It is interesting to compare an investment in Third Avenue Value Fund (TAVF) Common Stock with an investment as a passive investor in private equity funds seeking leveraged buy-outs. The differences appear to be about as follows:
- TAVF is riding the coattails of super-good managements with proven track records; e.g., Brookfield Asset Management (formerly known as Brascan Corp.), Forest City Enterprises, Nabors Industries, St. Joe Company and Toyota Industries. Managements running LBO companies are probably a lot more dicey.
- TAVF’s costs to the investor are a lot lower. TAVF had an expense ratio of 1.10% of assets under management for fiscal 2005, while the typical private equity fund charges a management fee of 2% of assets under management plus 20% of realized, and unrealized, profits. This is slightly offset in some cases where private equity funds share fees received, such as home office charges, with passive investors.
- TAVF tends to get into its investments at materially lower prices than private equity funds. The usual buy trigger for Third Avenue is where the common stocks of well-financed companies are available at prices that represent a meaningful discount from readily ascertainable net asset values. Private equity funds usually pay substantial premiums above estimates of net asset value.
- TAVF shareholders are not subject to lock-ups of any sorts (other than a modest redemption fee for shares held for less than 60 days) and TAVF shares can be redeemed daily. Most private equity funds forbid redemptions other than once a year, or quarterly after a one-year holding period.
- TAVF is not a control investor, by and large. Private equity funds are, by and large, control investors.
- TAVF does not borrow money. Private equity funds tend to operate with maximum leverage.
- TAVF shareholders are the beneficiaries of a comprehensive regulatory scheme designed to protect investors. Private equity funds are largely unregulated.
To date, TAVF’s longterm returns have been as good, or almost as good, as has been the case for the better-managed private equity funds .
Great Economists Can Learn A Lot from Value Investors
During the quarter, I reread three volumes authored by great economists: The General Theory of Employment, Interest and Money by John Maynard Keynes, The Road to Serfdom by F. A. Hayek, and Capitalism and Freedom by Milton Friedman. I came away with the impression that each was observing the earth with their naked eyes from 80,000 feet up. They missed a lot of details that are part and parcel of every value investor’s daily life.
To begin with, the three seem to recognize only three major forces directing the economy: capital (private owners, managers or entrepreneurs), labor and government. In fact, there are myriad other non-governmental forces directing any industrial economy, including, among others, management control persons (separate and apart from private owners); creditors; rating agencies; Boards of Directors; professionals, especially attorneys and accountants; trade associations; and self-regulatory organizations such as the New York Stock Exchange.
For the three great economists, governments perform four functions: control the economy; regulate sectors of the economy; set fiscal policies (budget surpluses or deficits); and set monetary policies (interest rates and the quantity of money). In the 21st century, it seems a lot more productive in determining how the nation’s resources are to be allocated by the private sector to look at governments as engaged also in the following activities:
- Levy taxes, with both tax rates and the specific methods of taxation being important
- Provide credit
- Enhance credit
- Provide subsidies
- Provide infrastructure frameworks, physical and procedural, including having reliable judicial systems
- Be a customer
- Be a competitor
- Provide public protection via the military, police and other
F.A. Hayek wrote The Road to Serfdom in the 1940’s. The book was relevant for its time. The gravamen of its arguments was that command economies without a private sector, e.g., the Soviet Union then (and North Korea and Cuba today), just do not work. They deny their populaces not only economic well-being but also freedom. Of course, Professor Hayek was 100% right about this. However, in no way does it follow, as many Hayek disciples seem to believe, that government is, per se, bad and unproductive while the private sector is, per se, good and productive. In well-run industrial economies, there is a marriage between government and the private sector, each benefiting from the other. Since World War II, there have been a significant number of large command economies that have worked well by utilizing an incentivized private sector. Such economies include Japan after World War II, Singapore and the other Asian Tigers, Sweden and China today. For the value investor, the issue is not government versus the private sector. Rather, it is that, in accordance with Adam Smith’s invisible hand, those in control, whoever they are, should be incentivized appropriately. Government has a necessary role in determining how control persons are incentivized; and where the private sector will allocate resources in accordance with the invisible hand so that private control persons can maximize wealth for themselves, and also, by indirection, their constituents who are usually the owners of private enterprises.
