Marty Whitman of Third Avenue Funds Third-Quarter Letter
GRAHAM AND DODD REVISED, UPDATED AND PLACED IN CONTEXT
Benjamin Graham and David Dodd (“G&D”) were prolific writers, publishing volumes in 1934, 1940, 1951, 1962 and by Ben Graham alone in 1971. A principal problem with G&D is that almost everyone in finance talks about G&D but very few seem to have actually read G&D. This letter is based essentially on the 1962 edition, Security Analysis Principles and Technique by Graham, Dodd and Cottle; and the 1971 edition of The Intelligent Investor by Graham.
Because so many have such a superficial understanding of G&D, their names have become synonymous with the term “value investing”. This, in turn, has led to some confusion about what it is that value investors do, particularly, the way that value investing in equities is practiced at Third Avenue Management (“TAM”). Though we are influenced by G&D, our methods, developed over the life of the firm, are basically different. Value Investing is one area of fundamental finance (“FF”). It involves investments in marketable securities by noncontrol outside passive minority investors (“OPMIs”). The other areas of Fundamental Finance involve the following:
• Distress Investing
• Control Investing
• Credit Analysis
• First and Second Stage Venture Capital Investments
Modern Capital Theory (“MCT”), like Value Investing, focuses on investments by OPMIs. Unlike Value Investors, MCT focuses strictly on near-term changes in market prices. In a number of special cases the factors important in MCT are also important in Value Investing. MCT is discussed briefly at the end of this paper.
G&D made three great contributions to Value Investing:
1) G&D distinguished between market price and intrinsic value (a concept that still seems alien to MCT). 2) G&D pioneered the concept of investing with a margin of safety. 3) G&D promulgated the belief that investment decisions ought to be based on ascertainable facts. (This was before the modern era – say after 1964, when for OPMIs the amount of factual material exploded and the reliability of factual materials became much enhanced).
The equity analysts at Third Avenue Management tend to follow the basic rule promulgated by G&D: acquire at attractive prices the common stocks issued by primary companies in their industries.
Both G&D and MCT focus on the investment process from the points of view of the OPMI. Little, or no, attention is paid to other points of view; and the particular factors needed to understand the dynamics driving individual companies, particular industries, control persons and putative control persons, as well as creditors. This emphasis on the OPMI is in sharp contrast to other areas of FF – control investing, distress investing and first and second stage Venture Capital. Here, the analysis does not focus on OPMI needs and decisions, but is rather a four-legged stool:
(1) Understanding the OPMI’s needs and desires.
(2) Understanding the company in some depth.
(3) Understanding the needs and desires of control persons and entities, present and future.
(4) Understanding the needs and desires of creditors.
Open-end funds, i.e., mutual funds (Investment Companies operating under the Investment Company Act of 1940 as amended), are required to operate mostly as OPMIs. Third Avenue, in the management of various portfolios is basically, but not wholly, an OPMI. But Third Avenue’s analytic techniques, unlike G&D’s, are the same as control investors, distress investors and creditors. The emphasis is on understanding in-depth, from the bottom up, the company and the securities it issues; and also the character and motivations of managements, other control entities, and others senior to the common stock, ranging from secured lending by commercial banks to trade creditors to holders of subordinated debentures to holders of preferred stocks. There is a de-emphasis on top-down factors emphasized by G&D and MCT – general stock market levels, near-term stock price movements, a primacy of the income account, a primacy of dividend income, quality or growth as defined by general recognition of such in the general market.
Many of the best value investors graduate into other areas of financial fundamentalism, especially control investing and distress investing. Names of such “graduates” which come to mind are Warren Buffet, Sam Zell, Carl Icahn, Bill Ackman and David Einhorn.
Analysts at TAM think like owners, like private acquirers or like creditors, emphasizing elements of FF that differentiate Third Avenue from G&D. For example, G&D emphasize the importance of dividends for OPMIs. In contrast, FFs look instead at the corporation optimizing its uses of cash. In general, corporate cash can be dispensed in three areas:
1) Expand assets
2) Reduce liabilities
3) Distribute to equity owners
(a) via dividends
(b) via stock buybacks
There are comparative advantages and disadvantages for dividends and buybacks, which are never discussed by G&D, because they only mention the stock buyback alternative as it relates to stock options for management.
