Third Avenue Value Fund commentary for the Fiscal Quarter ended October 31, 2015.
Dear Fellow Shareholders,
I love to eat, and perhaps my favorite food is a great Cheeseburger. To paraphrase Jimmy Buffet, “Cheeseburger is paradise”. In my opinion, like all great things in life, the brilliance in a great Cheeseburger is in its simplicity. A perfect afternoon for me is spent outside on my back patio, simply grilling a great Cheeseburger. Add the lettuce, tomato and a fresh roll and you have a tried and true formula to surprise and delight friends and family alike. As any great foodie, however, I do like to try new things, and given that I work in New York City, I am spoiled by the endless choices of what and where to eat. If one has a sense of adventure and a love of food, New York can produce exciting triumphs, but also unfortunately some unseemly food adventures. In the world of food, straying from a simple plan can be fun and involves little in the way of long term risk.
In the investment world however, straying for the simple plan is not advised. We agree with the quote by Sam Zell, Equity Group Investment LLC CEO in his review of Marty Whitman’s book ‘The Aggressive Conservative Investor’, where he writes “In reading this book, one is struck by the simplicity of the ideas and the dependence of the investor on his own understandings of reality as opposed to the myths on the street.” In our past letters, we reiterated that our investment philosophy remains unwaveringly committed to the pillars that define Third Avenue’s investment philosophy: creditworthiness, the ability for a company to compound growth of book value and, of course, discounted valuation.
On October 15th, 2015 we held our 18th Annual Value Conference. We were pleased with the opportunity to speak with many of you directly. At the Conference, we were asked a few times to expand on the definition of these pillars. We think it is worth sharing this discussion as it is what ultimately defines our style of value investing. We invest in a security as if we were purchasing the entire company, and therefore conduct exhaustive bottom-up analysis on a company’s fundamentals. The table below summarizes what we are looking for within each one of the pillars defining our investment philosophy, understanding there is no perfect investment that meets every criteria.
What shapes our value investment style is that our investments combine all three pillars; having one but not others is not enough. For us, it all starts with the balance sheet. By starting with a solid balance sheet foundation, we can invest in companies that can weather the unexpected bumps that any company may face along the business cycle. Companies with solid balance sheets are unlikely to be forced into adverse capital raising or asset sale decisions that can destroy equity value in times of duress. This is what we mean by risking “time and not capital”, which in our view, is one of Marty Whitman’s key teachings.
Once we see a company that combines low leverage, and a great track record of compounding value, we begin the next stage of our analysis which is to determine if the compounding in the past is likely to continue over the next three to five years, at a minimum.
What kind of value investing are we pursuing? As we all know, labels can be misleading, and we think the label of value is often misleading when thought of as being anti-growth. We do not think value means anti-growth, and indeed stress that the ability of a company to compound book value growth over time is a critical component of our philosophy and a main factor in determining if a company actually has a great business. In this current market environment we often see investors beginning their process seeking some kind of change or catalyst, as in corporate restructurings, or in searching for stock buybacks or even short term events that could potentially lead to earnings multiples expansion. A pursuit of this sort of short-termism overlooks our starting point which answers the question of why own an equity in the first place.
Regardless of short term movements in stock price, companies that can compound at double digit returns have proven to be consistent value creators over time. The ability to compound at double digit growth rates plus the discount provides attractive investment opportunities over the long-term.
Our brand of value mandates a focus on long term returns, and does not always fit the description of Contrarian, Catalyst Driven or other mantras used by some value managers. We are more Opportunistic value investors. Importantly, this focus also helps us avoid what we would describe as lower quality businesses, that might be in secular decline and thus value traps, but perhaps falsely attractive for the short term “resource conversion” opportunities such as the ability to buy back large amounts of stock or even spin or sell divisions in pursuit of multiple expansion. These types of activities are only attractive to us in business models that can consistently grow book value over time. That is why, when our analysis identifies that there is potential for resource conversion we welcome it, but do not have this as a requirement for investment.
Third Avenue Value Fund – Performance
The Third Avenue Value Fund generated -3.64% returns over the fiscal year 20151. As we reflect on the past twelve months, clearly we are disappointed with the negative returns. While we have high conviction in our philosophy and process, and high confidence our portfolio will deliver superior results over time, we do believe that analyzing performance along the way is instructive. While we typically do not try to rationalize broad market dynamics we find some market discussion relevant in this case.
The figures below illustrate the trend that has unfolded in the broader markets over this past year. The market narrowed around a small handful of larger cap growth stocks. The perceived growth dynamics of these companies provided a sense of security for investors who moved away from any companies that faced short term headwinds. Regardless of business quality, balance sheet quality and/or valuation the market in general sought safety in companies that posted positive earnings revisions, a top factor in returns over the past year. This chart reminds us of other periods where value investing moved out of favor for the short term, such as the 1997-2000 tech bubble and the 2005-2007 housing boom where growth optics trumped tried and true measures of valuation.
