A reader, the Great Sandesh, alerted me to this. By the way, I am not a fan of Prof. Greenwald’s book, Value Investing: From Graham to Buffett and Beyond written by Bruce C.N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema. But I do highly recommend his book, Competition Demystified, to learn strategic analysis.
Whitman discusses the book in his 2001 TAVF Shareholder Letter
There seems to be a general misunderstanding about wealth creation companies in the financial community and in academic circles. First, there is scant recognition of the fact that outside of Wall Street, where one deals with privately owned businesses, the vast majority of economic endeavor involves striving to create wealth in the most tax effective manner. Where control persons have choices, they would rather create wealth by some means other than having ordinary income from operations simply because striving for cash flows or earnings from operations tends to be highly inefficient tax-wise.
Second, in their new book, Value Investing — From Graham to Buffett and Beyond written by Bruce C.N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema (Greenwald and van Biema are faculty members at Columbia Business School), the authors seem to have trouble identifying, and valuing, net assets. They state, “in the contemporary investment world net-nets are, only with the rarest exceptions, a distant memory.” In fact, though, each of the nine wealth-creation common stocks Third Avenue acquired during the quarter is a net-net by any economic, non-accounting convention, definition of net-nets.
Greenwald, et al define net-nets only by looking at accounting convention,not economic reality. They define net-nets as a common stock available at a price that represents a discount from a company’s current assets after deducting all book liabilities, both short-term and long-term. The problem with this measurement is that for going concerns, much of their current assets are not current assets at all, but rather fixed assets of the most dubious value. For example, Sears Roebuck, like any other retailer, could not stay in business if it did not maintain inventories continually, which in Sears’ case have a carrying value of over $5 billion. In the aggregate, these inventories are a fixed asset for the going concern, not a current asset. Individual inventory items do turn to cash within 12 months and thus are, for accounting purposes, called current assets. In fact, though, Sears’ aggregate $5 billion investment in inventory is a permanent investment, particularly vulnerable to seasonal mark-downs, theft, obsolescence and mislocations.
Contrast this with Forest City’s developed real estate projects. While Forest City’s developed real estate is called a fixed asset, a substantial portion of these assets is really quite current, a source of almost immediate cash through sale or refinancing, without interfering with Forest City as a going-concern. Forest City Common is a true net-net. The same is true for other wealth creation common stocks acquired during the quarter at substantial discounts from readily ascertainable net asset values; — including the probable real estate values in Alexander & Baldwin and Catellus; the probable securities values in Brascan (including real estate), Phoenix Companies, MONY and Toyota Industries; and the probable values of Assets Under Management (AUM) for BKF and Legg Mason.
VALUE INVESTING AT THIRD AVENUE
The back of the Greenwald book describes the investment approaches of a number of highly competent value investors:
— Warren Buffett; Mario Gabelli; Glen Greenberg; Robert H. Heilbrum; Seth Klarman; Michael Price; Walter and Edwin Schloss and Paul D. Sonkin. It’s a worthwhile read. Third Avenue, in its practices, seems to have much in common with these investors. The front of the Greenwald book, though, describes underlying theories about value investing.
These theories seem to have nothing to do with the basic assumptions under which Third Avenue operates. Contrasting the Third Avenue approach with the Greenwald approach ought to be helpful in getting investors to understand the Third Avenue modus operandi.
A major difference between the Greenwald approach and the Third Avenue approach revolves around valuing a company and valuing a security. Greenwald, et al state, “There is general agreement that the value of a company is the sum of the cash flows it will produce for investors over the life of the company, discounted back to the present.” The Greenwald approach is far too general to be useful for Third Avenue. For TAVF, there exist four factors which contribute to corporate value and three factors which determine the theoretical value of a security.
THE FOUR ELEMENTS OF CORPORATE VALUE:
1. Free cash flow from operations available for the security holder: Very few companies ever actually achieve such free cash flows on a reasonably regular basis. While for any individual project to make sense it has to return a cash positive net profit over its life, this is not true for most companies (as distinct from stand-alone projects), especially expanding companies. Most businesses consume cash. TAVF likes to invest in the common stocks of those few companies in a position to create cash flows on a regular basis. The principal area where this takes place in the Fund’s portfolio is in money management companies: — BKF, John Nuveen, Liberty Financial and Legg Mason.
2. Earnings: Most prosperous going concerns create earnings, not free cash flows. Earnings exist where a company creates intrinsic wealth from operations while consuming cash. Since most going concerns consume cash, their earnings streams may be of limited value unless such flows are also combined with access to capital markets, either credit markets or equity markets or both. TAVF, in acquiring the common stocks of earnings companies, limits its acquisitions to businesses with exceptionally strong financial positions. This means, most of time, that the companies have far less need to have access to capital markets during any given period than run-of-the mill, less well capitalized, going concerns. More importantly, though, the companies whose issues the Fund acquires have rather complete control over the timing as to when they want to access debt markets or equity markets. Capital markets are notoriously capricious in terms of both pricing and availability. TAVF tries to avoid investing in the common stocks of less well capitalized companies, in part because such issuers frequently are forced to raise outside capital at the most disadvantageous times. Well-capitalized earnings companies whose common stocks were acquired by TAVF during the quarter include Energizer, Trammell Crow, American Power, Applied Materials, AVX, Credence, Electro Scientific, KEMET, MBIA, Nabors, and Vishay.
Most Wall Streeters and most academics, including Greenwald, et al, subscribe to a primacy of the income account point of view and believe that the dominant, and sometimes even the sole, sources of corporate value are flows from operations: — both cash flows and earnings flows. At TAVF, we have a balanced approach. Indeed, we think more corporate wealth is created in the U.S. by the two factors discussed below than by flows, even though frequently there tends to be a close, symbiotic relationship between flows, whether cash or earnings, on the one hand; and asset values and access to capital markets on