Third Avenue Value Fund portfolio commentary for the second quarter ended April 30, 2015.
Dear Fellow Shareholders,
In this quarter’s letter we discuss conviction –a key concept for fundamental, bottom up Managers of a concentrated portfolio such as the Third Avenue Value Fund (Fund). We talk about what conviction means to us and what drives our conviction in today’s portfolio. Rather than an academic discussion on the topic, we share with you the main aspects of our theses on a number of investments in the Fund as well as our views on some of the main themes in the portfolio.
Third Avenue Value Fund - Portfolio Activity
We have constructed a Fund that is opportunistic, eclectic and inclusive of individual stocks and credit instruments at substantial discounts from our conservative appraisal of intrinsic value of the companies. The concentrated nature of our portfolio is made possible by building conviction in our individual investment cases through quantitative and qualitative due diligence in our research efforts. We have built this conviction not by trying to prove our investment theses right, but instead by actively trying to prove ourselves wrong. Somewhat like a dentist poking a tooth to seek out decay, we focus our research on where things might go wrong. We start with the balance sheet to assess creditworthiness and systematically move to appraise the other aspects of a company’s financial statements, management strategy, competitive environment and current business results as a measure against these longer term goals.
The long road, including our three to five year investment horizon, is rarely smooth and consistent. As Marty Whitman has opined, consistency on a short term basis is not our primary goal, what we measure is consistent outperformance relative to the relevant index over any rolling three to five year period. With conviction in our investment thesis, we can weather periods where everything does not go exactly right for our investment cases, knowing that we are taking the risk of time as to when our investment case generates capital appreciation, vs. the risk of losing capital if not everything goes according to plan.
As we reflect on the results of our Fund over the first four months of this year, while we have compounded a positive absolute return, the relative return has trailed our primary benchmark, the MSCI World index, and been more consistent with our secondary benchmark the S&P 500. Just as we measure the quarterly results of our portfolio companies as periodic updates to our investment thesis, we take measure of our quarterly portfolio results to measure our portfolio construction and ensure our conviction levels remain high. In the aggregate, we have three major themes expressed in our portfolio construction currently. We own a few positions each in: overcapitalized financial companies, oil exposed exploration and production companies and companies that are levered to a strengthening US housing cycle. Our high conviction in each of these names and themes was tested this quarter, but as we look at our portfolio at quarter end, we can assure you the conviction in both our portfolio names and our overall construction is high. We are excited to watch our companies execute over the next three to five years.
Our investment experience with CK Hutchison Holdings (formerly named Cheung Kong) is a perfect example of why we need to maintain our conviction when our stocks are out of favor. It has been one of our biggest winners in 2015. The Value Fund made its first investment in Cheung Kong in May 2005. Over the ten year holding period, we have discussed it many times because it has had an impact on our performance (both positively and negatively). Despite the volatility of the stock price, the operating performance has been outstanding and consistent. It’s been said a picture tells a thousand words. We think the chart below tells you a lot about CK Hutchinson Holdings.
As the chart and total returns indicate, focusing on wealth creation is the right way to monitor an investment. Although book value per share isn’t a perfect way to measure changes in wealth creation, it’s a pretty good one. Despite two jaw boning stock price drops in 2008 and 2011, book value per share marched ahead, growing every year except one. Even when book value per share declined in 2008, it only dropped 1%. The impressive book value growth gave us the conviction we needed to stick with it despite the volatility. Our shareholders were rewarded handsomely as CK Hutchison Holdings outperformed the relevant indices. CK Hutchison Holdings had 11.7% annualized returns during the May 2005 to April 2015 period, while the MSCI World and the S&P 500 indices had 7.3% and 8.3% annualized returns, respectively.
Third Avenue Value Fund - Overcapitalized Financials: Our Inclination toward Regional Banks
In our October 2014 letter, we profiled three of our top financial companies, Bank of New York Mellon, Comerica and KeyCorp. The macro environment for these positions could not have been tougher over the last six months. The yield on the ten year US Treasury moved from 2.17% at year end to 2.03% at April 30th, touching a 50+ year low of 1.64% in the interim as the Fed most likely postponed its long anticipated first rate increase of this cycle from June to at least September and the US economy fell victim to a soft patch this winter with slower employment and GDP growth measures. While we could debate whether this weakness was due to a deep freeze that left us hoping for some localized global warming impacts as we stood in the wind on a cold train platform, we instead look at the individual developments of each of these investment cases over the last six months, and we do like what we see.
Bank of New York Mellon was a solid contributor this past quarter, recovering from weakness early in the year. In March, it passed the Federal Reserve stress tests and was given permission to repurchase up to $3.1 billion in stock. This is a credit to Bank of New York Mellon’s strong financial position and the soundness of its business model. The activist activity surrounding the company also began paying dividends. Trian Fund’s co?founder, Edward Garden, was added to the board of directors and specifically went on the Human Resources & Compensation and the Risk committees, where he will likely effect constructive changes. Cost control at Bank of New York Mellon has been a constant challenge since the completion of the Mellon Financial Corp. acquisition in 2007, but the past two earnings reports have shown disciplined cost management and better than expected results. In this case, the heightened scrutiny on costs from two activist investors is resulting in shareholder friendly actions. We are monitoring this activist situation closely.
Our conviction in Comerica held throughout the quarter, and the stock recovered from earlier in the year weakness to be a solid contributor for the Fund. The Wall Street community is very good at myopically focusing on issues. 7% of Comerica’s loan book is comprised of energy loans. In its first?quarter earnings release and on its investor call, management gave supporting evidence showing its energy loan book credit metrics remain solid and performing