10 The Third Avenue Formula for Investing

JULY 2009

  1. The company in which Third Avenue Value Fund (TAVF) would invest has to be extremely well-financed.
  2. The common stock has to be available at a meaningful discount from readily ascertainable net asset value (NAV), usually over 25%.
  3. We consider the Company to have favorable prospects for growth of better than 10% compounded per annum over the next five-to-seven years, without diluting the currently outstanding common stock.

All other systems – whether Graham & Dodd fundamental analysis, or Modern Capital Theory, or Technical-Chartist Approaches – are involved with predicting near-term price movements for securities. TAVF is so involved only in the relatively rare instances when it is involved in risk arbitrage, i.e., investing in securities where there will be relatively determinant work-outs in relatively determinate periods of time.

As a practical matter, Third Avenue rarely takes any course of action, or has any opinions as to what near-term price movements might be for individual securities or markets in general. Rather, in common stock investing, the sole, or almost sole, focus is on buying into well-financed companies at steep discounts from readily ascertainable NAV where there are reasonable prospects for double digit NAV growth over the next five years or so.

If the analysis is close to correct, long-term market performance ought to be pretty good either because of resource conversion activity (changes of control, mergers and acquisitions, recapitalizations, spin-offs, share repurchases); or because NAV for the going concern continues to grow. If NAV does grow, capital gains are assured as long as the discount from NAV does not widen materially.

There is no question but that over any short run, general market factors will more than anything else influence what individual securities prices will be day to day. The sole reason why TAVF Management does not pay any attention to general market factors, is that we are no good at making such prognostications. We don’t think anybody else – perhaps with the exception of a few geniuses who are unknown to us – is any good at it either. It seems as if the actions of the general market are truly a random walk.

In the analysis of many companies, short-term considerations can be very important. This tends to be true for companies that are not well financed, especially those that need relatively continuous access to capital markets. These are the types of companies in whose common stocks TAVF does not invest.

Resource conversion, in our opinion, is much more likely to occur in North America than in Hong Kong or Japan. In North America, there exists a good body of law about resource conversion activities, but above all, there exists an army of highly skilled, highly paid, investment bankers who are out there creating, encouraging and abetting various resource conversion deals. In contrast, it seems likely that the gains TAVF might realize from most of its East Asian investments would be attributable primarily to growth in NAV rather than resource conversion. It is Fund Management’s opinion that growth prospects in East Asia, especially mainland China, are considerably better than they are in North America at the present time.

It is absolutely ludicrous to suppose that TAVF faces an efficient market in its common stock investing, where an efficient market is defined as one in which rational pricing exists. Market prices in OPMI markets seem to be set by market participants focused on short-run outlooks and trying to pick market bottoms; technical chartist considerations; predictions about stock market movements over the near term; general stock market predictions at the expense of company analysis; emphasis on earnings per share, cash flow and dividends to the exclusion of balance sheet considerations, especially creditworthiness.

Such market participants include day traders, chartist-technicians; asset allocators; market participants financed with borrowed money; participants untrained in fundamental analysis; participants who don’t read disclosure documents; believers in Modern Capital Theory (The Efficient Market Hypothesis & Efficient Portfolio Theory); behaviorists and psychologists.

Why would anyone conclude that these market participants, with their investment criteria, would ever set prices, directly or indirectly, that would reflect efficient prices for Third Avenue?  Assuming Fund Management doesn’t screw up, we believe TAVF has the potential of performing as it has in the past; outperforming indexes and benchmarks on average, most of the time, and over the long term. There is no way TAVF will ever outperform indexes and benchmarks consistently, i.e., all the time. The Fund will always be subject to the same poor performance that afflicted it in 2008. Fund Management, though, operates on the assumption that 2008s will recur only in 15-to-25-year intervals. If, by and large, the Fund can generally avoid possible permanent impairments like MBIA –where Fund Management discovered that it was dealing not only with toxic liabilities (the extent of insurance losses could be far higher than MBIA’s reserves on its books), but also, in Fund Management’s opinion, was dealing with toxic management –performance ought to be okay.

