Martin Whitman’s Third Avenue Management letter to shareholders for the first quarter 2015
Dear Fellow Shareholders:
In guarding against market risk (security price fluctuations) and investment risk (events affecting the entity and the securities issued by the entity in which one has invested), the conventional wisdom, especially among financial academics, states that the market participant has to diversify. I believe that in a very important sense, recommending diversification is bad advice. Many of the most successful market participants concentrate, the exact opposite of diversifying. Those who concentrate include control investors, activist investors, most distress investors and first and second stage venture capitalists. Value investors, such as the Third Avenue Funds, who study companies and securities in depth, have considerably less need to diversify broadly than do conventional mutual funds and Exchange Traded Funds (ETFs) which do not study companies and securities but which, if they study anything concentrate on analyzing markets and security prices.
Martin Whitman’s Third Avenue: Diversification the best way to guard against investment risk
Yet diversification is the best, probably the only, way to guard against investment risk where the market participant knows little or nothing about companies and the securities they issue, has no elements of control over companies or reorganization processes; and is, in effect, price unconscious believing in the universality of efficient markets where values are fully reflected in the market prices of securities traded in public markets.
Such market participants for whom broad diversification is recommended, do not describe any of the funds managed by Third Avenue Management (Trades, Portfolio) (TAM). TAM Funds are basically passive (as opposed to activist) investors but concentrate on having detailed knowledge of companies and the securities they issue. TAM portfolio managers and analysts are extremely price conscious as is evidenced in most TAM common stock investments by their insistence that the securities be acquired at prices reflecting meaningful discounts from their best estimates of readily ascertainable Net Asset Values (NAV). The equity funds of TAM – Value, Small-Cap, International and Real Estate – while diversified since they are mostly non-control investors, tend to have far fewer securities in their portfolios than the average mutual fund.1 If a TAM equity portfolio manager has very strong convictions, internal TAM house rules would permit that fund to place up to 7% of its net asset value in that one security. Few other mutual fund families allow for that degree of concentration.
If you are a creditor, the best way to guard against investment risk lies in getting contractual protections, e.g., be an adequately secured lender where there are covenants that prevent the collateral from being invaded. This is quite different than Graham & Dodd, who, in credit analysis, believed the best protection for bond investors revolved around historic quantitative analyses, not around protective covenants.
Martin Whitman’s Third Avenue: Creating a margin of safety
Like Graham & Dodd, Seth Klarman and others, TAM analysts look to create a margin of safety in its investments. While others seem to find a margin of safety in a low price compared with intrinsic value, TAM adds a qualitative factor to define margin of safety, i.e., an insistence in common stock investing that the issuer be credit-worthy. Credit-worthiness exists for companies with strong financial positions, but occasionally includes companies with reasonably assured access to capital markets.
Many, probably a majority of the equity securities owned by TAM Funds, have four elements in common: 1.
The companies have strong balance sheets – there is an emphasis on credit-worthiness.
2. The common stocks are available at meaningful discounts from readily ascertainable NAV.
3. Disclosure is comprehensive with reliable audits – usually by one of the Big 4 – and the securities are traded in well regulated markets such as exist in the US, Canada, Japan, Hong Kong and the UK.
4. We have reason to believe that the prospects are good that NAV over the next 3 to 5 years will grow by at least 10% per year compounded annually including dividend payouts.
Martin Whitman’s Third Avenue: Exposure to common stock investments
Certain TAM funds have exposure to common stock investments in companies listed on the Hong Kong Stock Exchange, where companies in turn are heavily invested in income producing and development real estate in Hong Kong, Mainland China and Singapore. For these companies, NAVs and Price Earnings Ratios seem to be almost as low as they were in 2008. The average Hong Kong holding seems to be selling at a 40% to 50% discount from readily ascertainable NAV. In contrast, at January 31, 2015, the Dow Jones Industrial Average was priced at 3.04 times book value and the S&P 500 was priced at 2.73 times book value.2 PE ratios reflect the same disparities in price as do the NAVs. Most of the Hong Kong common stocks held in TAM portfolios are selling at 3 to 7 times reported earnings. In contrast, at January 31, 2015, the Dow Jones Industrial Average was priced at 15.5 times reported earnings and the S&P 500 was priced at 17.6 times earnings; these differences seem meaningful even though the Hong Kong reporting system is IFRS and the US reporting system is GAAP.
There are negatives to the Hong Kong investments but prices are so low, and the growth probabilities over the next 3 to 5 years seem so good that the negatives don’t seem to be show stoppers. In summary, the negatives seem to be about as follows:
- The macro outlook for 2015 for Hong Kong and China points to, at least, a mild slow-down.
