Third Avenue Funds Martin Whitman Third Quarter Letter
Throughout the years, I have frequently written about the great emphasis the Third Avenue Management ("TAM") investment team places on the quality and quantity of a company's resources when evaluating a potential investment. Put simply, most of the time, we seek to invest in the equity securities of companies with lots of cash and little, or no, debt. This quarter, I thought it might be of interest to my fellow shareholders to expand upon our thoughts on how cash can be most productively used by corporations.
Corporate Uses of Cash
In the broadest context, a corporation has only three uses of cash:
1) Expand assets 2) Reduce liabilities 3) Make distributions to shareholders a) Pay dividends b) Repurchase outstanding equity securities
For the vast, vast majority of corporations – and from the point of view of the corporation, itself – distributions to equity owners have to be a residual use of cash, distinctly subordinated to having the corporation expand assets and/or reduce liabilities. There are exceptions, however. Corporations which need relatively regular access to equity markets to raise new funds, will tend to pay out 70% to 80% of earnings as dividends in order to give these companies enhanced ability to sell new issues of common stocks, say every 18 months to two years, at prices reflecting a premium over book value. For most of the post-World War II period, this was the situation that prevailed for integrated electric utilities. Growth in demand ranged from 2% to 7%, per annum, year after year. It took capital expenditures of $5 to $7 to produce $1 of increased revenue. The integrated electrics were financed 60% to 70% with debt, mostly publicly-held first mortgages; 10% preferred stock; and 20% to 30% with common stock. Obviously given the physical growth, the large amount of capital expenditures and the need to maintain debt to stock ratios, companies in the electric utility industry had to raise capital periodically by selling new underwritten issues of common stock every 18 months to two years. What was true for the electric utilities was also valid for water companies, natural gas distributors and many expanding consumer finance companies. These were all, and to a considerable extent still are, high dividend payers. There are also a large group of companies with flow-through income tax characteristics, i.e., entities which are generally exempt from federal income taxes to the extent that income which would otherwise be taxable at the entity level is paid out to shareholders. These companies include registered investment companies ("RICs") and real estate investment trusts ("REITs"). Master limited partnerships ("MLPs") are flowthrough entities, whose earnings are taxable, not to the business entity, but to the partners themselves.
However, for most companies it is highly impractical to plan to raise new equity capital by making periodic trips to capital markets. These markets are notoriously capricious. At times, access to equity markets can be had on a super attractive basis – see the 1999 dot com bubble. At other times, there can be no access at all to equity markets at any price – see the 2008-2009 meltdown. In any event, raising new equity by accessing capital markets tends to be quite expensive; gross spreads range between, say, 21⁄2% and 7%. Rather, the vast majority of corporations will continue to get most of their new equity capital (and cash) through retained earnings, i.e., profits not distributed to shareholders.
Most of the companies whose common stocks are held in Third Avenue Management portfolios are in an especially good position to make distributions to common shareholders, especially to conduct long-term programs to repurchase outstanding common stock. These companies tend to combine super-strong financial positions with stock market prices that represent a meaningful discount from readily ascertainable, and economically meaningful, net asset value ("NAV"). Companies in the various TAM portfolios which exhibit such characteristics include the following:
Bank of New York Mellon Brookfield Asset Management Capital Southwest Corporation Guoco Group Hong Kong Property and Holding Companies (Cheung Kong Holdings; Hang Lung Group; Hang Lung Properties; Henderson Land; Hutchison Whampoa; Lai Sun Garment; Sun Hung Kai Properties; Wharf and Wheelock) Investor A/B Key Corp Toyota Industries White Mountains Insurance Group
In the above-mentioned list of companies, whose common stocks all are selling at meaningful discounts from NAV and which also enjoy super strong financial positions, long-term returns to TAM investors would likely be more than satisfactory, if the individual issuers could increase their NAV after adding back dividends by at least 10% per annum compounded.