Whether one likes it or not, how and where Adam Smith’s invisible hand allocates resources through actions by private enterprises will be determined in large part by what government actions are. Should these government reactions be random, or at least in small part, a product of planning? In the U.S. today it seems as if the federal government directs resources mostly by “who has political clout.” There is no question but that private enterprise, in its actions, is particularly sensitive to what the federal government does in terms of tax policy, both quantitatively and qualitatively; and what the government does in terms of credit granting and credit enhancing. Control persons in the U.S. private sector are extremely sensitive to, and react very efficiently to, government policies in terms of taxation and in terms of credit granting and credit enhancing. Put in Milton Friedman’s context, Adam Smith’s invisible hand turns out to be more than random. It will be directed, at least in great part, by the government’s tax policies, and the government’s credit granting policies. Put otherwise, what government policies contribute is important to the private sector’s determination of where the profits are.
Professor Hayek, however, seems to miss the opposite point that a free market situation is probably also doomed to failure if there exist control persons who are not subject to external disciplines imposed by various forces over and above competition: governmental, quasi-governmental and private sector. This is probably more true for financial markets than it is for commercial markets, but the point seems valid for both markets. Put simply, competition by itself, tends not to be a strong enough external discipline to make markets efficient. Where control persons are not subject to meaningful external disciplines, the following seems to occur:
- Very exorbitant levels of executive compensation, a shortcoming rampant in the U.S. today
- Poorly financed businesses with strong prospects for money defaults on credit instruments, e.g., look at the insolvencies in recent years of Long-Term Capital Management, Retail Chains and Motion Picture Exhibition companies
- Speculative bubbles, e.g., the 1998-2000 IPO boom
- Tendency for industry competition to evolve into monopolies and oligopolies where the companies involved have a large degree of insulation from competitive forces. TAVF loves to invest in the common stocks of companies which have built a “moat” around their operations, insulating the businesses, at least in part, from pure and perfect competition. Such investments include the common stocks of Toyota Industries, St. Joe, Brookfield Asset Management, Forest City Enterprises, and Nabors Industries. All these companies enjoy oligopolistic characteristics.
- Corruption: i.e., Enron, WorldCom, Refco.
It ought to be noted, too, that many highly competitive industries happen not to be subject to meaningful price competition. Two such industries are money management and investment banking. In the investment banking arena, there seems to be a universal 7% gross spread involved in bringing most new issues public. Third Avenue has invested heavily in the common stocks of financial institutions where price competition seems minimal, or non-existent; e.g., money managers such as Legg Mason and Nuveen; and broker-dealer financial advisors such as Jefferies Group and Raymond James. A principal disadvantage for TAVF in investing in distressed securities revolves around the rip-off of pre-petition creditors by professionals, mostly lawyers and investment bankers. Competition to obtain professional engagements in matters such as USG and Collins & Aikman is intense. But no professionals in the distressed world, with very minor exceptions, ever seem to compete on price.
Disciplines are imposed on control persons operating in free markets by many, many more entities than just governments and competitors. The great economists mostly fail to recognize the existence of these other forces imposing discipline. Some tend to be harsh disciplinarians — creditors and rating agencies; and some seem to be very weak disciplinarians — passive owners of common stocks and Boards of Directors. These other forces imposing disciplines on control persons include the following:
- Boards of Directors
- Creditors — especially banks
- Rating Agencies
- Labor Unions
- Trade Associations
Compared with value investors, great economists from Keynes to Modigliani and Miller seem largely oblivious to the very important role creditworthiness plays in any industrial economy. Indeed, a principal shortcoming of our current monetary and fiscal authorities, especially Alan Greenspan, is that creditworthiness does not seem to be on their radar screen at all. The authorities seem focused on Gross Domestic Product and the control of inflation-deflation. They worry not about creditworthiness, which ought to be the third leg of their analytical stool. Creditworthiness in the U.S. seems to be a mixed bag when looking at the three principal economic entities: Private Businesses, Governments and Consumers. On the one hand, corporations, in general, perhaps including depository institutions, probably have never been more strongly financed. On the other hand, Governments — federal, state and local — and Consumers probably have never been less creditworthy than they are now. I think the TAVF common stock portfolio is fairly well insulated against money defaults from any sector, but I’m not sure.
