The Third Avenue Value Investment Philosophy
It ought to be constructive for shareholders if I explain the Fund’s investment approach in some detail, describing both what Third Avenue Value Fund (TAVF) does and does not do. While I refer to myself in the narrative below as the Fund’s manager, it is important to remember that I function as manager under the supervision and direction of TAVF’s skilled and dedicated Board of Directors. Our investment philosophy encompasses two disciplines; one used in acquiring and holding credit instruments, and one used in acquiring and holding common stocks. Since Foster Brewing (Canada) and Reading & Bates matured, TAVF has been basically a common stock fund. At October 31, 1992, the portfolio broke down as follows:
|Asset||% of Total Assets|
|Cash and Equivalents||26.7%|
|Common Stocks and Equivalents||63.0%|
By the end of calendar 1992, the percentage of Fund assets in cash and equivalents is likely to be reduced materially because of several buying programs currently under way, both for credit instruments and common stocks. Credit instruments acquired by TAVF are strictly performing loans which I believe will continue to be performing, though one can never know for certain. The Fund tries to restrict such purchases to securities which afford a current yield, or a yield to maturity, at least 500 basis points above what comparable credits are selling for in the general market. Moreover, such instruments have to have strong covenant protections so that in the event of a money default TAVF will realize a profit, or at least not suffer any loss, on its investment in the consequent workout. The two credits held by the Fund — US Trails 12% Senior Notes due 1998 and Olympia & York Maiden Lane Finance Corp. 10 3/8% First Mortgage due 1995 — both benefit from having a first lien on underlying assets. To us, credit analysis is not so much a process of measuring the probabilities of whether money defaults will or will not occur, but rather measuring how the creditor will fare in a reorganization or liquidation if a money default does occur.
In acquiring common stocks, TAVF focuses on four characteristics:
- The issuer has to have a strong financial position measured not only by balance sheet data but also measured by off balance sheet liabilities and contingencies, whether or not disclosed in footnotes to financial statements.
- The issuer should be run by reasonable control groups and managements, as gauged by managerial competence as operators and investors, as well as by an apparent absence of intent to profit at the expense of stockholders.
- The business has to be one I understand, which generally means that the numbers reported (which are usually in accordance with Generally Accepted Accounting Principles) have to be reliable as objective benchmarks to aid in my understanding the business, its values and its dynamics.
- The price the Fund pays for a common stock ought to be no more than one-half of what I believe the issuer is worth as a private company.
TAVF is a buy-and-hold investor. The businesses in which the Fund invests, whether as a creditor or equity participant, are characterized by staying power. Fluctuations in market prices for securities tend to be ignored. General market, as distinct from fundamental, factors are always ignored. One reason is that the “market” tends to emphasize different things than TAVF does. For example, most analysts in research departments appear to be interested in current earnings and short-term earnings forecasts (this is especially true for computer stocks such as Apple Computer and Digital Equipment). TAVF is interested in long-term basic earning power. Another reason is that the Fund’s investments tend to grow out of intensive research. If I do not believe that I know much more than the “market” about a particular investment, the Fund ought not to be in that investment.
Our policy for selling positions held by TAVF has a number of components. First and foremost, the Fund sells promptly when I find a mistake has been made either because the future is unpredictable or the analysis that preceded the investment was faulty. However, the validity of an analysis ought to be gauged by events within the business, not by market price fluctuations. The Fund will also sell if I believe a security reaches prices that result in a gross overvaluation. Modest overvaluation is not a reason to sell, especially if the Fund continues to grow so that it always has new moneys to invest. I find that the TAVF type of analysis is much better suited to identifying attractive securities, then it is to identifying overvalued securities. I suppose this is so because there is a concentration on worst case scenarios in a TAVF type analysis rather than measuring realistic upside potentials. My guess would be that most of the Fund’s “sells” over time will come from situations working out, i.e., credit instruments maturing or portfolio companies becoming involved in asset conversion events such as mergers, acquisitions, restructurings and liquidations. For example, since the end of the October quarter, National Loan Bank announced an intent to wind up its liquidation by early 1993. Using management’s current estimates of likely realizations, the compound annual return to TAVF from this investment, based on its cost, should be not less than 20%.
Another principal reason why “sell” decision making is so tough is that corporate values are anything but static. Reasonably managed businesses which are reasonably well-financed, almost by definition, increase in value over long periods of time as the businesses progress. Insofar as this is so, bargains are created more by past corporate prosperity than by bear markets. The Fund’s position in Capital Southwest common stock, for example, has appreciated by about 27% since the Fund acquired its position. Yet Capital Southwest common stock is selling at the same, or a greater, discount from net asset value than existed when TAVF acquired its position. A well-defined sell strategy makes sense, theoretically, for money managers who: a) are trying to maximize profits; and b) are trying to outperform the market. I don’t try to maximize profits, but rather try to do “good enough”; and I definitely do not try to outperform the market.
