Third Avenue Funds portfolio manager commentary for the first quarter ended March 31, 2016.
Dear Fellow Shareholders:
I believe that the conviction in our investment philosophy, which has guided Third Avenue Management (“TAM”) over the last 30 years, will help us navigate through the challenges1 affecting the firm and the current turmoil in financial markets. This is as good a time as ever to remind ourselves of our core beliefs as investors. In the remainder of the letter I present you with an excerpt from a letter published in April 2013 which highlights the approach of long-term investing that emphasizes the discount to Net Asset Value (“NAV”).
This is not the approach for speculating in short-term events. One conservative, but highly productive, approach to long-term common stock investing is to acquire issues which have the following Characteristics:
1) The issuer has an especially strong financial position.
2) The common stock is selling at prices that reflect at least a 20% discount from readily ascertainable NAV as of the latest balance sheet date.
3) There is comprehensive disclosure including reliable audited financial statements; and the common stock trades in markets where regulations provide substantial protections for Outside, Passive Minority Shareholders (“OPMI’s”).
4) The prospects seem good that over the next three to seven years NAV will be increasing by not less than 10% compounded annually after adding back dividends. These Characteristics are most useful in investing in the equities of companies with income producing real estate and financial institutions. Characteristics 1), 2) and 3), are easily ascertainable but Characteristic 4) requires considerable analytic skill.
Concentrating on long-term growth in NAV ought to give OPMI’s far greater downside protection than would the conventional approach where the emphasis is on predicting periodic future operating cash flows or earnings (with earnings defined as creating wealth while consuming cash). For perhaps 90% or more of companies whose common stocks are publicly traded, 90% to 95% of the time, NAV or book value will increase in each reporting period. When this letter was originally published in April 2013, the last time the Dow Jones Industrial Average was over 14,000 was October 2007. Today the Dow Jones Industrial Average’s book value is some 85% higher than it was in October 2007. More importantly, the quality of that book value probably has improved dramatically since October 2007.
Thus, in order to not suffer large losses, all that has to happen is that discounts from NAV do not widen materially. Some of these “NAV common stocks” include issues by Brookfield Asset Management, Cheung Kong Property Holdings, Forest City Enterprises, Henderson Land, Investor AB, Lai Sun Garment, Toyota Industries, and Wheelock & Company. These common stocks sell at prices relative to NAV ranging from 0.3x NAV to 0.8x NAV. In contrast the common stocks of the companies that make up the Dow Jones Industrial Average and the S & P 500 are selling at close to 2.5x book value (which is closely related to NAV).
Unlike conventional analysis where there is a primacy of the income account and the managements are appraised mostly as operators of going concerns, in our approach managements are appraised not only as operators but also as investors and financiers. If economic times get very bad, and absent social unrest and violence in the streets, astute managements of credit-worthy companies will be in a position to make super-attractive acquisition deals just as was the case after the 2008 economic meltdown.
Astute managements which made super attractive deals after 2008 include Brookfield Asset Management, Cheung Kong Property Holdings and Wheelock & Company.
Conventional securities analysis, while helpful for trading purposes, contributes very little toward helping OPMI’s understand businesses or the securities they issue. This seems attributable to a gross overemphasis on four factors in conventional security analysis:
1) An emphasis on a primacy of the income account, whether to measure periodic cash flows or periodic earnings. There has been a consequent denigration of what, at least since 2008, has been the most important factor in financial and economic analysis, i.e., corporate creditworthiness. 2) Short termism. Short termism is the only way to go when dealing with “sudden death” securities, i.e., options, derivatives or risk arbitrage but it does nothing to help evaluate a business with a perpetual life.
3) An emphasis on top-down analysis (predicting market levels, interest rates, general business outlooks) versus examining businesses from the bottom up (contract terms, potential future competition, litigation, financing, and refinancing opportunities, changes of control).
4) A belief in equilibrium pricing. The OPMI market price is the right price in an efficient market and will change only as the market absorbs and interprets new information.
