Dear Fellow Shareholder,
Portfolio holdings are subject to change without notice. The following is a list of Third Avenue Small-Cap Value Fund’s 10 largest issuers, and the percentage of the total net assets each represented, as of October 31, 2015: Genpact, Ltd., 2.64%; CSG Systems International, Inc., 2.54%; Barnes Group, Inc., 2.48%; Tetra Tech, Inc., 2.34%; WCI Communities, Inc.; 2.30%; Commerce Bancshares, Inc.; 2.27%; Syntel, Inc., 2.22%; Standard Motor Products Inc, 2.21%; Kaiser Aluminum Corp., 2.19%; Viad Corp., 2.16%
As parents of three young children, my wife and I are continually managing the balance between nurturing their education, providing athletic outlets to keep them active and strong and most of all, keeping them healthy and safe. Despite our best planning, our children always seem to find a way to surprise, delight and frustrate us in new and unusual ways. The most recent example involves our 6th grade Football and Lacrosse player, and the concussion he got in Math Class. Clearly there were risks in letting him play these full contact sports, but they are his passion and with training and full pads, we decided to let him play. “They don’t call it the unexpected because you see it coming” is perhaps the best phrase I can think of to describe our thoughts on hitting one’s head in math class, especially in contrast to where we saw the potential for this sort of risk. Thankfully, he’s fine. As I reflect on this story now, not only do I realize it will be a source of humor for our family for some time to come, but also I feel it’s a good lead in to discuss how we build our portfolio to balance seen and unseen risks.
The three pillars of our investment philosophy—creditworthiness, the ability for a company to compound book value growth and low equity valuation—guide us to what we believe are investments that will generate attractive returns over the long term. Stock selection is a key driver of returns, however, as Marty Whitman well said “every investment has something wrong with it”. Our duty as Portfolio Managers is, therefore, not limited to finding the best investments but also to manage risk in order to reduce the chances of permanent impairment of capital and avoid investments that will not perform over the long term. This quarter we will provide insight as to which type of risks we are willing to take in order to achieve our investment goals.
Our collective 55 years of experience (25 for Chip and 30 for Tim) have taught us what we believe is one of the most important lessons in portfolio risk management: position sizing. This is especially true in a small cap strategy. The following figure illustrates the framework we use to think about position sizing, which involves striking the right balance between the fundamentals of the business—as defined by our investment philosophy—and the upside potential we see in an investment. We allocate more capital—larger position sizes—to investments that we believe have better business fundamentals and more upside potential. For example, Genpact—the largest position in the Fund—meets those requirements and thus has a 2.62% weight, as of October 31, 2015.
More importantly, our position sizing philosophy drives portfolio risk control by properly sizing intriguing investment cases that carry more risk, for example cyclical names such as Interfor or Circor, versus a “steady eddy” with less potential upside like Broadridge or DST.
Risk management is an art and a science. It involves evaluating the investments both individually and collectively, and typically requires focusing on what is not evident. At the stock level the focus is on creditworthiness—one of our three pillars—as we believe this provides downside protection. Companies with a solid balance sheet will likely not be forced into adverse capital raising or asset sale decisions that can destroy equity value in times of duress. At the portfolio level we conduct a host of analysis—screens, thematic categories, correlation studies—on a regular basis to identify risks. We devote a lot of our time to these kinds of analysis, some of which we provide more detail on below.
We will quote Marty again, “there is no general risk—only specific risk”. From our perspective, portfolio management faces five types of risks: macro, business, financial, valuation and sentiment. We will elaborate and discuss how we try to manage each one.
