Third Avenue Value Fund commentary for the third quarter 2014.
Also see Marty Whitman Q3 Letter to Shareholders: NAV vs Book Value
Dear Fellow Shareholders,
One of the common questions our fellow shareholders have asked recently is whether we are able to find good value investments given the strength of the markets, especially in the U.S. where the broad market indexes are near all-time highs. The short answer is absolutely. While current earnings and price trends are important, our investment process extends well beyond them. Our process is rooted in evaluating the entire enterprise, as opposed to focusing on more idiosyncratic quarterly earnings reports. In our analysis we are essentially counting up the assets and ascertaining a fair NAV for a company as if we were purchasing the entire business. From there we assess the company’s balance sheet and credit profile, to ensure that it has the financial capacity to meet obligations and investment opportunities, as well as the ability to survive market storms.
Our focus on the ability to compound NAV provides a distinction between higher quality companies and those that could be in secular decline or other “value traps” and reveals a lot more opportunities that may appear obscured by a standardized and generic approach to valuation. We ask ourselves what we would do to grow the business and create shareholder value if we were the CEO. We focus our company and industry research and our assessment of the company’s management team against our answer to this question. Thus, by focusing on a longer-term horizon, we see longer?term opportunities that investors absorbed by the shorter term overlook and/ or ignore.
As the U.S. Federal Reserve’s quantitative easing program winds down, we have seen a decline in correlations within equity markets. Investors are now forced to evaluate the risk and return metrics of individual securities. This is significantly different from the broader “risk on versus risk off” macro mindset that has dominated markets over the last few years. In addition, the coupling of cash availability with an improvement in confidence of corporate decision makers, CEOs and CFOs, has led to a resurgence in M&A and other resource conversion opportunities. These actions are a positive for our conception of value investing, as they illuminate the undervalued opportunities we have identified through our research. In market environments such as the current one, it is not surprising resource conversion is a common theme for many of Third Avenue Value Fund’s top performers during the quarter.
In the remainder of the letter we will discuss a number of investments, all among the top contributors to returns, which highlight how our disciplined investment process has enabled us to unveil opportunities in the U.S. Bank and Technology sectors; and in resource conversion opportunities, with examples in the Energy and Real Estate sectors.
Third Avenue Value Fund – Bank Investing and Downside Protection
TAM has a long history of investing in companies in the Financial sector. After the most recent global financial crisis our analysis found regional banks more attractive than money center banks. The focus on regional banks is driven by three main dimensions:
1. Attractive price to tangible book basis with a better return profile
2. Well capitalized
3. Provide downside protection when you need it most
Third Avenue Value Fund’s strategy of investing in regional banks has been a frequent topic of conversation with shareholders as money center banks have lower price to book ratios. In our view, a simple price to book analysis obscures some of the most compelling differences across banks.
The chart below shows fundamental information for Third Avenue Value Fund’s two regional bank holdings, KeyCorp (NYSE:KEY) and Comerica Incorporated (NYSE:CMA), displayed side by side with the same information for three widely held money center banks (Bank of America Corp (NYSE:BAC), JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc (NYSE:C)). Note that from a price?to?book (P/B) standpoint, the differences among these banks, ranging between 0.7 and 1.2, favors the money center banks.
We have preferred regional banks for three reasons. First, at TAM we focus on price to tangible book value (P/TBV) as opposed to simple P/B. Tangible book value is a better measure of intrinsic value as it excludes intangible assets which wouldn’t carry much value in liquidation. As discussed earlier, one of the dimensions we focus on as we evaluate companies is the assets. The valuations of KEY and CMA are much closer to peers listed above on a P/TBV basis. Evaluating just a single statistic may provide misleading conclusions when evaluating an investment. Thus, we also consider how well a company can compound its book value over time. As seen in the table above, both KEY and CMA are generating higher returns on assets (ROA) than peers. This is important as companies that generate higher returns deserve premium valuations. Again, we distinguish among the many metrics. We focus on ROA as the measure of ROA does not favor companies that carry higher leverage and perhaps higher risk.
Second, the Tier 1 Common Equity ratios for KEY and CMA compare favorably against the money center peers. This metric indicates that Third Avenue Value Fund’s regional banks are as well, if not better, capitalized than money center banks. As discussed in the opening paragraphs of the letter, the integrity of the balance sheet is a key dimension to our analysis.
Third, the chart above also shows the Level III assets for each company. Level III assets are not traded in liquid markets so prices are determined using a company’s internal models. Those prices could be entirely accurate, but as seen during the financial crisis, when liquidity dries up, asset prices of illiquid securities can get distorted quickly. We aren’t willing to take that risk. By focusing on KEY and CMA’s TBV and lower exposure to Level III assets, we gain additional comfort with their balance sheets. The regulators agree with our view. The table above shows “severely stressed capital ratios” from the Federal Reserve test earlier this year. The stress test assumptions are extreme (deep recession, high unemployment, 50% decline in equity prices and 2001 house prices), but the results do provide insight into the strength of the asset portfolios.
