42 The Third Avenue Approach vs. The Conventional Academic Approach

JULY 1995

The Third Avenue View Vs. The Conventional View

Generally speaking, most shareholders seem to prefer high, and increasing, dividends to modest, or no, common stock dividends. As is pointed out on page 549 of a leading academic text on finance, Corporate Finance (3d ed.) by Ross, Westerfield and Jaffe (“Ross, Westerfield”), “The stock market reacts positively to increases in dividends (or an initial dividend payment) and negatively to decreases in dividends. This suggests that there is information content in dividend payments.” Although situations have to be examined on a case by case basis, TAVF generally favors a no cash dividend policy, especially for companies, like Ryan Beck, having a demonstrated ability to earn huge returns on reinvested capital.

I continue to be struck by the fact that the Third Avenue Value Fund (TAVF) view of the financial world, in almost all respects, is almost 180 degrees different from conventional views, especially views expressed by scholars such as Ross, Westerfield. Furthermore, these academic views, which are discussed at some length below, seem to have been adopted virtually in their entirety by most money managers, including the managers of most mutual funds, especially those who are non-fundamental, top-down asset allocators. In addition, each and every manager of an index fund accepts the academic theories. These theories are, after all, the raison d’être of index funds.

Corporate dividend policy is just one area of difference separating TAVF from the conventional “plain vanilla” world of passive, non-control investments in marketable securities. It seems to me that if I can do a reasonable job of explaining to you, the Fund shareholder, where the TAVF approach fits in, and where the conventional academic approach fits in, you ought to come away with a pretty good idea of what TAVF is and is not. The downside to my having spent so much time and effort on academic finance is that this quarterly letter to Fund shareholders will be dull, boring and unimportant — hardly an earth-shaking event. Hopefully, though, the analysis of the basic differences in approach between TAVF on the one hand, and conventional academic finance as embodied in Modern Capital Theory (MCT), and its component parts, the Efficient Market Hypothesis (EMH) and Efficient Portfolio Theory (EPT) on the other, will be useful for you as a Fund shareholder.

Insofar as the Fund invests for cash return, it invests in debt instruments, not common stocks. TAVF follows this policy because where cash return is an investment objective, the buy-and-hold portfolio manager, and the portfolio, tend to be far better served if that cash return is received from the ownership of securities on which cash payments are a contractual requirement, i.e., credit instruments, rather than from non-guaranteed common stock dividend payments. TAVF restricts its investments in credit instruments to issues containing strong protective covenants; where the prospects of a money default are remote, where the Fund would fare at least okay in the subsequent reorganization in the event of a money default; and where the cash return appears to be at least 500 basis points better than can otherwise be obtained from a credit of comparable quality.

TAVF remains reluctant to hold the common stocks of highly leveraged holding companies whose principal assets, on a parent company basis, are the common stocks of highly leveraged, highly regulated subsidiaries. If academics analyze financial statements at all, they seem to focus on estimating cash flows on a consolidated basis. TAVF not only does not focus on one number, e.g., cash flow from operations, but the Fund also emphasizes different accounting entities depending on context, sometimes focusing on consolidated financials and sometimes focusing on parent company financials.

The Third Avenue Approach Vs. The Conventional Academic Approach

The characteristics I impute to the conventional academic approach comes from reading substantial amounts of academic literature. In writing this quarterly report, I cite largely from three books: Ross Westerfield (mentioned previously), Principals of Corporate Finance (4th ed.) by Brealey and Myers (“Brealey and Myers”), and Corporate Valuation-Tools for Effective Appraisal and Decision Making by Cornell (“Cornell”). Not every academic who basically subscribes to MCT will agree with everything contained in the three texts: MCT believers are not monolithic. Each of the three texts seems to lack internal consistency and some of my citations could be modified by other citations. Nonetheless, I believe I have stated fairly below the academic positions regarding market efficiency, price equilibrium, substantive consolidation, structural subordination, information flows, agency costs, risk, valuation, and the uses and limitations of financial accounting.

