From Third Avenue semi annual letter to shareholders. Marty Whitman discusses the superiority of the low NAV deep value investing approach.
Dear Fellow Shareholders:
One conservative, but highly productive, approach to long term common stock investing is to acquire issues which have the following characteristics:
1) The issuer has an especially strong financial position.
2) The common stock is selling at prices that reflect at least a 20% discount from readily ascertainable Net Asset Value (“NAV”) as of the latest balance sheet date.
3) There is comprehensive disclosure including reliable audited financial statements; and the common stock trades in markets where regulations provide substantial protections for Outside, Passive Minority Shareholders (“OPMI’s”).
4) The prospects seem good that over the next three to sevenyearsNAVwillbeincreasingbynotlessthan10% compounded annually after adding back dividends.
Characteristics 1), 2) and 3), are easily ascertainable but Characteristic 4)requires considerable analytic skill. Concentrating on long-term growth in NAV ought to give OPMI’s far greater downside protection than would the conventional approach where the emphasis is on predicting periodic future operating cash flows or earnings (with earnings defined as creating wealth while consuming cash). For perhaps 90% or more of companies whose common stocks are publicly traded, 90% to 95% of the time, NAV or book value will increase in each reporting period. The last time the Dow Jones Industrial Average was over 14,000 was October 2007. Today the Dow Jones Industrial Average’s book value is some 70% higher than it was in October 2007. More importantly, the quality of that book value probably has improved dramatically since October 2007.Thus, in order to not suffer large losses, all that has to happen is that discounts from NAV do not widen materially.The “NAV common stocks” with which various Third Avenue Management (“TAM”) portfolio managers are involved include issues by Brookfield Asset Management,Capital Southwest, Cheung Kong Holdings, Forest City Enterprises, Henderson Land, Investor AB, Lai Sun Garment, Toyota Industries, Wharf Holdings and Wheelock & Company.These common stocks sell at prices relative to NAV ranging from 0.3x NAV to 0.8x NAV. In contrast the common stocks of the companies that make up the Dow Jones Industrial Average and the S & P 500 are selling at close to 3.0x book value (which is closely related toNAV).
Unlike conventional analysis where there is a primacy of the income account and the managements are appraised mostly as operators of going concerns, in our approach managements are appraised not only as operators but also as investors and financiers. If economic times get very bad, and absent social unrest and violence in the streets, astute managements of credit-worthy companies will be in a position to make super-attractive acquisition deals just as was the case after the 2008 economic meltdown. Astute managements which made super attractive deals after 2008 include Brookfield Asset Management, Cheung Kong Holdings and Wheelock & Company.
Conventional securities analysis, while helpful for trading purposes, contributes very little toward helping OPMI’s understand businesses or the securities they issue. This seems attributable to a gross overemphasis on four factors in conventional security analysis:
1) An emphasis on a primacy of the income account, whether to measure periodic cash flows or periodic earnings.There has been a consequent denigration of what, at least since 2008, has been the most important factor in financial and economic analysis, i.e., corporate credit-worthiness.
2) Short termism. Short termism is the only way to go when dealing with “sudden death” securities, i.e., options, derivatives or risk arbitrage but it does nothing to help evaluate a business with a perpetual life.
3) An emphasis on top-down analysis (predicting market levels, interest rates, general business outlooks) versus examining businesses from the bottom up (contract terms, potential future competition, litigation, financing, and refinancing opportunities,changes of control).
4)A belief in equilibrium pricing. The OPMI market price is the right price in an efficientmarket and will change only as the market absorbs and interprets new information.
While I think that trying to buy growth in NAV at a discount is a highly productive pattern for OPMI’s to follow, it is important to recognize a number of shortcomings to the approach:
In 2013, managements of companies with super strong financial positions are sacrificing Return on Equity (“ROE”) and Return on Investment(“ROI”)for the safety and opportunism inherent in having a strong financial position.
Strongly financed companies without much, if any, Wall Street sponsorship, are frequently run by dead head managements who don’t own any common stock, but this seems a bigger problem for Japan than for the U.S.,Canada or China.
The OPMI market seems efficient enough most of the time that large discounts from NAV indicate an absence of catalysts that could result in dramatic near-term price appreciation for a common stock, e.g., a contest for control.
Unlike situations where market participants seek control, or elements of control, the NAV common stocks mentioned in this letter are marketable securities whose prices in the near term will be heavily influenced by market fluctuations in what is basically an irrational market from the point of view of long-term buy and hold investors.
For those interested in further reading, these are some of the concepts used by Third Avenue’s investment team, and are discussed in greater detail in my newly published book,Modern Security Analysis: Understanding Wall Street Fundamentals (John Wiley&Sons Inc., May 2013).
I shall write you again when the quarterly report for the period to end July 31, 2013 is published.
Chairman of the Board