Third Avenue International Value Fund Q4 Commentary
Dear Fellow Shareholders,
As you all well know, but it may be worth revisiting in the context of recent Fund performance, the Third Avenue International Value Fund (Fund) employs an opportunistic and long-term approach to fundamental value investing across international markets. The Fund has an unconstrained investment mandate which allows us to pursue what we believe are the best opportunities across geographies, industries and asset classes. We uncover each one of these opportunities by conducting thorough bottom-up company-specific research. The investments we select come together in a concentrated, high conviction portfolio, typically between 30 – 40 securities (vs. ~3000 stocks in the MSCI ACWI ex USA Index). It is natural, then, that our process results in a Fund showing minimal overlap with any broad market index. Many of our holdings are not part of an index at all and the Fund in aggregate has a 98% active share.1 Indeed, it is something of a rare occurrence for the Fund and an index to have similar characteristics or performance. Further, given a highly differentiated portfolio with minimal overlap with any index, it should not be surprising that high levels of tracking error, meaning periods of material outperformance and underperformance, have been the norm over the life of the Fund.
We construct a differentiated portfolio driven by company-specific fundamentals, including highly idiosyncratic factors such as the potential for value creating resource conversion opportunities. Portfolio performance, over the long-term, will thus be driven by the activities of these businesses, their ability to compete in specific industries and the deal-making acumen of those in decision making positions. However, short-term performance may ebb and flow to the tune of macro developments.
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For the fiscal quarter ending on October 31, 2014, the Fund’ Institutional Class shares returned -11.64% as compared to a commonly used international equity index such as the MSCI ACWI ex USA, which returned -5.20% for the same period.2 While we emphasize absolute performance over relative performance and are not particularly concerned with index composition, we provide index returns for convenience. Furthermore, the performance period under review is quite short for investors who are focused on time
1 Active Share is measured relative to the MSCI AC World ex USA Index. Active Share is the percentage of a fund’s portfolio that differs from the benchmark index. The Morgan Stanley Capital International All Country World ex USA Index is an unmanaged index of common stocks and includes securities representative of the market structure of over 50 developed and emerging market countries (other than the United States) in North America, Europe, Latin America and the Asian Pacific Region.
2 The Fund’s one?year, five-year, ten-year and since inception (December 31, 2001) average annual returns for the period ended October 31, 2014 were -10.79%, 4.45%, 4.71% and 8.36%, respectively. The MSCI ACWI ex USA one?year, five-year, ten-year and since Fund inception (December 31, 2001) average annual returns for the period ended October 31, 2014 were 0.49%, 6.55%, 7.06% and 7.72%, respectively. Third Avenue International Value Fund is offered by prospectus only. The prospectus contains more complete information on advisory fees, distribution charges, and other expenses and should be read carefully before investing or sending money. Past performance is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than original cost.
The Fund’s returns should be viewed in light of its investment policy and objectives and quality of its portfolio securities and the periods selected. M.J. Whitman LLC Distributor. If you should have any questions, or for updated information (including performance data current to the most recent month?end) or a copy of the Fund’s prospectus, please call 1?800?443?1021 or go to our web site at www.thirdave.com. Current performance may be lower or higher than performance quoted.
periods of three to five years (or longer) and is therefore only akin to one mile of a marathon. These points notwithstanding, we appreciate that it can be a challenge to fully understand the performance of a Fund from the outside looking in. We will therefore devote a portion of this letter to a discussion of these broad market movements which have negatively influenced the performance of the Fund during the quarter. It is our view that, as a result of recent purchases and dispositions as well as increasingly attractive valuations of a number of the Fund’s holdings, the Fund today is positioned extremely well to produce very attractive long-term returns. My personal response has been to materially increase my own investment in the Fund throughout the quarter. Following the performance discussion, we review investment activity during the quarter.
Germany and the Euro
In several ways, the last few months have been a reminder that few, if any, of the fundamental problems leading to the 2011 European Sovereign Crisis have actually been “solved”. Many symptoms are subject to ongoing treatment yet the illnesses linger. The reminders have come in many forms. Spreads between German and Greek bonds widened materially, political opposition to important economic structural reforms and anti-austerity movements continue to flare up and unpleasant German macroeconomic data is prevalent. European equities in general saw a material decline during the quarter though German equities saw among the strongest declines. The MSCI Germany index was down -6.97%, while the MSCI World returned 0.18% and MSCI USA had 4.86% returns over the fourth fiscal quarter. The Fund has roughly 16% of its holdings in Germany, well in excess of the index. We continue to be very pleased with the business developments and resource conversion activity surrounding each of our four German companies– Telefonica Deutschland, Daimler AG, Leoni AG and Munich Re, in order of size.