Before contrasting the TAVF approach with the academic approach, it is helpful to examine the conditions under which MCT theories appear to be wholly valid. This happens when two special conditions exist in concert:

Given these two conditions, there exists an efficient market for Outside Passive Minority Investors (OPMIs) who are traders seeking to maximize total return consistently. TAVF may be an OPMI, but it is not a trader; it is a buy-and-hold fundamentalist. OPMI traders are neither insiders, nor people trained in fundamental analysis, such as would be the case where the analysis is activist. The MCT approach also makes sense for money managers with little, or no, training or interest in fundamental bottom-up analysis; and who are required by clients, or circumstances, to value the portfolios they manage exclusively, or almost exclusively, by marking to market (i.e., pricing) on a daily basis.

The Cornell book points to three elements of the Efficient Market Hypothesis:

  1.  “Neither technical investors who rely on mechanical trading rules, nor professional money managers, as a group, are able consistently to earn rates of return greater than those earned by a simple buy and hold strategy.” (pages 40 and 41)
  2. “Because the current stock price reflects all currently available information, the EMH predicts that changes in stock prices are caused by the arrival of new information.” (page 41)
  3.  “Stock prices must respond immediately and without bias to the response of new information.” (page 42)

Incidentally, while TAVF, as an OPMI, relies exclusively on public disclosures in its fundamental analyses, so too do many non-OPMI control investors. For example, public (i.e., non-inside) information has to be relied on exclusively when one is attempting a hostile takeover.

The underlying problem with MCT is that it takes these narrow special cases, which are especially useful for passive day traders who ought to restrict their dealings to securities susceptible to simple, mathematical analysis, and tries, based on unproven anecdotal assumptions, to promulgate general laws of universal applicability. These general laws, based solely on studies of securities prices arrived at in markets populated by OPMIs, are used to reach conclusions and recommend courses of action, not only for buy-and-hold fundamental investors such as TAVF, but also for those involved with non-OPMI markets such as the markets for leveraged buyouts (LBOs), mergers and acquisitions and venture capital promotions; for financial managers who run companies; for the promulgation of Generally Accepted Accounting Principles (GAAP); for determining liabilities and damages in securities litigation (as for example, “fraud on the market” theories); for promulgating regulations of financial institutions; and for setting national fiscal policies (the balanced budget being one example).

Being a believer in MCT is not very helpful for portfolio managers who are buy-and-hold fundamentalists, but that consideration seems relatively unimportant in the overall scheme of things. The Fund really is not affected much, one way or the other, by MCT except that MCT disciples probably would never invest in TAVF Common Stock, except as “hot money” which TAVF management does not want anyway. From a public policy point of view, though, MCT appears to be downright dangerous insofar as MCT influences the decision making of corporate managements not seeking access to equity markets on a regular basis; GAAP (e.g., see the stock options controversy or the rules on the carrying values for portfolios consisting only of performing credits); securities law and litigation; financial institution regulation; and national fiscal and monetary policies.

Specifically, MCT appears to be largely irrelevant for that minority of portfolio managers, including the TAVF manager, trained to deal in fundamentals. MCT, EMH and EPT are chartist-technical approaches to security analysis, similar to all other systems based on studies of securities prices and securities markets. MCT does virtually nothing for analyzing corporate fundamentals, the behavior of activists and promoters, and the characteristics of corporations. MCT appears to be based on 10 propositions:

MCT Proposition 1: MCT examines all financial phenomena strictly from the point of view of the OPMI short-term trader, even when it comes to corporate, non-stockholder, matters. One example of this is contained on page 398 of Brealey and Myers where the authors state, “The choice of (corporate) capital structure is a marketing problem, find the combination of securities that has the greatest overall appeal to investors.” TAVF, on the other hand, puts its first emphasis on the point of view of the corporation in which it is investing, not the point of view of short-term OPMIs. For TAVF, the choice of capital structure is an internal, corporate problem revolving around giving the typical corporation comfort to be able to operate with some margin of safety in uncertain future periods; reasonable assurances of access to capital markets; and reasonable prospects of enjoying a “good enough” ROE. TAVF has a company point of view, first and foremost, not a stockholder point of view. Thus, TAVF thinks Ryan Beck would be better off retaining earnings, rather than paying large dividends in cash on its common stock, regardless of the immediate effect on the Ryan Beck common stock price of implementing that policy.