There is no discussion by G&D of stock buybacks as a method of enhancing a common stock’s market price over the long run, giving the management the flexibility to retain cash in troubled times, and also increasing the percentage ownership interest of each non-selling stockholder.
From a corporate point of view, distributing cash to shareholders has to be a residual use of cash, compared to expanding assets or reducing liabilities most of the time. Probably the most important exception to this exists where the payments of common stock dividends in cash gives a corporation better long-term access to capital markets than would otherwise exist. This seems to be the case for companies which, by the nature of their operations, consume cash in order to create wealth and are required to raise outside equity capital periodically, e.g., integrated electric utilities and certain financial companies.
G&D in their analysis of common stocks emphasize the following factors:
1) Primacy of the income account – forecast future earnings relying heavily on the past earnings record; 2) Dividend distributions; 3) The general level of securities markets; 4) Outlook for the economy; 5) Industry identifications; 6) General market opinion as to the quality and/or growth prospects of an issuer.
In a G&D primacy of the income account approach (or any other primacy of the income account approach) managements are appraised almost solely as operators. For FF, managements are appraised using a three pronged approach: 1) Management as operators; 2) Management as investors; 3) Management as financiers;
In appraising managements as financiers, the emphasis is on a primacy of credit-worthiness for either the company or for various securities in the capital structure.
G&D agree that the securities of secondary companies and workout situations can be attractive for Enterprising OPMIs, whom they distinguish from Defensive OPMIs. However, very little is really voiced by G&D as to how secondary situations and workout situations ought to be analyzed, compared with their views on how to analyze the securities of primary companies, other than to state that secondary common stocks should not be acquired except at prices of two-thirds or less of underlying value.
G&D believe it is important to guard against market risk, i.e., fluctuations in security prices. Thus, it becomes important in their analysis to have views about general stock market levels. FF practitioners guard only against investment risk, i.e., the problems of companies and/or the securities they issue. In FF analysis, market risk is mostly ignored except when dealing with “sudden death” securities – derivatives and risk arbitrage securities; when dealing with portfolios financed by heavy borrowing; and when companies have to access capital markets, especially equity markets.
In the analysis of performing credits acquired at or near par, emphasis by G&D is on quantitative data relevant to overall interest coverage, rather than any emphasis on covenants and/or collateral. FF emphasizes covenants and collateral in credit analysis. No matter how favorable the quantitative data, e.g., coverage and debt ratios, FF practitioners examining most corporate credits assume that the quantitative facts are likely to deteriorate over the longterm life (say a five to 15-year life) of a debt instrument. Such an assumption creates a margin of safety for a creditor.
In valuing assets, G&D seem to rely strictly on a classified balance sheet produced according to Generally Accepted Accounting Principles (“GAAP”). Thus, inventory is viewed as a current asset and real property as a fixed asset. In FF, the analysis tends to get different results. In the case of a retail chain which is a going-concern, inventories usually are a fixed asset of the worst sort – subject to markdowns, shrinkage, obsolescence, misplacement. On the other hand Class A, fully-leased income-producing office buildings tend to be current assets, probably an area where price agreement can be reached via one phone call.
For FF, GAAP in the U.S. is an essential disclosure tool, the best objective benchmark available to the OPMI analyst in the vast majority of cases. However, GAAP and related accounting measures, unadjusted by the analyst, are almost always misleading, in one context or another.
G&D stress the importance of adjusting GAAP to determine “true earnings” for a period. In FF, the analyst always adjusts GAAP, not only to determine earnings from operations, but also to determine credit worthiness and asset values.
GAAP recognizes three classifications on the right hand side of the balance sheet: liabilities; redeemable preferred stock; and net worth. In economic fact, there are many liabilities that have an equity component. It is up to the analyst to decide what percentages of certain liabilities are close to equivalent to payables and what percentage are close to equivalent to net worth. Take the liability account, deferred income taxes payable, in a going concern. If the cash saved from deferring income taxes are invested in depreciable assets, the tax may never become payable. However, the deferred tax payable account can never be worth as much as tax paid retained earnings (part of net worth) because the tax may someday become payable, especially if the company engages in resource conversion activity, such as being acquired in a change of control transaction. So, maybe there is as much as a 90% equity value in the deferred income tax accounts payable. On the other hand, deferred income taxes payable can never be as much of a liability as current accounts payable or interest bearing debt. Maybe, at the maximum, there is a 5% to 10% equity in the deferred tax payable account. GAAP is based on a rigid set of rules; it is no longer principles based. The appraisal of an account, such as deferred income taxes payable, is in the province of the users of financial statements, not the preparers of financial statements. For G&D values for stockholders are created by earnings which are then valued in the market by a price earnings ratio (or capitalization rate) and/or dividends, which are valued by the market on a current yield basis.
