Third Avenue is Different From Top-Down Mutual Funds
The vast majority of investment companies, as well as the dollar value of funds, are managed by disciples of modern capital theory, i.e., believers in an “efficient market.” Modern capital theory, in turn, is based upon the views that investors always know less than the “market”; that the principal factors to study are the behavior of securities prices and the behavior of security markets (i.e., a technical and chartist approach); and that appropriate diversification and asset allocation are the means to guard against risk (i.e., the market price of a security is always the right price and, therefore, it is impossible to guard against risk by buying cheap). These views may have validity in risk arbitrage type situations where one can forecast a reasonably determinate workout in a reasonably determinate period of time and when you keep score only by looking at closing prices every night.
The Third Avenue Value Fund (TAVF, “The Fund”) engages in little, or no, risk arbitrage; the Fund gives little weight to daily market prices and market price fluctuations. The Fund, purely and simply, rejects modern capital theory as totally invalid for buy-and-hold value investors. It is difficult to imagine TAVF making any investment if I did not believe, based on the factors that are relevant for the Fund (and these relevant factors do not include short run trading considerations), that Fund management knows much more than the “market” about the particular investment. To TAVF, the only two factors to study are the fundamentals of the business and the securities issued by the business. Specific risk for the Fund is measured by the quality of the issuer, the terms of the issue, the price of the issue, and, probably above all, the staying power of the issuer in the event that unforeseeable adversities occur. The historic behavior of securities prices and securities markets are pretty much an irrelevancy. Diversification and asset allocation, in the TAVF scheme of things, are merely surrogates for knowledge and control. One of the striking differences between the Fund and “plain vanilla” asset managers is that TAVF does not focus on the same criteria as those types of asset managers in making buy, or not buy, decisions. Insofar as I can tell, the typical fund manager emphasizes an issuer’s industry identification, reported earnings or cash flows from operations (especially those forecast for the quarter or year ahead), and Wall Street sponsorship, if any. The idea behind that approach is to try to forecast the relative immediate price performance of the security being examined, comparing how a particular security might perform relative to similarly situated issues or markets. The Fund, on the other hand, emphasizes the quality and quantity (i.e., net asset value) of the resources in the business, and then tries to estimate how those resources might be converted into earning power over a relatively indeterminate future.
Earning power will not necessarily be evidenced by earnings as reported for accounting purposes, but might also be measured by increases in unrealized, and therefore unreported, appreciation (e.g., St. Joe Paper), by increased cash flows (e.g., Forest City Enterprises), or by a company becoming an attractive sales, merger or acquisition candidate (e.g., Constellation Bancorp). The Fund does not try to forecast near-term security price performance; rather, it tries to gauge the ability of a business to build long-term values while minimizing long-term investment risks, at least for security holders. Comparative analysis is deemphasized; it will probably be good enough if the Fund, over a long period, can earn total returns of 20%, or better, compounded annually, without worrying about how that return compares with general market indices or other funds. TAVF’s concentration on the quality and quantity of resources in a business, rather than immediately forecasted earnings and cash flows for that business has a number of unique advantages from an analyst’s point of view. First, there is an absence of competition for identifying attractive securities. Second, one probably can make as good, or even better, forecasts of future earnings or cash flows, by using net asset value, rather than the past earnings record, as a starting point. Although some — modern capital theorists, for example — maintain that book value is unimportant, they forget that you need to have a book value figure in order to calculate the return on equity (ROE) figure, which they do regard as important. In fact, both a business’ past operating record and its current resources are essential tools of valuation, and one is not a substitute for the other. (If it were, I would prefer resources.) Incidentally, however, large amounts of resources in a business, such as airlines or meatpacking, may be more indicative of onerous overhead than of large future earning power; hopefully, this potentially negative aspect of large resources is not applicable to any of the equity issues in the Fund’s portfolio. A partial explanation for TAVF’s emphasis on balance sheet resources, rather than income account earnings flows and cash flows is that, unlike most funds, TAVF research has a very large corporate finance component and, unlike others, is not grounded in research performed for outside, passive, minority investors. In corporate finance one looks at resources and examines the ways in which superior returns might be achieved from those resources by obtaining new finance or refinance and/or by changing the way in which those resources are employed or managed. In contrast, outside passive minority investors, and modern capital theorists, assume implicitly that most resources will continue to be employed by the same managements in the same ways in which they historically were. Although this is occasionally a realistic assumption as it has been, say, for most electric utilities, it is just not the norm for most American public companies in any three-to-five-year period.