Third Avenue and 363 Sales

A 363 sale is the sale of assets by a company in bankruptcy in accordance with Section 363 of the Federal Bankruptcy Code. The process starts with a “stalking horse” bidder that enters into a purchase agreement for the assets. This provides a “floor bid” and serves as a basis for conducting an auction. As recognition of the expense and risk associated with entering into this agreement, the stalking horse bidder is entitled to a break-up fee and expense reimbursement if it is not the successful bidder. In conjunction with court approval of the stalking horse bid, dates are set for a bid deadline, auction and court hearing to approve the winning bid. If other bidders submit “qualified bids” by the bid deadline, they are permitted to participate in the auction, which typically is conducted by the law firm representing the debtor. Following the auction, both the winning bid and an alternate bid are approved in a bankruptcy court hearing. During the quarter, we were actively involved in two 363 sales processes:

Nortel. As we discussed in the last two letters, the Fund purchased $100 million (face) of Nortel Senior unsecured debt at an average price of 17% of claim following its bankruptcy filings in January 2009. We attended the auction of a portion of Nortel’s Carrier Networks business (its Code Division Multiple Access and Long Term Evolution assets) on July 24, 2009, at the office of Cleary Gottlieb Steen and Hamilton LLP (Nortel’s bankruptcy counsel). Nokia Siemens was the stalking horse bidder, a position that it earned by entering into a purchase agreement on June 19th to buy the assets for $650 million. The debtors (Nortel) determined that this agreement represented the best opportunity to maximize value for the assets and serve as a basis for conducting an auction. On June 29th and June 30th, respectively, the Canadian and U.S. bankruptcy courts approved Bidding Procedures, including a break-up fee of $19.5 million and expense reimbursement of $3 million if Nokia Siemens was not the successful bidder, and a July 21st deadline for competing bids. Additionally, a minimum overbid of $5 million was established.

Two additional parties, MPAM Wireless, Inc. (an affiliate of MatlinPatterson, a Nortel bond holder) and Ericsson submitted qualified bids prior to the deadline. These bids were required to exceed the stalking horse bid by the sum of the break-up fee, expense reimbursement and minimum overbid. The auction on July 24th consisted of seven rounds of bidding with no bids received in the last round. Ericsson’s sixth round bid of $1.13 billion was the Successful Bid, and Nokia Siemens’ $1.03 billion fifth round was the Alternate Bid. This was a terrific result for the Fund as Nortel bondholders, as Ericsson’s bid represented a 70% improvement compared to the stalking horse bid, even adjusted for the payment of the break-up fee and expenses.

Fleetwood. During the quarter, we entered into a stalking horse bid to acquire manufactured housing assets from Fleetwood Enterprises along with our strategic partner, Cavco Industries. Such assets would be acquired by FH Holding, Inc., a jointly-owned corporation. Fleetwood Enterprises, which filed for Chapter 11 protection on March 10, 2009, is the second largest producer of manufactured homes behind Berkshire Hathaway-owned Clayton Homes. Industry shipments have declined from a peak of 373,000 in 1998, when the industry benefitted from an easy credit environment much like what drove the site-built housing bubble of 2005-2006, to a current run-rate of around 50,000. Our stalking horse bid of $18 million (plus or minus net working capital) included seven operating manufacturing facilities and one non-operating facility, all of which someone from Third Avenue visited during the quarter. We believe that these facilities, which are operating at close to break-even levels during the current industry depression, are among the best in the industry, with extremely high quality and loyal work forces. Most importantly, we believe that our strategic partner, Cavco, is the best-managed company in the industry, led by Chairman and CEO Joe Stegmayer, who was formerly Clayton’s Chief Financial Officer.