Milton Friedman is “gung-ho” for free markets, unfettered by government intervention. As he states on p. 22 of Capitalism and Freedom , “To the liberal, the appropriate means are free discussion and voluntary co-operation, which implies that any form of coercion is inappropriate.” Professor Friedman also states on p. 13, “Fundamentally, there are only two ways of co-ordinating the economic activities of millions. One is control direction involving the use of coercion — the technique of the army and the modern totalitarian state. The other is voluntary co-operation of individuals — the technique of the market place.”
Professor Friedman, unfortunately, seems to have no background, or experience, in corporate finance. If he did, he would understand that public corporations just would not work unless, in the relationship between control persons and owners, certain activities would encompass voluntary exchanges while other activities would encompass coercion. So it is also on the national and global levels.
Also, given a background in corporate finance, Professor Friedman would get to understand that there are three general ways for coordinating the economic activities of millions, not two. One is central direction without the existence of a private sector. The second is complete voluntary cooperation without the existence of many coercive external disciplinary forces, whether governmental or private, influencing the marketplace. The third general way is the real world situation where governments and other external forces have an influence on, and frequently direct, the activities that transpire in the market place. Indeed, the various marketplaces in the U.S. seem to be ultra-sensitive to certain directions they get from governments through tax policies, credit granting and regulation.
In public corporations, there are certain activities that are essentially voluntary and others that are essentially coercive from the point of view of non-control securities holders. Voluntary activities, where each person makes his or her own decision whether to buy, sell, or hold, encompass open market trading activities, certain cash tender offers, private purchase and sale transactions and most exchanges of securities, including the out-of-court restructuring of troubled companies. Coercive activities, where each individual security holder is forced to go along with a transaction or event, provided that a requisite majority of other security holders so vote, encompass proxy voting for Boards of Directors; most merger and acquisition transactions including reverse splits and short form mergers; certain cash tender offers; calls of convertible bonds or preferred stocks; the reorganization of troubled companies under Chapter 11 of the Bankruptcy Act; and the liquidation of troubled companies under either Chapter 7 or Chapter 11 of the Bankruptcy Act.
I am as one with Professor Friedman that, other things being equal, it is far preferable to conduct economic activities through voluntary exchange relying on free markets rather than through coercion. But Corporate America would not work at all unless many activities continued to be coercive; security holders may get a right to vote (which vote may be pro forma and meaningless), but the security holders are coerced into going along whether they like it or not once a requisite vote has taken place.
Incidentally, appraisal rights under state law, can be pretty meaningless in the scheme of things in merger and acquisitions, and can hardly be thought of as voluntary. Without some element of coercion, two undesirable things are bound to occur in a free market:
- Adverse selection, i.e., individuals who believe they are benefited economically by a transaction go along, while those who believe otherwise opt out of the transaction. If this were permitted, there would be no mergers and no Chapter 11 reorganizations, something highly destructive to corporate well-being and the well-being of the general economy.
- There would be unsolvable hold out problems. For example, voluntary bond exchanges to make a company more creditworthy would frequently be doomed to failure because those who hold out know that because of their hold out, their bond position would be credit enhanced if most of the other bondholders exchange.
Assuming that the goal of an economy ought to be to maximize the average per capita income, and wealth, for its citizens (or residents), then adverse selection and hold-out problems have to modify, in certain areas, reliance solely on voluntary exchanges or the free market. Specifically, there are areas where, because of adverse selection and hold-out problems, the U.S. should not rely wholly on market mechanisms. These areas include the following:
- Medical Care. There is one good measure of how well cared for a population is; to wit, the average age of death. Here, the U.S. performs worse than most industrial economies. This seems a shame because the very best medical care in the world exists in this country for those who can afford it. The country would be much healthier if all its residents had access to decent medical care without adverse selection opt-outs.
- Social Security and Pension Plans. Clearly, the adverse selection problem will loom large if these retirement mechanisms are made wholly, or almost wholly, voluntarily.
- Education. This country seems to be falling behind much of the rest of the industrial world in elementary through high school education, even though the U.S. probably still has the best university system in the world. There seems to be a real problem between allowing each parent to pick the school which their child should attend and the problem of adverse selection. Tough choice; I don’t have any easy answers.
