Dear Fellow Shareholders: Academics involved with finance restrict their studies to analyzing markets and securities prices. As far as they are concerned, the study of companies and the securities they issue are someone else's business. I am disappointed that a Nobel Prize was awarded to Eugene Fama, who studies only markets and prices; and whom, I daresay, does not focus on Form 10-Ks or the footnotes to a corporation's audited financial statements. In fact there is no way of determining whether any market is efficient or not in measuring underlying values unless the analyst understands, and analyzes, the specific securities that are the components of that specific market.
Market participants make two types of decisions—market decisions and investment decisions. Market decisions involve predicting security prices and are, virtually, always very short-run oriented. Investment decisions involve, inter alia, determining underlying value, resource conversion probabilities; terms of securities; credit analysis, and probable access to capital markets particularly for providing bailouts to public markets at high prices (versus cost) for promoters, insiders and private investors.
Modern Capital Theory ("MCT") concentrates on market decisions and provides valuable lessons for specific markets consisting of Outside Passive Minority Investors ("OPMIs") who deal in "sudden death" securities, i.e., options, warrants, risk arbitrage, heavily margined portfolios, trading strategies and performing loans with short-fuse maturities. MCT is of little or no help to those involved primarily with making investment decisions—value investors, control investors, most distress investors, credit analysts, and first and second stage venture capital investors.
The most basic problem for MCT, and all believers in efficient markets, is that they take a very narrow special case—OPMIs dealing in "sudden death" securities, and claim, as the Nobel Prize winner does, that their theories apply to all markets universally. What utter nonsense! Most of the activity—and money—on Wall Street is in the hands of people making investment decisions, not market decisions. For the activist, and value investor, the market is a place for a bail-out at high prices (versus cost), not a place where underlying values are determined. MCT, in looking at Wall Street, concentrates on mutual funds which trade marketable securities. MCT seems oblivious to activists, not studying what activists do, and why they do it.
MCT, not only misdefines markets, but also seems to be sloppy science. The theory embodies the correct observation that almost no one outperforms relevant market indexes consistently. Consistently is a dirty word; it means all the time. In justifying and promoting Index Funds, MCT points to this failure of actively managed funds to outperform consistently. MCT acolytes, however, forget that many managed funds do tend to outperform relative benchmarks, over the long term, on average, and most of the time, notwithstanding their higher expense ratios. It's just plain stupid to state that the quality of money management is tested by looking at consistency. Insofar as MCT identifies what it describes as performance outliers, e.g., Berkshire Hathaway, no attempt is made to study what it is that outliers do that make them outliers, since this would entail the detailed analysis of portfolio companies and the securities they issue. How unscholarly!
MCT cannot possibly be helpful almost all the time to those focusing primarily on investment decisions, i.e., understanding a company and the securities it issues. This is because in MCT four factors are overemphasized to such an extent that economic reality is blurred.
1. A belief in the primacy of the income account with some emphasis on cash flow from operations rather than earnings. (Earnings are defined as creating wealth while consuming cash). If there is a primacy of anything in understanding a business, at least subsequent to the 2008 financial meltdown, it is creditworthiness, not periodic cash flows or periodic earnings.
2. An emphasis on short-termism. I think it is impossible to be market conscious about publicly-traded securities without emphasizing the immediate outlook at the expense of a longer-term view.
3. Overemphasis on top-down macro-factors such as forecasts for the economy, interest rates, the Dow Jones Industrial Average, with a consequent de-emphasis of bottom-up factors such as the financial strength of an enterprise, the relationship of a security's price to readily ascertainable net asset value ("NAV"), or the covenants in loan agreements. It is easy to appear wise and profound, for example, by forecasting outlooks for the general economy. Forecasting about the general economy almost all the time tends to be a lot less important for long-term buy-and-hold investors than are nitty-gritty details about an issuer. Indeed, it seems as if macro forecasts dominated in importance in the last 85 years only in 1929, 1974 and 2008-2009. Even in those years of dramatic down-drafts in the U.S., macro factors tended to be non-important (outside of immediate market prices) for adequately secured creditors seeking interest income or for well-financed companies with opportunistic managements seeking acquisitions.
4. A belief in equilibrium pricing. An OPMI market price is believed to value correctly and OPMI market prices change as the market receives new information. Such a view, though widely held, is ludicrous. The fact that the common stocks of many well financed, growing, companies sell at 25% to 75% discounts from readily ascertainable NAV is mostly lost on finance academics who believe in efficient markets. They do not believe that such pricing can exist, though it does.