Examining financial practices strictly from the point of view of the OPMI trader is akin to examining the marine food chain by restricting the study to observing the reactions of kelp and plankton which float passively on the surface of the sea and serve as the tail-end of a very complex food chain. One is really not going to understand the marine food chain unless one also studies systematically the actions, and reactions, of the myriad marine life existing beneath the surface. The players beneath the surface who, unlike the OPMIs, are basically actors rather than reactors, in the financial “food chain” include managements, control shareholders, creditors, deal promoters, investment bankers, securities salespersons and attorneys, among others.

OPMI traders and corporations have both communities of interest and conflicts of interest in their relationships with each other. The one time that a community of interest tends to predominate is when the corporation needs, or desires, access to equity markets. Here, treating the OPMI trader well may give the corporation better access to new equity capital than otherwise would be the case. Incidentally, the price at which a corporation can sell new issues of non-dividend paying common stock, as distinct from whether the corporation can issue new equity securities at all, is consideration of great importance to stockholders who might suffer from dilution, but it is not per se a corporate issue of much consequence. I’ve never seen this point made in any academic literature, probably because MCT does not view the corporation as a constituency separate and apart from the stockholder constituency.

One reason MCT concentrates so much on the OPMI and OPMI markets seems to be that the OPMI market is the only financial market where prices are always readily available on an instantaneous basis. Such precise prices are what MCT people need to undertake their algebra-based studies of past prices. Yet, there are numerous other markets populated mostly by activists who, unlike OPMIs, act rather than react. These other markets include LBO markets, merger and acquisition markets, first and second stage venture capital markets, markets for consensual plans when restructuring troubled companies, getting to be lead plaintiffs’ counsel in stockholder litigation markets, securities salespersons compensation markets, and markets for money management fees.

Each of these markets tends toward a price efficiency, but in many instances that tendency is so weak as to be negligible. Furthermore, a price efficiency in one market is, per se, a price inefficiency in another market. Put otherwise, a huge number of participants in financial processes earn, on average, excess returns including, so far, TAVF and a number of other funds concentrating on passive investments.

MCT Proposition 2: MCT assumes the existence of a substantive consolidation between the firm and its stockholders for almost all purposes. The corporation and its stockholders are treated as if they were one in examining investment opportunities, appropriate capitalizations, discount rates, and return on investments. This is demonstrated by Ross, Westerfield on page 69: “Suppose that firms are just ways in which many investors can pool their resources to make large-scale business decisions. Suppose, for example, that you own one percent of some firm. Now suppose that this firm is considering whether or not to undertake some investment. If that investment passes the NPV (i.e., net present value) rule, that is, if it has a positive NPV, then one percent of that NPV belongs to you. If the firm takes on this investment, the value of the whole firm will rise by the one percent and your investment in the firm will rise by one percent of the NPV of the investment.” If, as I think they are, Ross, Westerfield are saying that substantive consolidation is so pervasive, and OPMI markets are so efficient, that changes in underlying corporate values get reflected efficiently in OPMI market prices, then they have an utterly different view of the real world than does TAVF.

Further, in having corporations deal with their security holders it is apparently hard, under MCT, for there to be “win-win” situations. As Brealey and Myers state on page 289, “If selling a security generates a positive NPV for you (the corporation), it must generate a negative NPV for the buyer.” TAVF, of course, thinks this is an entirely unrealistic view of the real world where, in effect, deals get done by showing each constituency that it is obtaining a positive NPV for its purposes. Such constituencies include bank lenders, outside professionals, employees, OPMI investors, and investment bankers, among others.

