Third Avenue Management's Marty Whitman - Third-Quarter Letter
Most of the funds managed at Third Avenue Management ("Third Avenue") seek total return by acquiring "what is" on the bases that guard against investment risk, defined as the threat of a business or its' securities suffering permanent impairments, but not market risk, defined as Outside Passive Minority Investor ("OPMI") price fluctuations. In striving to achieve satisfactory returns on an overall risk adjusted basis, Third Avenue's approach is markedly different from the approaches used by almost all others who also are primarily OPMIs. Almost all others are influenced strongly by the writings of Graham and Dodd ("G&D") and/or the teachings of most academics under the rubric of Modern Capital Theory. ("MCT"). The basic goal of both G & D and MCT is to study the factors that affect market prices for common stocks in OPMI markets, especially short run factors. For Third Avenue, in contrast, the basic goal is to obtain deep understanding of specific businesses and the securities they issue, especially emphasizing longterm factors. G&D and MCT seemed focused, almost exclusively, on the needs and desires of OPMIs. Third Avenue's approach is more balanced, recognizing the needs and actions not only of OPMIs, but also the company itself, creditors, managements, control groups and Wall Street activists. The Third Avenue belief is that underlying values, and growth in underlying values, will eventually be recognized in OPMI market prices, especially if potential catalysts such as changes in control, or going private, exist.
G&D and MCT are helpful, and in many senses, essential to understanding OPMI equity markets, trading strategies, and near term price movements in OPMI markets. However, G&D and MCT seem not at all helpful and, in a sense, counterproductive in helping control buyers, distress buyers and long-term investors gain understanding of a business in depth as well as the securities that businesses issue. These shortcomings of G&D and MCT seem attributable to four factors, three of which characterize G&D and all four of which characterize MCT:
1. G&D and MCT believe in the Primacy of the Income Account as measured by recurring earnings and/or cash flow from operations. However, to appraise a business, its securities and its management, an analyst has to weigh three separate factors, not just recurring flows as reflected in income accounts. A decent analysis of the management of any corporation has to assay the people from three general angles:
a) As an operator creating recurring earnings or cash flows. (Earnings are defined as the creation of wealth while consuming cash).
b) As an investor, i.e., deal maker. Virtually no public corporation in the U.S. goes as long as five years without being involved in resource conversion activity, such as a merger or acquisition, change of control, going private, including leveraged buy-outs, sale of assets in bulk and spin-offs.
c). As a financier, financing, refinancing and reorganizing troubled issuers. Probably more wealth has been created for corporations and promoters in the U.S. by gaining super attractive access to capital markets than any other way. It appears as if the most important talent leveraged buy out ("LBO") sponsors bring to deals is super attractive access to capital markets, not only for obtaining attractive secured financing from banks, but also for obtaining mezzanine finance and for access to IPO markets for common stocks.
2. G&D and MCT are involved with short-termism. The most important thing for them to measure is immediate price impact in OPMI markets. This emphasis becomes irrelevant for control buyers and long-term investors, unless the particular asset is to be sold in the immediate future into a market or is margined. Short-termism is not something that contributes to understanding in depth a goingconcern with a perpetual life. For example, both G&D and MCT emphasize the importance of common stock dividends, largely because dividend payments impact immediate market prices. G&D and MCT pretty much ignore the probabilities that retaining earnings can foster future company growth.
3. G&D and MCT overemphasize top-down analysis at the expense of bottom-up analysis. G&D, in particular, attach great importance to forecasting gross domestic product, general stock market levels and interest rates. At this writing a principal top-down concern seems to be whether or not certain European Sovereigns (Portugal, Italy, Ireland, Greece and Spain) will suffer money defaults on outstanding Euro Bonds (I bet they will default sooner or later). At Third Avenue, however, it seems more important to focus on the bottom-up facts, like that the well-financed Wheelock & Company has its common stock selling at a 50% discount from readily ascertainable net asset value ("NAV") and that Wheelock's long-term growth prospects seem bright without worrying much about the general economy.