1. Macro risks. Factors such as commodity price changes, interest rate fluctuations, industry supply and demand imbalances, political upheavals, other countries’ government’s policy changes, war and others—the list is long—affect the prices of securities and may in turn affect the fundamentals of a company. While we do not make macro forecasts, we do assess the potential impact that such shocks may have on the value of our holdings. We believe that maintaining a diversified portfolio helps manage this risk. Proper diversification will ensure that a macro shock will not generate severe losses of capital. Note that when we think about diversification we are not thinking about increasing the number of stocks in the portfolio or matching industry exposure with the benchmarks. True diversification—in our view—can be achieved with concentrated position sizes as we assemble a group of uncorrelated stocks, stocks that will not be subject to the same macro shocks.
2. Business or operational risks. An in-depth fundamental analysis will help us to forecast potential problems with some degree of accuracy, but even the most thorough analysis cannot entirely predict new product launch success or failure, timing delays or industrial accidents. We manage operational risk via proper position size. A stock with the largest upside potential may not hold the largest position because the probability of realizing that potential might be limited and/or uncertain if the business fundamentals are not there. We balance the upside potential with business quality. Business quality is broadly defined as stability of revenues, margins, growth, as well as reinvestment opportunities. We would not own low quality businesses even at very attractive prices.
3. Financial risk. Our investments typically have high quality disclosure, which allows us to thoroughly evaluate the strength of the company’s balance sheet. We believe this provides downside protection as creditworthiness allows management the wherewithal to execute or defend their strategies, take advantage of industry opportunities, as well as the ability to survive turbulent periods.
4. Valuation. Investing doesn’t mean buying subpar businesses solely based on very low multiples such as Price to Earnings or Price to Book ratios. For us, value investing mean buying at a discount to a readily ascertainable net asset value. Before establishing each position, the analysis must cover various aspects of valuation so that we can feel reasonably certain of the NAVs and our price target. If the discount is not sufficiently large, the ideas go into our “bull-pen” list. Patient buying is a virtue in investing.
5. Sentiment risk. In spite of claims of rationality, many investors at times can be driven by wild optimism or unabated pessimism. We do not “follow the herd” buying momentum stocks of companies that do not make fundamental sense or are not in our valuation parameters. We believe this is a short-term strategy, and—like a mood—can reverse in a whim. Over the long term, we believe that fundamentals—and not sentiment—drives prices, but this implies that sometimes the short term will be volatile. Indeed, stocks with temporarily bad statistics and with correlating low expectations are common hunting grounds for our idea generation as negative sentiment can actually protect on the downside as well as provide future upside as clarity emerges.
Of course an idealistic preference would be to find risk free investments, but we are realistic. Portfolio management is about trying to measure and balance some reasonable risks to generate attractive returns over long term. That is where our efforts are focused.
New Positions
The volatile underlying markets in our fiscal third quarter ended October 31, 2015—Russell 2000 Value Index peak to trough move of over 13.5%—provided ample opportunities for new ideas. We initiated five positions over the quarter. We discuss our investment thesis for each below.
DST Systems Inc. (DST, Financial)
DST is the largest information processor for mutual funds in the US, and also offers software, securities processing and other services to financial services companies, insurance companies and third party administrators. DST’s offerings are high margin and high barrier to entry services that lower cost and increase service quality to its customers. DST has grown its book value at a 5-year CAGR of over 14% and we think this growth will continue as DST continues to penetrate the “in-house” serviced mutual funds, still about 50% of the industry, and also as it grows into health care and insurance claims processing.
We have followed DST for many years, and were able to initiate a position on the heels of a choppy second quarter earnings report at a 20% discount to NAV, where the market became concerned about higher security and compliance investments and the risk of a large customer, Cigna, transitioning away a portion of its processing business. These short term concerns pressured the shares, and overlooked the positives of i) abating mutual fund sub account conversion activity, winding down by year-end 2015, ii) the continued monetization of non-core investments, including State Street shares, pacing at approximately $100 million per quarter and iii) robust share repurchase activity. Moreover, since his appointment in August 2014, CEO Steve Hooley has been undertaking a review of all business units, to drive margin expansion, exit non-core units including record keeping and UK accounting and strategically investing to leverage the emerging demand for data analytics from DST customers. We believe this quality franchise will see increasing demand for its services and increased margin leverage from internal initiatives that should drive double digit equity compounding over the foreseeable future.