The one possible exception to substantive consolidation under MCT is in the methodologies used for valuations. Here, corporations are to be valued strictly as going-concerns based on forecasted cash flows from existing operations. Stock-holders, on the other hand, are to be valued as investment vehicles rather than going-concerns; the methodology here is to value by marking net assets to OPMI market prices consistently, rather than examining operating cash flows, i.e., dividends and interest from investments.

Under MCT, too, the changes in the going-concern performance of a business, as measured by periodic cash flows from operations and/or reported accounting net income, is deemed to be substantively consolidated, i.e., strongly correlated, with changes in the OPMI market price of a common stock, something that happens instantaneously. TAVF, on the other hand, does not tend to believe that such a substantive consolidation, if it does exist, is particularly important. As a buy-and-hold investor, TAVF analyzes most companies as a combination of strict going-concerns engaged in day-to-day operations, and investment companies deploying and redeploying assets in new areas from time to time, as well as undertaking financing and refinancing activities from time to time which are well outside the ordinary course of business. These investment company activities, as well as going-concern activities, cause changes in the underlying values of businesses. TAVF does not operate under the assumption, or belief, that such value changes get reflected in market prices, whether instantaneously or even over any definable time period.

For TAVF, substantive consolidation does not exist on Planet Earth. Even if there were price equilibrium for non-OPMIs (which I doubt), control issues on behalf of corporate managers, differentials in knowledge as between insider-activists and outsider-passivists, differences in tax structures, and differentials in the ability to finance, would preclude corporate decision makers from examining investment and reinvestment opportunities in the normal course of events on the basis of whether or not the corporation could earn better returns, risk adjusted, on moneys not distributed to shareholders than could the shareholders, especially where estimated shareholder returns on “risky assets” are measured by things like Beta, a study of the relative past price volatility of an OPMI traded common stock. The corporations whose securities are held by TAVF seem to make their NPV decisions based on the corporate universe, not the OPMI universe. Without considering OPMI NPV, corporations frequently do make massive cash and other property distributions to shareholders, but only a few of those distributions seem to bottom on a theory that stockholders have better risk-adjusted investment opportunities than the corporation. Rather, those distributions are undertaken in the context of delivering far above average returns to some other non-OPMI constituency such as promoters of leveraged buy-outs and management buy-outs.

MCT Proposition 3: MCT assumes the existence of structural subordination, where all other interests are junior to those of OPMIs, i.e., corporations and managements work in the best interests of OPMI traders. With the exception of agency costs, discussed below, the corporation and its management are supposed to work to maximize the near-term prices of the corporation’s common stock trading in OPMI markets. Indeed, in MCT, the normal tendency is to view the corporation and its stockholders as one entity.

If any reader believes such structural subordination actually exists for the vast majority of publicly traded equities, except in special cases where control of the corporation goes “into play” or, sometimes, when insiders are looking to cash-out of control positions, then I would like to sell that reader a certain bridge to Brooklyn.

MCT Proposition 4: MCT assumes the existence of agency costs between the stockholders on the one hand, and management on the other. Stockholders are the principals, and managements are the agents of the OPMI principals. There are conflicts between the principals and the agents. As Ross, Westerfield points out on page 18, “The costs of resolving the conflicts of interest between managers and shareholders are special types of costs called agency costs. These costs are defined as the sum of (1) the monitoring costs of the shareholders and (2) the incentive fee paid to the managers.” As an aside, the above statement again demonstrates the unrealistic MCT focus on substantive consolidation. Agency costs are not borne by stockholders; they are borne by corporations.

