9 The Concept of Net-Nets


Over 80% of the Fund’s common stock portfolio are in the issues of extremely well-capitalized companies that were acquired at prices, which at the time of acquisition, represented meaningful discounts from readily ascertainable net asset values. These net asset values became readily ascertainable insofar as the specific assets consisted of cash and equivalents; investments in marketable securities and performing loans; income-producing real estate; land suitable for development; and intangibles such as mutual fund assets under management. Rarely (except for cash and equivalents) were these readily ascertainable asset values classified as current assets under Generally Accepted Accounting Principles (GAAP). The Fund’s definition of Net-Nets is taken from Graham and Dodd’s Security Analysis, but with a few twists. Graham and Dodd relied on a GAAP classified balance sheet to define current assets in order to ascertain if a common stock was a Net-Net. Third Avenue Value Fund (TAVF) uses its own judgment rather than GAAP classification to define current assets in order to decide what is a liquid, i.e., current, asset.

Graham and Dodd describe Net-Nets in the 1962 edition of Security Analysis on pages 561 and 562:

Net­-Current­-Asset Value: 
We feel on more solid ground in discussing these cases in which the market price or the computed value based on earnings and dividends is less than the net current assets applicable to the common stock. [The reader will recall that in this computation we deduct all obligation sand preferred stock from the working capital to determine the balance for the common.]From long experience with this type of situation we can say that it is always interesting, and that the purchase of a diversified group of companies on this ‘bargain basis’ is almost certain to result profitably within a reasonable period of time. One reason for calling such purchases bargain issues is that usually net-current-asset values maybe considered a conservative measure of liquidation value. Thus as a practical matter such companies could be disposed of for not less than their working capital, if that capital is conservatively stated. It is a general rule that at least enough can be realized for the plant account and miscellaneous assets to offset any shrinkage sustained in the process of turning current assets into cash. [This rule would nearly always apply to a negotiated sale of the business to some reasonably interested buyer.] The working capital value behind a common stock can be readily computed. Consequently, by using this figure (i.e., net-net asset value) as the equivalent of ‘minimum liquidating value’ we can discuss with some degree of confidence the actual relationship between the market price of a stock and the realizable value of the business.” 

While Graham and Dodd seem to have invented the idea of Net-Nets, TAVF uses that idea with a number of modifications. First, the Fund is not interested in Net-Nets unless the company is extremely well-financed. A large quantity of current assets, especially if they consist of inventories, costs in excess of billings, or receivables from less than creditworthy customers, probably cannot help the common stock of a company which cannot meet its obligations to its creditors. Second, many current assets classified as current assets under GAAP are really fixed assets of the worst sort. Take department store merchandise inventories. If the department store is to be liquidated, merchandise inventories are indeed a current asset, convertible to cash within 12 months at prices that conceivably could be close to book value, although much less than book value may be realized if the merchandise is disposed of in a GOB (Going Out of Business) sale. On the other hand, if the department store is a going concern, merchandise inventories are a fixed asset of the worst sort. The merchandise inventories have to be replaced, are hard to value, and are subject to markdowns, obsolescence, shrinkage, seasonality and mislocation. The Toyota Industries portfolio of marketable securities seem to be much more of a current asset than department store merchandise inventories even though, for GAAP purposes, Toyota Industries’ marketable securities are not considered a current asset. Third, the Graham and Dodd formulation does not account for off balance sheet liabilities which may, or may not, be disclosed in footnotes, nor do Graham and Dodd take into account excessive expenses or losses; at TAVF such expenses or losses are capitalized and added to liabilities. Fourth, Graham and Dodd only seem to recognize partially that certain fixed assets, e.g., property, plant and equipment, can sometimes create cash. For example, under Section 1231 of the U.S. Internal Revenue Code, the sale at a loss of such assets used in a trade or business, usually gives rise to an ordinary loss for income tax purposes. In that case, a corporation may be able to apply the loss first to reduce current year taxes and any excess loss might be used to get “quickie” cash refunds from the IRS with regard to taxes paid in the prior two years.

The identification of Net-Nets has not proved that difficult for the Fund, even though most of the new investments now are outside the United States. The toughest problem faced by TAVF, by far, is to identify managements and control groups of these Net-Nets who are both able and conscious of the interests of outside, passive, minority investors such as Third Avenue. So far, the Fund’s results in this area seem to have been pretty good, though, of course, mistakes have been made. When all is said and done, however, TAVF management owes an enormous debt of gratitude to Graham and Dodd for introducing the concept of Net-Nets. It remains the most important single part of the Fund’s common stock portfolio.


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

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