Government regulation is not, per se, good or bad. There is good regulation and there is bad regulation. An example of good regulation is the Investment Company Act of 1940 as amended. An example of bad regulation is the Sarbanes-Oxley Act of 2002.
It ill behooves any successful money manager in the mutual fund industry to condemn the very strict regulation embodied in the Investment Company Act of 1940. Without strict regulation, I doubt that our industry could have grown as it has grown, and also be as prosperous as it is for money managers. Because of the existence of strict regulation, the outside investor knows that money managers can be trusted. Without that trust, the industry likely would not have grown the way it has grown. Outside investors know that the money managers cannot steal, cannot be involved in self-dealing, are limited in causing the fund to borrow money, fees charged are controlled, and the mutual fund must diversify as a practical matter. All of this occurs for the benefit of shareholders, while still permitting the money manager to prosper mightily from the receipt of management fees. This is an example of good, intelligent regulation. Messrs. Hayek and Friedman probably do not recognize the existence of such beneficial regulation.
On the other hand, Sarbanes-Oxley, (SOX) is an example of stupid, non-productive regulation. It seems to be regulation based on the belief that every company, every Chief Executive Officer, and every Chief Financial Officer, is associated with Enron, WorldCom or Refco. Every company, therefore, should be subject to onerous regulation although such regulation does not seem to do anything, or much at all, about investor protection. The upshot of SOX is that it detracts mightily from the attractiveness of U.S. capital markets. No CEO or CFO likes being subject to liabilities that arise out of SOX. Smaller public companies cannot afford to comply with SOX. Few, or no, foreign companies are going to subject themselves to American jurisdiction unless they absolutely need access to American capital markets trading publicly owned securities. It is likely that Messrs. Friedman and Hayek believe most regulation is SOX-like. I do not. Some regulation is good; some bad. It’s all case by case.
The goals desired by economists ought to be more balanced than they appear to be. Monetary and fiscal authorities seem focused only on maximizing periodic Gross Domestic Product (GDP) while avoiding rampant inflation or deflation. I think their goals ought to be broadened and encompass the following:
- Maximize periodic GDP within the context of controlling inflation and deflation, while keeping the principal sectors of the economy creditworthy. Certainly in recent years, the creditworthiness of governments and consumers has deteriorated.
- Maximize periodic GDP within the context of controlling inflation and deflation while providing safety nets for the poorest 25%-33% of the population.
- Maximize periodic GDP within the context of controlling inflation and deflation while enhancing long-term growth of the GDP. In the 21st Century, it seems obvious that long-term growth cannot be enhanced without emphasis on the education and training of the population.
I am no fan of Milton Friedman simply because he seems not to understand the many limitations that have to be placed on free markets if an economy is to function well. Yet, I found his ideas ever so useful when I recently testified about SOX before the SEC Committee on Smaller Public Companies. I recommended to the Committee that small issuers (and also foreign domiciled issuers) be exempt from SOX, provided the issuers present comprehensive disclosures in SEC filed documents, and/or other publicly available documents, about the disadvantages and risks investors would be taking if they chose to hold securities of companies that did not comport with SOX. Given this information, the free market would appraise the merits of SOX through adjusting the prices at which specific securities would sell. Maybe the securities of non-SOX compliers would sell at materially lower prices than the securities of SOX compliers; whether or not this would be the case would be determined in a free market whose participants are well informed. This is pure Friedmanesque-University of Chicago type thinking. I also recommended to the Committee that legislation ought to be enacted under which foreign domiciled issuers could be sued for alleged violations of securities laws only in their home jurisdiction, provided such issuers fully disclosed to investors the disadvantages and risks to such investors of not being protected by U.S. regulation and U.S. class action lawsuits. In fostering these proposals, I am really proposing compromising investor protection in order to enhance the growth prospects for U.S. capital markets, especially against the background that repeal of SOX seems to be a non-starter. Admittedly, it is also true that the adoption of these two proposals would be beneficial to many of the companies whose common stocks are held in the TAVF portfolio. It would also be helpful to the Fund itself as a shareholder of many small companies and many foreign domiciled issuers. For TAVF, it is a real disadvantage that so many of the foreign securities it holds are not traded at all in U.S. markets.
 Based upon long-term performance of the Cambridge Associates LLC U.S. Private Equity Index®