By co-blogger Sandesh Trivedi
Marty Whitman is truly a living legend in the world of value investing. It is always a pleasure to read and find great investing insights from his letters. Here in this letter from the year 2001 he reflects on “net nets” and investing practiced in the real world, as opposed to what is taught in the business schools. The concept of Net-Nets was invented by Graham and Dodd and is very rarely found in the present markets, however Marty Whitman refined this definition to the next level. He explains that for a retailer it’s inventory which is considered to be a current asset, is in fact a fixed asset of the worst type and it cannot stay in the business without maintaining a certain level of inventory. However, for a company which owns some real estate and has triple A tenants with long term leases in class A office buildings it can sell the properties or refinance them. It may be called a fixed asset, but it is much more current asset than a retailer’s inventory. Using this definition one can find companies trading below their net current assets.
He also criticizes the academic circle including Greenwald et al for being very theoretical and far from reality.
Below is his letter to the shareholders from the FY2001 Third avenue trust annual report.
Dear Fellow Shareholders:
There seems to be a general misunderstanding about wealth creation companies in the financial community and in academic circles. First, there is scant recognition of the fact that outside of Wall Street, where one deals with privately owned businesses, the vast majority of economic endeavor involves striving to create wealth in the most tax effective manner. Where control persons have choices, they would rather create wealth by some means other than having ordinary income from operations simply because striving for cash flows or earnings from operations tends to be highly inefficient tax-wise. Second, in their new book, VALUE INVESTING — FROM GRAHAM TO BUFFETT AND BEYOND written by Bruce C.N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema (Greenwald and van Biema are faculty members at Columbia Business School), the authors seem to have trouble identifying, and valuing, net assets. They state, “in the contemporary investment world net-nets are, only with the rarest exceptions, a distant memory.” In fact, though, each of the nine wealth-creation common stocks Third Avenue acquired during the quarter is a net-net by any economic,non-accounting convention, definition of net-nets.
Greenwald et al define net-nets only by looking at accounting convention, not economic reality. They define net-nets as a common stock available at a price that represents a discount from a company’s current assets after deducting all book liabilities, both short term and long term. The problem with this measurement is that for going concerns, much of their current assets are not current assets at all, but rather fixed assets of the most dubious value. For example, Sears Roebuck, like any other retailer, could not stay in business if it did not maintain inventories continually, which in Sears’ case have a carrying value of over $5 billion. In the aggregate, these inventories are a fixed asset for the going-concern, not a current asset. Individual inventory items do turn to cash within 12 months and thus are, for accounting purposes, called current assets. In fact, though, Sears’ aggregate $5 billion investment in inventory is a permanent investment, particularly vulnerable to seasonal markdowns, theft, obsolescence and mislocations. Contrast this with Forest City’s developed real estate projects. While Forest City’s developed real estate is called a fixed asset, a substantial portion of these assets is really quite current, a source of almost immediate cash through sale or refinancing, without interfering with Forest City as a going-concern. Forest City Common is a true net-net. The same is true for other wealth creation common stocks acquired during the quarter at substantial discounts from readily ascertainable net asset values; — including the probable real estate values in Alexander & Baldwin and Catellus; the probable securities values in Brascan (including real estate), Phoenix Companies, MONY and Toyota Industries; and the probable values of Assets Under Management (AUM) for BKF and Legg Mason.
VALUE INVESTING AT THIRD AVENUE
The back of the Greenwald book describes the investment approaches of a number of highly competent value investors: — Warren Buffett; Mario Gabelli; Glen Greenberg; Robert H. Heilbrum; Seth Klarman; Michael Price; Walter and Edwin Schloss and Paul D. Sonkin. It’s a worthwhile read. Third Avenue, in its practices, seems to have much in common with these investors. The front of the Greenwald book, though, describes underlying theories about value investing. These theories seem to have nothing to do with the basic assumptions under which Third Avenue operates. Contrasting the Third Avenue approach with the Greenwald approach ought to be helpful in getting investors to understand the Third Avenue modus operandi.
A major difference between the Greenwald approach and the Third Avenue approach revolves around valuing a company and valuing a security. Greenwald, et al state, “There is general agreement that the value of a company is the sum of the cash flows it will produce for investors over the life of the company, discounted back to the present.”
The Greenwald approach is far too general to be useful for Third Avenue. For TAVF, there exist four factors which contribute to corporate value and three factors which determine the theoretical value of a security.
The four elements of corporate value:
1. Free cash flow from operations available for the security holder: Very few companies ever actually achieve such free cash flows on a reasonably regular basis. While for any individual project to make sense it has to return a cash positive net profit over its life, this is not true for most companies (as distinct from stand-alone projects), especially expanding companies. Most businesses consume cash. TAVF likes to invest in the common stocks of those few companies in a position to create cash flows on a regular basis. The principal area where this takes place in the Fund’s portfolio is in money management companies: — BKF, John Nuveen, Liberty Financial and Legg Mason.