KEY and CMA’s above average results on the stress tests are another indication of the high transparency and durability of their balance sheets.
This analysis has important implications over how we manage Third Avenue Value Fund because we have a high level of conviction on the securities we select and we scrutinize companies along several dimensions and focus on the appropriate statistics,. One of the key questions we ask ourselves when making an investment is would we buy more if the stock price declined? We mentioned earlier in the letter that we ‘count the assets’ when determining NAVs. We need to be sure those assets will be there when we need them most, such as in times of market turmoil. We would be reluctant to add to our positions if we lost confidence in the values of the assets. This is particularly important when investing in financial companies where the assets values are harder to judge.
In sum, a discount to book value isn’t good enough for us at TAM to invest in a stock. We also need conviction in adequate downside protection. Investing in companies with low leverage and high quality assets helps us develop that conviction. CMA and KEY fit our strict criteria and have provided solid returns to investors thus far and as both grow book value plus dividends in the future, we are confident those returns will continue.
Third Avenue Value Fund invested in the common stocks in KEY and CMA at discounts to tangible book and with the expectation that they could grow book value at double digit rates over time. Given the satisfactory ROAs and BV compounding (trailing twelve month BV growth including dividends: CMA: 12%, KEY: 9.8%), we are happy with how our companies are executing, despite persistently low interest rates and sluggish loan growth. What’s more impressive is that our companies are able to generate higher ROAs despite carrying more excess capital which weighs on returns. Both companies are positive contributors to the Fund’s performance year to date.
Third Avenue Value Fund – Value in Technology: Intel
Some investments are NAV compounders, i.e., ones in which we would like to buy and effectively own ‘forever’. Other investments are more opportunistic in nature. These are investments which we hope to harvest from time to time. In both cases our investment approach remains the same. Our longer term focus on the entire business and its assets can help us identify investments where the short term mindset of the ‘galloping herd’ actually creates opportunities for patient and thoughtful investors.
A case in point is Intel Corporation (NASDAQ:INTC), a well-financed leader in designing and manufacturing microprocessor chips. We invested in Intel common stock early 2013 when the shares sold off meaningfully on investor fears of a poor near term outlook due to weak PC end?user demand and general macro related weakness in IT spending. In our view, these shorter term, more macro related concerns were ignoring Intel’s solid franchise in microprocessors for PCs and servers, which it has continued to enhance through its technological and manufacturing leadership. While Intel faces challenges in trying to capture share in faster growing mobile markets, we believe that there is substantial value in its core businesses. There are reportedly some 600 million PCs that are four years old or older vs. typical replacement cycle at around three years. Given the proliferation of new applications, many of which require greater computing power, an upgrade of one’s PC, particularly in the workplace, eventually becomes a necessity. For anyone who has experienced the frustration of trying to work on an older PC, watching the hourglass or equivalent thereof, slowly spin as an application is loading, you know what we mean! Further, we were being paid to wait, as the stock paid a 4.3% dividend; Third Avenue Value Fund was able to acquire shares at around 4.6 times EBITDA and 10 times earnings.
The strengths of Intel showed through in its second quarter 2014 earnings report which benefitted from an improvement in PC demand, helped by upgrades driven by the expiration of support for Windows XP and a realized 11% increase in pricing in its data center offerings, where Intel continues to be the market leader. We did take advantage of a rise in the stock price to trim Third Avenue Value Fund’s position as shares rose approximately 30% year to date and moved closer to our NAV target.
Third Avenue Value Fund – Resource conversion: A value creation theme
Management teams have many levers to pull from in order to generate value for shareholders. At TAM, we often describe the different types of value creation generally, under the catch-all phrase “resource conversion,” but it can essentially be defined as the many ways that a company has to create value for the underlying shareholder. Mergers, acquisitions, spin?offs, takeovers, asset disposition, large dividends or share repurchases each can be a powerful mechanism to surface value when it’s not fully recognized by the market. We have found that the optimal situation is when a management team has many tools to choose from and is able to capture value from the entire set of choices. This theme has emerged in full force in our energy holdings, which after several years of participating in the industrywide “land grab” now are positioned with diverse portfolios of assets and essentially too many opportunities to efficiently develop within a rational capital structure. Resource conversion was a key driver for the positive attribution from Third Avenue Value Fund’s energy holdings in the third quarter, and also provided us with the opportunity to initiate a position in Weyerhaeuser.
