The Importance of Buying Cheap, or Well Below Fair Value
Third Avenue Value Fund (TAVF) seems to have avoided a lot of trouble by being price conscious. The financial world is so complex and unpredictable that a fair amount of our analyses will prove to have been flawed. See USG Common and Repap Common. A dirt-cheap price is an anchor to windward against misperceiving current situations, or being unable to make accurate forecasts.
Over and above flawed analyses, it is important to buy cheap because increasingly, it seems as if activists are ripping off outside security holders, whether creditors or common stockholders, for ever-increasing amounts of wealth. These rip-off activists include corporate managements; lawyers and investment bankers involved with troubled company workouts; investment bankers in merger and acquisition situations; and members of the Plaintiffs’ Bar involved with asbestos litigation.
In dollar amount, our largest single holding at October 31 was Silicon Valley Common. On October 2, Silicon Valley announced that it was merging with ASM Lithography Holding, N. V. (ASM) in a common for common exchange as a result of which the former holders of Silicon Valley Common would own a 10% equity interest in the merged company. While the market value of the proposed transaction represented a substantial premium for Silicon Valley Common, the percentage ownership to be received by Silicon Valley Common seems unconscionably low, smacking more of an ASM takeunder than an ASM takeover. In addition, the terms of the merger agreement were markedly in favor of ASM, as for example no walk-away by Silicon Valley if the price of ASM Common craters while the merger is pending; and a bust-up fee of $47 million for ASM if a more attractive offer for Silicon Valley Common stockholders emerges. Still, it is hard for TAVF to argue against a substantial price premium above the pre-announcement market prices. On November 3, the preliminary merger proxy statement was made public. There it was disclosed that the top three members of Silicon Valley management had on October 1 entered into termination and separation agreements. Under these agreements, upon conclusion of the ASM transaction, the three are to receive compensation, mostly in cash, with a net present value of about $20 million. Perhaps, were termination payments lower, there might be more in the deal for the holders of Silicon Valley Common. As far as I can tell, Silicon Valley management is not acting differently than the way a majority of American corporate managements would act in similar circumstances. It just goes with the territory. Incidentally, the Silicon Valley merger transaction fees, mostly payable to lawyers and investment bankers, are estimated at $28 million.
When companies in distress are reorganized, either out of court or in Chapter 11, the company (sometimes known as the “Estate”) picks up with minor exceptions, such as U.S. government agencies, all the fees and expenses of all professionals: attorneys, investment bankers, consultants and appraisers not only for the company but also for various classes of creditors and, frequently, the common stockholders. These fees and expenses become priority claims, payable in full before amounts are paid to most pre-reorganization creditors. Professional fees and expenses have grown to such an extent that it tends to be utterly uneconomic to become a general creditor of a small, troubled, company. Thus, TAVF’s results as a Hechinger creditor are likely to prove to have been unsatisfactory solely because so much of the Estate is being eaten up by payments to attorneys and investment bankers. Put simply, these payments to attorneys and investment bankers come directly out of the hide of pre-petition creditors.
Payments to investment bankers by the distressed company are particularly galling to me. Over the years, I have been involved in the reorganization of many troubled companies. Most of the time, investment bankers have been much more disruptive than they have been constructive.
In 1993, I was the senior author of a law journal article in which it was suggested that no professionals, other than those representing the company, ought to be paid by the company before the end of a Chapter 11 case. Then, those professionals ought only to be paid if the court finds they had made a “Substantial Contribution” to the case. This idea seems to have no chance whatsoever of being implemented. This is, in fact, how the Plaintiffs’ Bar, which takes cases on a contingency basis, is compensated. No one is complaining that the Plaintiffs’ Bar does not attract highly skilled and highly motivated practitioners, even though they work on contingencies rather than for fixed fees; and their contingent payments are mostly subject to approvals by courts of law.
Finally, USG would not have the problems outlined above were it not for the Plaintiffs’ Bar in asbestos cases, where as a result of asbestos litigation, many lawyers have become very rich.
Note, though, that my statements here are financial commentary, not a statement of social and political philosophy. Indeed, our economy and our markets just would not function if it were not possible for insiders and activists to earn excess returns whether those are people who foster IPO’s, mergers and acquisitions, the reorganization of troubled companies, stockholder lawsuits, or the pursuit of redress for otherwise helpless citizens, such as individual asbestos victims. The point here is that it is important to realize that outside passive investors, whether creditors or stockholders, are going to have to pay the freight for these very expensive activist activities. To compensate for this disadvantage, the outsider ought to buy cheap — say, pay no more than 50 cents for each dollar a common stock would be worth were the company a private company or a take-over candidate; or acquire credits on a basis where the yield to maturity is at least 1000 basis points more than could be obtained from a comparable credit where people in the market do not foresee problems.
Buying at such prices is exactly what TAVF tries to do.
The Value Trap Versus the Growth Stock Trap
A number of people have asked me if I am concerned about the “Value Trap,” i.e., having the Fund own cheap stocks that just stay cheap forever. After all, the trader’s credo is, “A bargain that stays a bargain is not a bargain.” I don’t think the Value Trap really has any validity for the Third Avenue portfolio of value common stocks. Either portions of the portfolio are always working out, whether in takeovers or general market recognition, or the value analysis was not very valid to begin with.
In any event, it seems to be much more comfortable to be stuck in the “Value Trap” than to be caught in the “Growth Stock Trap.” Participants in conventional growth stock situations are bound to be really trapped if: a) general market conditions change such as might be the case if the NASDAQ Composite were selling at, say, 80 times trailing earnings rather than 120 times earnings; or, b) the growth stock investor, or analyst, turns out to have been overoptimistic in forecasts of revenues, cash flows or earnings.