While I think that trying to buy growth in NAV at a discount is a highly productive pattern for OPMI’s to follow, it is important to recognize a number of shortcomings to the approach: In 2013, managements of companies with super strong financial positions are sacrificing Return on Equity (“ROE”) and Return on Investment (“ROI”) for the safety and opportunism inherent in having a strong financial position.
Strongly financed companies without much, if any, Wall Street sponsorship, are frequently run by dead head managements who don’t own any common stock, but this seems a bigger problem for Japan than for the U.S., Canada or China.
The OPMI market seems efficient enough most of the time that large discounts from NAV indicate an absence of catalysts that could result in dramatic near-term price appreciation for a common stock, e.g., a contest for control.
Unlike situations where market participants seek control, or elements of control, the NAV common stocks mentioned in this letter are marketable securities whose prices in the near term will be heavily influenced by market fluctuations in what is basically an irrational market from the point of view of long-term buy and hold investors.
For those interested in further reading, some of the concepts are discussed in greater detail in my book, Modern Security Analysis: Understanding Wall Street Fundamentals. (John Wiley & Sons Inc., May 2013).
I shall write you again when the quarterly report for the period to end April 30, 2016 is published.
Martin J. Whitman
Chairman of the Board
Third Avenue Value Fund 1Q16 Letter
Dear Fellow Shareholders,
We are pleased to provide you with the Third Avenue Value Fund’s (the “Fund”) report for the quarter ended January 31, 2016.
“What happened to Value investing?”
This was somewhat a rhetorical question posed to us as portfolio managers this quarter as we met with a long time client, who sees eye to eye with us on the motive and merits of Third Avenue Management’s value investment philosophy. We could not help but respond with a riff on the well-known quote by Mark Twain, that “rumors of its death have been greatly exaggerated”. Rejoinders aside, we understand the frankness of the concern in the question. As we wrote in our Fiscal Year end letter ninety days ago, Value investing as a style has greatly underperformed momentum driven investment styles over the last several years. As a proxy we look at the outperformance of the Russell 3000 Growth Index vs. the Russell 3000 Value index of 9.22% in 2015, 2.08% per annum for a trailing 5 year period and 1.70% per annum since the market bottom of March 16, 2009. While we can suggest contributing factors to this disparity, such as a Federal Reserve Liquidity “put” supporting more leveraged and lower quality businesses, to a market that has found perceived safety in momentum growth strategies, we cannot argue the fact that Value Investing has faced an extreme and prolonged headwind.
As we are not “macro” forecasters, we cannot divine when these headwinds will cease, and revert, but we firmly believe two things. First, that even though our investment philosophy of creditworthiness, compounding of book value and a patient buy at a discount to our estimate of net asset value may struggle over certain periods of time we believe this to be a superior way to invest over the long term. Second, that it is not “different this time.” We have endured similar periods where Value styles were out of favor. We know that these periods can last longer and be of greater duration than we would expect. We have also seen the benefits of owning well capitalized companies with solid business models when metrics such as “clicks,” “eyeballs” and now “earnings revisions” lose favor in rapid fashion. Said differently, the current obsession with the “primacy of the income statement,” a term defined by Marty Whitman, is not a lasting substitute for a disciplined approach, i.e., the measurement of the value of the earnings ability of a business’ assets and liabilities that begins with the balance sheet. Despite the backdrop for value investors in general and a tough 90-day result in performance, we remain excited about the quality of the names owned in our portfolio and the upside returns we see in these investments over our long- term horizon of three to five years. Our feeling is that the market has dramatically oversold many names that detracted from the portfolio in the quarter, and the valuation levels to us feel like a coiled-spring that will revert to the positive. We are taking the opportunity to deploy capital in some of what we believe are the most unduly punished names in the portfolio as well as in new investment opportunities.
In contrast, many companies with top weightings in broad based market indices are dramatically overpriced. Given our high active share which by definition dictates we have a significantly different portfolio than the benchmark, we like the prospects for the Value Fund much more than the indices. Indeed, all three of us added to our holdings in the Value Fund in January.