In FF, stockholder values flow out of creating corporate values. There are four different ways corporate values are created:
1) Cash flows available to security holders. This is probably created by corporations fewer times than most people think.
2) Earnings, with earnings defined as creating wealth while consuming cash. This is what most well-run corporations do and also most governments do. Earnings cannot have a lasting value unless the entity remains creditworthy. Also, in most cases, in order to maintain and grow earnings the corporation or government is going to have to have access to capital markets to meet cash shortfalls.
3) Resource Conversion. These areas include massive asset redeployments, massive liability redeployments and changes in control. Resource conversion occurs as part of mergers and acquisitions, contests for control, the bulk sale or purchase of assets or businesses, Chapter 11 reorganizations, out of court reorganizations, spin-offs, and going privates including leveraged buy outs (“LBOs”) and management buy outs (“MBOs”).
4) Super attractive access to capital markets. On the equity side, this includes initial public offerings (“IPOs”) during periods such as the dotcom bubble. On the credit side, this includes the availability of long-term, fixed rate, and non-recourse financing for income producing commercial real estate.
G&D do not distinguish between cash return investing and total return investing. In cash return investing, returns are measured by current yield (or dividend return), yield to maturity, yield to worst or yield to an event. In total return investing, returns are measured in price paid relative to
cash returns plus (or minus) capital appreciation (or depreciation) in given periods of time. Many portfolios have to be invested only for cash return into high-grade credits, e.g., bank securities portfolios; insurance company portfolios, at least as to the amount of liabilities; certain pension plans. (In the current low interest environment, it seems almost impossible to be a rational cash return investor.) For G&D, the higher the dividend, the higher price at which a common stock would sell. G&D imply that the higher dividend issue should be acquired. G&D ignore that the lower priced security may be more attractive to the total return investor because of the lower price and the larger amount of retained earnings.
Two facts stand out in comparing dividend income in the U.S. with interest income:
• Dividends are generally tax-advantaged in the U.S., with individuals currently subject to a maximum federal tax rate of 15% on qualified dividends; and corporate taxpayers are generally entitled to a 70% exemption from income tax on dividends from domestic companies.
• In the U.S., as a practical matter, no one can take away a creditor’s right to a contracted interest payment (or other cash payment) unless that individual so consents or a court of competent jurisdiction, usually a bankruptcy court, suspends that payment.
Most OPMIs involved with common stock believe in substantively consolidating the company with its common stock owners. They believe they are buying General Electric (“GE”), not GE common stock. In FF, the company is a stand alone, separate and distinct from its shareholders, its management, its control group and its creditors. Essential for understanding the dynamics of many companies are not only consolidated financial statements but, also, how financial statements are consolidated. In many cases, it is important to know which liabilities of particular parents or subsidiaries are assumed or guaranteed by other companies which are part of a consolidation.
There are crucial differences between the analysis of companies as going concerns and the analysis of companies as investment vehicles. Most companies have both going concern characteristics and investment company characteristics. For both going concerns and investment vehicles, credit-worthiness is paramount for the company and its securities holders (except perhaps for adequately secured creditors). In going concern analysis, great weight is given to flows: whether cash or earnings. In investment vehicle analysis, great weight is given to asset values, especially realizable asset values. G&D emphasize going concerns except for a short description of Net-Nets, which focuses only on classified balance sheets and never mentions credit-worthiness or prospects for resource conversion, especially changes of control or going private.
The importance of market price depends primarily on two factors:
(1) The form of investments in the portfolio.
(2) How the portfolio is financed.
