Dear Fellow Shareholders,
I am honored to have taken the sole lead position on the Third Avenue Small-Cap Value Fund (Fund). My co-Portfolio Manager, Tim Bui, and I will continue to pursue the concentrated approach to value investing that has been the pledge of the firm since its founding. This vision for the Fund is rooted in Marty Whitman’s investment philosophy, which I embrace fully. Marty’s teachings have been an important influence on my own approach to investing.
We scour the investment universe seeking companies that combine the three main features that represent the pillars of Third Avenue’s investment philosophy: creditworthiness, a meaningful discount to a conservatively estimated net asset value (NAV) and the ability to consistently compound NAV. As we seek investments for the Third Avenue Small-Cap Value Fund, we are not looking for the “flavor of the month” in the US small cap universe; our initial targeted holding period is three to five years. We engage in rigorous financial statement analysis combined with industry studies and peer comparisons in our approach to determining value. We set our NAV as if we were acquiring the company, and then seek an appropriate discount from this target to enter an investment. A patient “price conscious” buy is a critical first step in both protecting capital and in realizing an attractive investment return up to our NAV.
We pursue financially healthy companies that have the ability to compound NAV, which is a critical differentiator of our investment philosophy versus shorter-term investors who focus solely on the ability to close the discount to an NAV target. The ability of Fund holdings to compound NAVs at double digit annual rates provides for the means to achieve a return from generating book value growth, measured in our view by retained earnings growth, while also recognizing the likely closing of the static discount to our NAV target. Compounding retained earnings growth also provides protection on the downside by allowing us to “risk time and not capital”. Yes, we like to see what we refer to as resource conversion, i.e., a spinoff, sale, buyback or any other event that will highlight the undervaluation of our investment, but it is critical that the first three aspects of our investment philosophy come first. By focusing on creditworthiness and compounding, our philosophy builds in the high likelihood that the price conscious discount that we have identified will close over time. The disciplined implementation of this approach is what differentiates this Fund from the “galloping herds”.
Sincerely,
Chip Rewey, Lead Portfolio Manager
Third Avenue Small-Cap Value Fund
Dear Fellow Shareholders,
As we reflect on the fourth fiscal quarter, a humorous saying comes to mind: “Don’t let the facts get in the way of a good story”. Perhaps this could be sage advice for entertaining friends, but clearly not an appropriate approach to investment management and portfolio construction. The story of August to October 2014, of course, was the sell-off in small caps. The financial press buzzed with the sell-off story, but the facts just aren’t there. For the quarter ended October 31, 2014, the Fund’s Institutional Class share returned 3.02%, trailing the Russell 2000 Value Index’s return of 4.10%.1 While the story is the sell-off that occurred from July month end to October 13, the Fund was down 5.61% while the Russell 2000 Value Index was down 5.89%; the quarter ending rally changed the facts. Because we focus on creditworthiness and downside protection, we are not too surprised to have trailed a “risk-on” rally over the last two weeks of the quarter (Fund up 9.15% vs. Russell 2000 Value up 10.62%), and as a result of this rally, for the quarter overall. Volatility such as this demonstrates a misplaced short-term focus vs. a fundamental driven philosophy of creditworthiness, discount to NAV and ability to compound NAV over our initial three to five year investment horizon.
As we read and reflected on Marty Whitman’s letter this quarter, one quote stands out clearly “…Wall Street analysis and Wall Street wealth derives from the fundamental in depth analysis of companies and securities, and not from the study of markets and securities prices”. The volatility witnessed from August to October, in our minds, is another reinforcing example of Marty’s philosophy. The NAVs of each of the companies we hold, which we derive through independent fundamental research, did not change over the ten-week sell-off and two-week snap-back recovery. What changed was the pricing of these securities in the markets.
Over the years, you have heard Third Avenue discuss the importance of executing on price conscious buys and remaining opportunistic. A price conscious buy sets the basis for future return potential and, as importantly, provides downside protection to avoid a return-sapping capital loss. In our view, the sell-off in the quarter provided the opportunity to increase our weightings in several portfolio names, and for a price conscious buy on a few new names where the discount relative to our NAV appraisal widened.
During the quarter we initiated three new positions, which we discuss below, and eliminated 16 positions. Many of these sales should be seen as completing the sale process of smaller position sizes. Of course this reduced the number of names in the Fund, now 65 at quarter end, and increased its concentration, a weighted average of 1.53% for each position. We view this level of diversification as more typical for the Fund, 60-65 names, with an average position size of 1.5% or greater.
