38 Third Avenue vs. Graham and Dodd

APRIL 1996

In past letters, I’ve contrasted the Third Avenue Value Fund (TAVF) approach with that of academic finance. In this letter, I thought it might be useful for TAVF shareholders if I compared the TAVF approach with that followed by those involved with more traditional fundamental analysis.

Graham and Dodd Revisted

The Graham & Dodd book, Security Analysis, is widely recognized as the bible of fundamental analysis. The funny thing about the book, though, is that very few people seem to ever have actually read it.

Graham & Dodd (G&D) in their approach have a number of things in common with the TAVF approach. Both focus on long-term fundamentals and reject all chartist-technical approaches whether promulgated by practitioners or academics involved with efficient markets and efficient portfolios. Both G&D and TAVF have long-term investment strategies but pretty much ignore trading strategies (the newest edition of G&D, however, has a chapter on speculating on short run changes in interest rates and the TAVF approach in this area has been used by TAVF in its sometimes forays into risk arbitrage). Both G&D and TAVF reject heavy emphasis on short-run operating results in analyzing companies and, when it comes to financial accounting, both believe that what the numbers mean tends to be far more important than what the numbers are reported to be most of the time.

Yet, the TAVF fundamental analysis is, by and large, different than the G&D fundamental analysis. G&D essentially is analyzing from the point of view of a minority holder of marketable securities seeking high dividends and capital appreciation. TAVF is essentially analyzing from the points of view of the company itself, and/or senior creditors and control shareholders, present and potential. There seem to be four basic areas of difference between G&D and TAVF:

  1. The G&D objective is to estimate prices at which securities will sell in markets populated by Outside Passive Minority Investors (OPMIs); TAVF focuses on what a business could be worth as a private entity or takeover candidate. G&D attempts to guard against market risk. TAVF attempts to guard against investment risk and ignores market risk rather completely.
  2. The G&D credit analysis of debt instruments is involved solely with estimating the probabilities of money defaults; the TAVF credit analysis of debt instruments focuses on estimating what values are likely to be realized by a creditor in a reorganization or liquidation assuming that a money default does occur.
  3. G&D believe that macro factors are crucial to the analysis of a corporate security (for example, “the economic forecast or a earnings estimate for the Standard & Poor’s 500 or other broad index; and Sector and industry earnings forecasts”). TAVF believes such macro factors are irrelevant.
  4. In common stock analysis G&D subscribes to a primacy of the income account theory — analysis starts with an examination of the past earnings record, and future returns to stockholders will be measured in part by future operating performance and in part by having acquired a security at a price below “central value,” where “central value” is essentially a function of general stock market statistics. For TAVF, there is a primacy of the quality and quantity of resources existing in a business at the time of analysis, and future returns to stockholders will be measured in part by any number of possible scenarios, including future operating performance, mergers and acquisitions, refinancings on ultra-attractive terms, spin-offs, divestitures and going-privates; and in part by having acquired a security at a price below a private business or takeover value.

Market Risk Vs. Investment Risk

On Page 441 of the 1988 edition of G&D, there is this remarkable statement,

“Clearly, the bond contract is inherently unattractive. In exchange for limited rights to share in future earning power, the bondholder obtains a prior claim on cash generated by the borrower and a definite promise of repayment at a stated date. Profitable growth will bring confidence to the investor but no material increase in return. The deterioration of profitability, however, will bring both anxiety and a downward market valuation of the issue.”

Why wouldn’t a downward deterioration in profitability bring even greater anxiety and even greater downward market valuation to the holders of that company’s common stock issue? As a matter of fact, if the bond is adequately secured or otherwise well-covenanted, no money defaults might occur, and the bondholder would feel no anxiety about his holding regardless of market price. The sophisticated bondholder would probably conclude that he was incapable of predicting bond prices in OPMI markets for lower-rated issues to begin with; TAVF would certainly so conclude.

G&D are probably right that there is a lot of OPMI market risk in holding the bonds of debtors experiencing a downward deterioration in profitability. However, TAVF finds that great investment opportunities are created when market risk is ignored and investment risk is examined and guarded against. Assuming good covenant protections, isn’t the bond form inherently attractive when purchases occur subsequent to a downward market valuation caused by anxiety and a downward deterioration in profitability?