The Third Avenue portfolios are replete with the common stock issues of companies which have great financial strength and are selling in the OPMI market at 25% to 75% discounts from readily ascertainable NAV. Such discounts would not exist if the companies could be involved in changes in control, whether hostile or friendly. If there were to be changes in control, the prices in many, if not most, cases would reflect a premium over readily ascertainable NAV. Which is the efficient price? That prevailing in the open OPMI market or the price likely to be obtained if there were a control market? As a long-term investor, I would suggest that the price to be realized in a control market is the more efficient price insofar as efficiency reflects economic value.
Insofar as an OPMI's ability to make sound investment decisions about underlying values exists, it is important to note that is easier and more productive to make such decisions today than it was in the Graham and Dodd ("G & D") era that ended in the 1970s. Starting with the Securities Act of 1964 as amended there has been a continuing disclosure explosion. It is now possible for trained OPMIs, like the various Third Avenue analysts and portfolio managers, to learn from public records tremendous amounts of pertinent information about a tremendous number of issuers. This disclosure explosion exists today not only for U.S. issuers, but also for companies listed or traded in Canada, Hong Kong, the UK and also for companies issuing American Depositary Receipts ("ADRs"). This disclosure explosion seems of little or no benefit to financial academics, ETF managers, or high frequency traders. Mostly, these people seem unaware of the existence of these disclosures. In any event, the vast majority of them seem to have no training in how to use the disclosure system that is in place, assuming they ever would want to take advantage of available disclosures.
Behavioral science has many shortcomings, in that it postulates that people in markets do a lot of things that are emotional and irrational. However, much of what those making market decisions do are rational in a market context, but irrational for investment decisions. If market players tried to do what Third Avenue does, most of them probably would be wiped out. Much of what Third Avenue managers do seems irrational from a market point of view. For example, Third Avenue managers tend to invest when the near-term corporate outlook is bad; the managers are value conscious rather than outlook conscious. The managers' talents lie in identifying long-term values, not in gauging immediate market outlooks. It is hard to be a well-capitalized value investor if one doesn't buy aggressively as market prices are declining. This factor, alone, prevents most value investors from outperforming markets consistently.
Very few Wall Street fortunes are made by OPMIs who buy general market securities in the open market. Rather, the fortunes are made by those able to obtain cheap stock prices for a company going public; certain opportunistic creditors; promoters who earn large managerial fees; investment banking fees; trading commissions, and carried interests. In a recent book, of which I am co-author, Modern Security Analysisthere are three chapters describing how OPMIs, through private placements, were able to enjoy huge returns—say 10 baggers to 20 baggers—by being early investors:
1. The limited partners in the three groups which acquired control from Ford Motor Company of Hertz Global Holdings in 2005. While Hertz has not prospered, the returns to limited partners have been huge because the sponsors—Clayton, Dubilier & Rice, Carlyle Corp. and Merrill Lynch have been so skillful in accessing capital markets.
2. The sponsors and promoters of Schaefer Brewing who received common stocks for $1 before Schaefer went public at $26 in transactions which allowed the Schaefer family to extract large sums from the company while still maintaining control of the company.
3. The Leasco transaction where Institutional OPMIs obtained a huge return by committing to finance transactions so that Leasco was able to obtain control of Reliance Insurance without putting up any meaningful amounts of money unless Leasco did, in fact, obtain control of Reliance Insurance.
Twitter (TWTR, Financial) went public November 7, 2013 at $26 per share. On the first day of trading, Twitter Common closed at $45.90.There are obvious benefits to being an early IPO investor, assuming you can get a position size large enough to make a difference to a portfolio's over all return. Even these investors, however, achieved returns orders of magnitude lower than those obtained by Twitter's early investors and its most senior employees. The prospectus discloses, inter alia that 42,708,824 options on common shares, exercisable at an average price of $1.84 per share, were outstanding on June 30, 2013. On occasion, Third Avenue's funds can attempt to recreate this type of scenario by participating in a capital raise or refinancing (see the Third Avenue Real Estate Fund's investment in Trinity Place Holdings, discussed in that team's fourth quarter 2013 letter) but mostly we seek to create the possibility of achieving outsized returns by purchasing undervalued securities in the open market.