1 The Fund’s one”year, five-year, ten-year and since inception (April 1, 1997) average annual returns for the period ended October 31, 2014 were 7.09%, 13.18%, 6.85% and 9.07%, respectively. The Russell 2000 Value one”year, five-year, ten-year and since Fund inception (April 1, 1997) average annual returns for the period ended October 31, 2014 were 7.89%, 16.15%, 7.81% and 9.74%, respectively. Third Avenue Small-Cap Value Fund is offered by prospectus only. The prospectus contains more complete information on advisory fees, distribution charges, and other expenses and should be read carefully before investing or sending money. Past performance is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than original cost. The Fund’s returns should be viewed in light of its investment policy and objectives and quality of its portfolio securities and the periods selected. M.J. Whitman LLC Distributor. If you should have any questions, or for updated information (including performance data current to the most recent month”end) or a copy of the Fund’s prospectus, please call 1”800”443”1021 or go to our web site at www.thirdave.com. Current performance may be lower or higher than performance quoted.
New Positions
Barnes Group Inc. (B, Financial) is a unique industrial company, with several smaller divisions, a few of which in our opinion are hidden gems for the company. Barnes’ operations in industrial tooling supply, spring and nitrogen spring motion control, commercial aerospace original equipment (OE), maintenance and aftermarket exposure don't make for a quick and easy summary. However, these operations combine for a unique and attractive NAV, with an extremely visible long-term ability to drive book value growth. On the industrial side, over the past two years, Barnes has divested its under-scale European and US distribution businesses at peak valuations, and invested in intellectual property-driven machine tool companies specializing in hot-runner technology, which have and should continue to drive revenues and margin expansion for the company. On the aerospace side, Barnes not only has high value OE engine content on platforms such as the 787 and A350 which have multi-year build backlogs, but also has the exclusive “life of program” right to supply replacement parts for CFM (GE/Safran Joint Venture) engines. This Revenue Sharing Program (RSP) business is a hidden aftermarket gem for Barnes that should compound value for decades as these engine programs are still actively being built, and will need to be serviced multiple times over their multi-decade service lives. The long-term visibility of revenues and cash flow from these programs also serve to support long-term creditworthiness and downside protection.
Anixter International (AXE, Financial) is a distributor of all types of cables and electrical wires for intra office and industrial plants to manage network connectivity and electrical systems. It also has a small division that distributes nuts and bolts for equipment manufacturers. We like Anixter because it is a very well-managed company with a global footprint, a scalable business model and large addressable markets—good ingredients for compounding value. The company serves as a crucial link between some 1,600 wire and cable manufacturers and over 100,000 customers who buy roughly 450,000 types of wires, cables and related data products. The company positions its role as the manager of procurement, inventory, quality testing, engineering advisory and just in time delivery for the Fortune 1000 companies. Anixter’s business model is unique in a sense that the items that it sells account for only about 5%-10% of the final value of its customers’ products or processes, but these products would cost the customers many times more if these items were mis-handled or delayed in delivery. Thus, customers normally seek competency rather than price in selecting distributors. Investors in Anixter are protected not only by the company’s competitive position and a strong balance sheet, but also the aligned interest of management. As an additional positive, Sam Zell, the Chairman, owns 11.5% of the shares, which in our opinion supports shareholder friendly decisions, including the current practice of distributing all of the free cash flow via special dividends or stock buy backs.
Clean Harbors Corporation (CLH, Financial) provides a unique mix of high margin, high barrier to entry businesses in the oil service, waste management and recycling industries. On the oil service side, CLH provides drilling services and fluid management in North America and globally. Through its Safety Kleen division, it recycles used motor oil to ultra high purity levels and re-markets it as its Ecopower brand. Its lodging services division provides remote location accommodations for the materials sector globally. These and other diverse sector exposures not only provide a balanced ability to compound value for the long term, but also likely provide interesting fodder for future resource conversion activity through spin-offs, divestures and targeted acquisitions.
In closing we will reflect on another closing; that is the end of the US Federal Reserve’s Quantitative Easing (QE) program in October. While we will leave our views on the program’s success or failure for perhaps another occasion, we believe the ending of the program is a clear positive for our fundamental driven philosophy. The program acted as a prop to equity markets, as it ultimately promoted risk-taking. Over the course of the program, many market participants viewed QE as a back-stop or put option wherein weaker companies with stressed balanced sheets would be, in effect, bailed out by the ability to issue capital easily and cheaply into risk-seeking markets. A strong balance sheet is a key determinant of our measure of credit-worthiness of a company, which is a key tenet of our investment philosophy. As QE ends, we believe the broader investment community will migrate back to a focus on downside protection as well as upside risk-driven optionality. Said differently, we believe individual stock selection will return as a key differentiator of markets and managers, as opposed to Exchange Traded Funds directional exposure driven investing. We look forward to this balance returning to the markets, noting we have not wavered from our view in our management philosophy.
We thank you for your continued trust and support of the Fund.
Sincerely,
Third Avenue Small-Cap Value Team
Chip Rewey, Lead Portfolio Manager
Tim Bui, Portfolio Manager
