Martin Whitman’s letter to Third Avenue Fund shareholders for the period ended July 31, 2015.
Dear Fellow Shareholders,
There are those who believe that markets are efficient—finance academics, traders, owners of Index Funds and ETFs, and market participants who study market price and security price movements while ignoring the study of companies and the securities they issue. They are wrong. There are those who believe that markets are inefficient—value investors, active investors, distress investors, control investors, many credit analysts and those who are first and second stage venture capital investors. They are also wrong.
The fact is that some markets are highly efficient, or tend to be, and some markets are grossly inefficient, or tend to be. It is a matter of individual differences among and between disparate markets. In one very important sense academic finance and economics seem to be immature social sciences compared with say, law, psychology or sociology. In academic finance and economics the emphasis is on discovering general laws while in law, psychology and sociology, the focus is not on general laws, but rather on individual differences on a case by case basis.
It is helpful to define efficiency. At Third Avenue Management (TAM) we believe efficiency breaks down into three parts:
- Value Efficiency: At TAM value efficiency is defined as that price, and other terms, which would be arrived at in a transaction between a willing control buyer and a willing control seller, both with knowledge of the relevant facts, and neither under any compulsion to act.
- Process Efficiency: Prices that would be arrived at outside of control markets. Such prices usually will be much below value efficiency prices where there are little or no prospects for resource conversions, especially changes of control, going private, or massive distributions to equity holders; where particular securities issues may lack marketability; where there is a lack of disclosures to passive investors, either through regulatory filings or management communications; or where there is an absence of regulatory protections for passive investors. Such prices also may be far higher than value efficiency prices. This especially seems to be the case where companies have access to capital markets at super attractive prices such as is the case of equity offerings of high tech companies during the IPO boom. Prices in excess of value efficiency prices are tricky because in the hands of competent management, overpriced common stocks can be a business’s most important and most valuable asset.
- Transaction Efficiency: Prices to be realized in sudden death situations where there are likely to be readily determinable work-outs in readily determinable periods of time; and where the securities are analyzable by reference to only a limited number of computer programmable variables. Such securities include options and warrants; pending merger transactions; tender offers; voluntary exchanges; balance sheet arbitrage, especially convertible arbitrage; and certain liquidations and spin-offs. Day traders too, deal in markets which for them are characterized by transactional efficiency, in that the trading horizon is ultra-short term. Transaction efficiency markets are almost always highly efficient. Finance academics seem to concentrate on the study of transaction efficiency markets because their concentration is on immediate changes in securities prices. They use such markets to postulate general laws, not realizing that transaction efficiency markets seem to be a special case; for example such markets seem to have little or no relationship to, say, control markets.
At the various Third Avenue Management Funds, the concentration is on acquiring common stocks that sell at meaningful discounts from fund management’s estimate of value efficiency prices. However, such investments tend to be restricted to the common stocks of companies which are strongly financed. In less well financed companies underlying values can dissipate quite rapidly, and often do.
Third Avenue: Passive markets seems to be inefficient
Most passive markets, excluding sudden death securities, seem to be very inefficient in measuring long-term value efficiency. This seems quite understandable in light of the things considered most important to most non-control market participants. Most non-control equity investors seem to believe the following:
- There is a primacy of the income account—especially current and near term forecasts from operations as measured either by cash flows or accounting earnings. Instead, TAM’s focus is on a company’s ability to grow NAV 10% per year, compounded.
- There is an emphasis on short termism—how might the price performance of the common stocks be in the immediate future. In contrast long term shareholders such as Third Avenue Management tend to concentrate on prospects over a three to five year time frame allowing for either resource conversion or market dynamics to realize value.
- There is an emphasis on top down considerations when making buy, hold, and sell decisions such as the general market outlook, interest rates, the Dow-Jones Industrial Average, Gross Domestic Product, etc., with a consequent downgrading of bottom-up factors such a refinancing, new capital expenditures, management changes, mergers and acquisitions, etc.
- There is a belief in equilibrium pricing, i.e., the current stock market price reflects a universal value and will only change as the market digests new information. In contrast, at Third Avenue Management we believe we can acquire common stocks at prices that represent meaningful discounts from value efficiency prices. Most market participants and finance academics focus on changes in security prices rather than corporate fundamentals in their analyses. It seems impossible, to me at least, to have a focus on security prices without being short term concentrated.
The promoters of ETFs and Index Funds believe securities markets are efficient because no one outperforms benchmarks consistently. Consistently is a dirty word. It means all the time. Many in the investment process do outperform benchmarks on average, most of the time, and over the long term, but not consistently. Such performance, however, is not enough to satisfy passive investors who seem to boast about their ignorance of companies and the securities they issue; they need the impossible – outperformance all the time. Those who seem to outperform over the long run, on average and most of the time include many, many, value investors, active investors, distress investors and certain venture capitalists. Insofar as these persons or institutions achieve superior results, it seems to center around their having intimate knowledge about companies and the securities they issue. Public disclosures have gotten better and more comprehensive over the years. The public record is now so good that outsiders can know much, much more about most companies than was dreamed possible in the Graham and Dodd days which stretched from the 1930’s to the 1970’s. Unless one seeks to have intimate knowledge of the companies and the securities that they issue, one seems restricted to being conscious of transaction efficiency even denying the existence of value efficiency and process efficiency. This seems to be the case for most day traders and most financial academics.
At Third Avenue Management, the emphasis in common stock investing is to acquire common stocks of well financed companies at meaningful discounts from our estimate of value efficiency prices. We also examine the probabilities for resource conversion activities which would eliminate process efficiency pricing or in any event, bring the pricing closer to value efficiency pricing. As passive investors it is hard to be accurate about forecasting resource conversions. In contrast, it is pretty easy for TAM analysts to have a good degree of confidence about the long-term growth of NAV’s and underlying efficiency values. The essential underlying fact is that historically, in over 80% of the cases, NAV seems to have been larger in the latest reporting period than it had been in the prior period; if TAM has bought in at a discount from NAV, then all that has to happen to get satisfactory market performance, is to have the discounts from NAV not widen and stay widened. This highly probable growth in NAV by no means guarantees satisfactory market performance but ought to put the odds in favor of good performance for various Third Avenue Management portfolios.
Several of the securities in Third Avenue Management portfolios lack relative marketability. As a consequence, their prices as measured by process efficiency are far, far below what the prices would be measured by value efficiency. The appreciation potential in these common stocks seem to revolve around either resource conversions or massive increases in NAV. In this regard it seems useful to look at the three things (other than being a nuisance) that can create value for a common stockholder.
- Owning common stocks can give the holder elements of control, or control, of a company. It seems as if most non-trading activities on Wall Street are involved in this type of security ownership even though it probably accounts for only of a small fraction of trading volume.
- Owning a security can give the holder access to cash payments by the company for interest, principal or premium for a credit instrument, or dividends or share buy-backs for an equity instrument.
- Owning a security can give the holder access to a market in which the security might be sold for cash or marketable securities. Put otherwise, the investor owns something with little or no value if he owns a common stock which has no nuisance value, pays no dividend, and does not provide the holder with a market out by sale to either a market or to the issuer itself. TAM does not want to own such securities regardless of what its value efficiency might be.
I shall write you again when the Third Avenue Management Annual Report for fiscal 2015 is published.
Sincerely yours,
Martin J. Whitman
Chairman of the Board
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