Because the Fund invests the way it does, its performance seems to have been, and I think likely will continue to be, independent of what happens in the general market. For the first three years of its existence, TAVF’s total annual return for its initial investors averaged approximately 30% compounded. I think it may be very difficult for the Fund to sustain 30% annual returns independent of the general market. A principal reason for the level of the Fund’s success over its first three years of life was that TAVF’s portfolio had no big losers, meaning no poor underlying business performances which then were reflected in securities prices. Avoiding big losers over long periods of time is almost certainly impossible for passive investors, at least for TAVF. Its managers are just not that good at predicting the future. This does not mean that I am anything but optimistic about the results the Fund is likely to obtain, given our investment discipline and regardless of the general level of securities prices. It does mean that I think it will be exceedingly difficult for TAVF to do as well in the next three years as in the last three, even though the Fund is operating with a manifestly lower expense ratio now, compared with that which existed when TAVF was much smaller.
The IPO Phenomenon and The Fund
Two watershed phenomena in the last 15 to 20 years, in my view, have altered materially the incentives for key players in the financial community. The first change involves the amounts of compensation available for securities sales forces following the elimination, in May 1975, of fixed commissions on securities traded on a secondary basis. The second change relates to a change in the manner in which investment banks employ their own funds.
One result of these changed incentives is the likelihood that Initial Public Offering (IPO) booms, and their related speculative excesses, may recur more frequently than in the past. The Fund’s investment in Sen-Tech Common, through a private placement, is designed, in part, to enable TAVF to profit from the next IPO boom, if not from the next boom’s speculative excesses. Put simply, we acquired our position in Sen-Tech at a price reasonably related to private business value. An IPO value for the Sen-Tech position, on the other hand, should be well in excess of its private business value. In any event, the prospects of SenTech’s ever going public are enhanced, and the IPO pricing in that event will be better, because of the excellent quality of Sen-Tech’s Wall Street sponsorship and ownership.
The elimination of fixed commissions on “May Day” 1975 has resulted in greatly increased emphasis being placed on financial products which compensate securities sales persons quite handsomely, i.e., products with very large gross spreads including, but not limited to, tax shelter limited partnerships, load mutual funds, and new issues of municipal bonds, junk bonds and common stocks. The sales representative at Prudential, Merrill Lynch or Bear Stearns, for example, really doesn’t have to compete with Charles Schwab for discounted commissions in the secondary market. Rather, he or she can collect as much as 2/3 of a 5% to 10% gross spread from selling IPOs — instead of arguing with a customer over whether the commission on the purchase or sale of existing publicly traded issues should be two cents or four cents per share. Further, IPOs tend to be an easy sale.
Although the rule of thumb is that a company won’t go public, and probably can’t go public, if a common stock issue can be priced only at or below private business value, once a typical, private company does go public, it ordinarily does so at a price which represents not only a substantial premium over private business value but, more importantly, also represents a meaningful discount, usually based on comparative analysis spread sheets, from anticipated market prices for the new issue. There is a conscious attempt to create an ebullient aftermarket for IPOs, which make them easy sells.
The changed investing practices of leading investment banks reinforces the tendency toward the creation of IPOs Before the late 1970s-early 1980s, most investment banks worked only for fees, while employing their own capital only in their own investment banking/brokerdealer activities. Now, in contrast, virtually all investment banks are merchant bankers — owning equities in companies they hope to sell, merge or take public. As a result, investment banks have become enthusiastic sponsors of IPOs because, in general, they own interests in the private companies which are going-public candidates.