Occasionally the above types of returns are available to OPMIs in the general market, e.g., Google Common, currently selling at $1,000 went public at $85. For us at Third Avenue, we mimic the Berkshire Hathaway mode in an attempt to obtain such returns. What Berkshire Hathaway concentrates on is increasing NAV over the long term, albeit Berkshire is basically a control investor rather than an OPMI.
A meaningful number of common stocks in Third Avenue portfolios enjoy Berkshire-Hathaway characteristics, i.e., finances are strong, the companies have superior managements and the prospects for NAV growth appear very good. Unlike Berkshire Hathaway, the various common stocks in the portfolio are priced at meaningful discounts from readily ascertainable NAVs. Such issues include Brookfield Asset Management, Capital Southwest, Cheung Kong Holdings, Exor, InvestorA/B,Pargesa, Toyota Industries and Wheelock and Company.
A large number of the Third Avenue Portfolio investments have the following four characteristics:
1. The companies enjoy super strong financial positions.
2. The common stocks are priced at discounts of 25% to 75% of readily ascertainable NAV. (In contrast, the Dow Jones Industrial Average, at October 31, 2013, was priced at 2.86 times book value).
3. Full disclosures, including reliable audits, are given to the OPMI and the securities are traded in markets that are highly regulated with substantial investor protections (e.g., U.S., Canada, Hong Kong, England).
4. The businesses have good prospects for growing NAV after adding back dividends, by not less than 10% compounded annually over the next three to seven years. One shortcoming of this approach is that there is probably little chance of resource conversion (especially changes of control) that would result, almost immediately, in the elimination, or sharp reduction, in the discounts from NAV. However, this shortcoming will be ameliorated if the businesses grow. There is one macro factor that seems to put the odds in favor of the OPMI achieving satisfactory, long term, investment returns, even if NAV growth is less than 10% compounded. The macro is that perhaps 80% of the time for at least 90% of the companies which are well financed, readily ascertainable NAV will be larger in the next reporting period than it was in the last reporting period. While not determinative of security prices in itself, these steady increases in NAV ought to put the odds in favor of the long-term OPMI who bought into equities at substantial discounts from NAVs. Good companies, with good growth prospects, selling at discounts of greater than 45% are not uncommon. I think mainland China has relatively bright long-term growth prospects. Five issues with direct or indirect presences in mainland China and selling at such discounts, as of the end of November 2013, were as follows:
I shall write you again after the fiscal period to end January 31, 2014. Best wishes for a happy, healthy and prosperous New Year!
Sincerely yours,
Martin J. Whitman
Chairman of the Board
Market participants make two types of decisions—market decisions and investment decisions. Market decisions involve predicting security prices and are, virtually, always very short-run oriented. Investment decisions involve, inter alia, determining underlying value, resource conversion probabilities; terms of securities; credit analysis, and probable access to capital markets particularly for providing bailouts to public markets at high prices (versus cost) for promoters, insiders and private investors.
Modern Capital Theory ("MCT") concentrates on market decisions and provides valuable lessons for specific markets consisting of Outside Passive Minority Investors ("OPMIs") who deal in "sudden death" securities, i.e., options, warrants, risk arbitrage, heavily margined portfolios, trading strategies and performing loans with short-fuse maturities. MCT is of little or no help to those involved primarily with making investment decisions—value investors, control investors, most distress investors, credit analysts, and first and second stage venture capital investors.
The most basic problem for MCT, and all believers in efficient markets, is that they take a very narrow special case—OPMIs dealing in "sudden death" securities, and claim, as the Nobel Prize winner does, that their theories apply to all markets universally. What utter nonsense! Most of the activity—and money—on Wall Street is in the hands of people making investment decisions, not market decisions. For the activist, and value investor, the market is a place for a bail-out at high prices (versus cost), not a place where underlying values are determined. MCT, in looking at Wall Street, concentrates on mutual funds which trade marketable securities. MCT seems oblivious to activists, not studying what activists do, and why they do it.
MCT, not only misdefines markets, but also seems to be sloppy science. The theory embodies the correct observation that almost no one outperforms relevant market indexes consistently. Consistently is a dirty word; it means all the time. In justifying and promoting Index Funds, MCT points to this failure of actively managed funds to outperform consistently. MCT acolytes, however, forget that many managed funds do tend to outperform relative benchmarks, over the long term, on average, and most of the time, notwithstanding their higher expense ratios. It's just plain stupid to state that the quality of money management is tested by looking at consistency. Insofar as MCT identifies what it describes as performance outliers, e.g., Berkshire Hathaway, no attempt is made to study what it is that outliers do that make them outliers, since this would entail the detailed analysis of portfolio companies and the securities they issue. How unscholarly!