SPX Flow Inc. (SPX Flow)
SPX Flow (FLOW, Financial) is a global supplier of flow control equipment including pumps, valves, mixers, filters, air dryers, separators and heat exchangers serving the food and beverage, power and energy and industrial markets. The company was spun out of SPX Corporation in September. The original SPX Corporation management team moved over to SPX Flow where they are continuing to execute on their multi-year restructuring efforts.
Post spin, management has already increased its segment operating margin targets, and announced plans to expand low cost manufacturing in Poland while shifting production from two higher cost European manufacturing facilities. Management is also focused on improving their material sourcing, streamlining the back office operations and reducing expenses.
From its post-spin levels of just under 3x debt to EBITDA, SPXFlow’s products should benefit from secular long-term growth in the dairy industry as developing nations increase their consumption. Although SPX Flow is facing a cyclical downturn in upstream oil and gas activity, this activity accounts for only 14% of total company revenue. The remaining power and energy businesses should benefit from increased demand from the midstream and power sectors. The industrial segment which primarily serves chemical and air processing industries should remain fairly stable.
We expect the company will generate around $100 million of free cash flow a year representing an 8% free cash flow yield which management will likely use to repay debt—the company’s leverage ratio is just over 2x—and eventually make acquisitions in the highly fragmented pump and valve industry. We also believe that SPX Flow could be an attractive acquisition target for a larger flow control peer, providing another aspect of our downside protection for the shares. At our purchase cost, we see roughly 40% upside to our mid-case NAV.
Kirby Corp.
Kirby Corp. (KEX, Financial) is the largest chemical tank barge operator in the United States. While many shipping companies tend to be commodity businesses with low margins and volatile earnings, Kirby is different. Margins on its inland and coastal barge businesses are near 25%, a profile you would expect in a consumer staple company rather than a chemical barge operator. Kirby’s margin profile results from two sources: industry structure and dominant positioning. Kirby operates in a Jones Act market. The Jones Act is a protectionist policy implemented by the United States government in the 1920s, which requires that all goods transported between US ports be carried on domestically constructed, US-flagged ships that are owned and crewed by US citizens. This structural barrier-to-entry lowers competition and creates high margins for the entire industry. In its markets, Kirby controls close to 30% of industry barges, well beyond its closest competition. Kirby therefore is able to lead on pricing in the market and on average has been able to raise prices above inflation.
Kirby’s management maintains an unlevered capital structure with significant liquidity, positioning itself to make acquisitions during times of industry distress when it can pick up quality assets at large discounts. However, like all managements, Kirby is not flawless. Indeed, it is the negative impact of the 2011 acquisition of United Engineers, a manufacturer and servicer of fracking equipment that contributed significantly to the decline in Kirby’s shares from a year ago ($125 to $61), which gave us the opportunity to initiate this position. While clearly the earnings and revenue from this acquisition have disappointed, we believe the selloff is overdone. United Engineers only accounts for 10% of Kirby’s operating income, and even with our valuation ascribing no value for this segment, we still see significant upside from today’s stock price. Kirby’s core barge operations are healthy, with spot rates close to current contract rates and it is still operating at 90%-95% utilization. More importantly, the chemical industry has committed to over $100 billion of capital expenditures through 2020 to build new chemical plants, setting up the industry for an increase in demand outpacing the current excess supply. At our purchase cost, we see almost 50% upside to our $90 mid case NAV.
Southside Bancshares
Southside Bancshares (SBSI, Financial) (Southside) is a retail and commercial bank in Texas. While off the radar of many investors, Southside has been in business more than fifty years and today is one of the ten largest banks based in Texas with nearly $5 billion of assets and a remarkable track record. Within the last year Southside acquired and has been integrating another bank in Texas named OmniAmerican (Omni) which we believe will be transformative for the company.
