Third Avenue Small Cap Value Fund’s letter to shareholders for the year ended December 31, 2014.
Dear Fellow Shareholders,
Our investment philosophy is to construct a concentrated portfolio, composed of companies i) with healthy balance sheets to try to provide downside protection, ii) with the ability to strongly grow book value over time and iii) that trade at an attractive discount to our conservative estimate of Net Asset Value (NAV).
In the past quarter, we saw several examples of what we call resource conversion that the Third Avenue Small-Cap Value Fund (Fund). A key differentiation point of our philosophy is that we welcome resource conversion opportunities that can drive value for sheets and the ability to compound book value must come first. Thus resource conversion opportunities are additive to our investment thesis.
Third Avenue Small?Cap Value Fund: Acquisition targets
Management teams across several holdings in our portfolio have engaged in resource conversion, either as takeover targets or targeting other companies for takeover, and other restructuring activities. Two of our positions were acquisition targets. City National, a 1.4% position in the portfolio, announced that it would be acquired by Royal Bank of Canada. City National offers banking, investing and trust services to small to mid-sized businesses, entrepreneurs, professionals and affluent individuals. We initially bought City National because it has a very capable management, a strong credit culture, a unique market position stars? and a large money management subsidiary. During the 2008-2009 global financial crisis, many depositors withdrew money from other banks and moved to City for better safe keeping. We started to build a position in City National in February of 2013 at about $55 a share, and Royal Bank has offered to buy City for $93.80 a share.
In November of 2013, 734 Agriculture purchased a 50.5% interest in Alico, a 1.5% position in the portfolio, effectively taking control of the company. Alico owns 130,800 acres of land in Southwest and Central Florida, and is engaged in agribusinesses such as citrus groves, sugar cane and cattle. Alico also possesses a hidden gem in its ability to use its land to help manage a perpetual problem in Florida ? the shortage of water. The company has been awarded a large long-term contract, which will be highly profitable for shareholders. We feel there is potential for additional contracts like this one in the future. Shortly after 734 Agriculture attained control, the new management spent $363 million to acquire three Florida citrus producers, which now makes Alico the largest citrus producer in the United States with annual production of 10 million boxes. As a result of this resource conversion activity, this long-time Fund holding was a top performer in the quarter.
Third Avenue Small Cap Value Fund: Management changes at CST Brands
Several of our companies were the initiators of takeover activity in the quarter as well. Over the last few months, management of CST Brands (CST), a 1.4% position in the portfolio, made Third Avenue Small-Cap Team Chip Rewey, CFA several strategic moves to improve the value of the company. CST, spun off from Valero (VLO) in April of 2013, operates around 1,900 gasoline stations and convenience stores across the United States and Canada. In August of 2014, CST acquired the general partnership of Lehigh Gas GP, LLC with the intent of eventually placing more stores and fuel supply businesses into this MLP structure to leverage the acquired General Partner interest. In addition, management is optimizing and improving the productivity of its large store network. CST, like most gasoline retailers, is benefiting from the large decline in crude prices which translates into low prices at the pump, which is a nice near term benefit but not a critical factor in our investment case.
All of these factors should Vail Resorts, a 1.6% position in the Fund, has been a long-term compounder, appreciating over 250% since we initiated the position in 2008. Management continues to be aggressive in resource conversion activities. In September of 2014, Vail acquired Park City Mountain Resort in Utah for Canyons properties will make it the largest mountain resort in the U.S. This Park City acquisition already large real estate portfolios surrounding its premier resorts such as Vail, Beaver Creek, Breckenridge, Northstar and Kirkwood. Leucadia the names in our portfolio, but is also a strong example of why we focus on the balance sheet of Swiss Franc, they had no choice but to accept the life line that Leucadia offered; terms of the loan effectively give Leucadia control of the company. target acquisitions are high and by definition the risk of integration is non-existent. Legg Mason, a position that we initiated in September of 2013 at about $34 a share is now about 2.3% of the Fund and a classic example of the type of business that we seek: companies with a good business model and shareholder oriented management. Over the last four years, Legg Mason (LM) has bought back 30% of its shares, in addition to increasing its dividend each year in the same period. The company continues to return excess cash to shareholders by starting a new $1 billion or 16% share buyback program, on its calendar fourth-quarter result. There are many other opportunities among companies in the Fund to engage in resource conversion. This is why we find improved measures of CEO confidence surveys and the pick-up in corporate activity to date encouraging.
Third Avenue Small?Cap Value Fund: Patterson Companies a strong performer for the Fund
We have owned Patterson Companies, a distributor of consumables and equipment in the dental, animal and medical rehabilitation market since May 2014 and it has been a strong performer for the Fund. Through its scale buying advantage, and its turnkey selling and service solutions for its fragmented customer base, Patterson has been able to compound tangible book value growth at 17% for the last five years. Patterson has continually built through acquisitions and steadily returned capital to shareholders, a combination we see as continuing to grow value over time. On the resource conversion front, we see the opportunity for Patterson to separate its relatively small medical rehabilitation unit, through a spinoff or a sale, which would provide better clarity on capital allocation decisions and return of capital to investors, with the resulting units likely to get a valuation uplift due to their superior growth and profitability profile.
Cubic Corporation, a Fund holding since 2013, is a company with two very distinct units, a defense training company, providing electronic warfare and soldier cultural immersion functions, and a transportation fare installation and processing company. Cubic has compounded book value growth at 11.7% over the last five years, and has a rock solid balance sheet with over $4 per share net cash. We think the military operations of Cubic, albeit high quality divisions, obscure the true gem of the transportation company. A separation of these businesses and a more aggressive use of the balance sheet would serve to dramatically improve the market trading value of the company in our opinion.