We reference this past year’s market dynamic as we think the opposite dynamic has overly punished still strong companies that did post modest negative earnings revisions, due to short term factors. We feel many of our holdings, which we discuss below, were overly punished for short term hiccups over the past year. While our fundamental work did identify the potential for some of the short term bumps our companies experienced, we felt the long-term investment cases, based on our three pillars, would mitigate price volatility over the short term. As seen in the charts above, clearly short term earnings momentum had a much greater share price impact than we would have expected.
Third Avenue Value Fund – Discussion of Detractors
As we look at our portfolio, the detractors can be distilled into two distinct groups, companies that have direct Energy or Materials exposure that correlated with the downdraft in commodity prices over the last year, and a separate group of high conviction companies that we believe continue to compound long-term value but were severely punished by the markets as they weathered short term bumps.
Third Avenue Value Fund – Apache and Devon
As we have written recently, the Fund’s investments with direct oil exposure are Apache and Devon Energy. Apache and Devon are more sensitive to swings in oil prices as they are focused only on exploration and production and lack downstream refining operations that serve as a hedge. Apache and Devon in combination accounted for 204 basis points (bps) of the Fund’s underperformance in the last twelve months. In retrospect, while we are convinced that the strength of these companies’ balance sheets and superior acreage positions will allow them to survive and thrive over time, we underestimated the magnitude of the drop in oil prices and the impact the negative sentiment towards Energy companies would have on their equity values. We believe that the impact on portfolio performance is transitory, and that we will likely see positive performance with a cyclical recovery.
The other large detractor, Posco Corporation, which accounted for 175 bps of the underperformance, remains extremely undervalued at 0.31 times its book value, commands world class low costs assets and is pursuing corporate restructuring initiatives that should improve profitability as global demand for their high value-added steel products recovers.
Conversely, what is less neatly explainable, and thus in our opinion more exciting, is the combined negative attribution of 323 bps for Weyerhaeuser, Comerica, CBS Corp., Brookdale Senior Living and Covanta Corporation. We next discuss each of these companies and our continued enthusiasm for each investment thesis in more detail.
Third Avenue Value Fund – Weyerhaeuser
Weyerhaeuser is a well-capitalized US-based forest products company with high quality assets in the form of 7 million acres of timberland that form one of the most valuable privately owned timber portfolios. It also has a wood products business used in homebuilding and a cellulose fibers business with product used for absorbency in items such as paper towels.
A number of macro headwinds negatively impacted Weyerhaeuser’s common stock price for the quarter: a decline in demand from China which led to pricing declines for Pacific NW logs, continued weak US housing markets which negatively impacted the wood products business, and port strikes and maintenance outages which disrupted the cellulose fibers business. These shorter term concerns did lead to earnings per share cuts for 2015. Despite these near-term macro headwinds, Weyerhaeuser is, in our opinion, well-positioned to compound NAV at a double-digit rate over the longer-term. First, Weyerhaeuser’s timberlands inventory, i.e., trees, are hard assets that can continue to grow; those that aren’t used this year continue to grow and become more valuable the following year. Second, we expect Weyerhaeuser’s cash flow and earnings to materially improve as US home starts recover from the cyclical downturn to more normalized levels. Further, the company has enhanced its timberlands portfolio and divested non-core businesses, cut costs and repurchased shares. While the ultimate timing of a housing recovery is unclear, we believe Weyerhaeuser will benefit when it does. In the meantime, given a 4% dividend yield, we added to our position on weakness in the quarter.
After quarter end, Weyerhaeuser announced a merger deal with Plum Creek Timber Company. Weyerhaeuser also announced that it is looking at strategic alternatives for its cellulose fiber business which could further enhance shareholder value. In our view, the deal with Plum Creek is NAV accretive as we believe it will accelerate cash flow growth, and increase exposure to the US south. Please refer to the Third Avenue Real Estate Value Fund letter for more detail on this transaction.
Third Avenue Value Fund – Comerica
Comerica (CMA) is the largest bank headquartered in Texas; it has a meaningful footprint in California and Michigan. Among the root causes of stock price dislocation was its exposure to Energy and low interest rates, which caused minor earnings per share estimate cuts for 2015. We believe those risks are mis-understood and overstated. While only 7% of CMA’s loan portfolio is linked to energy or “energy related” companies, it has been a source of investor scrutiny and confusion. Investors keep expecting net charge offs to rise, but they have remained marginal. Why? Comerica has an impressive underwriting history and we remain confident history will repeat itself. 95% of its energy loans outstanding are secured. Also, all underwriting decisions were based on “proved reserves” which should mitigate charge-off risk. Charge-offs will rise if the brutal decline in energy prices continues for extended periods of time, but we expect the risks to be manageable and much better than what is priced into the current stock price.
