There are two separate, and distinct, ways of analyzing a security. The first involves trying to predict the prices at which a common stock will sell in the immediate future, whether that immediate future is tomorrow, next week, next month, three months from now, or a year ahead. The focus here is on the trading environment; in the words of John Maynard Keynes, trying to fathom what will be “the average opinion of the average opinion.”
The second approach focuses solely on trying to understand a business and the securities issued by that business, either credit instruments, equities, or both. The Fund uses only this second approach, and TAVF analyses involve concentrating on underlying factors, both qualitative and quantitative. No attempts are made to predict what near-term market prices will be except for the occasional risk arbitrage investment, such as USG Senior Credits. (Risk arbitrage exists where there ought to be a relatively determinate workout in a relatively determinate period of time.)
Most people, including most fund managers, focus strictly on the trading environment. Here, insofar as company results are analyzed, book value (i.e., net asset value per share computed in accordance with Generally Accepted Accounting Principles [GAAP]) is usually ignored in almost all analyses of companies other than financial institutions and regulated utilities. Put simply, there exists in the trading environment a Primacy of the Income Account. Near-term common stock prices are going to be influenced mightily by what reported future income account flows will be, whether those flows are cash flows from operations or earnings from operations computed in accordance with GAAP. (Earnings are defined as those operating activities which result in the creation of wealth for companies and/or stockholders, while the company involved consumes cash). Changes in book value can pretty much be ignored in this trading environment simply because book value is unlikely to influence where a common stock will sell in the immediate future. As Graham, Dodd and Cottle point out in the 1962 edition of Security Analysis on Page 217, “There is good reason for not taking the asset-value factor seriously. The average market price of a common stock depends chiefly on the earning power and the dividend payments.”
Indeed, for the vast majority of common stocks, Ben Graham looked at book value only as an anchor to windward, a hedge against being wrong about earning power and dividend payments. Ben Graham never seemed to recognize that book value could be one tool to help an analyst forecast future earning power and dividend paying ability. As Graham states on Page 103 of the 1973 edition of The Intelligent Investor, we are led “to a conclusion of practical importance to the conservative investor in common stocks. If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at reasonably close approximations to their tangible asset value – say, at not more than one-third above that figure.”
Thus, it is prudent, valid and appropriate to state that in the trading environment, book value is relatively unimportant, insignificant most of the time compared with flows from operations, whether cash flows or earnings flows. “A Primacy of the Trading Environment” view has been adopted not only by most money managers, but also by most academics, by all television financial commentators and by many securities regulators, including the Securities and Exchange Commission (SEC).
However, if one’s goal is to understand a business, the securities issued by that business, and that business’ long-term outlook, a balanced approach is needed. Here, there exists no Primacy of the Income Account and certainly no Primacy of the Trading Environment. Where a business and its securities are being analyzed in depth, book value is as equally important, or unimportant, as reported earnings. There exists an accounting cycle, and every accounting number, say earnings per share, is derived from, modified by, and a function of, other accounting numbers, say book value for one. In fact, for most companies, the largest single component of book value is retained earnings, i.e., historic net income not paid out as dividends.
Modern Capital Theory (MCT) describes only the trading environment and misses completely the need for a balanced approach to understand almost any business enterprise. At best, MCT is involved with only half a loaf: 100% weight to flows and 0% weight to the amount of net wealth existing on corporate balance sheets. Neither of the leading texts, Principles of Corporate Finance by Brealey and Myers, nor Corporate Finance by Ross, Westerfeld and Jaffe, contain more than a passing mention of net asset values, or book values, in their volumes, which together, are almost 2,000 pages long. As Brealey and Myers state on Page 119 of their 7th edition, “Only Cash Flow is Relevant.”
The elementary fact of life when it comes to understanding a business is that corporate economic earnings, or cash flows, are valuable only insofar as they either enhance the wealth of a company, both qualitatively and quantitatively, or are available for distribution to securities holders. On the other hand, corporate asset values are valuable only insofar as they can be used in order to enhance future corporate cash flows and economic earnings, both qualitatively and quantitatively, or to enhance returns to corporate securities holders. Economic earnings for a corporation can consist of many things other than earnings, or cash flows, from operations. These other things encompass all the activities which create realized appreciation, unrealized appreciation (which is, of course, generally untaxed and not generally reflected in book value), as well as financing, and refinancing, opportunities.