The managements of many of the companies in which TAVF invests are ultraconservative — that’s where those huge cash positions come from in the first place. In many instances, I believe these managements are overly conservative. Also, many, if not most, of the managements and control groups of the Fund’s portfolio companies could not care less about the price of the common stocks of the companies they run. By virtue of their balance sheets, these are not companies seeking access to capital markets, nor are their principal owners seeking to sell out.
In some cases, insiders may have a strong incentive to keep the price of the common stock low. Principal owners of Forest City Enterprises, for example, may be faced with inheritance taxes. If so, it would be advantageous for them to have Forest City common stock valued, for estate tax purposes, at market on the American Stock Exchange at $17 per share; rather than at the values management and their real estate appraisers believe exist, a minimum of $80 per share, at January 31, 1992. In other cases, e.g., Dart Group and Penn Central, controlling owners have had transactions with the companies which, while they might meet tests of fairness, were not, by definition, arm’s length. Overall, though, I do not think that the managements running the TAVF portfolio companies compare unfavorably with the managements of public companies in general. In any event, I certainly prefer overly conservative managements to overly promotional managements. Because of various state laws and court decisions over the past 10 or 15 years, managements in general now have, in my view, considerably less incentive to foster the interests of outside, passive minority stockholders, than had been the case previously.
Large cash positions are more than a source of safety for companies, they are also a source of investment income. TAVF’s portfolio companies are cash-rich. However, earnings on that cash are now at a low point. Frankly, cash, as an earning asset, is now less attractive than it has been at any time in the last 40 years.
The Fund acquires all sorts of securities that meet its criteria. Some are actively traded issues of large companies — such as Apple Computer, Digital Equipment, Kemper Corp., Penn Central. Others are “penny stocks” — including First Constitution Financial Corp. and National Loan Bank. And others are hardly marketable at all within twenty-four hours — for example, Capital Southwest, Liberty Homes, Consolidated Tomoka Land, NAB Asset Corp., Public Storage Properties, and Dart Group, even though I believe each of the positions could be liquidated at around current market in seven days. These relatively unmarketable issues are what I call “Roach Motel” securities. It is easy to check in (buy), but you can’t check out (sell) on a day-to-day basis. It is very important in acquiring “Roach Motel” positions that the fundamental analysis be sound if draconian downsides are to be avoided.
TAVF does not pay much attention to diversification, other than to comport with regulatory and income tax requirements so that the Fund can qualify as a registered investment company under Subchapter M of the Internal Revenue Code and not be a taxable entity. Put simply, diversification is only a surrogate, and frequently a poor surrogate, for knowledge and control. Lacking control, unlike for example promoters of leveraged buyouts, common sense dictates that the Fund diversify to some extent. On the other hand, since our investments are based on specific knowledge, there is far less need to diversify than is the case for most mutual funds, especially those that are top-down investors using factors such as industry or country identification, indexes or market timing systems as a basis for investment decisions.
Also, in the Fund’s type of investing, identifying particular industries is something we underweight compared with the typical portfolio manager. Given TAVF’s investment criteria, it is more accurate to view the situation as the industry selecting the Fund, rather than TAVF choosing the industries in which to invest. One way of looking at the Fund’s industry selections is to observe that at October 31, 1992, TAVF was concentrated in the common stocks of financial institutions, real estate enterprises and computer companies. Such industry concentrations did not occur because of conscious forethought. Rather, this is where the Fund was able to acquire at attractive prices the securities of companies which appear to have substantial staying power and substantial long-term earning power.
TAVF’s analyses concentrate strictly on “what is” in terms of understanding a company and its securities. In contrast, most other analysts give considerable weight to attempting to fathom “what the market thinks,” best described by John Maynard Keynes as gauging “the average opinion of the average opinion.” There is an economic reality to these “average opinion” searches from a company point of view, since, if a company needs periodic access to capital markets, whether credit markets or equity markets, then what the market thinks has a lot to do with whether, or not, a company and its security holders will prosper. In the case of the Fund, though, a need for access to capital markets for the companies whose common stocks are in the portfolio is virtually nonexistent. The companies in which TAVF has common stock investments are largely self-financing, net cash generators. This leaves me free to concentrate on “what is.”
TAVF pays no attention to macro factors such as stock market levels, general interest rates, and business cycles: the various top-down factors on which most analysts concentrate. I, like almost all others, am not very good at predicting macro factors. Furthermore, such factors historically have not been of overriding importance to dedicated investors — and business people concentrating on a bottomup approach. It’s difficult to spend a lot of time learning the “nitty gritty” facts about an issuer and its securities; on the other hand, it’s easy to have opinions about things like the outlook for the overall economy.
