48 Value Investing

This year, I led seminars on value investing at the Schools of Management at both Syracuse University and Yale University. At the first session of the seminar programs, I contrasted the underlying assumptions pervading value investing with the underlying assumptions that seem to govern both academic finance and conventional research department analyses. Hopefully, it will be useful for Third Avenue Value Fund (TAVF) shareholders if I share with them what I said at these first sessions, as well as how I believe the Fund’s investment approach comports with a number of the underlying assumptions.

Academic and research department concepts that are part and parcel of value investing revolve around Net Present Value (NPV) and Present Value (PV). NPV is pervasive in value analysis and is used much more broadly than merely measuring Discounted Cash Flows (DCF). In Value Investing one tends to PV everything: asset values, liabilities, earnings, EBITDA, expenses; often converting fixed expenses into liabilities; and assured earnings and cash flows into asset values. For example, see the table below “Closed End Fund X.” An above normal expense ratio (4% rather than 1.5%) is capitalized as a liability and the present value of the excess is deducted from Closed End Fund X’s NAV. For value purposes Closed End Fund X’s common stock is deemed to be selling at a 6.7% premium over NAV, even though based strictly on Generally Accepted Accounting Principles (GAAP), it appears to be selling at a 20% discount from NAV.

Closed End Fund X
NAV $100,000,000
# shares outstanding 10,000,000 Shares
NAV Per Share $10
Annual Operating Expenses $4,000,000
Expense Ratio 4%(a)
Market Price of Common $8
Market Price as Discount from NAV — as reported under GAAP (20%) Adjust NAV to exclude Expense Ratio in excess of 1.5%
from NAV $2,500,000 capitalized at 10% $25,000,000
Adjusted NAV $75,000,000
Adjusted NAV — Premium over market price 6.70%

(a) TAVF expense ratio was 1.12% for fiscal 2004

37 Underlying Assumptions of Value Investing

Organized Under Five Titles:

  • Efficient Market Hypothesis (EMH)
  • Efficient Portfolio Theory (EPT)
  • Disclosure and GAAP
  • Economics and Markets
  • Security Analysis

Efficient Market Hypothesis

1.  The General Theory of Market Efficiency Some markets will tend toward instantaneous efficiency. Some markets will tend toward long term efficiency but rarely achieve it. Some markets are inherently inefficient. Which market exists is a function of four variables:

Who the market participant is
ii. How complex is the security, or the situation, being analyzed
iii. What are the time horizons of the participants
iv. How strong are the external forces imposing disciplines on a market:

a) Government external forces;
b) Private sector external forces.

In markets where instantaneous efficiencies exist, participants do not earn excess returns. In other markets, earning excess returns is to be expected. TAVF, a buy-and-hold cash investor, tends to invest in complex securities where the work-­out horizon is five years, or more. As such, the Fund operates in markets that rarely approach instantaneous efficiency.

2.  Financial markets almost never approach instantaneous efficiency unless they are strictly regulated.

3.  A market is defined as any financial, or commercial, arena where participants reach agreements as to price, and other terms, which each participant believes is the best reasonably achievable under the circumstances.

Efficient Portfolio Theory

4.  Diversification is a surrogate, and usually a damn poor surrogate, for knowledge, control and price consciousness. At April 30, 2005, the Fund had 104 common stock positions and the top ten issues accounted for approximately 40% of TAVF’s portfolio. Most mutual funds of similar size seem to hold 300 to 400 positions.

5. The objective of some securities holders is total return; others emphasize cash return; and some holders seek elements of both. TAVF is strictly total return conscious in its common stock investing. However, much of Third Avenue’s investments in credit instruments is cash return driven.

6.  Portfolio analysis differs from individual securities analysis. For portfolios, there is no such thing as a value trap.

Disclosure and GAAP

7.  GAAP provide objective benchmarks, not truth, except in several special cases. For example, see Toyota Industries (“Industries”). Over half of Industries’ assets at market prices are in a portfolio of marketable securities, principally Toyota Motor Common. For GAAP purposes, Industries reports only dividends and interest received from portfolio companies. On this basis, Industries Common is selling at around 22 times earnings. If Industries’ income account is adjusted to include Industries’ equity in the undistributed earnings of portfolio companies, Industries Common is selling at less than eight times earnings. GAAP for Industries is a good first approximation of periodic cash flow. Picking up the equity in undistributed earnings of portfolio companies is a good first approximation of Industries’ periodic wealth creation.

