Marty Whitman ‘s Third Avenue Value Fund commentary for the third quarter ended July 31,2016.
Dear Fellow Shareholders:
We are pleased to provide you with the Third Avenue Value Fund’s (the “Fund”) report for the quarter ended July 31, 2016.
Macro? No thanks. We’ll take fundamentals. We know the macro environment can be unpredictable. So macro forecasting as a starting point for our investment process has never been a part of our philosophy. The events that unfolded over the course of our fiscal third-quarter (May to July) are an excellent reminder of why such an effort is futile and why our focus continues to be on company fundamentals.That doesn’t mean we won’t exploit opportunities created by macro-induced market movements.We can and do.
As the quarter began,broader market expectations were for a continued strengthening of the U.S.economy, supported by growing employment, increasing wages and low inflation — essentially a continuation of the economic outlook that Fed Chairman Yellen described in December 2015, in conjunction with the 25 basis point increase in the Fed Funds rate.That point in time, in her words, marked “the end of an extraordinary era”of low interest rates. The broader market mood was up beat,with the MSCI World Index (“MXWO”) rising 1.84% and the S&P 500 rising 2.73% quarter-to-date through June 23, the eve of the Brexit vote.
Britain’s vote to leave the EU was an unexpected shock to the markets,which seemed to expect the opposite outcome.The quarter-to-date return on the MXWO and the S&P500 fell 5.38%and 2.75%, respectively through June 27th. Hopes for a June or July U.S.Fed Funds rate hike were dashed,and the interest rate on the U.S. 10-year fell sharply from1.75%June 23 to 1.37%on June 27.
And then began what many market pundits are calling the “most hated rally.” Most macro forecasters had just finished preparing for a Brexit sell-off. But then came the prospect of more government stimulus globally,with Britain, the EU and Japan promising more actions,and by default the expectations for U.S.Fed Funds hikes diminished,providing the equivalent of yet another round of quantitative easing (“QE”). By July 29th, the quarter-to-date return on the MXWO and the S&P 500 were up sharply, to a positive 3.81%and 5.82%, respectively,with the interest-rate-sensitive sectors of Utilities (+5.94%) and REITS (+10.07%) outpacing the indexes. The 10-year yield rallied to 1.56%by July 21st and finished the quarter at 1.45%.
The combination of more promised government stimulus globally and the expectations for U.S.Fed Funds hikes diminishing,provided the equivalency of yet another round of quantitative easing (QE). The equity markets rose in similar fashion as they have since the U.S.Fed unleashed round one of its QE in 2009, i.e. interest rate sensitive sectors of Utilities and REITS outpaced the MSCI World Index return. While we will not make a market call to forecast when rates might hit bottom,we do generally believe that the decline in interest rates is not reflective of a market with less risk,but a global search for yield and capital safety,as the yields on many non-U.S.government bonds, including Germany and Japan, imply negative returns.
This flight to safety better explains the movement in the U.S.10-year yield than does the fact that on March 6th, 2009, the market bottom of the great recession, the U.S. Government public debt stood at $10.9 trillion and the yield on the 10-year was3.83%versus$19.41 trillion,and 1.45%, respectively,on July 29 2016.
The unpredictability of the macro is why our focus continues to be on the micro. The fundamentals that impact our investee companies are paramount to us. Our aim is to invest in companies with strong financial positions that are well-positioned to grow and compound over the longer-term and whose securities we can buy at discounts to Net Asset Value (“NAV”).
Third Avenue Value Fund – Performance
Fund Results Positive with Few Outliers
For the quarter-ended July 31, 2016, the Third Avenue Value Fund returned 2.42%3 vs.3.81% for the MXWO and 5.81% for the S&P 500. Looking at attribution vs. the MXWO, security selection was positive 1.39%,while allocation weightings detracted 2.35%. In addition to strength in interest rate sensitive sectors,Health Care and Information Technology were strong sectors. Fundamentally, the portfolio did not have material outliers to the positive or negative in the quarter.
Calendar year-to-date performance remains positive,with the Third Avenue Value Fund up 6.45% vs. the MXWO up 5.31%and the S&P500 up 7.65%.
Opportunistic Buying and Selling
During the quarter,we took advantage of the market volatility. We sold securities near or above our Fair Value NAV estimates and near market highs of the quarterly period. We used the Brexit-related sell-off to establish two new positions, Amgen and LivaNova Plc, and increased the weights of several existing positions. We trimmed into strength early in the quarter,with portfolio cash reaching 9.94%by June 17th. Then we opportunistically added positions,and continued to build newer positions into the Brexit sell-off, so that as of July 12th cash had fallen to 6.87%.
Our patient buying stance was rewarded, as we were able to significantly continue to build positions added earlier this year. We increased our weighting in Johnson Controls, as the company continued to move towards closing its merger with Tyco International. We added to Ralph Lauren,where the new CEO Stephan Larsen laid out his long-term strategy to rebuild the brand at an investor day in June. We also added to Harman International,as the company continued to win new customers and build its backlog to record levels,while improving margins and cash flow.
We were able to add to Weyerhaeuser, Masco and Devon in February on weakness,and subsequently trim back these positions in the quarter on significant price appreciation ranging from roughly 40%to 90%. Aswe have previously discussed,we do opportunistically adjust our position weightings as part of our portfolio structure decisions.
We received Shire ADRs along with cash upon the completion of the acquisition of Baxalta.
We exited our long-held position in Symantec at a cumulative IRR of 54.2%. The company announced an agreement to acquire BlueCoat, a provider of web security solutions. While the transaction brings Symantec a new CEO and opportunities in the growing cloud access security broker market, the price paid seems expensive (6.1x non-GAAPFY16 revenue,10.7xmaintenance revenue and 20.9x adjusted EBITDA ) given the estimated mid-single digit market growth of BlueCoat’s historical secure gateway business. Further, the integration of the businesses is not without its challenges,especially given the large transformation Symantec has just undergone with the sale of its Veritas business. We decided to redeploy the proceeds elsewhere.
Opportunities in Healthcare
In the fiscal third quarter, our “bargain bin” happened to contain some healthcare companies. This is not a call on healthcare nor a decision based on benchmark sector weightings. The fundamentals of each company ultimately drove our decision. And volatility in the market caused by Brexit enabled us to get attractive pricing. Opportunities arise when industries with good longer-term growth prospects become out-of-favor for short-term reasons or for company-specific reasons such as a company missing quarterly earnings.Opportunities can also arise when a company engages in corporate operations which may not be recognized by top-down investors,as with the self-help discussion we wrote about in last quarter’s shareholder letter,whether that be from cutting costs, rationalizing operational efficiencies or leveraging a strong financial position to use for mergers and acquisitions.
Admittedly,we are generalists and not experts in healthcare,but we are