Marty Whitman’s third quarter letter to shareholders.
Dear Fellow Shareholders,
Most businesses (and governments) which are successful achieve success by creating wealth while consuming cash. In most cases, consuming cash carries a fair amount of investment risk because consuming cash requires the business to have access to capital markets, sometimes continuously as is the case for commercial banks and broker-dealers. Capital markets are notoriously capricious, sometimes not available at all – see the 2008?2009 financial meltdown; and sometimes are a source of almost free money – see the 1999-2000 IPO bubble.
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Marty Whitman: Wealth creation by having positive cash flows
Other businesses, a minority I expect, are designed to create wealth by having positive cash flows from operations; for example single income producing real estate projects, investment companies and investment management companies. Other things being equal, or close to equal, Third Avenue Management (Trades, Portfolio) (TAM) analysts and portfolio managers prefer to invest in the common stocks of companies with positive cash flows from operations, but not to the exclusion of the common stocks of companies creating wealth while consuming cash. As a practical matter, TAM is very price conscious and gives price, especially as related to estimated Net Asset Value (NAV), great weight in making buy, hold, or sell decisions whether the business creates wealth by consuming cash or is a cash generator.
In analyzing cash flows, it is super important that the analyst distinguish between project finance and corporate finance. Project finance looks at periodic net cash flows with a defined termination date. For any project to make sense it has to be based on forecasts of a positive Net Present Value (NPV), i.e., the present worth of the cash flows to be received over the life of the project plus cash to be received at the termination of the project, if any, has to be greater than the present worth of the cash costs involved with the project. In contrast, in corporate finance, one looks at the wealth creation to be realized by a business entity with a perpetual life. Wealth creation is a result not only of successful operations but also judicious investing and having attractive access to capital markets. While individual projects have to have a positive NPV to make sense, corporations with a perpetual life don’t. CIT (CIT) and GE Capital provide good examples of the interplay between project finance and corporate finance. Each receivable issued by CIT or GE Capital (i.e., loans to customers) is designed to have a positive NPV. This is project finance. But as the CIT or GE Capital receivables portfolio expands as net new loans are written, the companies become cash negative. This is corporate finance. The cash shortfalls are met by CIT or GE Capital (GE) by accessing capital markets – issuing new debt, commercial paper, bank loans and sometimes equity.
Marty Whitman: The TAM investment formula
The TAM investment formula for many common stocks is to buy into the common stocks of companies with super strong financial positions priced at meaningful discounts from readily ascertainable NAV, where analysis indicates strong probabilities that the NAV will grow over the long term by not less than 10% per annum compounded after adding back dividends. Advantages of strong financial positions include the facts that competent managements can be opportunistic and also tend to avoid becoming supplicants to having to access capital markets under conditions where managements have little, or no control of the timing of such access.
An investment in the common stocks of companies meeting the TAM investment criteria does not, of course, guarantee good investment performance but it certainly seems to put the odds in favor of good investment performance over the longer term, say at least three years. I believe, based on several studies that for at least 80% of the companies at least 80% of the time, NAV’s will be larger in the next reporting period than in the prior reporting period. If those increases in NAV continue to be created, the only way to lose money is to have the discounts from NAV at which price the security was acquired, widen and stay widened.
TAM analysts recently ran a statistical analysis,1 i.e., a screen, for a broad universe of global stocks,2 based on the following three criteria:
1) Ten year book value per share increased by at least 10% per annum
2) The common stock was selling at 1 times tangible book value, or less
3) Market cap > $1 billion
For the top 100 most well capitalized companies on this list based on total debt to capitalization (which ranged from 0% to 30%), the results were very interesting:
- For the ten year period, all but ten of the common stocks in the screen had a positive total return
- Of the ten common stocks without positive price appreciation, the largest annualized loss was only 6.7%3
- 55% of the companies in the screen enjoyed, at least, double digit annualized returns. Thirteen of the issues in the screen enjoyed ten year annualized returns in excess of 20% Using TAM analytic talent, the Third Avenue Funds seek to identify securities that have these and similar characteristics, which we believe will increase the odds that our Funds will have improved long term performance.
Marty Whitman: NAV vs Book Value
Is NAV, or book value, a good indicator of wealth in conservatively financed companies? The answer is yes and no. TAM focuses very much on the common stocks of companies where the NAV is readily ascertainable. Frequently it is not readily ascertainable. There are two widely used accounting standards used in the investment world: Generally Accepted Accounting Principles (GAAP) used in the U.S.A. and International Financial Reporting System (IFRS) used in the rest of the world.
Does GAAP give good approximation of NAV for financial institutions? Mostly yes. The assets of financial institutions are mostly paper which can be readily valued. The problem with many financial institutions is not valuing assets, but that it may be hard to ascertain what the real liabilities are. For example, in the case of many non?life insurance companies, especially casualty underwriters, the bulk of the liabilities will be determined by future events (e.g., hurricanes) which tend to be unpredictable.
Does IFRS give good approximations of NAV for companies whose assets consist largely of income producing real estate? The answer is yes. Under IFRS income producing real estate is carried on the balance sheet at appraised value with the appraisals conducted by recognized independent appraisal firms.
Do GAAP or IFRS give good approximations of NAV for going concerns engaged in manufacturing, distribution, or transportation where individual assets are not separable and saleable without jeopardizing going concern operations? The answer seems to be definitely no in most cases. Do GAAP and IFRS, for companies that are not well financed, or do not have easy access to capital markets, give good approximations of NAV? The answer is no in most cases. Indeed when a company is not well?financed, a large book value may be a negative factor. Frequently large book values tied up in, say, plant or equipment or inventories, may reflect very large overheads more than anything else.
Marty Whitman on Wheelock and Company Limited
In one sense large NAV’s for income producing real estate as ascertained by independent appraisers, may be one predictor of future cash flows. Independent appraisers typically use three approaches in an appraisal – the income approach, the market approach and the replacement cost approach. Insofar as the income approach is weighted it consists of the capitalization of estimated future cash flows. Wheelock and Company Limited (HKG:0020) common stock at this writing is selling around HK $40; NAV at December 31, 2013 was around HK $82. Insofar as the HK $82 was based on the income approach, the appraiser is stating implicitly that Wheelock Common is selling at a very low price relative to forecasted future cash flows. If there are investment problems with Wheelock, it does not seem to involve the long term profit outlook based on estimates of periodic cash flows. Rather the problems for outside, passive investors seem centered on the observation that for Wheelock it is extremely unlikely that there will ever be a change of control or a going?private transaction. I shall write to you again when TAM reports for the fiscal year to end October 31, 2014.
Chairman of the Board