Recent negative investment returns have been compounded by the close to 7% decline of the Euro in which roughly 35% of the Fund is denominated, relative to the US dollar. While it is healthy to frequently reevaluate the theses underpinning each of our investments, in this case, we have not been given any cause to change course. In fact, while in the short-term this has had a negative impact on the portfolio’s performance, the Euro decline is of net benefit to a number of globally exposed European companies, such as Daimler AG (XTER:DAI), which continues to produce operating performance exceeding our highest expectations. Further, just as at the height of the European Sovereign Crisis when we initiated investments in several European companies, we emphasize business fundamentals and business prospects rather than the short-term trading environment, except when the environment provides us with an attractive opportunity to buy or sell. In this case, we have taken the opportunity to add to several European names, including Daimler AG and Leoni AG.
The decline in global equities during the quarter was pervasive but particularly acute in smaller capitalization companies as compared to larger ones. The performance of global indices during the quarter and the year disguise the bifurcation of performance between smaller capitalization stocks and large capitalization stocks. In what was a decidedly negative quarter (August through October)
Straits Trading Ltd (SGX:S20)
The Fund acquired its shares of Straits in January 2013. Fellow shareholders may recall that the Fund had swapped its shares of WBL Corp, a Fund holding since May 2005 and the Fund’s largest holding since 2009, for shares of Straits Trading. For several years we had worked diligently to encourage a change in strategy within WBL’s board, attempting to produce a more proactive approach to value creation and realization. We shared a number of simple yet excellent ideas with regard to value creation. In the end, the resistance within WBL’s board proved a considerable obstacle, notwithstanding a number of changes we and other shareholders were able to make to the composition of the board over that time. Gradually, we concluded that the untangling of this knot required a single shareholder with control or virtual control of WBL to direct the process of harvesting the considerable value held hostage within the company. For this reason, we contributed our shares of WBL to Straits, already one of the largest shareholders of WBL, which in turn made Straits rather than WBL the largest position in the Fund. Shortly thereafter, recognizing that the balance of power had changed, companies historically affiliated with WBL rallied together to produce an attractive takeover offer for WBL. Straits accepted this offer and the Fund benefited via our ownership of Straits and later as recipients of some of the proceeds, which Straits paid out in the form of a special dividend.
The transaction, among several others executed by Straits during the last couple of years, positioned the company very nicely to execute on a plan to transform itself from an investment company rich with property and a variety of other investments, into a real estate-focused business profiting from the entire eco-system of real estate, from property development to real estate asset management. Straits is progressing down this path with an attractive business plan, considerable financial wherewithal and a very sensible management team. Our decision to exit the position derives first from the liquidity of the position and secondarily from its valuation. Our position was initially sized for a larger asset base and grew unwieldy as the size of the Fund declined. Given the very high level of controlling-family ownership and related low level of public float, Straits stock trades quite sparsely in public markets. It had always been our intention to exit the position through a “block transaction” rather than by selling into the open market. When presented with multiple opportunities to do just that we availed ourselves of the liquidity and greatly enhanced the flexibility of the Fund. Further, we would certainly not characterize Straits as an expensive or even “fully valued” company. It is reasonably attractive from a valuation perspective but the world in which the Fund operates has changed and materially more attractive valuations are currently available to the Fund and therefore the Fund’s flexibility to take advantage of various other investment opportunities has become increasingly important. PGS, described in the following section, is one such example. The combination of these considerations drove the decision to conclude a nine year investment at this time. From our initial investment in WBL in May 2005 through to our exit of Straits Trading, we realized an IRR of 6.2%.