The bidding procedures for our stalking horse bid entitled us to a $450,000 break-up fee, a $400,000 expense reimbursement and a minimum overbid of $100,000. Therefore, any other bid had to exceed ours by at least $950,000 (5.3%). Importantly, the bidding procedures also enabled us to credit bid our break-up fee. A subsidiary of Clayton Homes submitted a bid of $18,950,000 by the August 8th deadline, prompting an auction on August 10th at the offices of the debtors’ counsel in Irvine, CA.

We won the auction with a bid of $21.8 million (including a $450,000 credit bid) for the operating assets plus $4.8 million for an idle facility in Woodland, CA. Based on the $800,000 of value ascribed to our bid from purchasing this facility, which Clayton was unwilling to purchase, our net bid of $22,600,000 was determined to be superior to Clayton’s final cash bid of $22,500,000 (plus $400,000 for our expense reimbursement). Despite the $3,350,000 (19%) increase in the value of the operating assets from our stalking horse bid, we were very pleased with this result. Our purchase price represented a discount to the real estate value of the properties and ascribed no value to Fleetwood’s brand name or strong independent retail distribution network.

Advantages of 363 sales

363 sales can be preferable to corporate acquisitions for both buyers and sellers. Buyers benefit from asset purchases that are “free and clear” of all liabilities other than those that are expressly assumed (such as warranties). This simplifies the diligence process and enables buyers to avoid difficult-to-quantify liabilities such as retirement benefits and pre-petition litigation. Additionally, valuations in 363 auctions are typically attractive, based primarily on asset value supported by tangible assets, such as real estate, receivables and inventory, as opposed to going concern value.

Sellers benefit from a fair auction process in which price will usually be the sole factor in determining the winning bidder. This typically is not the case in corporate deals when management often drives the process to their benefit. For example, Instinet’s management and a private equity investor purchased the company’s agency brokerage business for $207 million, a discount of $100 million from what Third Avenue offered, and sold the business one year later to Nomura for $1.2 billion.  Companies such as GM and Chrysler that are burning significant cash from operations before debt service (not the case with Fleetwood or Nortel) may not experience a fair auction process, particularly if existing creditors are unwilling to fund additional losses. In these situations, the field of bidders is limited (only the US Government in the case of GM and Chrysler) and liquidation can be the only alternative to a fire sale. Fund Management seeks to avoid being creditors of these companies.

Ideas for Government Reform

The United States is a mixed economy. Both the private sector and the government have to be involved in economic activity. The government has a great role to play in providing incentives to non-government entities so that these other entities can become more productive.

Politics aside, two topics have emerged in the last year in Third Avenue’s investment process where it has become obvious that the government can do much to improve national productivity.

  1. Amend Section 382 of the Internal Revenue Code. The change of ownership requirement should be eliminated so that new providers of equity capital will not jeopardize a company’s ability to utilize its tax attributes. Section 382 limits the use of net operating loss carry-forwards for companies that undergo a change of ownership. At a time when the government should be encouraging private investment into troubled companies, this limitation has the opposite effect. We recommend that companies that receive cash infusions or conversions of debt to equity be exempt from Section 382 limitations insofar as the equity infusions involve changes in ownership. This would enhance immensely the ability of troubled companies to attract capital from the most dynamic elements existing in the private sector.
  2. Infrastructure spending should be credit-enhanced by the private sector with the U.S. Government acting as the ultimate financial guarantor. Monoline insurers, such as MBIA and Ambac, could provide underwriting and administrative services and assume first loss coverage protection. The U.S. Government should be the ultimate financial guarantor after the private sector absorbs the first losses; also, the government should charge fees that enable it to generate an attractive underwriting profit. The cost to issuers would be more than offset by the significant savings from lower financing costs. Credit enhancement has become an essential component of infrastructure financing because the purchaser of bonds knows that a competent party, the insurer, has investigated thoroughly, and because of the credit insurance the bonds become marketable. The United States government now has to be the ultimate guarantor because it is the only AAA credit left standing.


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

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