From the TAVF point of view, academics don’t have clue about agency costs. To begin with, there are myriad constituencies within the financial world, each of which has communities of interest and conflicts of interest with the others. Conflicts (and communities) are not limited to managements and OPMI traders. Other important constituencies include the corporation itself, long-term buy-and-hold OPMIs, non-management control shareholders, trade creditors, other creditors, customers, employees, governments, etc. In TAVF’s analysis, it is crucial to recognize the existence of the multiplicity of constituencies and the communities and conflicts of interest between and among each of them. Financial phenomena cannot be understood by restricting an examination to the relationship between managements and OPMIs, especially when the crucial examination ought to be between managements and corporations; the real world is far more complicated than MCT assumes. There are even distinguishable constituencies within the OPMI community. Certainly the Fund, as a buy-and-hold OPMI, finds itself with both communities of interest and conflicts of interest vis-a-vis OPMI traders.

Second, academics seem to believe that stockholders control companies because they can elect a Board of Directors, and thereby put a limit on agency costs. As Ross, Westerfield states on page 20, “Shareholders determine the membership of the board of directors by voting. Thus, shareholders control the directors, who in turn select the management team.” The fact, though, is that boards of directors are de facto elected, not by stockholders, but rather by those who control the proxy machinery and those who get the corporation to finance proxy solicitations. Such people are virtually never non-management, non-control stockholders. In general, if there has been any corporate (not stockholder) expense that has been uncontrolled in recent years, it appears to have been top management compensation (albeit, by and large, agency costs for most of the companies in the TAVF portfolio appear to be reasonable).

The Fund is always looking at distinct constituencies. To TAVF, the company is the company; it is not its stockholders; and it is not management. Among stockholders, the OPMI is the OPMI; the OPMI is not the company; and it is not the control group. The company, as the company, has conflicts of interest with each of the other constituencies, all of whom tend to want things, such as high Ryan Beck type dividends or management entrenchment provisions, which detract from corporate feasibility. However, the company, as the company, tends to have a unique community of interest with each and every other constituency, since each of these other constituencies likely would suffer if the company did not maintain a minimum standard of feasibility.

MCT Proposition 5: A price equilibrium exists. The price of a common stock in the OPMI trading market is, by far, the best measure of value for all purposes, whether such purposes are for OPMI trading, mergers and acquisitions, hostile takeovers, leveraged buyouts or restructuring troubled companies. As William F. Sharpe, a Nobel Laureate, and typical exponent of MCT, states on page 67 of the Third Edition of his book, Investments, “Every security’s price equals its investment value at all times.” Ross, Westerfield on page 363 states, “Because information is reflected in prices immediately, investors should only expect to obtain a normal rate of return. Awareness of information when it is released does an investor no good. The price adjusts before the investor has time to trade on it.” And also on page 363, “Firms should expect to receive the fair value for securities that they sell. Fair means that the price they receive for the securities they issue is the present value. Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient capital markets.”

TAVF utterly rejects any views that OPMI market prices are indicators of value for all purposes. The Fund also rejects any views that information is properly reflected in OPMI market prices at all, much less instantaneously. There is no question that the efficiencies inherent in price equilibrium and the disclosure of information do, in fact, exist for OPMI traders seeking to earn superior returns consistently. However, such efficiencies just do not exist for participants with other agendas, such as TAVF and for all others in other markets, despite the fact that there will be tendencies toward efficiency, however weak and unimportant, in any market. For example, at the time an LBO of a public company is to be undertaken, the price of the common stock in the OPMI market, say $20 per share, is an inefficient price compared with the premium price, i.e., the price in the LBO market necessary to get the LBO done, say $25 or $30 per share. By definition, the LBO promoter has to view the $20 OPMI price as an inefficient price for his purposes and his calculation of his NPV (and the NPVs of those who are financing the LBO promoter). If the “fair” value in the LBO market were not different, and higher, than the “fair” value in the OPMI market, then no LBO transaction likely could be consummated.

Few corporate managers believe that OPMI markets determine universal true values, which are valid in all contexts. Sometimes these managers view OPMI market prices as ridiculously high. They then cause companies to go public in events such as IPOs, and/or sell their personal holdings, and/or have the corporation use the overpriced common stock as a currency, a “Chinese Dollar,” to be issued in a merger transaction. Sometimes these managers view OPMI markets as notoriously underpriced; and they, perhaps in association with LBO promoters, acquire common stock in going-private transactions, or they place “shark repellents” in corporate governance documents driven, at least in part, by a desire to protect shareholders from being forced to part with their shareholdings at an unfairly low price.