Third Avenue Value Fund Performance
The Third Avenue Value Fund underperformed the MSCI World Index by 283 bps in our Fiscal First Quarter (November 1, 2015-January 31, 2016), down 10.8% vs. -7.97%. Our significant weightings in financial holdings and a lack of consumer staple holdings accounted for the largest deltas to the benchmarks, as would likely be expected with the general market weakness.
Some of the top contributors to the Fund during the quarter were Baxalta, NVIDIA, and our new position in Ralph Lauren. We initiated a position in Baxalta, a biopharmaceutical company, in the prior quarter. The company was the target of a takeover bid from Shire during this most recent quarter. Under the agreement, Baxalta shareholders will receive $18.00 in cash and 0.1482 Shire ADS for each Baxalta share. Based on Shire’s closing price, this represented a value of $45.57 per Baxalta share, resulting in an unrealized IRR of 26.0%. We are pleased that another party found Baxalta’s assets as interesting as we did. The Fund has owned NVIDIA shares since 2012. The company has done a good job building value over the years. Demand for its graphics processing units (GPUs) has grown, driven by growth in gaming along with more computer-intensive applications such as professional graphics, automotive and artificial intelligence. We exited the position during the quarter for valuation reasons, realizing an IRR of 35.4%, and redeployed the proceeds into other investments.
We continue to be confident in the names that detracted from performance, and attribute weak performance to the excessive focus by the market on short- term earnings and disregard for longterm growth prospects of these companies. We believe that companies like Bank of New York Mellon and Comerica, which were among the largest detractors to performance, are poised to benefit as investors shift their focus towards company fundamentals.
Bank of New York Mellon (BK) and Comerica (CMA) have been impacted by macro concerns. Both companies would benefit greatly from higher interest rates, but fears of a slowdown in global growth have prompted questions around central banks’ conviction to raise rates. This has soured investor interest in banks. BK and CMA felt the pain, each declining close to 20% this past quarter. Current operations do not support the recent declines. BK’s earnings have been impressive over the past few quarters. Management is finally achieving meaningful operating leverage as costs have been contained. Despite the tangible progress, investors sold indiscriminately. We detailed our thesis on CMA in the last letter, and it has not changed. CMA reported earnings a few weeks ago and charge-offs in its highly scrutinized energy portfolio remain modest.
Investors are forgetting that the energy book accounts for only 7% of loans and appears adequately reserved. We have stress-tested CMA’s book many different ways and there are sparse scenarios where book value doesn’t grow this year. Yet, CMA is now trading below tangible book value which makes little sense to us.
The three biggest losers last quarter were Cavco Industries, Comerica and Bank of New York Mellon. Cavco’s decline is misleading as it has more to do with the calendar than operations. It has been a stellar performer over the past year, but was down in 1Q after a rapid rise at the end of last quarter. It recently reported earnings and the company is executing at a high level. Cavco maintains a strong net cash balance sheet and is growing sales and margins. With the manufactured home industry growing at high-single rates, Cavco is well positioned to take advantage.
Third Avenue Value Fund – New Positions
Ralph Lauren (RL) is one of the crown jewels in retail. It is well capitalized with a net cash balance sheet and has historically earned a premium valuation. Given its compounding history, the premium valuation is justified. Due to short-term factors, the stock price has dropped over 40% from recent highs and now trades at absolute valuation levels last seen shortly after the financial crisis. It is a rare opportunity to buy a well-managed, well capitalized, owner-operator at an attractive price.