- Most managements may be insensitive to the needs of US taxpayers. While all of the Hong Kong common stocks owned in TAM portfolios pay dividends which mostly have increased every year or two, such dividends are taxed as ordinary income for US tax payers.
- There are few prospects for changes of control in any of the Hong Kong companies. o There are few prospects for going private.
Some Hong Kong securities trade in ultra-thin markets and, as a consequence, there is little interest in such securities by broker-dealers and many institutional investors. For example, Lai Sun Garment, whose Mainland China majority owned subsidiary is developing two interesting projects in Mainland China, sells at about more than an 80% discount from NAV, which NAV figure is based largely on independently appraised Real Estate values.
Many of the Hong Kong real estate common stocks trade at substantial discount from NAV. These securities have been good to excellent market performers over the years only because NAV has grown so much.
Buying into well-financed companies at a meaningful discount from NAV seems to create long term odds favorable to buy and hold investors. Historically, in 80% or more cases, NAV will be larger in the next reporting period than it was in the prior reporting period.3 If that turns out to be the case, market participants lose money only if the discounts from NAV widen almost continuously.
Martin Whitman’s Third Avenue: Problems with investment approach
One of the problems with the TAM approach is that, while it seems an excellent way of guarding against investment risk, it really doesn’t provide protection against market risk, which is inherently short run oriented.
Most analysts weight heavily (or even exclusively) forecasts in determining whether or not to acquire a common stock. Forecasts in almost all cases are notoriously unreliable. The Forecaster is going to be quite wrong a good deal of the time, especially about down drafts occurring either in market prices or business fundamentals. Thus for those who rely heavily on forecasts, diversification makes eminent sense for purposes of portfolio management.
In TAM investing, in contrast, less weight is usually given to forecasts because of the increased weight given to the common stocks of well financed companies priced at substantial discounts from readily ascertainable NAV. Because of these balance sheet considerations, TAM achieves some downside protections when, inevitably some of its forecasted outlooks prove to have been overly optimistic. Thus, TAM appears to have less need to seek broad diversification in guarding against downside risk. Also, there seems to be great risk in using borrowed money to fund buy and hold investments where the investor is purely passive. Needless to say, TAM funds do not borrow.
In guarding against investment risk, it is important to invest with management and control groups who have more communities of interest with outside investors than conflicts of interest. All TAM investments on the Hong Kong Exchange are in companies which are family controlled, probably, net-net, resulting in a balance toward the families having more communities of interest with outside minority investors than conflicts. Since academics study markets and security prices rather than companies and securities, academics tend to believe that all markets are efficient. The evidence, however, is that some markets are highly efficient, and some markets are notoriously inefficient, especially when it comes to the discrepancies between underlying values and the prices quoted in public markets populated by traders and passive, non-control investors.
Martin Whitman’s Third Avenue: Efficient markets
Efficient markets exist as a special case where certain types of securities are traded. Markets which are highly efficient exist where “sudden death” securities are traded, i.e., where an ending takes place in the relative short term: options, warrants, securities where there are outstanding tender offers, convertible arbitrage, merger arbitrage, and many performing loans with relatively near-term maturity dates. In these efficient markets, analysis involves only a very limited number of computer programmable variables and closing dates are pretty much known. Here the market participant emphasizes market decisions rather that investment decisions. In making market decisions, emphasis necessarily has to be very short term. In contrast, investment decisions about corporations with perpetual lives, have to be primarily long-term oriented.
In analyzing junior securities of companies with perpetual lives, especially the common stocks of corporations, markets tend to be quite inefficient in measuring long-term underlying value. Conventional analysis, even by Graham & Dodd, seems to be of little help in describing underlying long term values because of an overemphasis on four factors:
1. A belief in the primacy of the income account, whether measuring periodic earnings or periodic cash flows.
2. Great weight to short-termism.
3. Emphasis on top-down Macro analysis with a consequent down weight to bottom-up analysis of fundamental factors.
4. A belief in equilibrium pricing, i.e., the common stock markets reflect a universal value and prices will change as the new information is fed into the market. In contrast to the above, TAM, like control investors, emphasizes the following:
1. The whole accounting cycle counts, but if there is a primacy of anything, it is a primacy of credit-worthiness.
2. Long termism
3. Bottom-up analysis
4. Bargain prices
I shall write to you again when Third Avenue reports for the period to end April 30, 2015 are published.
Chairman of the Board