4. For MCT there is a belief in equilibrium pricing, i.e., the price of a security in an efficient market represents a universal value and prices change as the market receives new information. Equilibrium pricing does not exist in the world of corporate valuation. It does exist for a tiny minority of OPMI securities but a somewhat larger proportion of OPMI trading. An efficient market is faced by those involved in "sudden death securities" analyzable by reference to a very limited number of computer programmable variables and encompass derivative securities such as options and convertibles as well as risk arbitrage situations where there is likely to be a near term workout. For going concerns of any kind of complexity there is no understanding implicit in assuming an efficient market. For most of the securities in Third Avenue portfolios, pricing for the securities would be very different from what it is if prospects for changes of control existed. There just isn't one right price for the vast majority of equities, MCT beliefs notwithstanding. Using the Third Avenue approach it is feasible today as a total return investor to buy into blue chip common stocks which have the following characteristics and which, in my opinion, are attractively priced:
• Super strong financial position
• Priced at discount from NAV of 25% or more (Wheelock and Company Common and Henderson Land Common (HLDCY) are at discounts of about 50%). These NAVs do not reflect any control premiums that would exist if any of the issuers were "in play."
• Full comprehensive disclosures in English with audits by the "Big Four"
• Trading in markets where protections for OPMIs are strong
• Prospects seem good that that over the next three to eight years NAV will grow by not less than 10% compounded annually after adding back dividends. If such growth is achieved, the investments seem very likely to be profitable because if they are not, the discounts from NAV would have widened to unconscionable levels. For example, at this writing, Wheelock and Company is selling at HK$28.75 per share; NAV at December 31, 2011 was HK $60.32. Given 10% NAV growth for Wheelock, NAV in three to five years would be HK$78.63 and HK$94.09 per share respectively, after allowance for an annual dividend of HK$0.50 per share, the dividend rate established at the end of 2011. For the five years prior to December 31, 2011, after allowance for annual dividends of HK$0.125 per share, Wheelock's growth in NAV was 17% compounded annually. Wheelock Common's NAV increased each of the five years, as seems bound to be the case for 2012.
Other than a lack of catalysts, there does not seem to be much, if any, economic justification based on comparative analysis for the existence of any NAV discounts at all for the securities held in the various Third Avenue portfolios, where the NAV discounts average over 25%. In contrast, at July 31, 2012, the S&P 500 index was priced at a 116.2% premium above the book values of the companies making up the S&P Index. The asset-rich Third Avenue common stocks seem to be issues of companies much more strongly financed than the S&P 500 constituents. Also, growth prospects seem, to me, to be far better for the Third Avenue securities than they are for the issues in the S&P 500.
Growth in NAV seems a far better measure of how a business performed than is looking at growth in recurring earnings or cash flows from operations simply because the change in NAV measures management performance not only as operators but also as investors and financiers. On a macro basis, long-term growth in NAV seems mighty likely for well financed companies. Book value is only a surrogate for NAV, but often is a meaningful one, at least in the aggregate. In the 18 years prior to December 31, 2011, the book value of the S & P 500 increased in 16 of the 18 years, despite the severe recession which started in 2007-2008. For the last five years, most of the issues held in Third Avenue Value Fund in companies with strong financial positions exceeded the 10% growth bogey, despite the fact that 2007-2012 was a recessionary period. More important to me though are the market results of the three issues that didn't meet the 10% growth bogey: Capital Southwest, Investor AB and Toyota Industries. The market prices of two were modestly higher five years later and one, Toyota Industries, was down about 5% after being barraged by the worst publicity visited on almost any major company during the period.
While I, as an OPMI, am a true believer in the Third Avenue approach it would be incomplete if I did not enumerate what I think are the shortcomings of the approach: 1. Third Avenue could deal with a lot of dead head managements who don't care about their OPMI constituencies, in great part because they own little or no common stock in their companies; and also their companies have no need or desire to access capital markets. Obviously, the securities of such issuers should be avoided. These dead-head managements seem to be much more of a problem in Japan than the U.S., in great part because in the U.S. there seems to be much, much more of a change of control threat for underperforming managements than is the case in Japan. The control groups in each of the Hong Kong companies in Third Avenue portfolios are all major shareholders in their companies. Together with the families, each control group usually owns at least 50% of the outstanding common stock.
2. In concentrating on companies with strong financial positions, Third Avenue is dealing in 2012 with managements willing to sacrifice return on equity ("ROE") and return on investment ("ROI") for the safety and opportunism inherent in a strong financial position.
3. Third Avenue is involved largely with really deep down discounts from our estimates of NAV. The OPMI markets seem efficient enough to reason that in most cases deep discounts reflect a lack of near to intermediate term catalysts.
4. Third Avenue does not borrow money. Third Avenue pretty much ignores market risk and goes to great lengths to try to avoid investment risk. If one is to borrow money, it is advisable to try to guard against market risk.
5. Most asset-rich securities in the Third Avenue portfolios are general market securities. Near-term price performance seems likely to be dominated by top-down considerations, e.g., the Eurozone. I will write you again when the shareholder letters for the year to end October 31, 2012 are published.
Martin J. Whitman