Admittedly, IPO markets are especially capricious. There are times when it may be tough to sell any new issue, such as in 1989-1990. And there are times when the public falls over itself to buy “garbage” at outrageous prices, for example, 1993. Yet, if TAVF can acquire equity interests in well managed, wellcapitalized, private businesses early on, at prices which are no greater than, and probably less than, private business values, and where there is reasonable Wall Street sponsorship, then it is likely that, sooner or later (perhaps within the next two to five years), opportunities will exist to create an IPO for one or more of the Fund’s portfolio companies at attractive prices. To a great extent, this type of analysis drives the entire venture capital industry. I certainly believe it is a valid analysis for Sen-Tech, and Sen-Tech type investments. In these cases, the returns to the Fund ought to be pretty good.
It should be noted that TAVF, like any mutual fund, is not permitted to have more than 15% of its net assets, measured as of the time the last investment is made, committed to securities that are not readily marketable. Such nonmarketable securities include not only Sen-Tech type investments, but also bank debt investments such as Eljer Bank Debt.
Finding Bargains From the Bottom Up
In October, I addressed the Miami Bond Club in a talk entitled, “Finding Bargains from the Bottom Up.” The premise of my remarks was that despite the roaring general bull market from 1974 through 1993, numerous bargains continually were being created for investors such as TAVF through a) highly specific industry-wide depressions, b) favorable corporate operations which tend to be ignored by top-down investors, and c) the creation of financially strong companies through providing those businesses with access to junior capital in the form of junk bonds or IPOs at pricing levels that might have been extremely attractive both for the issuing company and for equity security holders who did not have to pay the high IPO prices. I think it will be worthwhile to share with you that October paper (reprinted below), particularly because the points were made by reference to various securities in the TAVF portfolio.
It is apparent to me that regardless of the general level of securities prices, past events are creating continually attractive investment opportunities for fundamentalist investors who follow a bottom-up, rather than a top-down, approach to securities analysis. A bottom-up approach emphasizes the study of individual issuers and specific securities. A top-down approach, in contrast, emphasizes the study of securities prices, general market histories, investor psychology, the level of interest rates, business cycles, overall industry trends, and other technical factors. Most Outside, Passive, Minority Investors (OPMIs) are top-down; virtually all activists such as those engaged in mergers and acquisitions, hostile takeovers, and leveraged buyouts are bottom-up. Academic finance is exclusively top-down. Indeed, academia is best described as consisting of stock market technicians with Ph.Ds.
Let me demonstrate the point about value creation being independent of general market levels by reviewing various investments that currently make up, or have in the recent past been, a significant part of the Third Avenue Value Fund portfolio.
As a bottom-up value investor, Third Avenue Value Fund follows two general investment criteria. Insofar as the Fund acquires performing loans, those instruments have two characteristics:
- A yield to maturity of at least 500 basis points more than performing credits of comparable quality.
- Protective covenants so that in the event of a money default, the Fund has reasonably good prospects of recovering at least its cost.
Insofar as the Fund acquires common stocks, or comparable equities, the issuing company, and the security, combine four characteristics:
- The company enjoys an exceptionally strong financial position as measured by an absence of liabilities, whether on balance sheet, in footnotes, or off balance sheet; and as measured by the company’s ownership, or control, of high quality assets.
- The company appears to be reasonably well managed.
- The company is readily understandable, which in practice means that the issuer complies with the filing requirements of the Securities and Exchange Commission, and issues financial statements which are meaningful and reliable.
- The price at which the common stock is available is no greater than 50% of what I believe the equity would be worth were the issuer a private, rather than public, business.
Implicit in the Third Avenue Value Fund approach is the belief (proven again and again over time) that many, if not most, financial forecasts will prove to be wrong because the forecasts were too optimistic. Thus, the Fund tries to buy “what is” cheap, rather than relying on forward looking information. Further, insofar as it acquires credits, the Fund wants covenant protection in the event that forecasts are wrong and a money default occurs. Insofar as the Fund acquires equities, it wants the businesses to have staying power.
