26 Third Avenue Approach to Valuation

APRIL 1998

The Third Avenue Value Fund (“The Fund”, TAVF) acquired an initial position in Toyoda Common during the quarter at an average price in U.S. dollars of $17.18 per share. Toyoda analytically consists of three elements: manufacturing operations, an investment in Toyota Motors Corporation Common Stock (“Toyota Motors Common”), and investments in other marketable securities:

toyoda-chart-ch-26

For TAVF, Toyoda Common is a very attractive value purchase at its current price, which is about equal to the Fund’s cost. TAVF has bought into a high quality business at a substantial discount from NAV. I have long thought that Toyota Motors was just about the best automotive company in the world. It, too, is extremely well-financed and seems to have decent, long-term growth prospects not only as an automotive manufacturer with a worldwide presence, but also as a promising participant in the telecommunications, housing and finance industries. I am not quite sure of what the Fund’s ultimate exit strategy for Toyoda Common might be, but it could include market appreciation if Toyoda remains in its current form, and/or appreciation arising out of a Toyoda resource conversion if, say, Toyoda is ever merged with Toyota Motors or if Toyoda’s portfolio, including Toyota Motors Common, is ever spun off as a separate investment company to Toyoda’s shareholders. The largest Toyoda shareholder is Toyota Motors, which holds an approximate 22% common stock interest in Toyoda on an all-converted basis. Toyoda is the largest holder of Toyota Motors Common, owning about 5% of the outstanding issue.Toyoda had founded Toyota Motors in 1933. The two companies became separate corporate entities in 1937. The relationship between Toyoda and Toyota Motors has remained close ever since. Approximately 51% of Toyoda revenues in the fiscal year ended March 31, 1997, were in the production of automobiles, castings and engines for Toyota Motors, another 23% were in the production of industrial equipment, notably forklifts, marketed under the Toyota name, and another 23% of revenues were in air conditioning compressors for automobiles. Further, most of Toyoda’s remaining investment portfolio, other than the investment in Toyota Motors Common, consists of the common stocks of other Toyota Motors’ affiliates.

The principal drawback for the Toyoda investment to Third Avenue is that the public disclosures are not as comprehensive (at least in the English language) or as timely as they ought to be and as they would be were Toyoda a filing company with the U.S. Securities and Exchange Commission. Other analysts will find much else wrong with Toyoda Common.

It ought to be instructive in giving TAVF shareholders insight into the Fund’s investment approach to examine not only how we, at Third Avenue, look at Toyoda Common but also how other analysts and money managers probably would view Toyoda Common. This comparative examination, of course, results in overgeneralizations about other analytic approaches since there will always be differences among individual analysts in assessing any specific security. Nonetheless, the exercise ought to be helpful. Other, non-TAVF, approaches include the following:

  • Control Investors
  • Risk Arbitrage
  • Academic Finance as embodied in the Efficient Market Hypothesis (EMH) and Efficient Portfolio Theory (EPT)
  • Graham and Dodd Fundamentalism
  • Broker-Dealer Research Departments and Conventional Money Managers

Most control investors, say Ron Perelman, Richard Rainwater and Larry Tisch, probably would agree with TAVF that Toyoda is an attractive common stock, price-wise. They probably would use pretty much the same analytic techniques as the Fund to determine that Toyoda Common was an attractive security at its current price. However, control investors probably would have no interest in Toyoda Common because it does not seem to be a “doable deal”; no elements of control seem available to anyone outside the Toyota family of companies. Toyoda Common seems like a lot of other common stocks control analysts look at. It tends to be not that hard to find “attractive securities” among publicly-traded common stocks from a control point of view. It tends to be a bitch, though, to find issues which are not only “attractive securities” but also “doable deals.”

Risk Arbitrageurs would have no interest in Toyoda Common now. Risk arbitrage exists where there are opportunities for profits from situations where there are relatively determinant values to be realized in relatively determinant periods of time. A risk arbitrage situation would exist, for example, if Toyoda and Toyota Motors announced now that they intended to merge. In that instance, risk arbitrageurs might acquire Toyoda Common at prices of, say, 24 or 27. Markets, especially risk arbitrage, markets, tend enough toward efficiency so that one cannot engage in risk arbitrage, unless one is willing to pay up compared with pricing that is attractive for TAVF. Within the risk arbitrage community, what Third Avenue does is known as “pre-deal” investing. However, what Third Avenue is doing in Toyoda Common may really be “pre-pre-deal” investing since, aside from a modest common stock buy-back program, there seem to be no indications that Toyoda management contemplates having the company undertake any activities outside of the ordinary course of business for the foreseeable future.

