Marty Whitman's Third Avenue Management First Quarter Investor Letter
Dear Fellow Shareholders:
The Third Avenue investment team approaches security analysis from a different perspective than most conventional security analysts. In fact, the Third Avenue approach has more in common with corporate finance than it does with the conventional approach. The conventional approach is accepted as basic tenets by Modern Capital Theory ("MCT"), in Graham and Dodd valuations ("G&D") and, to some extent, in Generally Accepted Accounting Principles ("GAAP"). The differences between conventional security analysis and other financial analysis bottom on conventional security analysis' over emphasis of three factors and consequent under emphasis of other factors that are equally important, and even more important, in most fundamental financial analyses. These other areas of finance include running a private business, control investing, most of distress investing, credit analysis and venture capital. The three factors overemphasized in conventional security analysis are as follows:
1) Primacy of the Income Account, i.e., the primacy of flows generated from operations as a valuation determinant – whether those flows are earnings flow or cash flows. (Earnings flows are streams of income which create wealth for economic entities while consuming cash. In the corporate world earnings flows probably are more common than cash flows available for securities holders).
2) Primacy of Short-Termism – Prediction of, and reliance, on immediate market prices and changes in those prices; these are crucial to equity pricing in securities markets dominated by Outside Passive Minority Investors ("OPMIs"). Determining near-term outlooks for a company tends to be a much more important variable in conventional analysis than is determining underlying value.
3) Primacy of Top Down Analysis – The most important element in predicting market prices in conventional analysis are macro factors such as Gross Domestic Product ("GDP"), the level of interest rates, technical market considerations, industry sectors and the trends in stock market indices. For conventional analysis, micro factors looked at from the bottom-up, such as loan covenants, appraisals of management, strength of financial positions and access to capital markets are down-weighted compared to top-down considerations.
As to the primacy of the income account, G&D recognized certain of its shortcomings, even though the most important component of their bottom-up analyses was forecasting future earnings. As G&D stated on Page 551 of the 1962 edition of Securities Analysis, Principles and Technique: "Most of all security analysts should reflect fully on the rather startling truth that as long as a business remains a private corporation or partnership the net asset value appearing on the balance sheet is likely to constitute the point of departure for determining what the enterprise is 'worth'. But once it makes its appearance as a 'publicly held company – even though the shares distributed to the public may constitute only a small part of the total – the net-worth figure seems to lose virtually all its significance.' 'Value' then becomes dependent almost exclusively on the expected future earnings"
This overemphasis on forecasting future flows from operations (whether earnings flows or cash flows) would be justifiable in the real world of fundamentalism, i.e., financial activities other than stock market trading, if the businesses being analyzed were strict going concerns; financed as they always have been financed; managed by operators in the same way they have always been managed; not subject to takeovers; mergers, going private or other resource conversion events; and without needs to ever access capital markets. The problem is that there are very few, if any, such companies whose common stocks are publicly traded in existence. Rather than being strict going concerns, virtually all businesses whose equities are publicly traded combine going concern characteristics with investment company characteristics. While income accounts, i.e., flow data, are integrally related to net asset value ("NAV"), for many companies NAV and changes in NAV are far more important determinants of value than are earnings, or cash flows, from operations. Such NAV-centered companies include Berkshire Hathaway, most mutual funds, most income-producing real estate entities (such as Forest City Enterprises), most control investors (such as Brookfield Asset Management), and most conglomerates (such as Cheung Kong Holdings). In conventional analysis, managements are appraised almost exclusively as operators. In the real world, in which Third Avenue operates, managements are appraised not only as operators but also as investors and financiers. Management roles as investors and financiers are frequently more important than their roles as operators in our analysis.
Even when emphasizing the primacy of the income account, many conventional analysts handicap themselves by failing to consider the importance of NAV in many instances as a tool for predicting future earnings. Graham and Dodd, for example, believe that the past earnings record is the best tool for predicting future earnings, virtually ignoring NAV. However, NAV is an essential tool (though not the sole tool) for predicting future earnings in those instances where data on Return on Equity ("ROE") are important to understanding a business. "E", or Equity, by the way, is NAV. Industries where ROE becomes a tool for predicting future earnings include income producing real estate, commercial banks, insurance companies, investment companies, conglomerates and hedge funds. The vast bulk of Third Avenue's common stock investments are in companies where the NAV figure is an important valuation tool. Most of the issues acquired by Third Avenue Funds have been acquired at prices that represent meaningful discounts from estimated NAVs.