A stock buy-in program, whereby a corporation repurchases some of its outstanding shares, could make it quite easy for several of the companies cited above to achieve the 10% growth bogey. Most of the managements and Boards of Directors are probably unaware of these benefits from a buyin program, so it is unlikely to happen in the case of most of the companies on the list (White Mountains Insurance seems a notable exception). A simple example should suffice. Investor A/B reported that at March 31, 2012 its NAV was 167,657,000,000 Swedish Kroner (SEK) on 760,505,872 common shares outstanding, resulting in a NAV of 220 SEK per share. The market for Investor A/B common at the time of this writing is around 130 SEK, or a 40.9% discount from March 31, 2012 NAV. Total debt outstanding was 45,575,000,000 SEK leaving Investor A/B with a stock to debt ratio of 79:21. If Investor A/B, using additional borrowings of 21,000,000,000 SEK, were to tender for 150,000,000 Investor A/B common at 140, (including expenses) and the tender offer succeeded, there would be outstanding 610,505,872 Investor A/B common, with an NAV of 146,657,000,000 SEK or 240SEK per share an increase of 9.1% in NAV per share. The basic question ought to be – would such a buy-in be a more productive use of cash than expanding assets? Whether, or not, such an Investor A/B tender offer attracted 150 million common shares, it seems likely that the immediate after market price for Investor A/B Common would be north of 130.
Mathematically all of the companies on the list could achieve results consistent with those in the Investor A/B example above but there are other limiting factors. Even for Investor A/B, dividends have an enormous advantage over buy-backs because the dividend payments are tax deductible to Investor A/B under Swedish law at a 28% rate while there are no tax benefits to Investor A/B from most buy backs. Capital Southwest is small and a major repurchase program might cause it to go private; Brookfield Asset Management probably feels its best growth opportunities are in expanding assets; and various Hong Kong control shareholders have been fairly aggressive buyers of common stock for their own personal accounts recently so that for them having their companies buy shares poses something of a conflict of interest.
From a management point of view, share repurchases are a simpler use of funds than expanding the asset base most of the time simply because the research task is so much easier. You are less likely to make analytic mistakes when involved with your own enterprise, rather than an enterprise controlled and managed by someone else.
From a shareholders' point of view, especially the point of view of shareholders affected by daily stock price fluctuations, there are important advantages to these shareholders if cash distributions to shareholders are made in the form of dividends rather than stock buy backs. First, the markets populated by outside passive minority investors ("OPMIs") are volatile. However, insofar as a company pays regular dividends which are increased periodically market prices tend to be a lot less capricious than would otherwise be the case because the shares tend to get priced, at least in part, on a return (or yield) basis. Second, many OPMIs rely on regular dividend payments to meet living expenses.
The above shareholder point of view is not the TAM point of view. TAM is basically a long-term buyand- hold investor. It seeks to invest in the common stocks of companies that have excellent prospects for increasing NAV by not less than 10%, per annum, compounded over the next three to seven years. And TAM would like to have its portfolio companies achieve this goal conservatively and in a very safe manner. To accomplish this, share buy-backs seem an ideal way to go, as long as common shares are available for purchase by strongly financed companies and priced at meaningful discounts from NAV. The Investor A/B theoretical tender offer cited above demonstrates this.
From a shareholder's point of view, buy-ins do have certain advantages over dividends:
Participating in a buy-in is voluntary for each individual shareholder. Receipt of a dividend, on the other hand, is mandatory to all shareholders.
Generally, a shareholder that participates in a buy-in will, subject to certain conditions, be treated for tax purposes as selling the shares back to the company and the shareholder will be taxed on any gain (proceeds minus cost basis) recognized from such sale. Depending upon the holding period, lower long-term capital gains rates may apply. On the other hand, the full amount of any payment treated as a taxable dividend may be subject to tax. If the qualified dividend rules do not apply, individual taxpayers may be taxed at rates which are higher than long-term capital gain rates. U.S. corporations eligible for the 70% corporate dividends received deductions could be taxed at an ultra-low rate.
Long-term market performance might be better with a buyin, because weaker shareholders are more likely to sell out in the presence of the corporate buying interest.
Buy-ins can cause market liquidity to dry up, a very distinct disadvantage for many OPMIs.
From a company point of view, buy-ins tend to have huge advantages over dividends:
• Regular dividends become, in effect, a fixed charge, payable in cash for the corporation. In contrast, management controls completely the timing of buyins. It can conserve cash as needed, giving expanding assets and/or reducing liabilities the priorities they deserve at the times they deserve it. versus paying out a regular cash dividend to shareholders.