Allianz AG (LSE:ATT)
We had initially purchased shares of Allianz, a global insurance company, in March 2008 and increased the position as we entered the global financial crisis. It was an environment in which all manner of financial institutions were deemed to be toxic with virtually no thought given to the tremendous distinctions in business models and financial positions. Allianz was also later maligned in the European Sovereign Crisis because it is an enormous owner of European sovereign bonds. These crises came and went (for the moment), there never was an insurance industry crisis and the frequency and severity of major insurance events has in the meantime been very benign. This last detail has led to the accumulation of hefty underwriting profits and in turn overcapitalization throughout the industry. Too much capital puts pressure on prices and tempts risk underwriters to stretch against their otherwise better judgment. Admittedly, this dynamic is most obvious within the catastrophe reinsurance industry rather than primary insurance, which is Allianz’s largest business. However, overcapitalization is not exclusive to reinsurance and falling reinsurance pricing can in turn put downward pressure on primary insurance rates. This pricing pressure is only exacerbated by the low interest rate environment which causes paltry returns to be produced by insurance company investment portfolios The low interest rate environment, particularly in Europe, has also put acute pressure on the profitability of Allianz’s life insurance business. Also, somewhere between one quarter and one third of Allianz’s value is attributable to its asset management division, which is primarily comprised of its ownership of PIMCO. Independent of what one might believe about the state of the fixed income market, one could justifiably be cautious about how large of a firm PIMCO had become and whether they could continue to produce quality results at that scale. At a minimum, one could easily be skeptical of PIMCO’s ability to continue to grow such a colossal asset base. With all of these considerations in mind, we had reduced our position in Allianz materially earlier in the year. At the end of the Fund’s second quarter (April 30, 2014), our position in Allianz was firmly in the Fund’s top ten holdings. As we headed into September of this year, the month in which Bill Gross’s departure from PIMCO was announced, the position size had been reduced to the 26th largest position in the Fund. The September announcement of Gross’s departure was for us a final straw of sorts. We certainly don’t know where the dust will settle for PIMCO, but the other parts of the business do not compel us to hold on until we find out. All told we realized an IRR of 3.1% since our initial investment in March 2008.
Precision Drilling Corp (PDS)
We first purchased shares of Precision Drilling in late 2011. The company, a North American land drilling company, operates in an industry renowned for historical boom and bust cycles, use of too much financial leverage and serial acquisition strategies. Precision Drilling is better than many on each of these counts but still exists within an industry driven by factors largely out of its control. With a multi-year tailwind in the form of a North American shale drilling boom having pushed the company along, and a sizeable capital expenditure cycle reemerging in the industry, which has a good probability of creating more supply than is necessary (often at exactly the wrong time), we began selling our holdings in Precision Drilling as early as April 2014. By the end of August we had sold ninety percent of the shares we held coming into the year. We completed the last ten percent in September and October. In hindsight, our timing might suggest some sort of prescience given the stock’s performance post our sale, though in reality the decision was driven by our perception of the mounting risks we described. Our investment in Precision Drilling produced an IRR of 6.2% during the three year holding period.
S.A. D’Ieteren NV
We exited D’Ieteren after an atypically short holding period of roughly one and a half years and would conclude that it was a mistake. This Belgian family-controlled holding company has a monopoly on Belgian import and distribution of the entire Volkswagen brand lineup. D’Ieteren also operates a vehicle glass repair and replacement business that is the world’s largest by a wide margin. From a business perspective, the latter is clearly the higher quality and more valuable of the two businesses. We sold our shares of D’Ieteren for two primary reasons. First, having sold a business not long before our purchase, the company had a considerable amount of excess capital on its balance sheet. It was our understanding at the time of our purchase that the company intended to make an acquisition with its excess capital but, in the event that they failed to identify an attractive acquisition within a fairly narrow band of industries, some portion of the excess capital would then be distributed to shareholders. The time horizon of the acquisition search has become less specific and the range of businesses of interest appears to have widened. Secondly, we have growing concerns about the vehicle glass replacement and repair industry, which represents the bulk of D’Ieteren’s value. There is some evidence that the competitive landscape is changing in several geographies and not for the better. Additionally, technological trends in passenger vehicles have some probability of upending the apple cart for the vehicle glass repair and replacement industry. In the event that technology embedded in vehicle glass grows prevalent (not a long shot), the potential exists for the technology to drive glass repair and replacement work back to auto dealerships which specialize in technology specific to a single automotive brand, as opposed to less expensive third party providers which provide more generalized services across all brands of automobiles. In short, the business of repairing windshields may require an awful lot more sophistication in the not too distant future. In contrast, our investment in Leoni AG is very much on the right side of the long-term trend of increasing electronics embedded in passenger vehicles. Given the way in which our D’Ieteren investment developed, we chose to sell the entire position which, over our entire holding period, had been among the smallest positions in the Fund. We realized an IRR of negative 10.3%.