Were TAVF unwilling to ignore market risk it never would have acquired, among others, Forest City Enterprises Common in 1991, Inverse Floaters in 1994 and Kmart Debentures in 1995. The investment analyses by TAVF were that Forest City Enterprises has unlimited staying power and an ability to continue to create valuable real estate; Forest City Enterprises Common might be a “home run” by 1997 or 1999 or whenever the real estate depression ends; Inverse Floaters were priced so that a reasonably attractive yield to maturity could be achieved on a reasonable “worst case basis” through owning government agency guaranteed instruments; it seemed likely that an above-average long-term return would be earned on Kmart Debentures whether the instruments were performing loans or participating creditors in a Kmart Chapter 11.

I single out Forest City Enterprises, Inverse Floaters and Kmart because at the time of purchase I thought each issue had huge market risk. It would have been utterly unreasonable to conclude that these issues were being acquired at prices that represented a bottom or even anything close to a bottom because, in each case, the OPMI consensus, which could have proved right, was that the near-term outlooks were horrible.

Credit Analysis

G&D state on page 242 of the 1988 edition, “Safety is measured by the issuer’s ability to meet all its obligations under adverse economic and financial conditions, not by contractual terms of the specific issue.”  Also it is stated on page 447, “. . . if a company is creditworthy, the investor should buy the higher yielding issue, which would be the junior or subordinated obligation.”   There might be something to buying the junior issue, if the analyst is in a position to determine that a creditworthy company will continue to remain creditworthy until after the bond owned matures. TAVF is just not that good at predicting future corporate outlooks — not even close. Further, many companies, if not most companies, issue junior debt and preferred obligations, i.e., mezzanine securities, because of senior lender requirements that the businesses have expanded borrowing bases. Put otherwise, if these companies were so creditworthy to begin with they never would have issued mezzanine securities in the first place.

In any event, TAVF is covenant driven, the exact opposite of G&D. About $14 million principal amount of Eljer Industries Secured Bank Debt has been held in the TAVF portfolio for several years as a performing loan. A principal subsidiary of Eljer, US Brass, is in Chapter 11 and it remains theoretically possible that a huge amount of product liability claims will be perfected against Eljer. If so, those claims should become unsecured obligations, junior to Eljer Bank Debt. Overall coverage for Eljer obligations could conceivably become quite weak; further, there might even be some market risk in holding Eljer Bank Debt. However, I still have not figured out what the credit risk in holding Eljer Bank Debt might be for TAVF.

Macro Factors

G&D are very involved with macro factors. As is stated on page 9 of the 1988 edition, “. . . the profitability of all business enterprises and the market value of their shares are to some degree affected by (or conditional on) external factors — principally the economy and the stock market.” On page 14 G&D state, “A competent analyst should be sufficiently familiar with important price patterns of the securities markets to draw intelligent conclusions about probable price movements of different types of securities issues.” And on page 52 there appears the following statement, “Economic forecasts provide essential underpinning for stock and bond market, industry, and company projections.”

TAVF believes that, at least for the U.S. Economy, spending a lot of time on macro factors, whether for the overall economy or for securities markets, e.g., the S&P 500, is not only a waste of time but also a refuge for articulate incompetents who are untrained in any aspect of corporate analysis, but can sound intelligent by making predictions about things that are unpredictable. In terms of the general business cycle relationship to the TAVF portfolio, it seems obvious that it will affect directly, and be affected by, the demand for automobiles and heavy duty trucks. As such, Ford Motor and Cummins Engine earnings ought to be influenced by factors such as the Gross Domestic Product (GDP) and the general level of interest rates on a year-to-year basis. However, it is hard for me to figure out what the effect of such “big picture” items ought to be on the rest of the portfolio, positive or negative — credit instruments with strong covenants; the common stocks of very well-financed companies engaged in funds management and insurance; depository institutions; real estate companies; credit enhancers; high-tech manufacturers; medical suppliers; and food purveyors. Some of the issues owned by TAVF might be hurt by “bad times”; some ought to be helped given that they tend to be a lot stronger financially than their direct competitors. Suppose there is rampant inflation. Some issuers owned by TAVF might be hurt because the cost to replace existing assets as they depreciate might skyrocket; others might be helped because the cost of entry into the industry will go up precluding new competition from coming in; further, prices paid to acquire control of certain companies in the TAVF portfolio might increase dramatically.

