November 1, 2010, marked the 20th anniversary of the launch of Third Avenue Management’s (TAM) first mutual fund, Third Avenue Value Fund (TAVF, “Third Avenue” or the “Fund”). Much has been accomplished in the past 20 years by TAM, in providing sound investment advice and good results for the shareholders of our four funds, registered under the Investment Company Act of 1940, as amended, and managed by Third Avenue: TAVF, Third Avenue Small-Cap Value Fund, Third Avenue International Value Fund and Third Avenue Real Estate Value Fund. I am particularly proud and pleased by what has been achieved by my partners at Third Avenue and by all the employees of the firm. They really are a remarkable bunch.
Twenty Years of Value Investing
When the Fund first reported to shareholders on October 31, 1990, it had a portfolio of ten securities including municipal bonds, corporate bonds, corporate preferred stock and common stock. “We suppose that many people who read this letter will conclude that the portfolio is speculative,” we wrote. “Certainly all the conventional thinkers believe the Fund is speculative. We disagree. Unconventional, sure. But given the prices at which the various securities were acquired, and given the extensive, in-depth research that went into the decision-making process for each investment, speculative versus conservative ought not to be measured only by what is cosmetically acceptable and what ratings services say. Rating services and conventional thinkers pay no attention at all to price. From the Third Avenue perspective, we believe that there ought to be, at the least, a price component in measuring whether an investment is speculative or conservative. There also ought to be a quality of research component. Third Avenue will try to stay conservative by these measures even though the portfolio is unlikely to ever be cosmetically correct.”
For two decades, a hallmark of Third Avenue’s style has been the search for safety in places where most investors would never look. In a mutual fund industry that has spawned narrower and narrower niches in response to the teaching of Modern Capital Theory (MCT) and the Efficient Market Hypothesis (EMH), Third Avenue has charted a unique path. Guided by an adherence to price consciousness and a deep understanding of underlying business fundamentals and asset values, Third Avenue managers have wide discretion to invest where and when they deem it appropriate. The results have been gratifying – returns that beat the market most of the time and over the long run. The experience has been unique. TAVF and its investors are rarely, if ever, invested alongside the galloping herds.
It was 1993 when the Value Fund first invested in Apple Computer. This was back when Apple’s products served a decidedly niche audience and the company seemed destined to, at best, maintain its position as a relatively small manufacturer of personal computers, if not to be outright crushed by Microsoft and computer manufacturers making machines that ran its operating systems. When we initiated our position, we did not know how truly iconic and enduring a fixture Apple would become. What we did know, from our fundamental bottom-up analysis, was enough to understand what the company was worth at the time and how the market, in its momentary ignorance, had left its securities undervalued. Apple enjoyed a super strong financial position. TAVF invested in technology companies large and small throughout the 1990s. In almost every instance, cash alone exceeded total book liabilities. Our investments in smaller semiconductor capital equipment stocks led to the eventual formation of the Third Avenue Small-Cap Value Fund. We avoided the speculative dot com stocks of the day, (including new issues that we called “schlock” in 1999), but we didn’t eschew investing in technology. Instead we invested in well-capitalized semiconductor companies, those that built the infrastructure of the Internet that endured, even as so many Internet pure plays fizzled into the ether. Outsiders were quick to judge us for not joining the dot com frenzy, with some wondering whether or not we were out of touch with a new era. We invested by the dictates of our philosophy and were ultimately vindicated. At the Value Fund we are now looking at some larger, undervalued American technology companies.
In the wake 2001’s shock to the U.S. economy, Third Avenue returned to its roots in distress investing. We invested in the high-yield debt of several troubled companies, seeking returns of 25% or more. We owned unsecured debt in Kmart, which sought bankruptcy protection in 2002. TAVF purchased common stock to help fund Kmart’s reorganization. Our Real Estate team determined that we were able to purchase Kmart common for less than the value of the company’s real estate. We exited our position when we believed the stock had become egregiously overvalued.
In 2004 and 2005, TAVF began making a number of overseas investments in common stocks, including companies such as South Korean steel producer POSCO and also in Hong Kong real estate and investment companies. These remain in the portfolio today. At the time, we said that “other things being equal, we would prefer to invest in this country (the U.S.),” but our price consciousness dictated that we look abroad. Once again, price led us in the right direction. It now seems that any long-term investor should want to have a portion of their assets in companies headquartered in and doing business in the Far East, including Hong Kong. TAVF became an excellent way to gain that exposure through a portfolio of the strongest companies that are run by management teams whose interests are aligned with those of Outside Passive Minority Shareholders (OPMIs), even when those shareholders are situated abroad. Third Avenue was able to make such investments with confidence because we have a long tradition of global value investing.