Generally, market prices are much less important if a portfolio consists of performing loans. Indeed, in some portfolios, e.g., high-grade municipal bonds held by individuals, almost no attention is paid to market prices. Market prices are almost always important in evaluating common stocks, except in instances where the common stocks are being accumulated with the idea of obtaining control or elements of control. Market prices are almost always of critical importance where the portfolio is financed by margin borrowings where the collateral for the borrowing are the securities that make up the portfolio.
Analysts really ought not to use the word “risk” without putting an adjective in front of it. G&D really do not distinguish often enough between market risk and investment risk, even though they recognize in measuring market risk that “Mr. Market” tends to be utterly irrational some of the time. Market risk refers to short-term fluctuations in securities prices. Investment risk refers to something going wrong with the company issuing securities or with the securities (e.g., dilution).
Sometimes analysis takes funny turns. In a poorly financed company, would one prefer to have had the company issue subordinated debentures or a preferred stock which is, of course, subordinated to the debentures? If there is a failure to pay interest or principal on a subordinated debenture, the one remedy available to the subordinated creditor is to declare an event of default. Then, either the indenture trustee, or usually 25% of the subordinated creditors, can accelerate the debt, declaring it due and payable. For a subordinate class, the right to accelerate most often is the right to commit suicide, because this action would likely result in a reorganization or liquidation where almost all, or all, the value will go to senior creditors. In contrast to an event of default, the preferred shareholder accumulates dividend arrearages. The company has less need to reorganize or liquidate. If an investor is making a capital infusion into a troubled company, the investor frequently is much better off from a safety point of view by having the issuer issue a preferred stock, rather than a subordinate.
G&D seem utterly silent about the compensation of promoters, which has to be understood if one is to understand Wall Street and/or corporate managements. Economists have it wrong when they say, “There is no free lunch”. What they should say is, “Somebody has to pay for lunch”. Those who most commonly pay are OPMIs.
In writing of growth stocks, G&D seem to define growth as that which is generally recognized in the marketplace as growth. Many growth stocks do not have general recognition and so they sell at very modest prices. Current examples include Applied Materials, Brookfield Asset Management, Cheung Kong Holdings, Hang Lung Group and Wheelock & Co.
While ignored by G&D, I am of the strong opinion that common stock prices never have to be rational in the absence of catalysts that are the bedrock of resource conversion. The most important catalyst seems to be changes of control and/or potential changes of control. In a conservative, non-control, FF investment, the common stocks contained in many TAM portfolios are those of blue-chip companies selling at substantial discounts from readily ascertainable net asset values (“NAV”). The exit strategies are based on the belief that NAVs will grow over the next three to seven years and that the discounts from NAV will not widen materially. Without catalysts, though, it appears as if the discounts from NAV are just a random walk at any particular time.
Where there are no prospects for changes of control or no Wall Street sponsorship (induced by generous compensation arrangements for managers and securities sales persons), prices in OPMI markets can be utterly irrational persistently. The very best companies whose common stocks are publicly traded and where no catalyst exists usually sell at discounts to NAV. Sometimes these discounts from NAV reach 50% or greater.
Many of these companies are extremely well financed and have most impressive long-term records of increasing NAVs and earnings per share persistently. Such companies include Brookfield Asset Management, Capital Southwest, Investor AB, and Cheung Kong Holdings. In contrast, there is a huge market for private equity that OPMIs spend billions of dollars to get into and which are priced at substantial premiums above NAV. These are the hedge funds. Typically their premiums above NAV are reflected in the present value of promotes paid to hedge fund managers. Those promotes normally run to 2% of assets under management plus 20% of annual profits after the OPMIs receive a preferred return of, say, 6%. Further, lengthy lock-up periods tend to exist for OPMIs owning hedge funds, while the publicly-traded common stocks cited above are all marketable. From a value point of view, there does not seem to be any rational reason why the publicly-traded issues mentioned above should sell at steep discounts, while the hedge funds are priced at premiums.
In FF, potential resource conversions, catalysts, and access to capital markets are included in the valuation process. FF puts a great premium on the value of control, something ignored by G&D. Asset values are very important insofar as they are readily ascertainable and exist in well-financed companies. Asset values are of limited importance in companies which are not well financed and where the principal assets are single purpose assets useful only to a going concern. These asset values can have a positive or negative effect on underlying value. They can help predict that future earnings will be high based on an ROE analysis (book value equals E) or they can indicate, and often do, very high overhead and very high fixed costs.
