Dear Fellow Shareholders,
On October 16, 2014, Third Avenue hosted its 17th Annual Value Conference. I would like to share some thoughts from a conversation that I had with our CEO, David Barse, which was part of the formal presentation schedule.
One of the questions related to how Third Avenue thinks about all the attention that passive investing has garnered from the greater investment community recently. While clearly market flows into ETFs have been robust, we believe that the risks of ETFs are not well understood by the market, as it appears the “galloping herd” believes this passive strategy is infallible. A five year bull market in which stocks moved in lockstep (i.e., high correlation) has provided the perfect backdrop for this trend. Investor risk aversion falls during the good times, fueling the mistaken assumption that a passive benchmark is a recommended allocation of an investor’s capital, and that it is risk-free. We have a different view; the risks to an investment exist in spite of them not being materialized. The benchmark is only risk-free in a relative world, i.e., relative to itself. At Third Avenue we ask the same question in every market environment: what can potentially go wrong with an investment? We do this because we are interested in long-term absolute investment performance. Well researched active investing in a concentrated fashion can, and in the history of Third Avenue has, produced investment outperformance over the long term. The value added by active investing is the ability to own well researched concentrated positions, and not have to be forced to own securities where you do not want to allocate your capital.
From a flows standpoint, passive strategies have seen relatively strong inflows. We believe this rush to ETFs has lessened broader investor focus on similar and/or competing strategies to our longer term focused funds. As fewer market participants take our longer-term view, we suspect we will see even more long-term opportunities for investment, as short-term swings are magnified by the “herd” rushing in the same direction. As we discuss later in this letter, the volatility that we witnessed in the fourth fiscal quarter of 2014 provided the opportunity for us to put our cash to work, in new names and in existing positions that had sold off to attractive levels. The appraised net asset values (NAVs) of our companies, set with a three to five year initial investment horizon, did not change through the general market sell-off, and we moved against the herd to selectively increase Fund holdings and opportunistically enter into new positions.
Another topic we covered during the conversation was where we are finding value in today’s markets and what themes we are pursuing. We do, to an extent, pursue investment themes in our idea generation and portfolio construction. This is different from a macro view, and more often than not, these themes are distilled from breaking down the investments that our team currently finds attractive.
Thematic recognition, whether housing, timber or asset sensitive regional banks can lead to additional investments, or finding a superior investment from the initial idea generation. For example, our investment in Weyerhaeuser, the largest held position at Third Avenue, is representative of our view of a strong US housing recovery, a view shared with and championed by our Third Avenue Real Estate team. Weyerhaeuser provides a compelling, yet not obvious, exposure to the US housing theme through its engineered wood products business, especially on the heels of the Weyerhaeuser Real Estate Company (WRECO) split off. In addition to Weyerhaeuser (WY, Financial), our holdings in Canfor (TSX:CFP, Financial) and Cavco Industries (CVCO, Financial) should benefit from a longer-term recovery in US housing. Canfor and Cavco are two well-capitalized and attractively priced companies involved in different points in the residential “value chain”. Cavco, a direct play on housing, is the second largest US producer of manufactured homes. Canfor is an integrated forest products company, focused primarily in lumber used to build houses. We started analyzing Canfor when doing our research on Weyerheauser as it is a competitor, but found its old growth log export market to Asia is very attractive.
Well capitalized, asset sensitive regional banks are another theme we are very bullish on today. The problems that banks faced going into the financial crisis are now completely reversed. No longer are banks full of troubled loans and facing liquidity problems. Now, banks are awash in excess capital due to shifts in regulation, and are facing a tepid loan growth environment due to a slower than historical economic recovery. Over time, we expect banks to better manage and deploy this excess capital, which should be helped by improving loan growth and a steeper rate curve that will once again provide a positive investment spread. Why regional banks? When we compare regional banks to money center banks, we find that the former are more attractive based on a price to tangible book basis with a better return profile, are very well capitalized and provide downside protection through extremely strong balance sheets, as verified by their above average performance in the “stress tests”. Comerica and KeyCorp, top holdings of the Fund, share positive leverage to this theme.