I am frequently asked to contrast the TAVF investment style with that of Graham & Dodd. There are similarities, but the differences are far more important. In terms of credit analysis, TAVF is covenant driven; Graham & Dodd is not covenant driven, but rather emphasizes quantitative analysis on an overall basis and seeks to avoid investing if there is any probability at all of a money default. In equity investing, Graham & Dodd concentrates on postulating a series of good caveats to follow if you really do not know much about the company in which you are investing. TAVF, on the other hand, concentrates on knowing much. One practical area where this shows up is the assessment of the importance of common stock cash dividends. Graham & Dodd view cash dividends as highly important. TAVF ordinarily ignores cash dividends as an investment consideration, and when it does consider them, the existence of a cash dividend is much more likely to be viewed as a negative, rather than a positive factor.
Academic finance, too, is relatively unimportant to TAVF. Put simply, modern finance theory is valuable in dealing with situations such as derivative securities, and merger arbitrage where there are a limited number of variables to be examined. The underlying assumptions of academic finance tend to be unrealistic or misleading when applied to the complex situations in which TAVF invests.
Timing of purchases is not a consideration in the TAVF scheme of things. If a security is cheap enough, it is acquired. Arguments might be made logically to elevate timing of purchases to an important consideration in making an investment decision about an individual security. Such arguments, though, have much less validity in the management of an entire portfolio. If the analysis of underlying values is correct, one or more of the issues in the Fund’s portfolio ought to be working-out periodically, say every six months or so; this ought to take care of any timing consideration.
TAVF views risk and reward quite differently than is conventional. The common view is that there is an elementary tradeoff: you have to take risks to obtain rewards. In the TAVF view, there is no such tradeoff but, rather, the cheaper you buy, the greater the reward and the cheaper you buy, the less the risk. In conventional thinking there are two components of the measure of degrees of speculation: quality of the issuer and terms of the issue. TAVF emphasizes a third consideration: price of the issue. Conventional wisdom assumes that securities prices at any moment of time are in equilibrium, i.e., the price is right. TAVF’s underlying assumption is that the price is wrong.
It probably is a mistake to talk about general risk. Rather the focus should be on specific risks — market risk, investment risk, interest rate risk, currency risk, etc. The Fund tends to take huge market risks in that no attention is paid to predicting near-term market prices. Indeed, I know from long experience when acquiring securities that no matter how low I think a price can go, it can, and usually does, go a lot lower. In contrast, TAVF goes to great lengths to try to avoid investment, risk, i.e., even using worst case scenarios the underlying values attributable to the securities in which TAVF invests ought to be greater than the Fund’s cost basis after allowing for a considerable dissipation of future values as events unfold.
In trying to avoid investment risks as a component of obtaining an increased upside potential, TAVF is like most active investors and business people. Most of the great fortunes probably have been built by activists who avoided risk. Activists avoid risks by getting paid off the top. In contrast, TAVF tries to avoid risks by buying cheap. Such risk avoiders include fund managers in managing their own businesses, who collect cash fees off the top; LBO promoters, who, by arranging attractive senior financing, get cheap, or free, common stock (plus cash fees); and by real estate entrepreneurs, who arrange nonrecourse mortgage financing. In contrast, TAVF tries to avoid risks by buying cheap.
I am also asked if TAVF acquires growth stocks or foreign issues. Sure we do, if the price is right. As a sort of topdown rule of thumb, TAVF looks at acquiring growth issues of unseasoned companies provided the price at which the common stock is available approximates the price that a first tier venture capitalist would pay. That price is almost always a small fraction of the Initial Public Offering price. No growth issues per se are in the TAVF portfolio at present. Foreign issues have to meet our basic criteria. As a practical matter, this means the particular issue has to be registered with the U.S. Securities and Exchange Commission. TAVF has no foreign issues in its portfolio at present, unless one deems Digital Equipment, well over half of whose revenues are derived from offshore sources, to be a foreign issuer.
TAVF differs from many other very fine and capable value investors in that if I think a value is good enough without reference to other factors, the Fund will buy. In contrast, others want not only value, but also a catalyst, i.e., evidence that something is going to happen within a determined period of time. For example, the Fund holds a position in St. Joe Paper, a storehouse of value which holds, among other things, 3% of all the land acreage in the State of Florida. Others would rather not own St. Joe Paper until there is some tangible evidence that values will be realized for the benefit of St. Joe shareholders in the foreseeable future. The objective of the Fund is to earn a satisfactory return for its investors, say 20% compounded annually. Whether or not we outperform other funds or the general market is not of great moment. It might be noted that the insiders hold substantial investments in TAVF Common Stock. My family and I own 149,129 shares, or 6.4% of the shares outstanding at October 31, 1992. The Board of Directors and Officers of the Fund, together with my family, hold 176,774 shares or 7.6% of the outstanding issue.