Marty Whitman’s letter to Third Avenue Management shareholders for the second quarter ended April 30, 2015
Dear Fellow Shareholders:
Financial accounting is based on one of two protocols – Generally Accepted Accounting Principles, or GAAP, used in the United States; and International Financial Reporting System or IFRS, used in the rest of the world.
A principal difference between GAAP and IFRS lies in how each accounts for income producing real estate. Under GAAP, income producing real estate is carried on the balance sheet at depreciated historical cost less impairments (i.e., a write?down of the value of the asset), if any; income statements reflect periodic charges for depreciation. Under IFRS, in contrast, income producing real estate is carried on the balance sheet at independently arrived at appraisal values; income statements reflect periodic Fair Value gains (or losses) on investment properties (i.e., periodic changes in appraisal values). In all the reports I’ve look at where IFRS is used, two earnings figures are disclosed in total and on a per share basis – underlying profit before the fair value change and underlying profit after the fair value change.
Marty Whitman: Analysts downweigh the significance of appraised values
The vast majority of market participants and security analysts seem to ignore, or downweigh, the significance of appraised values for income producing real estate by placing dominant weight on underlying profit before the fair value change in their analysis and in making buy, hold, or sell decisions. This is understandable where the emphasis is on short?run predictions of stock market prices, and a belief in the primacy of periodic income or cash flows from recurring operations in determining stock market prices. This seems to be the mind set of most security analysts whether located in New York City, Hong Kong, or elsewhere in developed and developing countries.
As a result of ignoring, or downweighing, IFRS derived Net Asset Values (NAV’s), many well?financed, and growing companies have their common stocks selling at 30% to 70% discounts from IFRS reported NAV’s. Such issues held in various Third Avenue Management (TAM) portfolios include Henderson Land, Hysan Development, Lai Sun Garment and Wheelock. These discounts compare with the approximately 3 times book value where the Dow?Jones Industrial Average and the S&P 500 Index currently are selling.
While IFRS reported NAV’s and fair value changes are not helpful in aiding an investor to estimate near term stock market price changes, for long term buy and hold investors such as the funds managed by TAM, IFRS reported NAV’s are a god?send. First, virtually all independent appraisals rely, directly or indirectly, on an income approach: the investor gets a cash flow estimate based on the appraiser’s estimate of NAV. This is demonstrated in a footnote to the Henderson Land 2014 audit where it is stated “The valuations of completed investment properties in Hong Kong and mainland China were based on income capitalization approach which capitalized the net income of the properties and taking into account the reversionary potential of the properties after the expiration of the current lease.” Second, if properties are to be sold or refinanced in bulk, the IFRS reported NAV’s undoubtedly provide a better estimate of what the selling terms will be (or what the new financial arrangements will be) than do stock market prices.
No accounting number, and certainly not IFRS reported NAV, determines economic reality for the analyst. Rather, it gives the analyst objective benchmarks which the analyst then uses to determine his or her views as to what economic reality is. I have no question that for income producing real estate IFRS give analysts far better value benchmarks than does GAAP in helping to determine present values, and what are likely to be future cash flows from existing income producing real estate.
A principal reason such huge discounts from NAV’s exist for the income producing entities held by TAM, is that for these companies there appear to be little or no possibilities of a change of control or going private (as an aside such discounts for the common stocks of quality companies seem unlikely to exist in the US for undervalued entities where a very sophisticated investment banking industry continuously promotes resource conversions). Rather than relying on resource conversions to achieve appreciation in common stock prices, TAM relies basically on long term growth in NAV’s. Such growth seems a good prospect, based not only on the long term track records of the companies in various TAM portfolios but, more importantly, assuming that the independent appraisals represent reasonable estimates of future cash flows for existing properties, then future cash flows should be relatively large compared to the current discount market prices for the relevant common stocks. Incidentally, the various IFRS reported NAV companies whose common stocks are in TAM portfolios do pay modest dividends, which have been increasing moderately year by year for most of the TAM holdings.
Marty Whitman: IFRS appraisals
IFRS appraisals are much more meaningful for market participants when such appraisals are used for the valuation of companies that are well and comfortably financed. Investments by TAM in common stocks are pretty much restricted to companies that are quite well?financed.
IFRS would be even more useful if the independent appraisals were publically available, possibly as a footnote or addendum to periodical financial statements. This is not the case, now.
Another problem many analysts have with relying on appraised values is that appraised values fail to measure directly periodic cash flows for the company whose assets are being appraised. For TAM, this is unimportant. First, investments are pretty much restricted to companies that are well?financed. Second, it is important to recognize what an income statement should reflect. It should reflect a company’s cash flows for a period and also, its wealth creation during the period. Very often, highly creative and useful wealth creations results initially in cash depletion, not cash generation. IFRS reported NAV and valuation changes are excellent benchmarks or clues as to what wealth exists for the company, and what wealth?creation has occurred during the period for which the accounting statements were issued. Wealth creation, by the way, seems to be the goal of most investors most of the time in managing their own portfolios.
Analysts point out that the discounts from IFRS reported NAV’s have always existed. They assume that the discounts always will exist. The analysts are probably right as long as there is an absence of resource conversion activities, e.g., changes of control, going private or massive restructurings such as the impending separation of assets by Cheung Kong and Hutchison –Whampoa into two new companies; one a real estate holding company and the other an industrial?utility holding company. Even if the discounts persist, those discounts seem justifiable only for stock market reasons, and seem, in no way, justified by underlying business value considerations. If a company is well?financed, bad times (as currently exist for much of Chinese real estate) provide managements with opportunities to make attractive acquisitions as was the case for example, in 2012 when Wharf Holdings, a 57% owned subsidiary of Wheelock, made an equity capital infusion into Greentown China, a major mainland Chinese real estate developer.
I shall write to you again when Third Avenue reports for the period ending July 31, 2015 are published.
Martin J. Whitman
Chairman of the Board