Third Avenue Value Fund’s Energy holdings
Each one of Third Avenue Value Fund’s Independent Energy and Production (E&P) company holdings, Apache, Devon and Encana, moved forward with resource conversion activities in order to surface shareholder value and better focus their drilling and production spending. We were able to build each of these positions when the companies were deploying capital to acquire attractive assets, looking through the markets’ skepticism on the transformation of these companies and focusing on the value that could be created longer term by integrating these properties and optimizing the overall asset base. What was clear to us was that the valuation disparity between pure play E&Ps and more diversified ones allowed us to acquire many attractive assets within these companies essentially “for free” as the market failed to recognize the value of the under?developed assets in their portfolios. In each case, management’s ability to refocus on improving capital efficiency and a bit of successful “self?help” has transformed the profile of these portfolio holdings. We note that we welcome and have benefited from the rise of activist investors’ positions in the sector as their increased public scrutiny has accelerated the resource conversion process.
Encana Corporation (NYSE:ECA) was a pure play natural gas company when fracking technology dramatically expanded the supply of natural gas on the North American market. The company initially struggled to optimize its capital allocation across a very broad portfolio of assets, concentrated on gas. Under the new leadership of CEO Doug Suttles, the company unveiled a strategic shift to focus on its five core liquids?rich plays in North America. Suttles moved to monetize underutilized assets including the sale of the Jonah, Big Horn and East Texas properties for over $4 billion and focus on the highest return assets.
Devon Energy Corp (NYSE:DVN) has benefitted from the merger of Crosstex Energy with Devon’s midstream assets to form the EnLink MLP which strategically unlocked billions of dollars of value that was hidden in these assets. Devon now is focused on the development and optimization of its five premier asset plays, including its prolific Eagle Ford assets and its Permian basin acreage. These actions have transformed Devon from a primarily natural gas producer to a more balanced oil and gas company. Apache (APA) is transforming its holdings from a diversified array of E&P assets to one that is more focused on unconventional onshore liquids plays. We expect the company to live within its cash flow, excluding the CAPEX required for its two liquid natural gas (LNG) projects, Wheatstone and Kitimat. Longer term, we think Apache will at least partially monetize LNG projects, which are operated by Chevron, to focus on higher return projects that support production and cash flow growth. Although not expected nor central to our investment thesis, the recent involvement from JANA Partners further validates our view that significant value remains under?appreciated within Apache’s still fairly diverse portfolio of E&P assets.
Third Avenue Value Fund initiates a position in Weyerhaeuser
Third Avenue Value Fund initiated a position in Weyerhaeuser Co (NYSE:WY) as the company moved to finalize the distribution of its WRECO homebuilding subsidiary in an exchange offer with Tri Pointe Homes Inc. Weyerhaeuser is a Real Estate Investment Trust with wood products and wood fiber businesses, and the second largest owner of timberlands in the U.S. It is worth noting that Weyerhaeuser was sourced with TAM’s Real Estate team and is a solid example of the ability of the Fund to pull ideas from across the entire TAM research team. The Reverse Morris Trust distribution of WRECO was structured as an exchange offer, whereby shareholders could choose to accept shares in the new Tri Pointe, or to retain their interest in Weyerhaeuser. We chose not to indicate for Tri Pointe shares, and were pleased that the exchange offer was oversubscribed so that we retained our full position in Weyerhaeuser. The net effect of the transaction from our perspective was a resource conversion event in which WRECO was traded for a large repurchase transaction, representing roughly 10% of Weyerhaeuser shares plus $700 million in cash.
We see the remaining businesses of Weyerhaeuser, led by CEO Doyle Simons, trading at a substantial discount to our estimated NAV combined with a solid outlook of secular growth, selfhelp margin improvement initiatives and a good way to gain exposure to a recovery in the U.S. housing market.
Post the WRECO divestiture, the remaining operations are Timberlands (about 46% of operating income), Wood Products (35%) and Cellulose Fibers (19%). The timber division owns forests in the U.S., Canada and Uruguay, and recently added 645,000 acres of strategic Pacific Northwest forest with the purchase of Longview Timber in July 2013. The Longview acquisition not only provides operational scale and cost reduction opportunities, but increases Weyerhaeuser’s exposure to the lucrative Asian export log markets, primarily China and Japan. Weyerhauser is able to accelerate the harvest on its acquired Longview acreage, as the average age of the acquired trees was over the optimal twenty five to forty year growth cycle the company targets. The Wood Products operations produce Lumber, Oriented Strand Board (OSB) and Engineered Wood Products and have clear upside cyclical leverage to the nascent recovery in the U.S. single family housing market. The Cellulose Fiber division produces fluff pulp and specialty pulps used in a wide variety of consumer end markets. Division management is focused on reducing costs and increasing manufacturing efficiency to compete in this cyclical industry.
Looking forward, we remain pleased with the current portfolio and optimistic about prospects for future growth. We look forward to writing you again after the fourth fiscal quarter of 2014. Thank you for your continued interest and support of Third Avenue Value Fund.
Sincerely,
The Third Avenue Value Team
Chip Rewey, Lead Portfolio Manager
Michael Lehmann, Portfolio Manager
Yang Lie, Portfolio Manager
Victor Cunningham, Portfolio Manager