• Bought-in shares can offset the dilutive effects of issuing employee stock options.
Many, if not most, managements share the TAM view that the long-term object of the company is to grow economically meaningful NAV safely, conservatively and cheaply.
As an aside, it ought to be noted that there are four ways to acquire common stock for cash, whether for buy-in or other purposes:
• in the open market
• in private transactions
• via tender offers
• by use of the proxy machinery, for cash out mergers or reverse splits
Most purchases are open market purchases made after a Board of Directors authorizes the management of a company to repurchase a certain amount of shares.
Large enough purchases or use of the proxy machinery can result in a company going private or "going dark". This seems unlikely to happen to the various companies in the TAM portfolios, but one never knows. The effect can be disastrous if the going dark price does not reflect a substantial premium over market. I am not too worried on this score. The Hong Kong companies, in particular, seem safe from a take-under because the listing rules in the Hong Kong Stock Exchange make it almost impossible to use proxy machinery to go private. Also, the companies are so big that they are likely to stay public, even though control insiders have been regular and sometimes large, buyers of common stock.
For market participants focused on growth in NAV, there are a lot of differences between the last time the Dow Jones Industrial Average ("DJIA") was above 13,000 (December 2007) and the current 13,000 level. Book value for the DJIA is not exactly the same as NAV for the securities listed above; but, it remains a pretty good, albeit rough, surrogate for NAV. The book value for the DJIA at April 30, 2012 was 42.2% greater than the book value at December 31, 2007. More importantly, though, is the probability that the quality of the book value at April 30, 2012, as measured by the financial strength of the thirty companies making up the DJIA, was far superior in April 2012 compared to what it was in December 2007.
Do not rely on OPMI markets for economic logic. In OPMI markets, sponsorship and promotion seem to count much more than does economic logic. Two of the most successful private equity firms acquiring elements of control over the companies in which they invest, based on their long-term track records, are Capital Southwest and Investor A/B. As of this writing, Capital Southwest is trading at about a 43% discount from estimated NAV and Investor A/B is trading at about a 41% discount from estimated NAV. How do these extremely well financed companies compare with private equity limited partnerships and hedge funds, few of which have been as successful as these two in growing long-term NAV?
1) The private equity limited partnerships and hedge funds are not priced at any discount from NAV.
2) The private equity limited partnerships restrict investors from cashing-in their investments. Capital Southwest and Investor A/B are marketable as long as securities markets are open (i.e., almost all the time). 3) The overall all-in expense ratios for both Capital Southwest and Investor A/B are probably less than 1%. The typical private equity partnership or hedge fund probably charges a management fee of 2%, plus a 20% profit participation after meeting a bogey of, say, 6%, to the limited partners. Most fees earned by a private equity limited partnership or hedge fund (banking fees, home office charges, etc.), probably belong mostly to the general partners, not the limited partners. 4) Most private equity partnerships and hedge funds are probably more leveraged, i.e., less well financed, than are Capital Southwest and Investor A/B. 5) Investor protections are manifestly greater for market participants holding common stocks than they are for market participants who are limited partners. Especially strong investor protections exist for Capital Southwest, which is registered as an investment company under the Investment Company Act of 1940, as amended.
One final observation. Academics are mostly believers in Modern Capital Theory ("MCT"). In the efficient market in which they believe, situations like the companies in our list could not exist. For them, efficient pricing would get rid of the large discounts at which each security sells. This MCT view is diametrically opposed to the TAM view. In the TAM view, securities markets populated by OPMIs tend very much to be price inefficient, unless there exist catalysts. Principal catalysts include prospects for changes of control, going private, mergers and acquisitions, spin-offs and major asset or liability re-structurings. If there is anything wrong with the TAM list of companies cited, it is a lack of catalysts. Yet, over time, the TAM portfolios have performed satisfactorily even in the relative absence of such catalysts. And, perhaps most important of all, the probabilities seem to be that none of the companies will suffer permanent impairments no matter how unfavorable the various topdown economic outlooks might be.
I will write you again when the shareholder letters for the period to end July 31, 2012 are published.
Martin J. Whitman
Chairman of the Board