fund shareholders are subject to ordinary income tax on the annual unrealized common stock appreciation of the PFICs. To date, most foreign issuers in which TAVF holds investments have not been deemed to be PFICs. Hopefully it will stay that way, but one cannot be sure. The PFIC problem arises for TAVF because the U.S. income tax legislation was drafted so poorly.

It is interesting to contrast the TAVF style of investing with that used on behalf of limited partners in private equity funds involved with Leveraged Buyouts (LBO). LBO participants pay premium prices, i.e., control premiums, which are then offset by the availability of attractive senior finance coupled with prospects for asset redeployments plus constructive management changes. TAVF, on the other hand, buys in at non-control discounts, hopefully very steep discounts, and then leaves things on the corporate level as is, not seeking any asset redeployment, liability redeployment or management changes. Of course, expenses for TAVF shareholders are much more modest than is the case for limited partners in private equity funds. Third Avenue’s expense ratio is around 1.10%. In contrast, the typical private equity fund will charge a management fee of, say, 2%, and also allocate 20% of profits from operations, realized gains and unrealized appreciation to the general partner after the limited partners receive a priority return of, say, 6% to 10%.

As far as I can tell, there ought to continue to be available many attractive situations selling at discounts from NAV. For one thing, in conventional security analysis, many believe that there ought to be a “normal holding company discount” of around 20%. The vast army of believers in the Efficient Market Hypothesis seem convinced that NAV discounts don’t exist, and never have.

I daresay that in my lifetime, most participants in the non-control investment community will continue to believe in the Primacy of the Income Account, and will treat almost all companies as strict going concerns creating value only from operations. This seems to be the case even though, increasingly, most companies seem to have become basically investment vehicles rather than merely operating entities. If so, there are likely to continue to be opportunities for TAVF to invest in the common stocks of well-financed companies at prices that reflect meaningful discounts from NAVs.

Within the Fund’s NAV portfolio, two sectors have not been increasing NAV, at least, at a 10% compound annual rate. One sector is Japanese non-life insurance companies, and the other is Mutual Holding Companies (MHC), i.e., certain small U.S. community banks. If interest rates increase materially in Japan, I think the non-life insurance companies would have a good chance of exceeding a 10% return on NAV. The MHCs are held by TAVF mostly because they appear to be attractive acquisition candidates.  Academics, whether efficient market theorists or behaviorists, spend much effort in postulating how information impacts markets. The underlying problem academics seem to have is that they think of material information in terms of impacts on day traders. The fact is that what is material information for Third Avenue are things that are quite different from what is material information for day traders. One suggestion is that academics be required to spend two to three hours a day for six months reading Forms 10-K, Forms 10-Q, Forms 8-K, and Proxy Statements before making pronouncements about what information is and how information impacts markets.

Insofar as TAVF keeps expanding in size as new moneys come into the Fund, or in any event, the Fund does not shrink because of redemptions, there is little pressure on the Fund to sell securities in the portfolio. Insofar as NAV companies show promise that NAV will continue to grow over the long term; and the common stock does not appear to be grossly overpriced, Third Avenue will not sell the issue. Time has proven that in following the Fund’s “safe and cheap” approach, the analytic discipline works much better on the buy side than the sell side. In other words, absent compelling reasons to sell, most of the common stocks in the TAVF portfolio are very, very, long-term holdings.

In NAV investing, scant attention is paid to top down factors such as predicting Gross Domestic Product, interest rates, the Dow Jones Averages, federal deficits or balances of payments. Rather, the emphasis is on bottom-up “nitty gritty”. It is assumed that the NAV investor ought to do okay long term as long as there exists political stability and an absence of violence in the streets. This has been the case for value investing since World War II. The Fund is betting that the environment of the last 60 years, where macro factors have been relatively unimportant for value investors, will continue.

One of the huge advantages of being a long-term investor in well-financed companies is that the strong finances give reasonably competent managements opportunities to be opportunistic, something probably unavailable to most managements when they are forced to be supplicants to creditors.

TAVF, in its analyses, uses GAAP as an objective benchmark, adjusting the numbers to reflect an economic reality. For example, over half of Toyota Industries’ assets are invested in securities, principally a larger than 5% interest in Toyota Motor Common. Only dividends received from its portfolio holdings are reflected in Toyota Industries’ income account, so that on a GAAP basis, Toyota Industries Common is selling at over 27 times earnings. However, if the Toyota Industries’ GAAP income account is adjusted to pick up Toyota Industries’ share of the portfolio companies’ retained earnings (i.e., earnings not distributed as dividends), then Toyota Industries Common is selling at less than 10 times earnings. Forest City Enterprises creates great amounts of cash flow without it being reflected in a GAAP income account. Say Forest City finances one of its office buildings with a $100 million, 15-year issue of a non-recourse, mortgage loan. The building, well maintained, tends to increase in value over time insofar as high quality, long-term leases are entered into. Say in seven years, the loan is paid down to $80 million and Forest City refinances with a new non-recourse mortgage for $120 million. Forest City on this transaction gains $40 million of new cash without any effect on its income account.

The U.S. securities laws as enforced by the Securities and Exchange Commission (SEC) are designed to provide Investor Protection. The laws seem to have three principal functions:

  1. Maintain free, fair and orderly trading markets;
  2. Provide disclosure; and
  3. Provide some oversight of professionals such as broker-dealers, accountants, corporate executives and other insiders.

TAVF is interested particularly in the disclosure area where over the past forty years, the SEC has done a magnificent job of improving disclosure to outsiders. Going forward, however, I think it is increasingly important that the authorities recognize that the best investor protection in the disclosure area is Self Protection. Make disclosures available. If participants – say day traders – don’t want to use that information, that is their business. Disclosure requirements ought to be based on the view that disclosure is geared toward a reasonably intelligent, reasonably diligent, long-term investor – say someone akin to a long-term, unsecured, private placement creditor. From GAAP, such an investor needs objective benchmarks, not truth. Adopting such an attitude might be a boom for American Capital Markets, which seem to be losing out to foreign markets at a rapid rate.

[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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