We believe the acquisition will significantly increase Southside’s growth profile. Since its founding in 1960, Southside has been predominantly focused on East Texas and has grown to command a dominant position within the market. Based in Fort Worth, Omni now gives Southside a platform with which to expand within the fast-growing Dallas-Fort Worth metroplex. Moreover, Southside has been able to dramatically reduce expenses at Omni and sees significant opportunities for adding offerings to the bank outside of lending. Simultaneously, Southside has begun an aggressive organic expansion into the Austin market which has become the fastest-growing city in the country. With Southside’s over-capitalized balance sheet, particularly after the Omni acquisition, it has more than sufficient capital with which to expand in these new markets.
In addition to Southside’s outlook for growth, we would highlight the bank’s extraordinary track record and strong management team. In an industry rife with subpar capital allocation, Southside has proven itself to be a very conservative lender, always maintaining a strong balance sheet and credit culture and very high credit quality. This has resulted in exceptional compounding of the company’s book value at over 11.5% for the past ten years and over 16.5% when adding back dividends paid.
We believe investor neglect and misunderstanding gave us the opportunity to purchase Southside, as the markets indiscriminately sold banks fearing energy loan exposures. Conversely, Southside’s direct energy exposure is de minimis at less than 1.5% of its loan portfolio and indirect energy exposure even less. Intentionally, Southside also has no presence in the Texas geographies most exposed to the energy sector such as Houston and West Texas. We believe that at the undemanding valuation of 13-14x earnings this was a very attractive opportunity for the Fund, allowing us to buy a strong compounder at a reasonable 30% discount to our NAV estimate.
We would also note that Southside’s success over the years and strong prospects aren’t lost on other banks in the market and that Southside could become an acquisition target itself in time.
DSW Inc.
DSW Inc. (DSW, Financial), which stands for Designer Shoe Warehouse, is one of the largest discount shoe retailers in the US. The company operates 430 stores in 42 states and also sells its merchandise online. Its strategy is to offer a large assortment of some 24,000 pairs of shoes of various styles for both men and women through its warehouse style showrooms. Customers freely browse the store to try on different styles from the shoes displayed without needing to request salespeople to fetch proper sizes. Its business model is to leverage its large purchasing power and pass through the 20-30% savings to consumers. Despite the highly competitive nature of the retailing industry, the company’s value and convenient offerings provide a unique market position that allows it to defend against the onslaught of newly formed ecommerce companies, as indicated by its stable market share. DSW shoppers value the ability to see, touch and try on shoes as part of their shopping experience.
Similar to clothing, shoes are a seasonal business. The recent extreme weather, a very seasonally warm Fall, has impacted sales much more than management’s efforts to weatherproof the operations. We see this weather issue as temporary, but it did significantly contribute to the almost 50% decline in share price since April, and provide an opportunity to invest in DSW. In any typical year the business is very profitable and generates high level of free cash flow.
On a longer term note, we endorse the company’s investment in technologies to expand its online business, improve inventory management, and reduce future store opening needs. Having the “omni-channel” capability, where customers can order online and have the items shipped to one’s house or picked up at a nearby store, provides the advantage that many other competitors do not have. Furthermore, better technologies will enable the company to carry shoes suitable to local market demands. Better inventory management also means lower markdowns. More importantly, if the online strategy succeeds, DSW will be able to reach a larger market without having to build new stores, all of which should allow DSW to improve its profitability and increase operating margins 150-200 basis points over the next two years.
From a financial perspective, DSW is trading at about $23.50 a share as of November 27, 2015, with a very strong balance sheet with net cash and investments of $5.24 per share. We think in a normal year, DSW has a $2.50 a share earning power, which provides a mid-case NAV target of $40, a level it traded at earlier in the year.