As in the US housing and regional banks themes, it is typically the case that we find a basket of well capitalized and attractively priced companies through which we incorporate our views or themes in the portfolio. But in general we will work on and pass on many more stocks than we will ever own. We do not look at this effort as fruitless, but rather as a benefit of building what we call our institutional knowledge of a company and the industry in which it operates. Often, we find we like the company and the industry, but the discount to our NAV is not compelling enough to merit a buy decision at the current time. In this situation, we add the name to our formal watch list, with the thought that all-else-equal, we would like to own the name at a better entry point. In fact, we wrote about the importance of a patient buy decision in our last letter and the impact on downside protection and eventual upside return. Thus, it should not come as a surprise to our shareholders that over the quarter we have added to portfolio names on weakness, and we were able to deploy capital into four new names. We acted opportunistically on a double digit stock price decline from summer 2014 peaks on each individual buy. Three of these names came from our watch list: Valmont, CBS Incorporated and Brookdale. It is worth noting that Brookdale was co-sourced from our Real Estate team. General Motors was more an opportunistic buy, although as a firm we have extensive knowledge of the automotive space and the name.
The agricultural sector is another example of a fruitful area of idea generation for us over the past few years. Due to weather-related factors, the supply trends have been all over the board, creating high volatility in the stock prices of agriculture-related companies. The volatility in supply is countered by a very strong and steady demand. World population and income levels are growing, driving demand for beef and other protein products. As demand for protein grows, agricultural demand grows with it. At Third Avenue, we are attracted to those situations. Short-term dislocations can produce attractive prices, when the long-term trends are favorable. This means that on occasion we have the opportunity to acquire shares at a discount from our conservatively estimated NAV in the well capitalized companies that we consider to have the ability to compound their NAVs at double digit rates over time. We believe this combination has the potential to generate attractive returns for our shareholders.
We discussed our investment in AGCO (AGCO, Financial), a manufacturer of agricultural equipment, in a recent shareholder letter. Another twist on this theme is irrigation. The largest user of freshwater is agriculture. Thus, irrigation demand is connected with the overall demand for food as the world population grows. It is also driven by water scarcity. Only 2.5% of the total worldwide water supply is fresh water and of that only 30% of fresh water is available to humans. Irrigation demand also stems from (i) conversion from flood based to mechanized irrigation, (ii) replacement demand for parts, and (iii) conversion of non-irrigated land. Mechanized irrigation can improve water application efficiency by 40-90% over traditional irrigation methods such as drip. During the quarter, the Fund acquired shares of Valmont Industries. Valmont is the leader in mechanized irrigation equipment with 40% market share.
As a manufacturer of fabricated metal products, Valmont also makes poles, towers and other structures used for utility transmission, outdoor lighting and wireless communication systems. Valmont’s utility business is also facing a supply/demand imbalance, similar to what we observe in agriculture. While the utility business is facing short-term pressures on pricing, we are optimistic about the longer-term prospects of this industry, given an aging electric power infrastructure in North America and growth potential in developing countries. According to the US Department of Energy, investment in electric transmission infrastructure declined from 1980-1999, while electricity consumption increased by approximately 58%, resulting in increased grid congestion and power outages, some of which were very disruptive (e.g., the August 2003 blackout in the Northeast and rolling blackouts in California in 2001). Further, spending on transmission should be positively impacted by the implementation of FERC Order 1000, a series of measures that requires planning for the connection of renewable energy to the electric grid.
We were able to acquire shares of this well-capitalized, well-positioned company which has compounded book value at nearly 16% over ten years, with our cost basis at a 12% discount to our conservatively estimated NAV. The company’s stock declined recently as a result of pricing pressure in the utility segment and weaker irrigation demand after drought-induced record years in 2012-2013. Interestingly, during the quarter, one of Valmont’s competitors in the utility structures business was acquired by Trinity Industries. This could result in better supply/demand characteristics, and in any case, demonstrates potential attractiveness in a resource conversion scenario.