Academics would be unconscious of the business characteristics underlying Toyoda Common. This is not what they do. If asked to explain why Toyoda Common, as a marketable security, sells at such a substantial discount from the value of Toyoda’s net assets, which are also measured largely by the market values of its portfolio securities, the likely explanation would revolve around something called “investor expectations.” The primary thrust of most academic analyses would be to measure the past total return performance of the fund holding Toyoda Common, versus indexes or other funds with the same investment style. Academics also might be interested in asset allocation — how much of a fund’s assets ought to be in Japanese securities or automotive securities. If Toyoda Common were to be valued independent of its market price, that value would be determined by forecasts of discounted cash flows.

Some Academics might be aware of the efficient market arbitrage inherent in the principal characteristics affecting Toyoda, to wit, the Company enjoys an exceptionally strong financial position; Toyoda Common sells at a low price compared with underlying values; and Japanese interest rates are ultra-low currently. For example, Toyoda, theoretically, could borrow on a long-term basis the equivalent of about $1,125,000,000 at 3% and use the proceeds to acquire via a Cash Tender Offer 50,000,000 Toyoda Common at $22.50 per share, equal to a premium over current market of about 28%. The net interest cost to Toyoda for the borrowing, after eliminating the dividends on the 50,000,000 shares of Toyoda Common to be acquired would be less than $28 million per year before taking account of possible tax savings from substituting interest charges for dividend payments. Partly because such a transaction would result in increasing Toyoda’s pro-forma earnings per share and Toyoda’s pro forma NAV per share, and partly because such a transaction would indicate that Toyoda management is employing its resources more aggressively, TAVF would conclude that the Cash Tender Offer would likely result in an improved market price for Toyoda Common after the conclusion of the Cash Tender Offer over what the market price would otherwise be. Most Academics, in contrast, would likely conclude that the benefits of such a theoretical buy-back are already reflected in the existing market price of Toyoda Common.

In an important sense, Graham and Dodd might be just like TAVF in finding Toyoda Common attractive because it is priced below the per share value of its net current assets, including investments at market value, after deducting all book liabilities short term and long term, except for deferred income taxes on the unrealized appreciation of portfolio securities. However, outside of these “net-net” considerations, Graham and Dodd would tend to emphasize a whole gamut of factors pretty much ignored by TAVF. Graham and Dodd probably would place great weight on Toyoda’s earnings record over the past five years; its present dividend rate and dividend policy; and the immediate outlook for the Japanese economy, the Japanese Stock Market, and the worldwide automotive industry. For Graham and Dodd, the perceived exit strategy for Toyoda Common would be sale in the stock market as reported earnings increase. Graham and Dodd probably would weight much less heavily than TAVF possible exit strategies occasioned by resource conversion events, such as mergers and acquisitions, spin-offs or massive share repurchases.

The primary objective of Broker-Dealer Research Department Analysts and Conventional Money Managers is to estimate the price, or range of prices, at which Toyoda Common (or any equity security) might trade in markets for passive investments over the next 30 days to, say, one year. The probable approach would emphasize top-down considerations (rather than TAVF’s bottom-up). Factors that Research Departments and Conventional Money Managers probably would emphasize encompass the following:

  1. Outlook for the Japanese Stock Market with the outlook for the Japanese economy a principal variable in determining a market outlook
  2. Outlook for the worldwide automotive industry in the period just ahead
  3. Earnings outlooks for the next year for Toyoda and Toyota Motors
  4. Is Toyoda Common selling at a lower price earnings ratio than comparably situated issues?
  5. Is the fact that Toyoda Common trades at a discount from “net-net” asset value unique? (A fair number of Japanese equities seem to be trading currently at prices less than net-net asset value.)
  6. Is there any resource conversion catalyst in evidence that might cause the Toyoda common NAV discount to narrow or disappear over the next year or so?
  7. Is Toyoda Common trading near the lows of recent years? (It is trading about in the middle of its five-year price range.)

Probably, neither the Research Department Analyst nor the Conventional Money Manager would have any interest in Toyoda Common, unless they thought there was a rational basis for expecting near-term price appreciation in Toyoda Common. Many of these analysts might conclude that Toyoda Common was a good way to participate in a Japanese Stock Market rebound. But they would be unlikely to become bullish about Toyoda Common, unless they first foresaw a Japanese Stock Market rebound.

I, personally, am very comfortable with the TAVF approach to analysis as embodied in the reasoning behind the Fund’s investment in Toyoda Common. While the Fund seems quite different than others in its analytic approach, TAVF has no magic formula. There are things to be said in favor of the approaches followed by Risk Arbitrageurs, Academia, Graham and Dodd, and Conventional Money Managers, especially if one’s portfolio management bottoms on having concerns about near-term market performance for individual securities. Many of these near-term concerns are quite legitimate in connection with the management of other portfolios. They just don’t seem to have any relevance for the management of the TAVF portfolio.

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