In an industry where independent thinking, fundamental analysis and conviction-based investing have been abandoned by so many other managers, in order to force their investment strategies to match a benchmark or fit someone else’s mandate or style box, I am proud to say that we have remained true to our investment philosophy for our entire 20 years. Every step of the way we have “eaten our own cooking,” investing our personal money in our funds, alongside and on the same terms as you, our fellow shareholders. I guess that makes us biased. But we are biased on your side.
Efficient Market Hypothesis Revisited
While I have written about the subject many times over the past twenty years, it seems productive to write to you about the disparities that exist between the analyses that goes into the bulk of Third Avenue Management’s (TAM) equity investments on the one hand, and the beliefs and analyses that pertain to the efficient market hypothesis (EMH) on the other hand. EMH is believed in by almost all academics – whether finance professors or economists and probably by most mutual fund managers – almost all of whom sign off on what is called MCT. Put simply, in the efficient market hypotheses, market prices for individual securities in markets populated by OMPIs almost always reflect some sort of universally accepted value.
In the last quarterly letter, for the period ended July 31, 2010, I discussed TAVF’s investments in securities which I called Graham & Dodd net-nets on steroids. These securities account for about 60% of TAVF’s net assets. The Graham & Dodd net-nets on steroids virtually all have the following characteristics:
- The companies enjoy super strong financial positions.
- The common stocks were purchased at prices that represented at least a 25% discount from readily ascertainable Net Asset Values (NAV), with the average discount probably closer to 35% to 40%.
- The disclosures available to OPMIs were, and are, comprehensive, complete and understandable.
- Past records of the companies were, and are, very good with most growing NAV (after adding back dividends) at compound rates during the previous five years of better than 10% – in fact closer to 15%.
- The prospects for growth in NAV in the next three-to-seven years at rates better than 10% compounded seem very good.
- Current earnings and cash flows are strong.
There is one other very important characteristic to all these Graham & Dodd common stocks whose names include: Brookfield Asset Management, Capital Southwest, Cheung Kong Holdings, Hang Lung Group, Henderson Land Development, Investor A/B and Wheelock & Co. That other characteristic is that in each instance, there are little or no prospects for changes of control. If there were prospects for changes of control, not only would the discounts from NAV disappear, but control buyers probably would pay control premiums (maybe substantial premiums) over NAV, in part, because given the super strong financial positions of the companies, most acquisitions could be financed on extremely attractive terms. Thus, it seems obvious that here OPMI market prices do not come close to reflecting underlying corporate values.
It is fair to argue that efficient market pricing reflects all relevant factors, not just underlying corporate value, and lack of prospects for changes in control are a very relevant factor in analyzing the Graham & Dodd net-nets on steroids. But this deserves little or no weight in a TAM analysis, where the emphasis is on acquiring securities on a safe and cheap basis – i.e., the common stock is priced at a big discount from underlying corporate value; the company is well-managed and enjoys super strong finances; and fund managers can see a long-term, highly profitable exit strategy. For TAM, the efficient market does not exist; MCT misleads far more than it informs.
Underlying corporate values are created in four different ways, sometimes related to each other, sometimes not. Briefly the four ways underlying corporate values are created are as follows:
- The company has free cash flow from operations available to security holders. This is probably rarer than most people think.
- The company has earnings, with earnings defined as creating wealth while consuming cash. Earnings are the flows that are most common not only for businesses but also for governments. In most instances earnings cannot create long-term value unless it is also combined with access to capital markets in order to finance cash shortfalls. Put otherwise, most of the time a business has to stay creditworthy if its earnings are to be valuable to security holders. MCT postulates that each good investment has to have over its life a positive net cash flow, i.e., a positive Net Present Value (NPV). This concept is valid for project finance, but not for corporate finance involving going concerns with perpetual lives.
- There exist resource conversions. Resource conversions include: changes of control; mergers and acquisitions; tender offers; massive asset redeployments; massive liability restructurings, whether in leveraged buyouts or the reorganization of troubled companies; large scale distributions to stock holders in the form of dividends and/or stock buy- backs; and split ups.
- Access to capital markets, either equity or credit markets, on a super-attractive basis is available. One example of such super-attractive access to equity markets revolves around the dot-com bubble prior to the year 2000, when high tech start- ups could go public and get virtually free money. One such example of super-attractive access to credit markets revolves around the availability of long-term, fixed low-interest rate, non-recourse financing for many income-producing real estate properties.
Because there seems to be a dearth of resource conversion opportunities for the Graham & Dodd net-nets, at least as far as changes in control are concerned, and probably limited opportunities for super-attractive access to capital markets, the TAM analysis focuses on forecasting future flows – both cash flows and earnings. These flows are reflected in future NAVs and future distributions to shareholders. If the analyst is close to right about double digit growth in NAV, the holding of the security will tend to be quite profitable, unless the discount from NAV widens very materially. So far, in the twenty-year history of TAM, the TAM analysts seem to have done a pretty good job of buying into the common stocks of companies with growing NAVs, the severe business recessions that occurred during this period notwithstanding.