GM, one of the largest automotive companies in the world, has been on the receiving end of much criticism over the last five years. So much so, that its stock price dropped to levels below its 2010 IPO of $30 per share. Much of this criticism has been well deserved. A high profile bankruptcy coupled with long-term pension woes have turned investors off from this company. GM further compounded its problems earlier in the year by getting embroiled in a high profile ignition recall scandal.
In late September, amidst all the negative recall headlines, S&P upgraded GM's debt to investment grade. The report caught our attention and inspired us to look under GM's hood. Indeed, negative sentiment corresponds to a dated perception of GM. GM today is very different from the company that, saddled by debt and management problems, filed for bankruptcy in 2009. Today, the century old automaker has a clean and strong balance sheet, significantly streamlined operations and is one of the most attractively valued large caps in the US.
Everything we do at Third Avenue starts with the balance sheet. We were happy to learn that GM's automotive unit was carrying a net cash balance of $20 billion, which is impressive considering that GM's market capitalization is only around $50 billion. During GM's analyst day in October, the CFO referred to its priority of maintaining a "fortress-like” balance sheet. We like that! GM is sharing the wealth too with a current dividend of 4%, which appears sustainable given GM's strong financial position.
In the past, management had a propensity to postpone tough decisions, leaving the company vulnerable to steep losses. Management is now positioning the company for less boom and bust results. One fact that resonated with us was that GM had lost $7 billion in North America in 2006 despite higher car sales than current levels. Now sales are lower, but GM is on pace to earn $8 billion in North America this year. Head-count and platforms have been reduced so now GM's break-even levels are over 30% lower than before the crisis. Overseas, GM still has work to do to restore consistent profitability. Cost cutting programs in other geographies are harder to implement. Despite taking a dour outlook on future overseas earnings, we still felt GM's valuation was heavily discounted. The struggles overseas obscure GM’s success in China. China is the largest car market in the world. GM has a long, distinguished history in China and currently holds 14% market share and is generating roughly $2billion in profits through a joint venture relationship, primarily on the local strength of its Buick brand. Moreover, its projected that China will be the largest luxury market in the world by the end of the decade and GM is confident that its Cadillac brand is well positioned to grow with this trend. Furthermore, GM has substantially improved its pension plans and the liabilities are at manageable levels. If interest rates rise, as many expect, those liabilities could improve dramatically.
One of the more common concerns investors have regarding GM is that car sales in the US will decline. We don't share that view. Although sales have improved from the bottom in 2009, they aren't back to 2006 levels. Most importantly, the average age of vehicles remains elevated: 40% of vehicles on the road in the US are over 12 years old. We believe the replacement cycle will last longer than people expect. In addition, fuel efficient cars and enhanced technology in vehicles will drive future sales as well. Although we believe the negative thesis on GM is over-done, we acknowledge that there are risks to this investment. As discussed in the previous paragraph, our thesis hinges to some extent on GM having a strong business in the US, thus a slowdown of the US economy may have a negative impact on this investment. Auto manufacturing is a cyclical business, and we took this into consideration as we conservatively estimated our NAV for GM.
Finally, recalls are a risk of investing in any automotive company, but we are comfortable with that risk given GM's strong balance sheet and current cash flows. Third Avenue's credit team has studied the company closely over the last five years and gave us valuable insights in assessing the risks to this investment.
A lot has transpired in GM since the bankruptcy in terms of balance sheet improvement and streamlining of the business. As value investors it is hard to pass on such an attractively priced company, in spite of (or maybe even because of) the excessive negative sentiment it has generated. After a very detailed look under the hood of GM, we think that the “new” GM is an attractive use of your and our capital.
