Third Avenue Value Fund commentary for the Fiscal Quarter ended October 31, 2015.
Dear Fellow Shareholders,
I love to eat, and perhaps my favorite food is a great Cheeseburger. To paraphrase Jimmy Buffet, “Cheeseburger is paradise”. In my opinion, like all great things in life, the brilliance in a great Cheeseburger is in its simplicity. A perfect afternoon for me is spent outside on my back patio, simply grilling a great Cheeseburger. Add the lettuce, tomato and a fresh roll and you have a tried and true formula to surprise and delight friends and family alike. As any great foodie, however, I do like to try new things, and given that I work in New York City, I am spoiled by the endless choices of what and where to eat. If one has a sense of adventure and a love of food, New York can produce exciting triumphs, but also unfortunately some unseemly food adventures. In the world of food, straying from a simple plan can be fun and involves little in the way of long term risk.
In the investment world however, straying for the simple plan is not advised. We agree with the quote by Sam Zell, Equity Group Investment LLC CEO in his review of Marty Whitman’s book ‘The Aggressive Conservative Investor’, where he writes “In reading this book, one is struck by the simplicity of the ideas and the dependence of the investor on his own understandings of reality as opposed to the myths on the street.” In our past letters, we reiterated that our investment philosophy remains unwaveringly committed to the pillars that define Third Avenue’s investment philosophy: creditworthiness, the ability for a company to compound growth of book value and, of course, discounted valuation.
On October 15th, 2015 we held our 18th Annual Value Conference. We were pleased with the opportunity to speak with many of you directly. At the Conference, we were asked a few times to expand on the definition of these pillars. We think it is worth sharing this discussion as it is what ultimately defines our style of value investing. We invest in a security as if we were purchasing the entire company, and therefore conduct exhaustive bottom-up analysis on a company’s fundamentals. The table below summarizes what we are looking for within each one of the pillars defining our investment philosophy, understanding there is no perfect investment that meets every criteria.
What shapes our value investment style is that our investments combine all three pillars; having one but not others is not enough. For us, it all starts with the balance sheet. By starting with a solid balance sheet foundation, we can invest in companies that can weather the unexpected bumps that any company may face along the business cycle. Companies with solid balance sheets are unlikely to be forced into adverse capital raising or asset sale decisions that can destroy equity value in times of duress. This is what we mean by risking “time and not capital”, which in our view, is one of Marty Whitman’s key teachings.
Once we see a company that combines low leverage, and a great track record of compounding value, we begin the next stage of our analysis which is to determine if the compounding in the past is likely to continue over the next three to five years, at a minimum.
What kind of value investing are we pursuing? As we all know, labels can be misleading, and we think the label of value is often misleading when thought of as being anti-growth. We do not think value means anti-growth, and indeed stress that the ability of a company to compound book value growth over time is a critical component of our philosophy and a main factor in determining if a company actually has a great business. In this current market environment we often see investors beginning their process seeking some kind of change or catalyst, as in corporate restructurings, or in searching for stock buybacks or even short term events that could potentially lead to earnings multiples expansion. A pursuit of this sort of short-termism overlooks our starting point which answers the question of why own an equity in the first place.
Regardless of short term movements in stock price, companies that can compound at double digit returns have proven to be consistent value creators over time. The ability to compound at double digit growth rates plus the discount provides attractive investment opportunities over the long-term.
Our brand of value mandates a focus on long term returns, and does not always fit the description of Contrarian, Catalyst Driven or other mantras used by some value managers. We are more Opportunistic value investors. Importantly, this focus also helps us avoid what we would describe as lower quality businesses, that might be in secular decline and thus value traps, but perhaps falsely attractive for the short term “resource conversion” opportunities such as the ability to buy back large amounts of stock or even spin or sell divisions in pursuit of multiple expansion. These types of activities are only attractive to us in business models that can consistently grow book value over time. That is why, when our analysis identifies that there is potential for resource conversion we welcome it, but do not have this as a requirement for investment.
Third Avenue Value Fund – Performance
The Third Avenue Value Fund generated -3.64% returns over the fiscal year 20151. As we reflect on the past twelve months, clearly we are disappointed with the negative returns. While we have high conviction in our philosophy and process, and high confidence our portfolio will deliver superior results over time, we do believe that analyzing performance along the way is instructive. While we typically do not try to rationalize broad market dynamics we find some market discussion relevant in this case.
The figures below illustrate the trend that has unfolded in the broader markets over this past year. The market narrowed around a small handful of larger cap growth stocks. The perceived growth dynamics of these companies provided a sense of security for investors who moved away from any companies that faced short term headwinds. Regardless of business quality, balance sheet quality and/or valuation the market in general sought safety in companies that posted positive earnings revisions, a top factor in returns over the past year. This chart reminds us of other periods where value investing moved out of favor for the short term, such as the 1997-2000 tech bubble and the 2005-2007 housing boom where growth optics trumped tried and true measures of valuation.
We reference this past year’s market dynamic as we think the opposite dynamic has overly punished still strong companies that did post modest negative earnings revisions, due to short term factors. We feel many of our holdings, which we discuss below, were overly punished for short term hiccups over the past year. While our fundamental work did identify the potential for some of the short term bumps our companies experienced, we felt the long-term investment cases, based on our three pillars, would mitigate price volatility over the short term. As seen in the