I largely disagree with G&D as to when low pricing creates a margin of safety. For G&D the margin of safety is created mostly by depressed prices in the general market. For FF, the margin of safety is derived largely from micro factors affecting a company and its securities, not general stock market levels. G&D seem to have a valid point in terms of guarding against market risk. FF is involved with investment risk, not market risk.
Diversification, quite properly, is key in a G&D analysis. It is an OPMI analysis which relies heavily on predicting future earnings and future dividends, something extremely hard to do well. In FF there is much less need for diversification which is viewed in FF as only a surrogate, and usually a damn poor surrogate, for knowledge, control and price consciousness. Non-control investors need a modicum of diversification, but nowhere near to the degree emphasized by G&D, MCT and academics in general.
G&D is mostly a tool for top-down analysis; while FF, in contrast, is almost completely bottom up. G&D describe how to forecast for a coming five to ten-year period:
• Formulate a view as to the general economic climate;
• Anticipate future earnings from the Dow Jones Index and the S&P 500;
• Forecast earnings for individual companies.
In FF, the essential analysis is of the individual company and the current price of the security versus its estimated intrinsic value. Instead of just forecasting earnings, in FF, prognostications are made about:
• Potential resource conversions;
• Access to capital markets.
There are always trade-offs in FF investing. For example, a strong financial position in 2011 means one is dealing with a management willing to sacrifice returns on equity, for the safety and opportunism inherent in a strong financial position. Also, and this is a possibility that G&D do not consider, there are incentives for certain control people to prefer low prices for publicly-traded common stocks:
1) Those doing estate planning;
2) Those contemplating taking the company private, including LBOs; Going private entails cashing out public shareholders. To go private two conditions have to be fulfilled:
a) Low, to reasonable, price;
b) Strong finances – usually by the company itself, or it could be by the buyer or both;
3) Control person is insulated from changes in control.
MCT, like G&D, is focused on looking at economic and financial phenomena from the point of view of OPMIs. Unlike G&D, the entire focus of MCT is on near-term changes in market prices. MCT operates on the false assumption that markets are efficient for all participants. Unlike one of G&D’s great conceptual teachings, MCT does not distinguish between market price and intrinsic value.
When it comes to corporate finance, MCT offers a valuable approach to project finance, but contributes little to corporate finance as visualized by FF participants. The concept of net present value (“NPV”) is essential for understanding project finance. For a project to make sense, estimates of the NPV of cash outflows has to exceed the NPV of cash inputs. In terms of corporate finance, there can be other reasons for undertaking (or not undertaking) a project than positive (or negative) net cash generation. In terms of capitalization, most MCT believers sign off on the Modigliani-Miller Theorem that if a management is working in the best interest of shareholders, the capitalization is a matter of indifference. The Modigliani-Miller Theorem is an absolute non-starter in FF. One can’t measure creditworthiness without also appraising capitalizations.
In FF, quarterly earnings reports tend to lack significance. However, there are instances where quarterly earnings reports can be important. This tends to be the case for most poorly financed companies, which need virtually continual access to capital markets. FF and MCT tend to coalesce when dealing in “sudden death” securities or absolutely credit worthy debt obligations. Such securities seem a special case and encompass the following:
1) Credit instruments without credit risk;
3) Risk arbitrage, with risk arbitrage defined as situations where there is likely to be a relatively determinant workout in a relatively determinant period of time.
In much of what MCT and G&D do, the goal is to estimate the probable effect of certain items on near-term market prices in OPMI markets. Thus, G&D emphasize the importance of determining “true” earnings for a period. In contrast, for FF, the possible or probable effect on OPMI market prices is pretty much ignored in most, but not all, cases. Rather, the goal in FF is to understand the underlying values of a business as well as the business’ dynamics. Such understanding requires a study not only of flows – whether cash or earnings – but also, resource conversion possibilities, access to capital markets and the quality and motivations of management and control persons.
As practiced at Third Avenue, Value Investing is a component of Fundamental Finance that stresses intellectual rigor and a long time horizon. The contributions of Graham and Dodd to this approach have been valuable, but they are only part of the story.
I will write to you again when the 2012 First Quarter Report is published. Best wishes for a happy and healthy New Year.
Martin J. Whitman
Chairman of the Board