Furthermore, the LBO buyer (and as an aside, TAVF) looks at different information, or weights the same information differently, than does the OPMI trader analyzing a going concern. For OPMI traders, the dominant considerations are likely to be reported earnings, especially forecasted earnings over the next quarter or two, industry identification, comparative analysis of this issue with others in the same industry, sponsorship, stock promotion activity, market liquidity for the particular security, technical market considerations, and predictions about macro factors such as the level of the Dow Jones Industrial Average, forecasts of interest rates and GDP. In the LBO (and TAVF) context, though, the concentration in the use of information will tend to be on ability to finance the proposed transaction, the long-term outlook for the specific company, exit strategies and, if the LBO is not a purely financial transaction, strategic fit. (LBO promoters, incidentally, ought to be characterized as information creators, rather than information reactors, vis-a-vis their relationships with the OPMI trading community.)

The fact that an efficient price in the LBO, or takeover, market is different than an efficient price in an OPMI market is an alien concept under MCT. MCT adherents believe there is a “true value.” As Brealey and Myers state on page 294, “Competition among investment analysts will lead to a stock market in which prices at all times reflect true value” — true value “means an equilibrium price which reflects all the information available to investors at that time.”

Interpreting information is a difficult task for which OPMI traders and MCT academics seem untrained and ill equipped. Take one information example out of thousands. Suppose new public disclosures are needed about replacement costs. Suppose, further, that an inflationary situation exists where the replacement value of the Property, Plant and Equipment (PPE) used in a capital intensive company is far above the depreciated cost basis at which the PPE is being carried on the company’s books. This means that accounting depreciation charges are inadequate and the corporation is overstating earnings, at least by the amount of underdepreciation. This also may mean, however, that the corporation is insulated against new competition coming into the industry because the cost of entry into the industry has become prohibitive. Is the new information about replacement cost bullish or bearish? It depends; but, I doubt that the OPMI market prices can reflect an accurate analysis from the point of view of buy-and-hold OPMIs or anyone actively involved with the particular corporation and its industry.

In terms of the information content of financial statements, MCT people seem very worried about the fact that GAAP frequently does not reflect economic reality. As a matter of fact, financial statements rarely reflect economic reality. For TAVF, accounting statements are something entirely different. They are, by far, the best objective benchmarks available for use by buy-and-hold fundamentalists as tools essential, most of the time, for reaching reasonable conclusions about what economic reality might be. TAVF cares about what the numbers mean, rather than what the numbers are.

One of the key questions that passive, non-control investors such as the Fund almost always must resolve in any analysis relying strictly on the public record is, “What am I missing?” If GAAP audited financial statements did not exist, this probably would become a nearly impossible question to answer, certainly in terms of what contingencies might be important, and what documents (e.g., loan agreements or acquisition agreements) ought to be reviewed in detail. Interestingly, MCT never asks the question; MCT assumes the OPMI market already has answered the question.

In justifying the alleged existence of a universal price equilibrium, Ross, Westerfield states on page 370, “All the efficient market hypothesis really says is that, on average, the manager will not be able to achieve an abnormal or excess return.” This statement seems to be the result of sloppy analysis and is offered without proof. The proven valid statement is, instead, that, “All the efficient market hypothesis really says is that few, if any, OPMI traders will be able to achieve an abnormal or excess return consistently.” TAVF, on its almost five-year record, has outperformed the market on average. So have a large number of other passive money managers, especially others who are also buy-and-hold fundamentalists.