One reason, but far from the only reason, that TAVF ignores factoring into its investment decisions any views about general economic outlooks, about stock market outlooks, and about interest rate outlooks, is that we are no good at making such predictions and we have never run into anybody who is. Furthermore, we are buy-and-hold investors who are prepared to average down as long as the company in which we have invested continues to appear to be solid. Continuing to appear to be solid is a function of corporate analysis, not market prices. Since we are likely to hold the securities of good companies over their business cycles, and we know that we will rarely, if ever, buy at, or near, a low, why should TAVF be hung up today on attempting to gauge for 1996 and 1997, the levels of inflation, the GDP, the S&P 500 and interest rates?

From the TAVF point of view, securities bargains are created much more by past corporate prosperity than by bear markets. Value is a dynamic concept ever changing, and if TAVF is putting the right issues in its common stock portfolio, ever increasing. For example, SunAmerica, Capital Southwest, Zygo, Raymond James Financial, St. Jude Medical and MBIA Inc. are far more valuable properties today because of their corporate achievements than they were when TAVF first acquired their common stocks. Assume that each of those companies are to have very disappointing operations in 1996 and 1997. Each would still remain far more valuable than when TAVF acquired their common stocks — their ultra-high PE ratios for 1996 and 1997 notwithstanding — provided, of course, that each continues to enjoy exceptionally strong financial positions.

TAVF invests on the basis that there has been a fundamental change in the business cycle since the end of World War II. It is not that industries no longer have depressions that are as bad as anything experienced in the 1930’s; but it is that such depressions seem to have little, or no, domino effect. There has been a plethora of severe industry depressions in the last 20 years: energy, automobiles, steel, aluminum, row crops, real estate, retail, savings and loan, and commercial banks. These depressions tend to result in the creation of attractive buy-and-hold opportunities for fundamental investors with a long-term point of view regardless of the levels of the general market as measured by popular indices.

Only infrequently over the years has general market performance been of such overwhelming significance as to overshadow the performance of specific corporations whose common stocks are held in the portfolios of fundamentalist buy-and-hold investors who have staying power. Changes in general market levels became of paramount importance, I suppose, in 1929, 1933, 1937, 1974 and, maybe, 1962 and 1987. These occurrences are just not frequent enough so that fundamentalists ought to worry much about them, even assuming the fundamentalists had useful tools for predicting the timing and severity of draconian bear markets.

I’ve said in previous letters that TAVF ought to do okay for its shareholders as long as the U.S., or wherever TAVF invests, enjoys political stability and an absence of physical violence in the streets; and TAVF avoids investing substantial funds into outright clinkers. None of these three things seem to me to be “slam-dunks,” especially the third one, avoiding clinkers. As to avoiding material clinkers, it’s been achieved over the first five years of TAVF’s existence. TAVF will continue to stick to its discipline but, believe me, there can’t be any guarantees. Corporate futures are just too unpredictable.

In terms of meeting the needs of the TAVF shareholder constituency, analyzing our securities as long-term buy-and-holds seems appropriate for those of us, myself included, who have long-term objectives such as retirements, college educations for children, meeting pension fund obligations, etc. If an investor needs near-term performance, or a fund that will outperform an index or peer group consistently, TAVF is not for him or her.

Micro Factors

The underlying G&D assumption is that a company ought to be viewed as a stand-alone going concern that is going to continue to operate in the future in the same industry as it has in the past. The rewards to the holders of common stock will come from the sale in a public marketplace of the common shares of a business which has increased its earning power and distributable income. Insofar as the common stock was acquired at prices below a “central value,” the greater the profit to be realized. Against this stand-alone, going concern background, it is thoroughly understandable that G&D adopt the position that the past earnings record is the starting point for the analysis of an equity security. As G&D state on page 533, “The concept of earning power has a definite and important place in investment theory. It combines a history of actual earnings performance over a period of years with a reasonable expectation that the past level or trend will be approximated unless extraordinary conditions supervene. This performance may be measured in terms of either 1) the earnings per share of common stock or 2) the rate of return earned on the common stock equity.” Also the following statement appears on page 595, “In 1962 we stated, ‘The basic fact is that except in certain limited parts of the common stock universe, asset values are virtually ignored in the stock market.’ Since then there has been a modest shift toward greater use. The rash of mergers and acquisitions has focused attention on asset values, particularly when a portion of the acquired company may be sold off.”