2. Earnings: Most prosperous going concerns create earnings, not free cash flows. Earnings exist where a company creates intrinsic wealth from operations while consuming cash. Since most going concerns consume cash, their earnings streams may be of limited value unless such flows are also combined with access to capital markets, either credit markets or equity markets or both. TAVF, in acquiring the common stocks of earnings companies, limits its acquisitions to businesses with exceptionally strong financial positions. This means, most of time, that the companies have far less need to have access to capital markets during any given period than run-of-the mill, less well capitalized, going concerns. More importantly, though, the companies whose issues the Fund acquires have rather complete control over the timing as to when they want to access debt markets or equity markets. Capital markets are notoriously capricious in terms of both pricing and availability. TAVF tries to avoid investing in the common stocks of less well capitalized companies, in part because such issuers frequently are forced to raise outside capital at the most disadvantageous times. Well-capitalized earnings companies whose common stocks were acquired by TAVF during the quarter include Energizer, Trammell Crow, American Power, Applied Materials, AVX, Credence, Electro Scientific, KEMET, MBIA, Nabors, and Vishay.
Most Wall Streeters and most academics, including Greenwald, et al, subscribe to a primacy of the income account point of view and believe that the dominant, and sometimes even the sole, sources of corporate value are flows from operations: — both cash flows and earnings flows. At TAVF, we have a balanced approach. Indeed, we think more corporate wealth is created in the U.S. by the two factors discussed below than by flows, even though frequently there tends to be a close, symbiotic relationship between flows, whether cash or earnings, on the one hand; and asset values and access to capital markets on the other.
3. Resource conversion activities encompass repositioning assets to higher uses, other ownership or control, or all three; the financing of asset acquisitions, the refinancing of liabilities or both; and the creation of tax advantages. These activities take the form of mergers and acquisitions, contests for control, leveraged buyouts, restructuring troubled companies, spin-offs, liquidations, massive securities repurchases, and acquiring securities in bulk through cash tender offers or exchange offers. Within the Third Avenue portfolio, it appears as if some 3% to 5% of the common stocks held are subject to takeover bids of some sort by control investors every quarter. Common stock issues acquired during the quarter which may very well be involved in getting taken over in the years ahead include Energizer, Phoenix, Alexander & Baldwin, BKF, Catellus and MONY, albeit Fund management has never been really good at identifying which companies will be “in play” at any given time in the future.
4. Access to capital markets at super-attractive prices: There seems little question that far more corporate wealth has been created in this country by taking advantage of attractive access to outside capital than by any other single source. The Greenwald book, and indeed virtually all economic literature, ignores this factor as a source of wealth, or a source of franchise. Unfortunately, as a passive value investor, the Fund does not often get to benefit from super-crazy prices that exist in equity markets from time to time. To benefit from these super-crazy prices as a price-conscious value investor, TAVF would have to become a venture capital investor seeking IPO bailouts; something that seems to be outside Fund management’s sphere of competence. Fortunately though, many of the companies in whose common stocks Third Avenue has invested have super attractive access to credit markets where they are able to obtain low interest, long term,non-recourse financing for major portions of the projects which they build,or in which they invest. Companies whose common stocks the Fund invested in during the quarter, with such attractive access to capital markets, include Alexander & Baldwin, Brascan, Catellus and Forest City.
The language used by all academics, including Greenwald, et al, that securities values are a function of the present worth of “cash flows” is unfortunate. From the point of view of any security holder, that holder is seeking a “cash bailout”, not a “cash flow”. One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.
Greenwald, et al have a monolithic approach to analysis using three tools to analyze all companies — replacement cost of assets, earnings power, and franchise value. TAVF, on the other hand, analyzes different businesses differently, ranging from analyzing strict going concerns by giving heavy weight to earnings power, as for example AVX or Nabors; to analyzing businesses which are really investment companies masquerading as something else. Here, heavy weight is assigned to readily measurable asset values as well as an appraisal of managements’ abilities to increase these net asset values over the long term. Catellus, Forest City, Hutchison Whampoa, Investor AB, and Toyota Industries are examples of such situations.
Greenwald, et al, like almost all academics, consciously or unconsciously, look at companies as substantively consolidated with shareholders. This tends to be a non-productive approach almost all the time. At the Fund, companies are analyzed as stand-alones or parent-subsidiary. The common stock for TAVF is a different constituency from the company, or its management — separate and apart.
Most academics pay much attention to an artificial calculation: — the Weighted Average Cost of Capital (“WACC”). WACC measures the cost of outside capital to a company as a blend of after-tax interest rates and capitalization values for common stocks based on references to current common stock prices in public markets. Interest is, of course, a cash cost, while capitalization rates for publicly traded common stocks have nothing to do with most companies since they do the bulk of their equity financing by retaining earnings rather than by selling new issues of common stock to the public. More importantly, though, WACC is not very meaningful for companies who have rather complete control of the timing as to when, or if, to access capital markets. Such companies will access outside sources of capital at the time WACC type pricing is most attractive to them. These are the companies in whose common stocks TAV
F invests. A contemporaneous calculation of WACC for these companies tends to be not meaningful.
Greenwald, et al discuss risk in general but do admit that relative price volatility in the securities market may not be an adequate measure of risk. For TAVF, the word risk cannot be used without putting an adjective in front of it. There is no general risk. There is market risk, investment risk, currency risk, terrorism risk, inflation risk, failure to match maturities risk, commodity risk, etc. The Fund tries to avoid investment risk; i.e., that the companies in whose securities we have invested will suffer permanent impairments. The Fund ignores market risk; i.e. that the trading prices of the securities held will fluctuate.
Greenwald, et al assume, quite properly, that an overpriced common stock will attract new competition. Greenwald, et al, however, ignore something that may be much more important. An overpriced common stock, in the hands of a reasonably competent management, is frequently a most important corporate asset. Much of the small cap- high tech investments of the Fund are in companies which were able to build up huge cash positions by taking advantage of the crazy prices that existed in IPO markets in the late 1990’s.