Piramal Enterprises Ltd (BOM:500302)
We first purchased shares of Piramal Enterprises in June 2013. This Indian family-controlled holding company was, at the time of our purchase, mostly a pool of cash and financial assets that would soon be converted into cash. Over recent quarters, Piramal has begun putting its liquidity to work, thereby clarifying, to some extent, what its future may hold. Coincident with these developments, Indian equity markets became euphoric during Narendra Modi’s ascendency and coronation. During the period of our ownership, Piramal’s stock price has appreciated much more so than its underlying value has grown or its prospects have improved, and is therefore much less cheap than it used to be. In today’s environment, we have more attractive uses for our capital. Our investment in Piramal produced an IRR of 15.9%, which is materially better than the Fund’s performance over the same period though quite similar to Indian equity market indices over that time frame.
New Investments Initiated During the Quarter
During the quarter, the Fund initiated a new position in Petroleum Geo-Services (PGS), which is a global leader in marine seismic services. The Fund has owned PGS once before, so in some regards the position is not “new”. Further, this is the third time the Fund has invested in the marine seismic industry. The undeniable fact of the industry is that it has historically been prone to industrial cycles of considerable amplitude. Previously, we owned PGS in the wake of the Macondo blow-out (BP’s accident in the Gulf of Mexico in 2010) that resulted not only in an environmental disaster but in a virtual halt to exploration activity in the Gulf of Mexico. Under normal circumstances the Gulf of Mexico is an area very busy with exploration activity, so when activity halted, the companies that provide exploration and development services (e.g., seismic) found themselves with far more capacity than the shrunken industry demand could absorb. Capacity utilization rates and pricing of services suffered significantly. We purchased PGS in that environment and later concluded the investment very successfully as the industry normalized. In the earlier days of the Fund’s operation, we came to have a considerable portion of the Fund (roughly 15%) invested in oil service companies. The opportunity then was not the result of an accident but rather that hydrocarbon exploration and production companies were increasingly buckling under pressure from shareholders who demanded better returns on capital and the return of more free cash flow to shareholders. These are shareholder euphemisms for “invest less money”, which is exactly what the oil majors did. However, most companies are loath to shrink, which is the fate of a company in the business of harvesting and depleting natural resources, unless of course the company is able to find and replace as much as it produces. The narrative may sound familiar as it is again on the front page of today’s newspapers with stunning similarity to the early 2000s. Oil majors are again bowing to pressure and capital expenditure budgets are again shrinking. While we don’t expect another “desktop drilling” scandal will develop as it did in the early 2000s, the significant and indisputable rates at which oil and gas majors are depleting their existing resource bases necessitates that new resources will eventually have to be found. The marine seismic industry bears the brunt and the benefit of this manic behavior.
What is particularly attractive about the seismic industry today, and PGS specifically, has much to do with the structure of the industry. At no time in our experience has there been such a strong bifurcation within the seismic industry. PGS is head and shoulders above its competitors in terms of balance sheet quality, vessel quality and some would say the quality of its management team. Further, the valuation of the industry is extremely compelling with PGS, the best in class, currently trading at less than 60% of stated book value. To be sure, there is little chance that the headwind being endured by the industry will subside overnight. In fact, our ideal scenario is for the downturn to persist long enough to further cripple one or two competitors which have frightfully weak balance sheets. It is our expectation that industry capacity will continue to be curtailed through the removal of higher cost vessels and that owing to its modern low cost fleet and industry-best balance sheet, PGS will emerge from cyclical lows as an even more dominant player.
During the year to date, we have greatly increased the liquidity of the portfolio through the disposition of multiple large, less-liquid positions, enhancing our ability to respond quickly to new and more exciting investment opportunities. Our activity on the new opportunity front has been brisk. These investments represent a broad range of businesses and geographies but share a few features that reflect our investment philosophy. The companies we have added to the Fund have solid balance sheets, pricing that reflects a considerable discount to long-term business value and an underlying value that we believe is not only enduring but has clear prospects for compounding over time. The short-term performance impact of environments such as the one experienced during this quarter may be unpleasant in the moment, but in truth, an opportunistic value Fund’s ability to produce attractive long-term performance is only enhanced by such environments. We believe that the current portfolio holds some of the most exciting investment ideas in the international equity space and furthermore that the Fund is as well-positioned and attractively valued as it has been in years.
Thank you for your continued interest and support of the Fund. The Third Avenue International Value team and I look forward to writing to you next quarter. In the meantime, should you have any questions or comments please don’t hesitate to reach out.
Best wishes for a happy and prosperous New Year!
Matthew Fine, Lead Portfolio Manager
Third Avenue International Value Fund