Conventional market indices measure the extent of the enormous bull market in general securities that has occurred since 1974. The Dow Jones Industrial Average, which opened at around 880 in 1974, is now at approximately 3600. During the same interim, the Standard & Poor’s 500 Stock Average increased similarly during the same interim from about 99 to approximately 460. Yet, during the past 19-20 years, large proportions of Corporate America (and Real Estate America) were being savaged, going through experiences as devastating, or even more devastating, than had occurred during the Great Depression of 1930s for many industries. These draconian events affected, among others, most of the country’s manufacturing base, including automobile manufacturers and suppliers; integrated steel mills; aluminum smelters; base metal companies; airlines; real estate (twice); savings and loans (twice); energy; agriculture; computer hardware; defense suppliers; home builders; and department stores.
Despite the buoyant general market, each of these debacles resulted in the securities of victimized companies becoming available at ultralow prices, even though many of the companies and securities, whether distressed credits or equities, met Third Avenue Value Fund criteria. For example, the Fund reached the analytic conclusion that despite the plethora of bad loans (mostly real estate) made by most depository institutions, many of such banking companies were not only inherently profitable but also very good takeover candidates provided that they could become “adequately capitalized” for regulatory purposes. The way to make these inherently profitable institutions “adequately capitalized” was to directly infuse equity into the banks; put otherwise, it made much more sense to buy newly issued bank common stocks from depository institutions, rather than already outstanding common stock from bank stockholders. This the Fund was willing to do provided that the Fund received freely tradable securities; and also acquired its position at a price that was no greater than 75% of proforma book value, and preferably at a discount from market. Thus, Third Avenue Value Fund acquired equity positions in Constellation Bancorp, People’s Heritage Financial Group, Crossland Federal Savings Bank, Glendale Federal Bank, and UnionFed Financial Corp. The game plan is for these banks to be run conservatively for five years, or so, during which period they ought to earn at least 10% per annum on equity. If at the end of that period, an institution is acquired in a stock swap at, say, two times book (the average deal now takes place at more like 2 ½ to 3 times book), the compound average annual return to the Fund will exceed 35%. Most of the bank managements of the companies in which the Fund has invested seem to concur with this agenda; there seems little question that the wave of bank mergers and acquisitions will continue. Hard times in the lending and real estate industries created these investment opportunities in the midst of a bull market for most other securities. The Fund also had opportunities in the two years to acquire real estate equities in companies unquestioned staying power at ultralow prices compared with reasonable, long-term appraisal values.
At any given time, the best performing equities in a market will be those that are reporting improving earnings per share quarter to quarter, those that have the most popular industry identification, and those that are most heavily promoted by insiders and members of the financial community. These three market factors are ignored by the Fund. Rather, Third Avenue Value Fund focuses on quality of the financial position and quantity of resources in the business relative to the security’s price. Quality of financial position plus quantity of resources, incidentally, translates into long-term earning power, whether that earning power evidences itself as unrealized and, therefore, unaccountable for appreciation of undeveloped land (St. Joe Paper); growing cash flows (Forest City Enterprises); enhanced attractiveness as a takeover candidate (Constellation Bancorp or DCA); or rapid increases over long periods in earnings per share as reported for GAAP purposes (SunAmerica).
It is the past prosperity enjoyed by these businesses that created the earning power values the Fund is interested in, rather than bear markets. For a large portion of the Fund’s equity portfolio, tremendous business values were created by past corporate prosperity. In a few cases, e.g., Apple Computer and Digital Equipment, much of the corporate wealth created seems to have been dissipated by current difficulties; but the businesses remain quite strong, and they seem to have quite large resources relative to the prices of their equities. Equities in the Fund’s portfolio which appear to have created large corporate wealth through good operations in the past include Penn Central, SunAmerica, USLICO, Danielson, Consolidated Tomoka, Forest City Enterprises, Capital Southwest, Liberty Homes, Dart Group, St. Joe Paper, Apple Computer, Digital Equipment and Fund American Enterprises.