Most businessmen, and businesses, have as their primary goal the creation of wealth rather than the creation of income. In this sense they are exactly like Outside Passive Minority Investors (OPMIs) who seek to maximize risk-adjusted total returns rather than to maximize income from dividends and interest. Given a choice, most businessmen would prefer to create wealth in the most tax-advantaged manner which means striving for realized appreciation, unrealized appreciation, and financing opportunities, rather than having operating, and therefore taxable, earnings. This desire to create wealth by means other than enjoying operating earnings is mitigated by a number of factors. One, many businesses don’t have any choice but to create wealth through successful operations. Two, insofar as wealth is created by having access to capital markets, having more reported earnings from operations tends to stand a company in better stead when raising equity capital at attractive prices (or at all) on Wall Street rather than having less operating earnings. Nonetheless, it should be noted that striving to create wealth through realized appreciation, unrealized appreciation and financing opportunities has a balance sheet (i.e., book value) emphasis, not an income account emphasis.
Almost 65% of the common stocks in the Third Avenue portfolio are of companies which essentially strive to create wealth through means other than having operating, and therefore taxable, earnings. These “primarily asset value emphasis” companies include financial institutions (29.9% of the total portfolio), land development companies (8.9% of the total portfolio) and real estate companies (8.2% of the portfolio). In contrast, only about 35% of the TAVF common stock portfolio are “primarily earnings emphasis companies.” It should be noted that very few companies are either pure asset value plays, or pure earnings plays. Most who emphasize building asset values also pay attention to operating earnings, and vice versa.
No one can understand corporate finance in general if their focus is strictly on cash flows from operations. It is just not productive outside of the trading environment to place any reliance on the academic view that has prevailed at least since 1938, that “Investors only get two things out of stock: dividends and the ultimate sales price, which is determined by what future investors expect to receive in dividends.” This shibboleth ignores two obvious factors of key importance in corporate finance: wealth creation is the primary goal for most participants in investment processes; and control (not dividends) is the sine qua non for acquirers of common stocks who don’t happen to be OPMI’s.
Book value, and reported earnings, are frequently unimportant in a microanalysis, i.e., when analyzing an individual company. In contrast, book value is almost always extremely important on the macro level, i.e., where one is trying to determine if general market prices are too high or too low. At August 1, 2003, the S&P 500 Stock Index, according to Barron’s, was trading at 2.82x book value. In contrast, the TAVF portfolio, excluding real estate common stocks, was priced at around 1.5x book value.
TAVF’s principal goal in most of its common stock investing is to try to establish positions in well-financed, well-managed companies whose common stocks are selling at substantial discounts from readily ascertainable Net Asset Values (NAV). In determining the readily ascertainable NAV, a Third Avenue analysis always starts out with book value. The book value is then adjusted in an analysis to reflect the Fund’s version of economic reality. But book value is always the starting point, even though it is rarely the ending point. For Toyota Industries, the cost basis book value is adjusted to reflect the market value of its portfolio holdings of common stocks of other companies (mostly business affiliates). For St. Joe, book value is adjusted to reflect probable values for undeveloped land. For MBIA, book value is adjusted to reflect the company’s equity in unearned premiums, and for Forest City Enterprises, book value is adjusted to reflect the capitalized value of expected future rental income from credit-worthy tenants.
GAAP, as reported, has to be accurate, or truthful for the trading environment with emphasis on Earnings Per Share (EPS) as reported. However, in understanding a business, no one expects GAAP to be accurate or truthful. Rather, it provides the analyst with objective benchmarks derived from that relatively rigid, and therefore frequently unrealistic, set of rules known as GAAP. When trying to understand a business, there is no particular emphasis on any one number, whether that number is EPS or book value. Here the GAAP numbers serve as the one essential objective benchmark which the analyst uses as a tool to assist in determining his or her version of reality.
Toyota Industries serves as a good example of potential differences between GAAP reporting and economic reality. Over half of Toyota Industries’ assets consist of portfolio securities of common stocks based on the market prices for those common stocks. Since no one of the portfolio securities constitutes as much as 20% of the common capitalization of that issuer, none of Toyota Industries’ share of the undistributed equity in the earnings of these portfolio companies is reflected in Toyota Industries’ GAAP earnings. This is in accordance with both U.S. and Japanese GAAP. GAAP rules require that Toyota Industries report as Toyota Industries’ earnings only dividends received from Toyota Industries’ portfolio of common stocks, since none of Toyota Industries’ portfolio positions carry a presumption of influence or control. Viewing the reported earnings on a GAAP basis, Toyota Industries Common sells at around 20x earnings. Viewed on a “look-through” basis, where Toyota Industries picks up as its earnings the earnings of portfolio companies’ common stocks which were not paid out as dividends, Toyota Industries Common is selling at around 8 times earnings. Which is more realistic, 20x earnings or 8x earnings or some number in between? That is something for the analyst, the user of financial statements, to decide, not something to be decided upon by the CPAs who prepared the financial statements, or the politicians who dreamed up the Sarbanes-Oxley Act.