Outlook
In spite of market volatility, the Fund outperformed the Russell 2000 Value benchmark by 1.61%1 for the year ended October 31, 2015. We attribute this to a combination of successful stock selection and risk management. The Fund has an active share of 96% as of October 31, 2015.2
Thematically, we are excited about the positioning of the Fund, with several fundamental positions exposed to the improving US housing recovery, and overcapitalized and asset sensitive regional banks. We have added to selective consumer and energy positions.
In conclusion, I’ll quote my wife on our view of raising our children “They are our inspiration and our perspiration”. Like stocks, they can challenge us in the short term, but it’s important to keep one’s long term goals in mind. This view is very similar to the thoughts Tim and I have shared with you in this letter on portfolio construction.
While we cannot possibly control every risk in every investment we make, by adhering to our time tested and simply stated philosophy and building a portfolio that balances risks through position size management, we believe we can construct a portfolio that can outperform over time.
In our letter for the Value Fund, we reference the year-to-date market that has rewarded earnings growth and momentum strategies over value. We, too, see this impact in small cap and thus are not only pleased that our value driven strategy has continued to outperform, but are also excited as we see investment opportunities in strong companies that have been oversold. This sort of volatility is the friend of the patient investor, and our work-in-process lists remain full with potential opportunities.
We thank you for your trust and support and look forward to writing again after our first quarter.
Sincerely,
The Third Avenue Small-Cap Value Team
Chip Rewey, Lead Portfolio Manager
Tim Bui, Portfolio Manager
1 The Fund’s Institutional share class one year, five year and ten year average annual returns for the period ended October 31, 2015 were - 1.27%, 10.02% and 5.11%, respectively. The Fund’s Institutional share class one year, five year and ten year average annual returns for the period ended September 30, 2015 were -0.70%, 9.84% and 4.39%, respectively. Past performance is no guarantee of future results; returns include reinvestment of all distributions. The above represents past performance and current performance may be lower or higher than performance quoted above. Investment return and principal value fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. The Fund’s total operating expense ratio, gross of any fee waivers or expense reimbursements, was 1.15%, as of April 30, 2015. Risks that could negatively impact returns include: fluctuations in currencies versus the US dollar, political/social/economic instability in foreign countries where Fund invests, lack of diversification, volatility associated with investing in small”cap securities, and adverse general market conditions. Prospectuses contain more complete information on management fees, distribution charges, and other expenses. Please read the Prospectus carefully before investing or sending money. For current Fund performance or a copy of the Prospectus please visit our website: www.thirdave.com or call 800”443”1021. M.J. Whitman LLC, Distributor. Member FINRA/ SIPC.
2 Active Share is the percentage of a Fund’s portfolio that differs from the benchmark index.
This publication does not constitute an offer or solicitation of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this publication has been obtained from sources we believe to be reliable, but cannot be guaranteed.
The information in this portfolio manager letter represents the opinions of the portfolio manager(s) and is not intended to be a forecast of future events, a guarantee of future results or investment advice. Views expressed are those of the portfolio manager(s) and may differ from those of other portfolio managers or of the firm as a whole. Also, please note that any discussion of the Fund’s holdings, the Fund’s performance, and the portfolio manager(s) views are as of April 30, 2015 (except as otherwise stated), and are subject to change without notice. Certain information contained in this letter constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe,” or the negatives thereof (such as “may not,” “should not,” “are not expected to,” etc.) or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of any fund may differ materially from those reflected or contemplated in any such forward-looking statement.
Third Avenue Funds are offered by prospectus only. Prospectuses contain more complete information on advisory fees, distribution charges, and other expenses and should be read carefully before investing or sending money. Please read the prospectus and carefully consider investment objectives, risks, charges and expenses before you send 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.
If you should have any questions, please call 1-800-443-1021, or visit our web site at: www.thirdave.com, for the most recent month-end performance data or a copy of the Funds’ prospectus. Current performance results may be lower or higher than performance numbers quoted in certain letters to shareholders.
M.J. Whitman LLC, Distributor. Date of first use of portfolio manager commentary: December 9, 2015.