8.  Every GAAP number is derived from, modified by, and a function of, other GAAP numbers.

9.  Documentary disclosures to creditors and investors have never been better, or more complete, than they are now, at least in the U.S. Some of the credit for this goes to the Plaintiffs’ Bar.

10.  In value investing and control investing, what the numbers mean tend to be much more important than what the numbers are.

11.  GAAP are more useful insofar as this accounting system is designed to meet the needs of long-term creditors rather than stock market speculators. Fund management basically analyzes all securities, including common stocks, as if the securities were long-term debt instruments.

Economics and Markets

12.  The concept of risk is not useful unless a modifying adjective precedes the word “risk.” Market risk — fluctuations in securities prices — is a different animal from investment risk — changes affecting a business’ operations or investments. Other risks include commodity risk, terrorism risk, credit risk, failure to match maturities risk, weather risk, reorganization risk. See the contrast discussed above under cash management between credit risk on the one hand and capital risk on the other.

13.  Once instantaneous efficiency is not present, measuring investment risk and market risk involve three factors:

i.  Quality of the issuer
ii.  Terms of the issue
iii.  Price of the issue

Assuming price equilibrium, there is no need to factor in price of issue. If one factors in price, the lower the price the less the risk of loss and the more the potential for gain. When factoring in price, no risk/reward trade-off exists. Fund management is first safety conscious, and then, price conscious.

14.  The basic interest of most market participants is wealth creation, an asset value concept, not DCF. DCF is just one method of creating wealth, and frequently a method that carries tax disadvantages. Over 80% of TAVF’s common stock portfolio consists of securities, which were acquired at prices well below estimates of readily ascertainable NAVs. Current and immediately prospective Price Earnings Ratios are either downplayed in a TAVF analysis or completely ignored.

15.  Debts — whether incurred in the private sector or by governments — are usually never repaid. Rather they are refinanced by those wealth-creating entities which are able to remain creditworthy. The Fund sells common stocks immediately when the businesses no longer appear to be creditworthy. To Fund management, this spells a permanent impairment.

16.  There is a long-term arbitrage between business value and common stock prices:

Common stock prices high relative to business value — Go Public
Common stock prices low relative to business value — Go Private, or semi­private

17.  Assets can have an in-use value separate and apart from any market value.

18.  Fairness in financial dealings is that price, and other terms, that would be arrived at in a transaction between a willing buyer and a willing seller, both with knowledge of the relevant facts, and neither under any compulsion to act. In a going private situation, one is faced with a willing buyer (who frequently is also a fiduciary)–coerced seller situation. Fairness opinions are then used, and should be based on simulating the prices and other terms that would have existed were there actually a willing buyer-willing seller situation. TAVF, and its sister funds, complain loudly and/or take other actions when we become a forced seller at prices we think constitute a “takeunder” rather than a “takeover.”

19.  You can’t understand corporate finance if all you do is look at corporations and securities wholly, or mostly, from the point of view of common stockholders who are Outside Passive Minority Investors (OPMIs). To understand corporate finance, you have to be cognizant of the interests and beliefs of other important constituencies — Managements, Creditors, Promoters, Underwriters, Governments.

20.  Assuming relative political stability and an absence of violence in the streets, macro factors tend to be unimportant for value investing. The Fund’s satisfactory investment experience after 1997 in Japanese non-life insurance common stocks is a good example of this. At the time these investments were made, Fund management had no idea that the Japanese business depression would turn out to be as deep and protracted as it was, and that interest rates would stay so low for so long.

21.  Any and all resource conversion activities (e.g., mergers and acquisitions, initial public offerings, restructuring troubled companies, refinancings) involve huge costs payable to investment bankers, brokers, lawyers, accountants, lenders, and promoters. This is something Fund management has to consider for most of its investments. This expense problem seems exacerbated for small-cap companies.