TAVF cannot, and has not, outperformed the market consistently; I don’t think the Fund ever will. To outperform the market consistently one has to load up the portfolio with those securities which the analyst believes are the most popular or are about to become the most popular. This is the very antithesis of value investing. Going forward, TAVF would like to be able to enjoy, on average, an ROE of at least 20% per annum regardless of what happens in the general market. To continue to meet this 20% bogey the Fund managers are going to have to be both good and lucky regardless of what happens in the general market.

MCT Proposition 6: Generalized risk is measured, at least in part, by examining “the riskiness of assets.” The riskiness of assets is measured essentially by looking at past price volatility in OPMI markets, with such measures encompassing the concepts of Beta and the Capital Asset Pricing Model. If one were to look into companies, rather than market prices, riskiness of assets would be measured by the quality of the issuer and the terms of the issue. It has to be this way for MCT because price of the issue would not be a consideration since price is always in equilibrium.

TAVF rejects any concept of general risk, or any concept that the information content of past price performance in OPMI markets tends to be material. Risks are specific, and one always must put an adjective before the word “risk” to differentiate between and among the different types of risk: market risk, investment risk, inflation risk, excess leverage on the right hand side of the balance sheet risk, and new competitors coming into a market risk, among many others. TAVF takes huge market risks in that it pretty much ignores OPMI markets. The Fund focuses on avoiding investment risk by being extremely price conscious and by trying to buy well-covenanted credits and the equities of financially strong companies.

MCT guards against generalized risk by causing portfolios to be diversified according to the precepts of EPT. TAVF believes that diversification is only a surrogate, and usually a poor surrogate, for knowledge, control, price consciousness and, in the case of a passive investor such as the Fund, restricting equity investments to well-financed companies which would have unquestioned staying power when, and if, things do go wrong. Diversification is clearly the correct course for OPMIs untrained in fundamentals who assume that, at any particular time, security prices are in equilibrium. At the other extreme, diversification would make no sense at all for a young person starting out and using all his resources to start up a new business. TAVF, as a matter of common sense, would always diversify, at least to a modest extent, because it is a passive, non-control, investor. The Fund, however, is much less diversified than other mutual funds of similar size run by managers who concentrate on macro top-down considerations and are not price conscious.

When one is price conscious, as the Fund is, the analysis of risk becomes the exact opposite of the MCT view. In the MCT view there is a risk/reward ratio; if one desires greater returns, one has to take greater risk. The TAVF view is the cheaper the security, the less the risk; the cheaper the security, the greater the profit potential; therefore, the lower the risk, the greater the reward potential.

MCT Proposition 7: Value is determined essentially by a corporation’s forecasted free cash flows discounted to present value at an appropriate rate. As Ross, Westerfield states on page 37, “In determining the economic and financial condition of a firm, cash flow is more revealing [than net income].”

Here MCT becomes utterly confusing by failing to distinguish between values for individual assets and groups of assets on the one hand, and values for going-concerns on the other. For individual assets or groups of assets to have a reliable positive value, those assets, as used in operations, ought to generate a positive cash flow. However, most going-concern corporations (and incidentally all growing national economies) are cash consumers, not cash generators. What are the real elements that go into a corporate valuation from the TAVF point of view? There are four such elements:

  1. free cash flow from operations; or
  2. earnings, with earnings defined as creating wealth while consuming cash. This is what most growing economic entities do. Earnings, as defined, can have no value unless they are also combined with access to capital markets, whether those markets are credit markets, equity markets, or both; and
  3. the existence of separable and salable assets which can be disposed of without reducing cash flow or earnings, or as a substitute for cash flow or earnings; and
  4. access to capital markets — both credit markets and equity markets — on a highly attractive basis
  5. MCT Proposition 8: Comparative analysis, especially as embodied in the concept of NPV, is the key to all valuations.

NPV is a very important and valid concept but its usefulness in the real world seems more limited than is assumed under MCT. Since substantive consolidation is a myth, corporations are unlikely to undertake an NPV analysis using as a standard ideas of what shareholders could earn, risk adjusted, on funds distributed to them rather than retained by the firm. The usefulness of NPV is further limited by questions of control and knowledge, and above all by the feasibility of particular deals. In looking at the common stocks of potential takeover candidates, TAVF is much more influenced by whether or not a deal at a substantial premium over market might close, as compared with which of several attractive securities is priced more attractively as a going-concern based on an NPV analysis.