Third Avenue's approach to finding values seems to be a lot more broadly based than is the case for conventional stock market analysis. In this regard, Third Avenue seems to be in good company. Others more broadly based in their analyses include those running private businesses, most distress investors, virtually all control investors, most credit analysts and virtually all first and second stage venture capitalists.
Factors considered by Third Avenue and these other economics analysts in appraising a company and its securities encompass the following:
1) Credit worthiness 2) Flows – both cash and earnings 3) Long-term outlook 4) Salable assets which can be disposed of without compromising much, or at all, the going concern dynamics. 5) Resource conversions such as changes in control, mergers and acquisitions, going private, and major changes in assets or major changes in liabilities. 6) Access to capital markets – both credit markets and equity markets.
In general, there probably is no primacy of anything. If anything, since the 2007-2008 economic meltdown, for Third Avenue there has been a primacy of credit-worthiness in analyzing any equity security. At Third Avenue there never has existed a Primacy of Earnings, a Primacy of Short- Termism or a Primacy of Top-Down Analysis.
It seems important to define credit-worthiness, both for private sector analysis and the analysis of sovereigns. Creditworthiness has three elements:
1) Amount of indebtedness 2) Terms of indebtedness 3) How productive are the Use of Proceeds – this third factor is usually the most important.
It ought to be noted that in the aggregate, indebtedness is almost never repaid by entities which remain credit-worthy. Rather, maturing debt is refinanced and new levels of debt are incurred as credit-worthy entities expand and become more productive. Despite the 2008-2009 economic meltdown, most of the companies held since then in Third Avenue portfolios have grown and prospered, e.g., the Hong Kong Holdings, Brookfield Asset Management (BAM) and Posco (PKX). Today each of these companies has considerably more borrowing capacity than they had when the positions were initially acquired by Third Avenue.
A primacy of earnings approach clearly is in conflict with the desire of most corporations to minimize income tax burdens. Income from operations are taxed at maximum corporate rates. Taxation of capital gains is much preferred, because the taxpayer usually can control the timing as to when the tax becomes payable. And the ultimate corporate tax shelter for businesses which don't need cash return is unrealized appreciation.
In conventional analyses today, there is almost no understanding of risk. The prime example of this is the conventional belief that long-term U.S. Treasury Notes, selling near par, are safe and free from risk. Not so. The U.S. Treasury Notes, paying say 2%-3%, do not carry any credit risk; but, they are replete with several other types of risk, e.g., inflation risk and capital deprecation risk, while at the same time there are no prospects for capital appreciation. The huge amounts of realistic risk inherent in owning U.S. Treasuries today is offset greatly if the portfolio holding these instruments is a dollar-average and will continue to acquire new U.S. Treasuries as interest rates fluctuate. Nonetheless, for most portfolios in 2012, the way to guard against economic risk is to be a total return investor in things such as Third Avenue Funds, rather than to be a cash return investor in U.S. Treasuries.
The common stocks in Third Avenue Funds almost all have the following characteristics:
1) The companies enjoy super strong financial positions, which provide "insurance" to investors and opportunism to management 2) The common stocks were acquired at prices that represent meaningful discounts from estimated NAVs. 3) The companies provide comprehensive, relatively complete, disclosures and operate in markets where regulators provide significant protections for minority investors. 4) The companies seem to have excellent prospects for growing NAV by not less than 10% compounded annually over the next three to seven years.
Short-termism is rampant among market participants. Much of short-termism is appropriate, justifiable and essential for many market participants. It just happens to be irrelevant largely for Third Avenue, which focuses mostly on buy-and-hold, long-term investments.
One had better be very short-term conscious where the portfolio is highly leveraged; where the market participant doesn't know much about the company or the securities it issues; where the market participant uses trading systems, or a technical approach to the market; and where the more important variable in an analysis is what is the near-term outlook, rather than what are the underlying values existing in the company and the company's securities.
