Martin Whitman's Third Avenue Third Quarter 2013 Letter to Shareholders
There was an interesting article in the July 22, 2013 issue of Fortune entitled "The Party Could be Over for Stocks." The most interesting part of the article is that it describes precisely what Third Avenue Management does not do when it comes to analyzing equity securities.The Fortune analysis seems irrelevant for Third Avenue shareholders.
The gravamen of the article is that the Federal Reserve Board might reduce its $85 billion of monthly bond purchases and end the program entirely by mid-2014. As part of the change in the Fed, the government agency will no longer deploy extraordinary measures that have driven down interest rates over the last five years. Low interest rates resulted in a bull market for equities because the yields on bonds that compete for investors' money stayed so unenticingly low. This bull market was never justifiable based on so-called fundamentals—dividend yields and earnings potential.Also, lower interest rates mean that earnings are not likely to increase. Further, Price/Earnings ratios are currently quite high—the S&P 500 P/E ratio stands at 18.4x for the latest twelve months period and 23.6x for the 10-year average of inflation adjusted earnings.
The article ignores completely three fundamentals that are crucial in any Third Avenue analysis of a common stock— first the creditworthiness of the company issuing the equity; second, the ability of the issuer to grow net asset value ("NAV") (or its surrogate book value) over the intermediate to longer term; and, three, the price of the common stock relative to NAV.
While anecdotal, it seems likely that U.S. corporations whose common stocks are publicly traded are more creditworthy today than has been the case since the 1950s and the 1960s. In part this is an outgrowth of the era of easy money from2007 to 2013.
NAVs have continually increased. At July 31, 2013, the book value of the companies making up the Dow Jones Industrial Index was 60.7% higher than it had been at December 31, 2007; and the comparable increase for the S&P 500 was 28.4%.
At July 31, 2013, the Dow Jones Industrial Index was selling at 3.0x book value and the S&P 500 was selling at 2.5x book value. In contrast, most securities in the various Third Avenue portfolios are selling at anywhere from 0.6x NAV to 1.0x NAV. Since the companies in Third Avenue's portfolios enjoy Returns on Equity ("ROE") comparable to the companies in the S&P500,the P/E ratios for the Third Avenue companies are much below those of the S&P 500.Third Avenue's P/E ratios are estimated at around 10x, rather than the 18.4x for the S&P 500. Further the Third Avenue companies on average are probably more credit-worthy than the S&P 500 companies, i.e., they enjoy stronger balance sheets. Also,for the Third Avenue companies, I am confident that most of the issuers will increase NAV in most future reporting periods(as has been the case in the past) albeit it may be that such NAV increases will be smaller than had been the case from 2007 to 2013.
At Third Avenue we know how hard it is to predict the future, and we are especially skeptical of anyone's ability (including our own) to make successful macroeconomic predictions. Assuming that conditions are bad economically, but without social unrest and physical violence in the streets, many Third Avenue portfolio companies will be in a position to make super attractive acquisitions, as was the case after the 2008 Financial Crisis. Such Third Avenue portfolio companies include Brookfield Asset Management, Cheung Kong Holdings, Exor, Investor A/B, Pargesa and Wheelock & Co. One final comment about the Fortune article. It seems doubtful that there is a close relationship between bond yields and dividend returns on common stocks. The correlation certainly exists where the investors are primarily interested in cash return. As far as I can tell, most common stock investors are interested primarily in total return,with cash return being distinctly secondary, and most bond investors do not own common stocks because they need contractually guaranteed interest payments, (e.g., banks and insurance companies).
MOTOR CITY BLUES
While Third Avenue is not directly involved, our readers might be interested in my take on the Chapter 9 bankruptcy of Detroit.
In the USA, outside of a court proceeding (usually a bankruptcy case), no one can force a creditor to give up a right to a money payment for principal,interest or premium unless that individual creditor consents. Therefore, a voluntary program in Detroit could never have worked— too many hold-outs.Chapter 9wasinevitable.
Creditors in Chapter 11 and Chapter 9 cases, can be coerced into accepting a reorganization with either the requisite votes of the impaired classes of creditors, or a cram down (a reorganization workout ordered by the bankruptcy court without the requisite vote of impaired classes of claimants and parties of interest). True liquidation does not seem to be an option for Detroit. For practical purposes,Chapter 9 is just like Chapter 11, except that the period of exclusivity for the debtor to propose a Plan of Reorganization ("POR") lasts forever, and unlike corporate Chapter 11, as part of any reorganization it may be impossible to give ownership interests to pre-petition creditors to satisfy part or all of their claims. Also in Chapter 9, no trustees are likely to be appointed. After all, unlike corporations,Detroit and Michigan are sovereign entities. The goal of Chapter 11 and Chapter 9 is to make the debtor feasible (i.e., creditworthy) within the context of maximizing present values ("PVs") for creditors and also comporting with a rule of absolute priority where no creditors of a class are treated to different values than other members of the class.There are two broad classes of credits in Detroit—Secured and Unsecured. Secured credits ought to include certain municipal bonds which become senior up to the value of the collateral. Pension, retirement and healthcare liabilities seem to be unsecured. This will be vigorously argued for a long time by very able lawyers and investment bankers, all of whom will be paid by Detroit.
To accomplish a successful reorganization, you follow what you would do for a Leveraged Buy Out ("LBO")—first determine forecasted cash flows, realizations from asset sales and the debtor's dynamics. Then, apply an appropriate capitalization to the above. In an LBO, you leverage up. In a Chapter 9, you deleverage as part of a POR.
To make Detroit feasible on an operational level seems a Herculean, possibly impossible, task. Maybe regional authorities like Port Authority of New York, Metropolitan Transportation Authority, or Bay Area Rapid Transit can be important contributors to a feasible reorganization. No matter the difficulties, reorganization has to take place somehow. Perhaps Detroit and the surrounding region can attract new, productive investments. Detroit seems to enjoy a relatively efficient infrastructure (e.g., a great highway system), lots of land and, probably, sharply reduced labor costs.
For Detroit to obtain a feasible capitalization, provided operations can be stabilized, there are only a few things that can be done to compromise some $18 billion of obligations:
• Reduce principal
• Reduce interest rates and/or cash interest payments
• Alter covenants
• Extend maturities
• Provide credit enhancements
I would bet that as part of a POR the State of Michigan, the private sector and/or Federal agencies will have to provide credit enhancements to Detroit via either dedicating tax revenues to Detroit and/or guarantying obligations. There is ample precedent for this. New York State,through the Municipal Assistance Corporation ("MAC"), credit enhanced New York City obligations in the 1970s.Credit enhancements,incidentally,could create a lot of investment opportunities for Third Avenue.
Detroit's Chapter 9 will take a long time and be very, very expensive. Detroit, under Chapter 9, will have to pick up all administrative expenses for almost every participant in the reorganization (say, professionals hired by the Committee of Retirees) i.e., lawyers, investment bankers, accountants, actuaries, etc. Detroit will pay them on a priority basis in cash with perhaps minor holdbacks on a pay as you go basis. I can almost guarantee that Administrative costs for Detroit will be at least $500,000,000 and might well be in excess of $1,000,000,000.
I shall write you again after the end of the 2013 fiscal year for the Third Avenue Funds on October 31st.
Chairman of the Board