MCT cannot possibly be helpful almost all the time to those focusing primarily on investment decisions, i.e., understanding a company and the securities it issues. This is because in MCT four factors are overemphasized to such an extent that economic reality is blurred.
1. A belief in the primacy of the income account with some emphasis on cash flow from operations rather than earnings. (Earnings are defined as creating wealth while consuming cash). If there is a primacy of anything in understanding a business, at least subsequent to the 2008 financial meltdown, it is creditworthiness, not periodic cash flows or periodic earnings.
2. An emphasis on short-termism. I think it is impossible to be market conscious about publicly-traded securities without emphasizing the immediate outlook at the expense of a longer-term view.
3. Overemphasis on top-down macro-factors such as forecasts for the economy, interest rates, the Dow Jones Industrial Average, with a consequent de-emphasis of bottom-up factors such as the financial strength of an enterprise, the relationship of a security's price to readily ascertainable net asset value ("NAV"), or the covenants in loan agreements. It is easy to appear wise and profound, for example, by forecasting outlooks for the general economy. Forecasting about the general economy almost all the time tends to be a lot less important for long-term buy-and-hold investors than are nitty-gritty details about an issuer. Indeed, it seems as if macro forecasts dominated in importance in the last 85 years only in 1929, 1974 and 2008-2009. Even in those years of dramatic down-drafts in the U.S., macro factors tended to be non-important (outside of immediate market prices) for adequately secured creditors seeking interest income or for well-financed companies with opportunistic managements seeking acquisitions.
4. A belief in equilibrium pricing. An OPMI market price is believed to value correctly and OPMI market prices change as the market receives new information. Such a view, though widely held, is ludicrous. The fact that the common stocks of many well financed, growing, companies sell at 25% to 75% discounts from readily ascertainable NAV is mostly lost on finance academics who believe in efficient markets. They do not believe that such pricing can exist, though it does.
The Third Avenue portfolios are replete with the common stock issues of companies which have great financial strength and are selling in the OPMI market at 25% to 75% discounts from readily ascertainable NAV. Such discounts would not exist if the companies could be involved in changes in control, whether hostile or friendly. If there were to be changes in control, the prices in many, if not most, cases would reflect a premium over readily ascertainable NAV. Which is the efficient price? That prevailing in the open OPMI market or the price likely to be obtained if there were a control market? As a long-term investor, I would suggest that the price to be realized in a control market is the more efficient price insofar as efficiency reflects economic value.
Insofar as an OPMI's ability to make sound investment decisions about underlying values exists, it is important to note that is easier and more productive to make such decisions today than it was in the Graham and Dodd ("G & D") era that ended in the 1970s. Starting with the Securities Act of 1964 as amended there has been a continuing disclosure explosion. It is now possible for trained OPMIs, like the various Third Avenue analysts and portfolio managers, to learn from public records tremendous amounts of pertinent information about a tremendous number of issuers. This disclosure explosion exists today not only for U.S. issuers, but also for companies listed or traded in Canada, Hong Kong, the UK and also for companies issuing American Depositary Receipts ("ADRs"). This disclosure explosion seems of little or no benefit to financial academics, ETF managers, or high frequency traders. Mostly, these people seem unaware of the existence of these disclosures. In any event, the vast majority of them seem to have no training in how to use the disclosure system that is in place, assuming they ever would want to take advantage of available disclosures.
Behavioral science has many shortcomings, in that it postulates that people in markets do a lot of things that are emotional and irrational. However, much of what those making market decisions do are rational in a market context, but irrational for investment decisions. If market players tried to do what Third Avenue does, most of them probably would be wiped out. Much of what Third Avenue managers do seems irrational from a market point of view. For example, Third Avenue managers tend to invest when the near-term corporate outlook is bad; the managers are value conscious rather than outlook conscious. The managers' talents lie in identifying long-term values, not in gauging immediate market outlooks. It is hard to be a well-capitalized value investor if one doesn't buy aggressively as market prices are declining. This factor, alone, prevents most value investors from outperforming markets consistently.