SemGroup, a Fund holding since 2011, has operations in oil pipelines, storage terminals and natural gas processing facilities. Over our holding timeline, SemGroup has built and acquired assets and moved to monetize them by drop downs to its MLP units, which leverages the value of its GP holding. The company has come under pressure from activists to accelerate the pace of asset sales to its MLP unit. This dropdown strategy is the roadmap SemGroup intends to follow, and we agree a more aggressive pace on dropdowns would accelerate the attainment of our NAV targets for the company. Post the quarter end, Semgroup did announce another drop-down transaction of $325 million of assets, confirming our view of the trend for value creation.
JZ Capital Partners, which shows over a 60% discount to its own published NAV of ‘W657.70 per share, continues to harvest its small cap US holdings, including the sale of Milestone Aviation Group Ltd to GE Capital Aviation Services this quarter. Even factoring in a holding company discount that management team.
We view these and other potential resource conversion opportunities as nice optionality for portfolio companies with strong balance sheets and credible NAV compounding abilities.
Third Avenue Small?Cap Value Fund: Portfolio activity
In the quarter we initiated two new positions, WCI Communities and Viad Corporation.
One area that we continue to be particularly excited about at Third Avenue as we look into the next few years is the recovery of the US housing market. US new home sales activity stalled in 2014 for several reasons, resulting in a recalibration of earnings growth projections for homebuilders. This development affected the share prices of small-cap builders the most, which allowed us to initiate positions in the common stock of WCI Communities at a price close to book value. WCIC develops luxury single and multifamily homes in most of coastal Florida’s highest growth and largest markets, controlling approximately 10,400 home sites. t/??predecessor filed for Chapter 11 in 2008 and emerged from bankruptcy in September 2009. During the process, the company wrote down its assets at the time of the emergence in 2009 due to fresh-start accounting, establishing a average margin of mid 20s. Although WCIC has recently emerged from bankruptcy, its management team has extensive experience in the industry, having worked at leading homebuilders prior to joining WCIC. Should the stock continue to trade at a significant discount to its intrinsic net asset value, we believe its unique qualities, such as long dated land bank with desirable geographic Small-Cap Value Fexposure among other things, will appeal to larger builders as the uncertainty around the U.S. housing market recovery decreases. In the meantime, the company has a fortress like balance sheet with a long duration land bank (largest in the space) that appears significantly undervalued on its financial statements. As larger builders run short of high-quality, buildable lots, WCIC may become an attractive acquisition candidate.
We started to build a position in Viad Corporation. Viad was spun off from Dial Corp in 1996. Dial was a conglomerate that owned disparate businesses such as Greyhound Buses, Dial Soaps, Purex Detergents, Renuzit Air Fresheners and Amour Star canned meat. Viad itself at one time also owned Travelers Express and MoneyGram International, but now has two remaining businesses: Tradeshows and Recreation. Through its subsidiary Global Experience Specialists, Viad is the second-largest general contractor that sets up some 2,400 exhibitions such as tradeshows, conventions and corporate events worldwide annually. GES is responsible for constructing marquee expositions such as the Farnborough Air Show in Hampshire, England that has 2,000 exhibiting companies from 50 countries and 200,000 attendees and the ConExpo-Con/Ag, the largest international tradeshow for construction and agricultural equipment in Las Vegas. Under its Recreation segment, Viad owns three travel companies that offer hotels and tour packages in Banff, Alberta, Montana and Alaska. We like Viad due to its unique assets that have high entry barriers and its ability to generate high level of cash flows.
The current management team is long tenured at Viad, having built and grown the assets they now operate. The company has no debt and has been using excess cash flow to buy back shares and pay special dividends. From a resource conversion standpoint, the company has discussed its willingness to separate Viad into two companies after it has built up the scale in each. We estimate that as independent entities, the value of these two segments could be worth $37 to $40 a share. In the meantime, we believe stock is undervalued, trading at 5.4% of its free cash flows. Although the Fund was down slightly on an absolute basis in our fiscal first quarter, we believe the underlying fundamentals for the market and moreover our investment philosophy continued to improve. As we have discussed in the past, we do not forecast macro-economic data nor select predictions. However, we are pleased to see the broader indicators of the U.S. economy showing a continuing recovery, albeit at times with some mixed signals. U.S. GDP figures continued to strengthen from November through January, the unemployment rate stayed on its downward trend and surveys of consumer confidence remained at high levels. Perhaps most importantly, we have also seen surveys of CEO confidence, which summarize the views of decision makers and capital allocators, showing optimism. We have noted that the tone of the conversations that we have had with management teams underwent a noticeable shift in tenor in 2014, from a focus on protecting their companies from a renewed recession, to focusing on where to reinvest, the need to add capacity and how best to deploy capital to accelerate growth. In short, we see corporate management teams as having moved past the financial crisis, and now of managers to managing the business as a solid leading indicator. Additionally, we believe that a of equity indices to fall, as investors reward stronger companies and avoid financially challenged companies and companies that do not have the ability to compound book value.
Third Avenue Small Cap Value Fund
In conclusion, we are optimistic about the holdings in the portfolio as the companies have the financial strength, the market position and track records of compounding value. Furthermore, many companies have opportunities to unlock value, beyond the operational improvement. Most importantly, we feel that the portfolio is further protected on the downside because the holdings are selling below our appraised intrinsic values. In closing, our work-in-process list remains full and currently has opportunistic representation in Energy, Consumer Cyclicals and Financials. While we will work on many more names than we will ever own, we look forward to discussing our new ideas with you in our letter next quarter. Thank you again for your trust and support in the Fund.
Third Avenue Small-Cap Value Team
Lead Portfolio Manager