Further, the purpose of the G&D fundamental analysis is to make a judgment about what future prices are likely to be in an OPMI trading market. At any time, and for most issues, G&D have correctly observed that for the stand-alone going concern, the market price of its common stock is likely to be influenced much more by current earnings than by current book value. As is stated on page 597, “The asset factor is a primary consideration in valuing most privately owned businesses. This procedure is not followed for publicly traded, marketable common stocks.” Thus the G&D emphasis on the primacy of the income account is also understandable.

The TAVF approach turns G&D on its head. TAVF does not think of the companies in which it invests as merely stand-alone going concerns. Given any three-to-five year period, TAVF believes that for most companies whose common stocks are in its portfolio, to use G&D language, “extraordinary conditions are bound to supervene.” These extraordinary conditions, or conversion events, encompass mergers and acquisitions, hostile take-overs, massive refinancings, divestitures, spin-offs, refinancings, accessing public or private markets at ultra-attractive prices and going privates. I think the evidence is overwhelming that few, if any, companies remain stand-alone going concerns for protracted periods. This used to be true for electric utilities but such no longer appears to be the case even in that industry. Against this background it is understandable that TAVF would focus first on the quality and quantity of resources in a business, a balance sheet approach, rather than on the earnings record, an income account approach. G&D appraises managements as operators of going concerns; TAVF appraises managements not only as operators of going concerns, but also as investors engaged in employing and redeploying assets and refinancing liabilities.

Also, TAVF does not look to OPMI markets for bailouts from its common stock investments. Rather, TAVF looks for premium prices out of future conversion events such as mergers, spin-offs, divestitures, recapitalizations and share repurchases, including Leveraged Buyouts (LBOs) accomplished via cash tender offers, exchange offers or merger transactions. If such conversion events are to be a long-term norm, it seems logical again that the TAVF approach should emphasize the quality and quantity of resources in a business rather than earnings.

G&D does not ignore asset values. TAVF does not ignore earnings or the earnings record. However, the relative weights assigned to earnings and assets in an analysis tend to be quite different as between G&D and TAVF.

In practical terms, the micro factors G&D concentrate on in most security analyses seem to encompass the following:

  • Earnings
  • Trend of earnings
  • Dividends
  • Industry identification
  • Return on equity
  • Comparative analysis vs. other industry participants.

In practical terms, the micro factors TAVF seems to concentrate on are similar to the variables LBO promoters concentrate on:

  • Ability to finance
  • Long­term outlook
  • Exit Strategies

TAVF is, of course, in a different position than an LBO buyer who can use corporate assets to help finance his purchase of control. TAVF also gets no control benefits from its passive investment. And TAVF cannot precipitate changes in returns on corporate assets by causing them to be used smarter or more aggressively. TAVF tries to compensate for this by buying much safer and much cheaper than would be the case for an LBO. In virtually every case, the common stocks of companies in which TAVF invests have extremely strong financial positions and TAVF, at the time of purchase, tries to pay no more than 50% of the price we think would be paid for the common stock were the company an LBO or merger candidate.

It ought to be noted too that many control buyers are at times a lot less divorced from the G&D micro standards than is TAVF. Insofar as a control person is looking at exit strategies that entail going public via an Initial Public Offering (IPO), the G&D considerations tend to be a lot more important than the TAVF considerations in both getting better pricing for the IPO, or getting the IPO off at all.

Obviously I think the TAVF methodology has many advantages over the G&D methodology. Two advantages come immediately to mind. First, it’s a lot less competitive; there are any number of smart analysts focused on earnings. Not too many seem to care about balance sheets. Second, I’m convinced that those of us who focus on the quality of resources existing in a business are a lot less subject to truly unpleasant surprises than are those whose primary emphases are elsewhere.


Dear Fellow Shareholders... Copyright © 2016 by Martin J. Whitman. All Rights Reserved.

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