Very few Wall Street fortunes are made by OPMIs who buy general market securities in the open market. Rather, the fortunes are made by those able to obtain cheap stock prices for a company going public; certain opportunistic creditors; promoters who earn large managerial fees; investment banking fees; trading commissions, and carried interests. In a recent book, of which I am co-author, Modern Security Analysisthere are three chapters describing how OPMIs, through private placements, were able to enjoy huge returns—say 10 baggers to 20 baggers—by being early investors:
1. The limited partners in the three groups which acquired control from Ford Motor Company of Hertz Global Holdings in 2005. While Hertz has not prospered, the returns to limited partners have been huge because the sponsors—Clayton, Dubilier & Rice, Carlyle Corp. and Merrill Lynch have been so skillful in accessing capital markets.
2. The sponsors and promoters of Schaefer Brewing who received common stocks for $1 before Schaefer went public at $26 in transactions which allowed the Schaefer family to extract large sums from the company while still maintaining control of the company.
3. The Leasco transaction where Institutional OPMIs obtained a huge return by committing to finance transactions so that Leasco was able to obtain control of Reliance Insurance without putting up any meaningful amounts of money unless Leasco did, in fact, obtain control of Reliance Insurance.
Twitter (TWTR, Financial) went public November 7, 2013 at $26 per share. On the first day of trading, Twitter Common closed at $45.90.There are obvious benefits to being an early IPO investor, assuming you can get a position size large enough to make a difference to a portfolio's over all return. Even these investors, however, achieved returns orders of magnitude lower than those obtained by Twitter's early investors and its most senior employees. The prospectus discloses, inter alia that 42,708,824 options on common shares, exercisable at an average price of $1.84 per share, were outstanding on June 30, 2013. On occasion, Third Avenue's funds can attempt to recreate this type of scenario by participating in a capital raise or refinancing (see the Third Avenue Real Estate Fund's investment in Trinity Place Holdings, discussed in that team's fourth quarter 2013 letter) but mostly we seek to create the possibility of achieving outsized returns by purchasing undervalued securities in the open market.
Occasionally the above types of returns are available to OPMIs in the general market, e.g., Google Common, currently selling at $1,000 went public at $85. For us at Third Avenue, we mimic the Berkshire Hathaway mode in an attempt to obtain such returns. What Berkshire Hathaway concentrates on is increasing NAV over the long term, albeit Berkshire is basically a control investor rather than an OPMI.
A meaningful number of common stocks in Third Avenue portfolios enjoy Berkshire-Hathaway characteristics, i.e., finances are strong, the companies have superior managements and the prospects for NAV growth appear very good. Unlike Berkshire Hathaway, the various common stocks in the portfolio are priced at meaningful discounts from readily ascertainable NAVs. Such issues include Brookfield Asset Management, Capital Southwest, Cheung Kong Holdings, Exor, InvestorA/B,Pargesa, Toyota Industries and Wheelock and Company.
A large number of the Third Avenue Portfolio investments have the following four characteristics:
1. The companies enjoy super strong financial positions.
2. The common stocks are priced at discounts of 25% to 75% of readily ascertainable NAV. (In contrast, the Dow Jones Industrial Average, at October 31, 2013, was priced at 2.86 times book value).
3. Full disclosures, including reliable audits, are given to the OPMI and the securities are traded in markets that are highly regulated with substantial investor protections (e.g., U.S., Canada, Hong Kong, England).
4. The businesses have good prospects for growing NAV after adding back dividends, by not less than 10% compounded annually over the next three to seven years. One shortcoming of this approach is that there is probably little chance of resource conversion (especially changes of control) that would result, almost immediately, in the elimination, or sharp reduction, in the discounts from NAV. However, this shortcoming will be ameliorated if the businesses grow. There is one macro factor that seems to put the odds in favor of the OPMI achieving satisfactory, long term, investment returns, even if NAV growth is less than 10% compounded. The macro is that perhaps 80% of the time for at least 90% of the companies which are well financed, readily ascertainable NAV will be larger in the next reporting period than it was in the last reporting period. While not determinative of security prices in itself, these steady increases in NAV ought to put the odds in favor of the long-term OPMI who bought into equities at substantial discounts from NAVs. Good companies, with good growth prospects, selling at discounts of greater than 45% are not uncommon. I think mainland China has relatively bright long-term growth prospects. Five issues with direct or indirect presences in mainland China and selling at such discounts, as of the end of November 2013, were as follows:
I shall write you again after the fiscal period to end January 31, 2014. Best wishes for a happy, healthy and prosperous New Year!
Sincerely yours,
Martin J. Whitman
Chairman of the Board
