There is the tale about a finance professor and a student who came upon a $100 bill lying on the ground. The student stooped to pick up the bill. “Don’t bother,” says the professor, “If it really were a $100 bill, it wouldn’t be there.” This story misses the main point relevant to financial analysis. Neither by training, nor by background, would the finance professor be able to identify what the piece of paper lying on the ground was — a $100 bill or a scrap of worthless paper. Trying to distinguish between the two is what fundamental value analysts, and most control investors, do. Academics, on the other hand, are technician-chartists with PhD’s. They study markets and securities prices, not fundamentals. You need to be literate about fundamentals if you are to have any hope of distinguishing between $100 bills and garbage in the field of security analysis.
Starting in the 1960’s, the theories embodied in Academic Finance which revolve around the study of security prices, have taken over security analysis rather completely. The quants rule the roost; Graham and Dodd is mostly dead except for the small minority of outside investors who have a Third Avenue type of approach.
If one signs off on the assumptions underlying Academic Finance, the investment techniques that are an outgrowth of Academic Finance make sense. Indeed, most common stock investment today follows academic precepts. It dominates investment styles. Most investment techniques used by passive investors bottom on the academic theories of the Efficient Market Hypothesis (EMH) and Efficient Portfolio Theory (EPT) as for example:
- Asset Allocation
- Top Down Market Strategies
- Value is determined strictly by forecasts of discounted cash flows (DCF)
The bedrock of Academic Finance is the assumption embodied in EMH that the market is efficient, or to put it in Third Avenue Value Fund (TAVF) language, the market attains instantaneous efficiency.
TAVF has a markedly different view of efficiency than the academics. It ought to be helpful to Third Avenue shareholders to explain the differences:
The Academic View
- The market is efficient, or achieves instantaneous efficiency. The market is defined as trading marts populated by “investors,” i.e. Outside, Passive, Minority Investors (OPMIs). The principal trading marts for securities are sites such as the New York Stock Exchange and NASDAQ.
- Without access to superior information, no OPMI can hope to outperform the market, or relevant benchmarks, consistently. Consistently means all the time, or almost all the time.
- Market prices value any business at any time more correctly than any other measure that might be used. Thus, if a debt free company has 50,000,000 common shares outstanding, and the shares are quoted at $10, the best measure of the value of the company for all purposes is $500,000,000 (50,000,000 shares times $10 per share price).
There are markets that are characterized by instantaneous efficiency. These markets, however, seem to be narrow special cases. The underlying problems of Academic Finance here seem to be two-fold. First, academia takes these special cases and tries to make a general law out of them covering all, or almost all, securities investments. Second, academics look at investments only from the viewpoint of the OPMI, rather than the varied viewpoints of the many participants in the investment process.
TAVF does not, with rare exceptions, participate in those markets characterized by the existence of instantaneous efficiencies; markets achieving instantaneous efficiency seem to have two characteristics:
- The “Investor” is a trader seeking to maximize a marketrisk adjusted total return realizable in cash, consistently (TAVF is a buyandhold investor with little or no demonstrated skill in shortrun trading)
- The securities (or commodities) being analyzed, can be analyzed by reference to only a limited number of computer programmable variables. These special case securities seem to be limited to three types of issues:
If one believes that all markets attain instantaneous efficiency, one also has to believe that in all markets, there exists instantaneous, or almost instantaneous, convergence. Convergence refers to the belief that like securities trading in the same, or different, markets will end up selling at the same price. For example, Tecumseh Class A common selling at $49.44 per share at January 31 is exactly the same security as Tecumseh Class B common selling at $45.38, except that only the Class B common has voting rights. Under convergence theory, market forces will buy Tecumseh Class B increasing its price; and market forces will sell Tecumseh Class A decreasing its price. In short order, both Tecumseh A and Tecumseh B ought to be selling at, say, $47. The truth is that the discount at which Tecumseh B sells, has persisted for a long time and probably will continue to exist until, say, an activist Tecumseh Board makes the “B” stock convertible into “A” stock on a share for share basis.
Convergence pricing seems to approach instantaneous efficiency most of the time in the “special case” markets I’ve identified above. For most of what Third Avenue does, however, there is no instantaneous efficiency. Almost all of the convergence that actually takes place, takes place because active players act rather than because amorphous market forces identify disparities in value between related securities; and then cause the spreads to narrow, or disappear, as if an invisible hand uses “magic.”
Unlike academics, Third Avenue management and similar fundamentalists are probably pretty good at identifying $100 bills, for which we, at TAVF, try to pay not more than $50. Our problem, and the problem of other fundamentalists similarly situated, is not so much in identifying the $100 bills, but rather in how to get enough efficiency into one, or more, markets, so that the realization on the $100 bill can be $100, or even $65 or $70. Most investors comparable to TAVF try to do this by either identifying catalysts or becoming catalysts themselves (See Mutual Shares in pressing Chase Manhattan Bank to sell out, or Gabelli in encouraging a bidding process in connection with the sale of control of Paramount Pictures). At Third Avenue, management spends little time identifying, or seeking, catalysts. Rather the TAVF approach revolves around relying on a long-term tendency toward efficiency. The fund owns a large number of common stocks of well-financed companies that have been acquired at what seem to be steep discount prices. The view is that while Fund management cannot time when individual situations will work out, enough situations in the Fund’s portfolio are likely to work out on a lumpy, rather than consistent, basis, so that overall the TAVF portfolio ought to perform okay.
The TAVF portfolio seems to be loaded with $100 bills acquired for $50 or less. It is much easier for Fund management, and I suspect everyone else, to identify $100 bills using a balance sheet, rather than an income account, or cash flow statement, approach, albeit any good security analyst considers all elements that go into the accounting cycle. Common stocks in the TAVF portfolio that appear to be $100 bills bought at large discounts include the following:
TAL serves as a good example of how instantaneous convergence does not work in complicated situations. At January 31, 2001, TAL Common closed at $19.26 per share. Its assets consisted of holdings of Toyota Motor Common with a market value of approximately $21 per TAL share; other marketable securities with a market value of about $8–$9 per TAL share; and magnificent, world-wide, operating businesses with a probable present value of $6–$9 per TAL share after deducting all debt. If Toyota Motor, which owns 22% of TAL Common, and/or TAL, as activists, do not undertake one or more of the several corporate actions available to them, the disparity between the market price of TAL Common and the underlying net asset values inherent in TAL, more likely than not, will persist.
There are all sorts of real world frictions that argue against the elimination of convergence, at least in the context of instantaneous efficiency. One example revolves around the near-universal existence of management entrenchment provisions embodied in corporate charters and by laws; state corporate laws; and certain Securities and Exchange Commission regulations. The costs to an outside activist trying to cash in that $100 bill the business would really be worth if there were a change of control can be prohibitive even where the activist might be able to acquire non-control common stock in the OPMI market for, say, $30 or $40. Other frictions discouraging convergence include management stock options; huge administrative costs for attorneys and investment bankers; and traditional corporate policies such as those that seem to govern the actions, and non-actions, of TAL and Toyota Motor.
The belief in instantaneous efficiency, and that the prices in the OPMI market reflect economic reality better than anywhere else pervades many areas of American life, including law and sociology as well as finance. There are now many proposals being floated to privatize partially social security on the theory that Wall Street is better able to identify attractive common stock investments in an efficient market then could government investing in credit instruments without credit risk. TAVF would never trust any of its investments to mainstream Wall Street. After all these are the same people, trained in academic finance, who brought us the dot.com madness of 1997 to early 2000, probably the greatest speculative bubble in the history of mankind.