During the quarter the Fund initiated a position in CBS Corporation. CBS derives revenues from i) advertising on its owned and operated TV and radio networks, ii) content licensing and distribution and iii) affiliate and subscription fees (retransmission fees). The investment opportunity presented itself when shares sold off in the quarter, likely due to the unwinding of short-term event driven positions in the stock following the spin-off of its outdoor advertising unit, CBS Outdoors, and short-term concerns over a softer ad market.
However, we believe the long-term investment case is compelling, as the company is well positioned to capitalize on a new phase of industry transformation where boundaries between distribution and content are being blurred. The new paradigm is likely to benefit the content owners over distributors as the digital revolution has opened multiple new avenues of distribution that will compete for quality content. This change in relative leverage in the media value chain is likely to translate into earnings growth via i) retransmission fees and ii) content monetization. We believe CBS will benefit significantly from this secular change as it is one of the best curators of content in the industry. Over the last decade, the mix of the 20 highest rated shows in the US has changed meaningfully, but the one constant factor has been CBS’s ability to get eight to ten of the top 20 shows consistently, something which no other network has come even close to matching. At its core, this ability to consistently create top notch programming is what differentiates CBS management from all the other networks, in our view. CBS should benefit from incremental demand from content distributors, including TV networks, Subscription Video on Demand (SVOD), and virtual MVPDs (multichannel video programming distributors).
CBS is also leading the way in pushing for broadcast station retransmission fees and has grown EBITDA contribution from its retransmission by 18 times to approximately $500 million since 2008 and is targeting $1 billion in retransmission revenue by 2017 and $2 billion by 2020. As of now the company is pacing ahead of its $2 billion target. As these high margin fees are a “new” source of revenues for existing content, they almost entirely flow down to earnings. Furthermore, CBS has a strong balance sheet with net debt to EBITDA of 1.6x, and is able to generate $1.5 billion to $2 billion of free cash flow per year. CBS is embarking on a $6 billion share buy-back program, allowing it to retire close to 20% of its outstanding shares in the coming six quarters.
We believe CBS presents a compelling investment opportunity, with our cost basis at a meaningful 20% discount to our conservative estimate of NAV, and is likely to continue to grow NAV at 10%+ a year via i) retransmission fees, ii) content monetization and iii) share buyback. While short-term volatility around advertising spot market prices should be expected over our initial three to five year horizon, more material risks that would lead us to reconsider our investment would include an inability to continue to produce high quality content or a failure to achieve a higher normalized compensation level for this content.
In closing, we wanted to reflect on the volatility in the broader markets from July to August, where a steep move down was quickly met by a frenzied rally into quarter end. Critical to our philosophy is our recognition that the appraised Net Asset Values of our companies did not change over the sell-off and ensuing rally. What did change was the discount to the NAV, which provided us with the opportunity to deploy capital opportunistically. A price conscious buy decision is a key lynchpin to our philosophy. We have said before that we work on many more companies than we will ever add to the portfolio, with the dual benefit of this work serving to broaden our institutional knowledge and to fill our work-in-progress list of strong companies that we continue to monitor should an attractive opportunity develop. The popularity of short-term “hedged” and passive strategies, in our opinion, will continue to drive volatility at a high level, creating overvalued situations to harvest and undervalued situations to opportunistically buy. We view our three to five year holding period as a pillar of strength and a strong differentiator to value creation.
We continue to be extremely positive about the outlook for our portfolio companies. Recent market volatility has not compromised our investment theses. Instead, it has presented a buying opportunity; we have added to several names in the Fund. We thank you, as always, for your trust and your support of the Value Fund. We look forward to writing to you again at the end of the next quarter and wish you a happy and healthy new year.
The Third Avenue Value Team
Chip Rewey, Lead Portfolio Manager
Michael Lehmann, Portfolio Manager
Yang Lie, Portfolio Manager
Victor Cunningham, Portfolio Manager