Looked at from the bottom-up, it is hard to say that OPMI markets reflect realistic values for going-concerns with perpetual lives from any rational point of view. Indeed, at TAM, we believe that without prospects for changes of control, market prices in Japan never have to be anything but a random walk. Thus, in recent years TAM funds have lightened up on their holdings of well-financed Japanese companies, because of the belief that managements and control groups tend to be indifferent to the interests of OPMIs. Therefore, Japan’s market prices never have to reflect any rational values because, generally, there are no prospects for changes in control. (As an aside, it seems as if the absence of change of control possibilities combined with the indifference toward OPMI interests have been important contributors to Japan’s twenty-year long recession.)
The factors that OPMIs emphasize just do not reflect underlying values for going concerns with perpetual lives. The factors emphasized by most OPMIs seem to encompass the following:
- An extreme short run orientation. Short run market prices are important. Try to pick price bottoms to buy and price tops to sell.
- Emphasize the Primacy of the Income Account, at the expense of paying attention to the qualitative and quantitative aspects of balance sheets.
- Most market activity is undertaken by people with no training, no talent and no time for fundamental analysis, e.g., high frequency traders and day traders. The underlying view is the market knows all – certainly more than I do. Therefore study markets, not companies or the securities they issue.
- Focus on the macro. It is much more important to have views about the economy, general markets and interest rates, than it is to be bottom-up, i.e., focus on analyzing the company and the securities the company issues.
- Be outlook conscious at the expense of determining whether a security is priced at a discount from, or a premium above, underlying value.
Saying the above does not mean that there do not exist OPMI markets that are highly efficient. It just means that TAM does not, as a rule, play in those efficient markets. Efficient markets exist where short-run price swings have great significance and where prices are determined by reference to a very few computer programmable variables. In my view, efficiency dominates in markets characterized by the following:
- Credit instruments without credit risk, e.g., U.S. Treasuries.
- Derivatives, including options, warrants and convertibles.
- Risk arbitrage, with risk arbitrage being defined as situations where there will be relatively determinate workouts in relatively determinate short periods of time, e.g., a publicly announced merger.
For an efficient market to exist, four conditions have to be met:
- The market participant is ignorant of, or chooses to ignore, fundamental analysis for the medium- to long-term.
- The securities to be analyzed can be analyzed by reference to a few computer programmable variables.
- Short-term price movements are of primary importance.
- External forces impose a strict discipline on the market place. These external forces can be, among others, competition, government regulations, boards of directors, labor unions, attorneys, accountants, and community representatives.
Also, near-term price tends to become important when the market participant finances his, her or its activities with borrowed money. No TAM entity uses borrowings. In the TAM scheme of things, we place much less weight on market prices than is the case in MCT.
Cash bailouts for securities holders come from three sources.
- Payments by the company – to creditors as interest, repayment of principal and premium. Equity payments are in the form of dividends and share repurchases. If a TAM Fund owns a performing loan providing a double digit yield to maturity, market price is less relevant than owning a non-dividend paying common stock.
- Sale to a market
- Obtain elements of control. The value of control is something almost completely ignored in MCT.
Sometimes market price even has a perverse value. Assume one holds a portfolio of performing loans that is expanding in size and whose maturing obligations are always being reinvested in new performing loans. Assume also that the liabilities financing the portfolio consist of non-interest bearing obligations, e.g., life insurance companies and pension plans. If the market value of this portfolio increases, future net investment income will be less than would otherwise be the case, because interest rates will have come down. Concomitantly, if the market value of the portfolio decreases, future net investment income will be greater than would otherwise be the case. One way of looking at this is to state that cash return analysis is sometimes quite different than total return analysis. There seems to be no recognition of the difference in MCT.
One of the things Fund Managements at TAM try hard to do is to avoid permanent impairments to investments. Generally, TAM seems to have done a reasonable job in this respect, with a very few notable exceptions, e.g., MBIA Common Stock.
The TAVF Portfolio of Graham & Dodd net-nets is quite conservative. Certainly returns might be higher if the Fund were willing to take more investment risk. This is not going to be the case. TAVF is not going to be involved in certain areas:
- Equities of companies that are basically in emerging markets
- Equities of companies which borrow heavily
- Companies that do not provide comprehensive, understandable, disclosures
- Discovery companies
MCT offers as proof of an efficient market the fact that no one outperforms relevant indices consistently. Consistently is a dirty word; it means all the time. TAM is happy if the Funds’ absolute returns are OK and if the Funds outperform relevant indices on average, most of the time and over the long run. TAM will never outperform indices consistently.
The principles followed by TAM, as enumerated above, are not restricted to value investing. Emphasizing underlying corporate values are also the tools of choice in distress investing, control investing and credit analysis.