22.  There exist strong Wall Street pressures to have periodic IPO booms:

i. Huge gross spreads
ii. Exclusive Product
iii. Easy Sell

23.  Passive investment products tend to be sold by salesmen, rather than bought by investors.

24.  The markets for top management compensation and top management entrenchment tend to be inefficient. Therefore, top managements, as a group and individually, earn excess returns. This, too, is a factor in Fund management’s decision making.

25.  All financial relationships combine communities of interest and conflicts of interest. Agency costs are a non-starter.

26.  In the financial world it tends to be misleading to state, “There Is No Free Lunch.” Rather the more meaningful comment is, “Somebody Has To Pay For Lunch.”

Security Analysis

27.  Substantive Consolidation of the interests of the Company itself and its OPMI stockholders is a relatively rare special case. The Company is the Company. The Company is not the management. The Company is not its stockholders. All TAVF analyses treat the company as a stand-alone. For example, Fund management recognizes that stock options are a stockholder problem, and only rarely, a company problem.

28.   The worth of any security is the present value of the future cash bailouts to be received by security holders. Cash bailouts come from three sources:

i. Cash Distributions by issuers in the forms of interest, principal, premium; dividends, and securities repurchases
ii. Sales to a market
iii. Control

29.  Passive securities, for most economic purposes, are a different commodity from control securities, albeit they are identical in legal form. From a TAVF point of view, if a passive security is to become a control security, the holder (hopefully Third Avenue) is entitled to a premium price.

30.  Outside of a Court Proceeding, usually Chapter 11, no one in the U.S. can take away a creditor’s right to a money payment for interest, principal, or premium unless that individual creditor so consents. A creditor has only contract rights, not residual rights.

31.  Equities represent ownership and only very rarely require cash service. Equity owners have residual rights vis-à-vis the company and its management; e.g., management has a duty to deal fairly with stockholders.

32.  In all transactions, consider the use of proceeds. Corporations can only use cash proceeds in four ways:

i. Pay expenses
ii. Expand the asset base
iii. Service and/or repay liabilities
iv. Distribute to equity via dividends and/or buy­backs

Distributions to equity are almost always a residual use of corporate cash. The principal exception is where the payment of dividends gives capital hungry companies better access to capital markets than they otherwise would have. (TAVF tends not to invest in the common stocks of such companies.) Excluding this consideration, buying in common stock is almost always a preferable method of distributing cash to shareholders from both a company point of view and a TAVF point of view compared with paying cash dividends. This tends not to be the case from the point of view of short run oriented OPMIs.

33.  In passive investing, decisions should be based more on a “reasonable worst” case basis than on a “base case” basis.

34.  Management appraisals involve looking at managements not only as operators but also as investors and financiers.

35.  Weighted Average Cost of Capital (WACC) is a non-starter for two reasons:

i. From a creditor’s point of view (and without getting into the issue of effective differences in cost between, say, short-term senior secured issues and long-term subordinates), the cost of creating corporate creditworthiness is very different in the case where the company issues debt securities which have a required cash cost on the one hand, and where the company issues equity securities which don’t require cash payments on the other hand.
ii.The vast majority of equity financing takes place via having the company retain earnings, rather than having the company market new issues of common stock. The PE ratio, or cap rate, at which a common stock sells in an OPMI market, has no particular meaning for a company in-creasing its equity base through retaining earnings. Here Return on Equity (ROE) gives a better estimate of the “cost” of equity capital to the company than does a cap rate measured in part by OPMI market prices, albeit many cash conscious managements and companies will view retaining earnings as a cost free method of increasing equity capital.

36.   The liability side of the balance sheet is a lot more than obligations and net worth. Rather, it is a layer cake consisting of at least the following:

i.  Secured obligations
ii.  Unsecured obligations
iii.  Subordinated obligations
iv.  Liability reserves which analytically have an equity component:

a.  Preferred Stocks
b.  Common Stocks
c.  Common Stock Derivatives

Whether an issue is debt or equity depends on where you sit. To senior lenders, subordinated debt is a form of equity. To common stockholders, subordinated debt is debt.

37.  Many disciplines can be helpful in contributing toward making one a successful value investor. There are three areas, though, where it is essential that the participant needs to be well informed, i.e., needs to be knowledgeable enough so that at the minimum, the analyst can be an informed client. These three disciplines are as follows:

2. Securities Laws and Regulation
3. Income Tax


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

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