“Superforecasting”
"Superforecasting," by Philip E. Tetlock and Dan Gardner, is a recently published book that studies the idea of whether certain individuals can be better at predicting measurable outcomes, and if so, how they go about achieving those superior results. Through Tetlock and Gardner’s years of studies they seemed to be able to identify a small sub-set of individuals that made markedly more accurate predictions across a wide range of fields than so called experts in those respective areas. And not just over the short-term but over a number of years. To summarize the book, the “superforecasters” weren’t always ones with the highest IQ scores, but instead individuals that followed a very similar process of predicting outcomes whereby they would: (i) gather a wide range of information on a subject with a preference for comparing contrasting views; (ii) use that information to make probability weighted predictions or forecasts; and then (iii) continuously reassess that forecast as new information became available, either supporting or disproving the original prediction as well as incorporating other views. Frankly the process outlined in the book is not dissimilar from the one utilized by the Third Avenue Real Estate team when analyzing investment opportunities, investing in securities, and managing the Fund. To wit, we engage in deep-dive fundamental research, utilize those findings to derive risk-adjusted return expectations, and then concentrate the Fund’s capital around those top ideas while adjusting the portfolio as return expectations change either through changes in price or the incorporation of additional information.
With a similar process in place as these so called “superforecasters”, we believe that if these individuals were tasked with having to make a forecast of what factors would have a high probability of driving performance for the Third Avenue Real Estate Value Fund in its 18th year they would agree on the three following sources:
1. NAV Growth: The Fund is invested in a select group of property companies that control very high-quality portfolios of commercial real estate properties that are also in the process of delivering substantial new development or redevelopment projects. These new properties should meaningfully enhance cash flows as the projects open and stabilize, leading to outsized value creation, NAV growth, and ultimately market recognition of the underlying value of these properties. A prime example is one of the Fund’s core holdings, Westfield Corp., an Australian based company (for now) that owns an irreplaceable portfolio of market dominant malls in the US and UK as well as strategic development projects, including the $2 billion Westfield World Trade Center mall that will be among the most iconic and valuable shopping centers globally when it opens next year and could potentially coincide with the company moving its listing to the US.
2. Improving US Residential Markets: A number of companies owned in the Fund have very strong ties to the US residential markets where construction activity has improved materially over the past few years but remains well below long-term averages. At the current pace of building, which is estimated to be 1.1 million housing units annually, the US is still running a production deficit of nearly 30% based upon the long-term averages—which may prove conservative given the significant increase in the US population over that time period. With low levels of existing supply, both on the single-family and multifamily side, future household formation is very likely to require additional construction activity benefiting those companies that provide inputs to the residential construction process such as lumber (Weyerhaeuser) and well-located land (Newhall Land & Development).
3. Resource Conversion Activity: Given the discounts that a large number of publicly traded real estate companies are currently trading relative to their underlying private market value, it seems highly likely that there will be additional merger and acquisition activity in the space. This is especially the case when considering the performance of most real estate securities this year (indices are negative year-to date) and the vast sums of capital that have been raised by private equity companies (in excess of $75 billion year-to-date). As outlined in previous letters, this capital has begun to be redeployed by privatizing companies that previously traded at sizable discounts to private market values including some owned in the Fund (e.g., Songbird Estates, Quintain Estates). This trend should continue in 2016 and drive performance in a number of the Fund’s “special situation” investments.
Recognizing that the world is highly uncertain, having expectations of what could drive performance like the “superforecasters” is about as far as we go in terms of forecasting at Third Avenue. In fact, if there was one shortcoming with Tetlock and Gardner’s otherwise outstanding work it was looking at what events or outcomes the “superforecasters” were unable to predict. In the studies, forecasts that were wrong were just simply wrong. There weren’t any repercussions to the forecaster. That isn’t the case for the Fund. When investing capital, if one is wrong there can be a permanent impairment of capital, which can be incredibly difficult to ever recoup. This is especially the case when one tries to forecast or invest in such binary scenarios as the ones analyzed in the book. At Third Avenue, we attempt to avoid such binary investments where it either works (i.e., realize a short-term gain) or simply doesn’t work (i.e., total loss of capital). Instead our focus in common stock investing is to buy “what-is” at a significant discount to a readily ascertainable and durable NAV, thus limiting the downside, while making sure that the issuer of those securities is so well financed that it can withstand any unpredictable shocks to avoid any permanent impairments of capital. The Fund also maintains prudent diversification across companies, property types, and geographies so that low probability events don’t impact a disproportionate share of the Fund’s capital (e.g., a “Black Swan” event).
To further mitigate against the prospects of losing capital, steps are also taken to protect against adverse scenarios even if they seem to be low-probability events and may take many years to actually play out. For instance, Fund Management remains mindful of what the impact of higher interest rates might be on property values and real estate securities globally. As we outlined in the shareholder letter published in the first quarter of 2013, the Fund was being repositioned so that it would (i) protect capital in a rising interest rate environment and (ii) potentially even benefit from higher rates. This repositioning was primarily being accomplished by eliminating securities that were popular with income-oriented investors and had been bid up in excess of its fundamental value because of the dividend yield it provided. Instead the Fund’s capital was refocused on securities that traded at discounts to durable values while emphasizing businesses that had portfolios with shorter lease terms (e.g., shorter duration portfolios) and other avenues to increase cash flows in a better economic environment. Furthermore, the Fund initiated investments in a handful of real estate related business that might actually prosper in a rising rate environment, such as US-centric banks like PNC Financial Services and Wells Fargo, that would likely achieve higher Net Interest Margins (NIM’s), Returns on Equity (ROE) and Price to Book multiples as a result of higher rates.
Since that time, there have been three periods where yields for the United States 10-Year Treasury Bond have increased by more than 50 bps (0.5%) in an eight week stretch or less. In all three periods, the Fund has meaningfully outperformed the broader real estate indices. While there certainly can’t be any guarantees that the Fund will produce similar results in future periods, it seems as if the Fund’s positioning is accomplishing what we initially set out for in terms of protecting capital and potentially even benefitting from rising rates. As highlighted in the chart below, this is especially the case for the Fund relative to other real estate investment vehicles.
This differentiated positioning may very well be put to the test again this year as most are calling for the US Federal Reserve to increase the Federal Funds rate for the first time in nearly a decade. We will not engage in speculating on the timing of such a move but these “forecasts” only reinforce our view that long-term investors should maintain a focus on real estate and real estate related securities, similar to those owned in the Third Avenue Real Estate Value Fund, that seem to be less vulnerable to rising rates over time. We thank you for your continued support and look forward to writing to you again next quarter.
The Third Avenue Real Estate Team
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