Ascertaining the economic NAV of Capital Southwest Corporation, a very low expense ratio business development company, is something best left to analysts, and not to CPAs who prepare financial statements or the politicians who dreamed up the Sarbanes-Oxley Act. At June 30, 2003, Capital Southwest reported that its NAV was $56.12 per share after deducting an allowance of $18.94 per share for deferred taxes on net unrealized appreciation. Those deferred taxes may never become payable, and if they do, Capital Southwest ought to have considerable control over the timing for incurring any actual tax liability. Meanwhile, Capital Southwest has completely free use of the assets offsetting the $18.94 per share “tax liability” just as it has free use of retained earnings. What is the appropriate NAV for Capital Southwest: $56.12 per share, $75.06 per share, or something in between? This analyst opts for something in between.
There are many tools analysts can use to predict future earning power of a company. No one method ever has to be used exclusively to the exclusion of other methods. Graham & Dodd seem to rely mainly on the past earnings record. For predicting the future earnings of many of our common stocks, i.e., MBIA and AMBAC, the past earnings record may well be prologue. Equally important in forecasting for these companies, however, is to estimate future Returns on Equity (ROE). Here “R” equals earnings, but guess what, “E” equals book value. Thus, book value is very often a key tool in the business world for estimating future earnings.
The Fund’s investments in the common stocks of well capitalized regional, or community, depository institutions, serves as a good example of how TAVF uses “E,” i.e., book value, to forecast future earnings and exit strategies. Third Avenue acquired around 10% of the outstanding common stock of Woronoco Bancorporation at about 80% of book value about 3 years ago. The theory behind the Woronoco investment was that the bank, a recently converted mutual, ought to enjoy an annual ROE of at least 10% going forward (non-troubled banks normally have ROEs of 8% to 20%), and that in five years, Woronoco could be taken over at two times book value because it operates in an industry where takeovers at better prices than two times book value are fairly common. If this 10% annual ROE, and two times book value exit were to occur, the Internal Rate of Return (IRR) to TAVF on the investment would be 32%. Actually, Woronoco’s ROE has been better than 10% in recent years, and Woronoco Common is performing better than we had forecast when TAVF acquired its Woronoco position.
High book value frequently has negative connotations. Other than OPMIs who are not on margin, no one, and certainly no corporation, can own or control assets without assuming material obligations in connection with such control or ownership. Assuming obligations means assuming costs and liabilities, whether for licenses, storage, property taxes, environmental matters, employee protection, etc. If the assets are not earnings assets, the corporation will suffer far greater losses than would be the case were those non-productive assets to be shed. This highly realistic negative thought does not seem to pertain to TAVF. First and foremost, in looking at book value, the Fund concentrates much more on the quality of book value than it does on the quantity of book value. Put simply, if the candidate for inclusion in the TAVF portfolio is not extremely well financed, TAVF is unlikely to own that company’s common stock.
Mitigating the negatives that can attach to high book values are three factors. First, a high book value might create tax advantages for U.S. Corporations. The sale of assets used in a trade or business (Section 1231 Assets) at a loss generally creates an ordinary loss that the corporation can apply to offset current year taxable income, if any, thereby reducing current year tax liability. Any excess losses may be carried back in order to get a refund for income taxes paid in the two prior years, and then if losses remain, a 20-year carry-forward is created as a potential offset to income taxes on future earnings. Also in legal cases, say statutory appraisal proceedings in certain states, the courts may attribute a separate value to NAV. Third, other things being equal, the more retained earnings a business has, the more dividend paying ability the company will have. For most companies, a majority of book value consists of retained earnings. The sine qua non for a company to have dividend paying ability, however, tends more to be a function of adequate finances rather than large amounts of retained earnings. For TAVF, our common stock portfolio is invested in the issues of companies which enjoy great financial strength, and where the price of the common stock is much closer to the amount of retained earnings than is the case for general market common stocks. I think there exists a lot of dividend paying ability in the TAVF portfolio, especially when related to the market prices for the Fund’s portfolio securities.
Tangible book value has become less and less important as a measure of NAV than had been the case before, say 1960. In the old days, hard assets–receivables, inventory, property, plant and equipment–constituted a lot more of corporate America than is now the case. These hard assets have become less important as intangibles, like intellectual property and franchises, have become more important. Also, increasingly, the U.S. economy has become a service economy rather than a manufacturing economy. Again, this hardly seems a key factor for the Fund since Third Avenue has almost no investments in the common stocks of old economy, U.S. manufacturing companies.