Even for the largest institutions, it seems to be impossible to have underlying knowledge about an individual security where the portfolio consists of a huge numbers of securities (say over 500 different common stocks); and those securities are traded frequently. This includes high frequency trading portfolios. If that's where one's interest and attention lies, one should be short term. This is not what TAM does. TAM believes in limited diversification. Diversification is only a surrogate, and usually a damn poor surrogate, for knowledge, control and price consciousness. TAM has to be moderately diversified, because the various Third Avenue Funds are essentially passive, rather than control, investors.
Also, there are certain types of securities – I call them "sudden death" securities – where all the focus has to be short term. These securities are derivatives and risk arbitrage securities, with risk arbitrage being defined as situations where there will be a relatively determinant workout in a relatively determinant period of time, e.g., a publicly announced merger or tender offer.
Even Third Avenue is sometimes short-term oriented, but not most of the time. This occurs where there is a resource conversion event, such as a merger or tender offer, where the price to be paid is a substantial premium above the preannouncement market price. In that situation, the Third Avenue fund manager tends to make a market decision, rather than an investment decision. Although the price offered in the resource conversion may still reflect a big discount from NAV, as long as it reflects a substantial market premium, the Third Avenue fund manager is likely to take his profit and move on to something else. Resource conversions do occur periodically. For analysts who subscribe to the G&D approach to investing, there is nothing more important in an analysis than to give dominant weight to top-down predictions of the outlook for the economy and the outlook for specific securities markets. Third Avenue, on the other hand, does not ignore top-down considerations but certainly underweights their importance compared with bottom-up considerations. For this, there are two reasons. First, over the long term bottom-up analysis will tend to be a much more important factor in value realization than top-down factors (probably absent social unrest). Second, Third Avenue, like everybody else, doesn't seem to be too accurate as a top down forecaster, especially when it comes to short-term forecasts.
A good example of how we meld the top-down with the bottom-up lies in the reasoning behind our investments in Hong Kong, China and South Korea. The top-down analysis centers on the belief that over the next three to seven years, that part of the world will grow faster than the rest of the industrialized world, especially Europe and North America. The bottom-up analyses center on the facts that the businesses in which Third Avenue has invested are all eminently credit worthy; that the common stocks were acquired at significant discounts to our estimate of NAV; and that the common stocks are the issues of companies that provide comprehensive, written, disclosures; and are regulated by government agencies whose principal interest seems to be investor protection.
Prior to 2008, long-term, buy-and-hold investors did not have to pay too much attention to top-down factors, such as the business cycle. This no longer seems true. Since the meltdown, business cycle factors seem to have become more important than had been the case from the end of World War II until 2008. Despite this, Third Avenue will continue to give more weight in the vast majority of its analyses to bottom-up factors, rather than top-down factors.
PROMOTION OF IAN LAPEY TO SOLE MANAGER OF THIRD AVENUE VALUE FUND
As many of you know, I entered the mutual fund business when I was 67 years old and having a pre-determined succession plan has always been very important to me, so that I can be assured that my family and fellow shareholders' money will be managed by someone I can depend upon long after I retire. To that end, I designated Ian Lapey as my successor as manager of the Third Avenue Value Fund in 2006. I have co-managed Third Avenue Value Fund with him since 2009. Ian is a most adept analyst across industries and asset classes and is a very capable value and distressed investor. Therefore, Ian was promoted to sole Portfolio Manager of Third Avenue Value Fund, as of March 1, 2012. I have not retired. I remain Chairman of the Third Avenue Trust Board of Trustees and will continue actively mentoring our research team. I will also manage a private concentrated value fund, available to accredited investors.
Ian's promotion is well deserved. I have the utmost confidence in him. My family and I will remain significant shareholders in Third Avenue Value Fund. I know that Ian will always act in the best interest of our shareholders. Ian, of course, will continue to be supported by the same team of portfolio managers and analysts who have supported me for these many years.
I will write you again when we publish our reports for the quarter to end April 30, 2012.
Martin J. Whitman
Chairman of the Board