The TAVF objective is to enjoy at least a 20% ROE regardless of the performance of other mutual funds with which the Fund might be compared. This absolute standard for TAVF, rather than any comparative analysis calculation, probably leaves a lot to be desired. However, I don’t think that TAVF is all that comparable to most other funds and to the general market. More importantly though, if the Fund can earn 20% on average, then I think most TAVF shareholders will conclude that such results are good enough.

MCT Proposition 9: All portfolios ought to be marked to market since total return is the one thing that counts most.

Most investors probably invest for assured cash return, not total return. For TAVF both total return and cash return count, with different weights at different times. For example, the Fund’s rather successful investment in Inverse Floaters was based on a duality of objectives. First, a minimum yield to maturity could be locked-in regardless of price performance of the Inverse Floaters in the market. Second, TAVF could get lucky and earn a super total return if interest rates went down. Unlike MCT, we were willing to have two objectives; either an above average yield to maturity, or an above average total return. To get to this “win-win” situation, TAVF had to ignore the market risk it was taking; the Inverse Floaters (it bought at 50) could have sold in the OPMI market at 30 shortly thereafter, even though the Fund had locked in a pretty good minimum yield to maturity. One of the reasons the Fund had to take such huge market risks with the Inverse Floaters is that I am not equipped, by background or training, to forecast the general level of interest rates, and the near-term market performance of Inverse Floaters was strictly a function of short-term interest rates.

MCT seems to fail to understand that there are huge numbers of portfolios in which maximizing a risk-adjusted total return becomes unimportant. This includes, besides TAVF as an Inverse Floater investor, most life insurance companies, most pension plans, and most high net worth individuals who acquire tax-exempt securities. Insofar as such entities continually have new funds to invest and reinvest in performing credit instruments, the worse the current market performance for the portfolio, the greater the future investment income on the portfolio will be. This occurs because the new investments will enjoy higher interest returns as a result of declines in market prices. Of course, this negative weight for market prices does not exist for all portfolios. It certainly does not exist for OPMI portfolios financed with borrowed money. Put otherwise, there are few, if any, meaningful general laws in portfolio management. Each one ought to be approached on a case by case basis.

MCT Proposition 10: The worth of any common stock is the present value of all future dividends to be received plus the present value of the exit price.

For TAVF, the theoretical value of any stock has two components: either the present value of any future cash bail out and/or the present value of control arising out of common stock ownership. TAVF, as a non-control investor, always has to visualize a cash-out exit strategy. For common stocks this almost always means sale to a market, though not necessarily an OPMI market. For performing credit instruments the market is far less important than in the case of equities. The Fund will have a cash bailout of credits it holds, as long as each credit instrument performs in accordance with the money terms of the instrument as they exist at the time they were acquired, or as they might be modified. Furthermore, in the case of performing credits acquired at a discount from the principal amount, time alone can correct market mistakes, something that does not have to happen with common stocks. Just hold the credit instrument to maturity and the discount at which the security was purchased will disappear.

I’ve now reviewed a fair amount of the MCT literature. I remain amazed at how flawed almost all the MCT analysis is, especially where MCT authors write about topics in which I have special expertise. Two areas that are particularly striking to me are MCT explanations of why most closed-end investment company common stocks sell at discounts from net asset values, and MCT theories about restructuring troubled companies. The literature about closed-ends is, I think, mind-boggling in terms of the intellectual contortions scholars go through to defend the indefensible; why, if the OPMI market prices efficiently, should closed-ends sell at a discount, or even come into existence in the first place? Many academics and money managers seem to be staking their careers and livelihoods on continuing to stress the basic tenets of the EMH: there exists a unitary true value, and there exists a universal price equilibrium. Maybe so, but not for TAVF.



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

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