Another extremely important source of corporate wealth creation is access to outside capital on an ultraattractive price basis (i.e., at price levels far higher for the purchaser than would be available in normal commercial transactions involving private businessmen and private lenders). Such attractive access to outside capital has been available as never before for many companies in the past two years who have tapped the “junk bond” and IPO markets. The IPO market sells to relatively unsophisticated OPMIs, individual or institutional, who are basically traders and will immediately sell any security which no longer has market momentum because of a disappointing quarterly earnings report (Syntellect), or because an industry falls out of favor (e.g., medical equipment). Yet, raising money through IPOs gives many of these companies considerable financial strength. The prices at which the common stocks of IPOs which disappointed momentum investors are available frequently are no greater than that which a first stage venture capitalist would pay, even though the company is well financed and already public. The Fund, for example, recently ran a spreadsheet on all Compustat listed companies which were selling at not more than a 60% premium over book value, and whose cash holdings alone equaled not less than 80% of total book liabilities. 172 issuers made the list, the vast majority of which were cratered IPOs. Third Avenue Value Fund took positions in 13 of these companies: Central Sprinkler, Handex Environmental, Integrated Systems, Interphase, Meadowbrook Rehabilitation, Micronics Computers, PharmChem Laboratories, Photronics, Syntellect, Telco Systems, UTILX, VLSI Technology and Zygo Corp.
Passive investing on a bottom-up basis, it seems to me, is a lot easier than being a trader, or trying to do what academics focus on for OPMIs — beat the market continuously.
The bottom-up investor can average down with impunity. The bottom-up investor with cash reserves can invest with aplomb when markets are in vicious down drafts or there are, for example, large amounts of tax loss selling. The bottom-up investor buys when he believes prices are good enough, not when he thinks the market has hit bottom.
While the bottom-up investor, like the Fund and predecessor investment vehicles, will be wrong about almost a certain percentage of investments over the long term, most of the investments ought to work out “good enough” regardless of what happens in the general market.
Timing is not a problem when managing a bottom-up portfolio. While no individual security bought on a bottom-up basis can be expected to work out in a given period of time, if specific securities in an overall portfolio are not working out from time to time, say every six or nine months, that means that the fundamental analysis was probably bad to begin with.
Bottom-up value investing seems to be quite different than top-down performance investing. For one thing, each tends to focus on different variables (e.g., corporate staying power vs. quarterly earnings as reported for GAAP purposes). Probably the worst dilemma facing the top-down analyst, and quantitative analysts, in general, is the worry about “what does the market know that I don’t?” or “what is the message the market is sending?” For the Bottom-up these are not great problems. Frequently, the analyst can be confident that he, or she, knows more about a particular situation than the “market” does. In any event, in bottom-up investing the strong tendency is to focus on different information, and different time horizons, than is usual for those involved with the general market.
While the bottom-up investor has to spend considerable time on research, I think the workload is manifestly lighter than it is for top-down analysts who have to worry about day-to-day price movements and who have to spend a lot of time studying and opining about “will-o’-the wisp” matters such as the historic behavior of markets (i.e., BETA), the direction of interest rates, and other things they can’t possibly know much about.
There are problems with being a passive bottom-up investor:
- Few analysts have the requisite training
- It can be a risky business if conducted with borrowed money
- It is out of the mainstream; you are viewed as a speculator because most of your investments may not be cosmetically correct. There is little appreciation of the underlying fact that the best way to not speculate is to buy cheap; the best way to maximize profits is also to buy cheap. Believers in the efficient market state that you cannot buy cheap; believers in the efficient market are mostly “looney tunes,” as I demonstrate in other papers. But they seem to be the cosmetically correct majority view.
Bottom-up investing entails focusing on the same valuation variables as activists. Frequently, activists will preempt those values for themselves by causing changes in credit agreements, or by the forced acquisitions of common stocks in leveraged buyout and going-private transactions. In such force-out transactions, the activist has many advantages, not the least of which is complete control of timing. Suppose the private business value of Company X, attributable to its common stock, is $10; X Common initially trades at $5; bear market, or poor quarterly earnings, causes X Common to sell at $2; activist proposes cash merger at $3; passivist is screwed.
Nothing is perfect. But I submit that bottom-up investing is a very attractive activity. Appropriately done, it ought to obtain good results for investors independent of what happens to general securities markets. Those of you stuck with top-down disciplines certainly ought to consider investing a portion of a portfolio’s funds in a bottom-up portfolio if for no other reason than it ought to be market neutral.