Few banks would benefit more from a rise in interest rates than CMA as 85% of its loan book is floating rate. The Federal Reserve’s reluctance to raise rates has been frustrating, but it will come. When it does, it will have a material impact on CMA’s earnings power.
In our view, CMA has one of the strongest balance sheets in the industry with a Tier 1 Common Equity ratio exceeding 10%. Despite the interest rate headwinds, it is still compounding at high single rates (including dividends). With a little help from rates, that should jump to double digits rates. Yet, CMA common stock only trades at slight premium to tangible book value. We like the potential of getting paid through book value compounding and multiple expansion with limited financial risk. CMA is one of those situations. At slightly over 1x tangible book value of 34.35, we think CMA could also be an accretive takeover target for a number of large US or foreign banks.
Third Avenue Value Fund – Covanta
Covanta is a leader in providing waste to energy services. Covanta processes approximately 5% of the solid waste generation in the US annually and uses this waste to generate 10 million megawatt hours (MWh) of baseload electricity annually through 41 Energy from Waste (EfW) facilities in North America. The company also recycles 500,000 tons of ferrous and non-ferrous metals annually.
Covanta shares weakened in 2015 due to the delayed start-up of the new Durham York EfW facility in Canada, as well as lower metals and electricity prices. Here too, these impacts caused short term earnings estimates to be revised modestly lower. We believe that these issues are short term in nature as the Durham York facility is set to begin operations in early 2016. Although metals and electricity prices are near cyclical lows and are likely to remain depressed in the near-term, two-thirds of Covanta’s revenue is derived from waste processing services where volume and pricing continues to grow and nearly half of Covanta’s electricity generation is contracted at above market rates through 2016, which provides significant earnings stability.
We remain confident in Covanta’s ability to compound EBITDA at a 10% compound annual growth rate as the NYC waste transfer contract continues to ramp up, the Durham York facility begins operations in 2016 and the Dublin facility is completed in 2018. In addition continued cost improvements, the recently announced joint venture in Australia, a new metals processing facility and five acquisitions of small environmental service companies will contribute to continued earnings growth. In the meantime the 6% dividend yield provides us with downside protection, and the ability to be patient.
Third Avenue Value Fund – Brookdale Senior Living
Brookdale Senior Living is the largest and best in class owner-operator of senior housing in the US.3 Brookdale also owns 399 high quality senior housing properties. We believe that these properties represent approximately 50% of the company’s asset value that the market is not currently recognizing. In addition to being a best-in-class operator with valuable hard assets, Brookdale has attractive long-term tailwinds from an ageing Baby Boomer population. Finally, Brookdale is well-financed. It has approximately $6.8 billion of mortgage debt and capital leases on an estimated asset value of more than $20 billion, making it very well-capitalized.
Brookdale ran into two short term problems that have resulted in negative earnings revisions and a share price decline over the past six months. Brookdale merged with competitor Emeritus last year and integration issues have led to lower-than-expected occupancy, and high level executive turnover created uncertainty regarding the company’s ability to execute.
Despite these short term issues, the investment case remains unchanged. At the end of our quarter, Brookdale traded at $22.20 per share. From this depressed price, we believe there is tremendous upside, particularly if the company manages to monetize its real estate. Without any operating improvements, we believe Brookdale’s net asset value to be near $38 per share. Including synergies from the Emeritus merger and likely improvements in occupancy and average rents, Brookdale’s value could be well in excess of this estimate.
Third Avenue Value Fund – CBS Corporation
CBS is a media company that creates and distributes industry-leading content across a variety of platforms to audiences around the world. CBS owns the most-watched television network in the US and one of the world’s largest libraries of entertainment content. Under the leadership of CEO Les Moonves, our “internal activist”, CBS has succeeded in its goal of being a true content company and monetizing this content value across any distribution channels.
CBS has reduced its cyclical advertising revenue through the spin-off of its outdoor billboard division and the growth of retransmission and reverse compensation fees, and is ahead of its targets to grow fee based retransmission and reverse compensation revenues to $1 billion by 2016 and $2 billion by 2020. With a more stable fee income revenue stream, a strong cash flow and the ability to potentially monetize more non-core assets, CBS is aggressively returning capital to shareholders, and is over half-way through its $6 billion share repurchase program. In fact, there is only $2.5 billion, or just over 10% of the equity market value for the company, left in the share repurchase program. We believe this powerful combination of content monetization, fee revenues growth and capital return should drive share value to our NAV target of $67.