Any entry on the asset side, or the liability side, of the balance sheet can serve as an objective benchmark for the analyst striving to understand a business. In contrast, in the trading environment, certain balance sheet entries can be ignored because, given the Primacy of the Income Account, managements are appraised strictly as operators of going concerns. Thus, it makes sense in a trading environment to eliminate from an analysis consideration of Purchase Goodwill. Positive Purchase Goodwill refers to the premium over fair value paid by a corporation for another business when pooling of interests accounting was not used. (Pooling of Interests GAAP accounting was eliminated for mergers initiated after June 30, 2001). In striving to understand a business, managements are appraised not only as operators, but also as “resource converters” engaged in mergers and acquisitions, liquidations, spin-offs and diversifications; and also in financing and refinancing the liability side of the balance sheet. Purchase goodwill acts as an objective benchmark helping the analyst decide on management skills in the “resource conversion” area. Third Avenue knows well that there are very few strict going concerns; most businesses will not go as long as five years without engaging in major “resource conversion” activities. TAVF normally will not acquire common stock interests in serial acquirers (i.e., WorldCom or Tyco International) unless the corporate management has shown exceptional skill over the years in the acquisition arena. Two such managements would appear to be the people running Nabors Industries and Quanta Services.
In the years after World War II, there had been a set of Pervasive Principles governing GAAP. These Pervasive Principles have now been all but forgotten. One of the old Pervasive Principles of GAAP was that financial statements were prepared under the assumption that the user of the financial statements was intelligent enough, and well trained enough, so that he, or she, could understand the uses and limitations of financial statements. This Pervasive Principle has now been completely eliminated for those operating in the trading environment. For them, financial statements are now supposed to be accurate and are supposed to tell them the truth, especially about one number, reported EPS. The goal of GAAP today, which seems to be impossible to fulfill, is to make GAAP useful for the “average investor.” GAAP tends to be complex in an understanding of the business environment. In this business environment, it seems likely that GAAP can be useful only to “the reasonably diligent, reasonably well trained, investor or creditor.” The “average investor” is going to be hopelessly lost. Only in the business approach is the old Pervasive Principle understood, that any accounting number, book value or reported EPS is useful only insofar as it gives the analyst objective benchmarks, not the truth. It is the analyst’s job to take these objective benchmarks and use them as tools to help him or her determine his or her version of what economic truth might be.
In the book, Value Investing — From Graham to Buffett and Beyond, by Greenwald, Kahn, Sonkin and Van Biema, there are discussions of NAV. An important point in the book revolves around the view that if the market price of a common stock is well above the reproduction value of assets, the company and the industry, in the normal course of events, will draw new competition which will result in diminished returns unless the company can build a moat to insulate itself from new competition (i.e., Coca-Cola, Gillette and WD-40). From a strict operating point of view, this observation seems quite valid. From a corporate management point of view, though, it seems to be incomplete. In the hands of a reasonably competent management, an overpriced common stock tends to be an important asset with which to create future wealth by issuing that common stock in public offerings, and in merger and acquisition transactions.
With the TAVF emphasis on understanding the business and using a balanced approach where reported earnings and book value tend to be given even weights, the Fund’s analytic activities tend to be a lot less competitive than is the case for those analysts concentrating on the trading environment.
Without a balanced approach which involves an examination of the balance sheet, the income accounts and the footnotes to audited financial statements, it becomes virtually impossible for an analyst to start to answer a key question he or she almost always has to ask: “What don’t I know that I should know?” An analyst can’t even contemplate that question if the approach to the analysis revolves around placing almost sole reliance on the Primacy of the Income Account. Things the analyst trying to understand a business will want to know that can’t be gotten from the income account include, among others, measures of corporate financial strength; contingencies, risks and uncertainties; key contracts; pension plans; out-of-the-ordinary financing arrangements; representations, warranties and indemnities; and certain transactions with control persons.
There does exist a trade-off within corporate managements between striving to improve ROE, and striving to enhance corporate feasibility, i.e., corporate financial strength. TAVF, in its investments, opts for managements more interested in feasibility than enhanced ROE, for better or worse.
In summary, if you are to operate in a trading environment, book value tends to be unimportant. However, if you are to operate in an understanding-the-business environment, book value is just as important, or unimportant, as reported EPS; they are both made of the same stuff. For TAVF, book value tends to be very important as the starting point for most analyses. It is rarely the finishing point.