Despite our view of the strong outlook for CBS, shares sold off in 3Q15 as the broader investment community became concerned about the short term strength of the cyclical advertising market. These short term headwinds impacted earnings per share by two pennies, as CBS reported $0.88 cents for 3Q15 vs. original expectations of $0.90, but again the share price impact was grossly magnified, down 30% from June to September. We took advantage of this weakness to increase our position, a move that has, to date, paid off nicely as CBS delivered on its long term strategy mileposts in its 3Q15 report, while also confirming its short term outlook for advertising strength into 4Q15.
CBS’ share price movement in 3Q15 is a good example of how our long term orientation can benefit from short-termism, as in reality all that changed was the discount to our NAV, which gave us the ability to increase our position weighting in the shares.
The price of the common stock for each of Weyerhaeuser, Comerica, Brookdale Senior Living and CBS Corp has declined over the last 12 months in spite of these companies having grown shareholder value. We strongly believe that these are all great businesses. We expect them to be outsized contributors going forward.
Third Avenue Value Fund – New Purchase: Baxalta Inc.
Over the past quarter, we acquired one new position, Baxalta.
Baxalta is the biopharmaceuticals business recently spun off from Baxter International Inc. We have followed Baxter for years, as it is a company that we have long admired. Spin-offs have always been an interesting source of ideas for Third Avenue, as they are often under-followed, yet historically tend to benefit from greater management focus and better capital allocation decisions as a stand-alone company. Recent volatility in the general market and healthcare stocks in particular, provided us the opportunity to initiate a position in Baxalta at an attractive valuation.
Baxalta is a leader in differentiated therapies that seek to address unmet medical needs across many disease areas such as hemophilia, immunology and more recently, oncology. We are attracted to the company due to its solid market position, the chronic use profile of its core drugs, opportunities for growth and solid financial position. The disease areas that Baxalta targets, such as hemophilia, primary immunodeficiency (PID), multifocal motor neuropathy (MMN), alpha-1 antitrypsin deficiency and von Willebrand disease (VWD), are under-diagnosed and under-treated. Baxalta is also enhancing its product portfolio with oncology assets, both via acquisition as well as through collaborations with other companies. Important for all healthcare companies is their pipeline and Baxalta’s is broad, with approximately 20 new products expected to be launched by 2020, a diversified and thus lower risk basket of compounds. We believe that Baxalta’s solid market position in these large and growing markets speaks volumes to the quality of the business and its ability to compound net asset value in the medium to long term. Baxalta is a well-financed company that is well-positioned to grow its businesses longer-term and should benefit as its newer products launch.
Further, the company could be a target for resource conversion. In fact, it received an unsolicited takeover offer from Shire over the summer. Baxalta management has so far rebuffed the offer, indicating the initial offer price as too low. Shire continues to publicly indicate interest in Baxalta. Our investment thesis certainly does not rely on a deal. Whether or not a deal transpires, we believe Baxalta is well-positioned to grow and compound value for shareholders over the longer-term.
In summary, we continue to have high conviction in our philosophy and we are excited about the positioning of the Fund. We see the recent weakness in high conviction investments as creating greater upside return targets over our three to five year investment horizon and potentially sooner as many of the recent detractors we discussed revert from short term oversold levels. The Fund’s 99%+ measure of “Active Share” means that over 99% of our holdings are different than the MSCI World Index. Of course, this means our short term return patterns will be different than this primary benchmark as well, but in our estimation the portfolio is positioned well to outperform over the next three to five years.
Narrowly driven market environments such as the one we have experienced over the last twelve months tend to forge some of the most exciting investments opportunities. We are devoting our efforts to identifying and buying the best investment opportunities for the Fund.
While the stock market will at times in the short term reward different flavors of investing strategies, like growth and momentum over the last twelve months, we have and will remain focused on our straight forward philosophy which has proven to outperform over the long term. We readily acknowledge that it can be frustrating to stand apart from the herd and post investment returns that trail the flavor of the day in times where the market has little regard for our philosophy. However, it is in exactly these periods that we can get excited about increasing our ownership weights in great companies that we own, and also finding new investment opportunities where the market have given us an attractive discount. This sort of volatility is the friend of the patient investor.
The good part about the short term is that it doesn’t last forever. We’ve seen our style move in and out of market favor before, and it is the investments we make now that will set us up for long term outperformance as we stick to our simple plan.
We thank you for your trust and support and look forward to writing again after our first quarter.
The Third Avenue Value Team
Chip Rewey, Lead Portfolio Manager
Yang Lie, Portfolio Manager
Victor Cunningham, Portfolio Manager