Although retail has historically been an area that Third Avenue Management (TAM) shies away from, RL is an exception. It meets our three pillar criteria as it is a credit worthy compounder trading at a discount to NAV. Over the past five and ten year periods, RL has grown book value (including dividends) 11% and 13%, respectively. It is a blue-chip asset with a more stable operating history than most players in the space. For example, sales only declined marginally in 2009, following the financial crisis. Although it could be categorized as a retail company, considering that roughly half of RL’s sales are wholesale/licensing and its brand strength, it’s more comparable to Nike than a typical retailer. Besides macro concerns about an economic slowdown, company specific issues have soured RL’s near-term outlook. We have assessed these risks and feel it is a classic case of investor short-termism. First, the strong USD has impacted sales. One-third of RL’s sales are from outside the US, so currency translation has pinched sales and margins. Also, 20% of RL’s sales come from foreign tourists shopping in the US. Those sales have been pinched as tourists are choosing to stay home as the costs of traveling to the US have risen with the stronger USD. RL continues to experience double digit samestore sales growth in flagship stores overseas, so it does not appear to be a brand problem.
Another major factor impacting RL is the implementation of its Global Reorganization Plan (GRP). Management is investing for growth by creating a brand based operating structure, implementing a global SAP system (US completed and Europe in-process) and expanding its global footprint and internet presence. All initiatives make sense in the long-run, but have been costly in the short-run. The slower than expected sales and additional costs have pressured margins, creating investor angst. Management projects cost savings of $100 million per year once the initiatives are completed later this year. Investors are struggling to see through the near-term noise which has created a worst-case scenario valuation.
A final catalyst is the hiring of CEO Stephan Larsson. Larsson is a young, ambitious retail executive who had highly successful stints at H&M and Old Navy. With Ralph Lauren now 75 years old, Larsson’s hiring makes strategic sense. Lauren will remain a creative force at the company, but Larsson’s expertise in understanding the fast fashion landscape (H&M) and turnarounds (Old Navy) might be the shot in the arm RL needs.
In summary, we feel that the favorable long-term prospects heavily outweigh the near-term concerns embedded in RL’s current valuation. Higher sales, a weaker USD and lower GRP costs can all contribute to a brighter outlook for RL’s operations. With the additional benefit of a highly motivated new CEO, the pace of change has probably been accelerated.
We initiated a position in Harman International, a leading provider of in-car software solutions for infotainment, high-end audio and telematics with annual revenues of approximately $7 billion. Harman may be better known to many of you through their brand named audio divisions serving automotive, high end consumer and professional markets under the Harman/Kardon, JBL, Mark Levinson and Bang & Olufsen brands.
We have known Harman for many years, and have taken advantage of market fears and misunderstanding about Harman as an automotive exposed stock to initiate a position. Harman has sold off from almost $150 per share in May 2015, to the current price in the mid-$70’s as the Street has grown concerned about the current auto cycle approaching ‘peak’ levels. Investors, based on a primacy of the income statement mentality, have sold the stock off to approximately 10x FY2017 (June) EPS, in line with most auto suppliers. However, despite roughly 70% of Harman’s revenue coming from automobiles, we think Harman can continue to grow revenues and compound earnings at double digit rates for at least the next several years. This revenue growth, in our opinion, is more secular than cyclical, as automakers accelerate both the penetration and functionality of infotainment and telematics across their vehicle fleet. Harman has historically served the higher end luxury automakers—BMW, Mercedes and VW—who were early adopters due to the price point of more luxury vehicles. However, Harman has developed a scalable platform that will accelerate adoption through the mid and low range of vehicle fleets. Indeed, Harman has won significant business with GM, Fiat Chrysler, Subaru, Hyundai and even Geely in China. We further believe, as has been stated by Harman and demonstrated with win rates, that Harman’s systems will be an enabler of Apple, Google and Baidu automotive products and not a competitive offering, as Harman’s software will be the platform to access these offerings, while providing the safety and security features necessary in an automotive environment. Indeed, it is our speculation that at ‘only’ a $5 billion market cap, Harman would make a nice acquisition for any of these larger players.
Beyond infotainment, Harman has increased its offerings in its home audio lineup, and is now entering high end earphone markets. Even more exciting is Harman’s new Connected Car division, which incorporates its recent Symphony Telca and Red Bend acquisitions, which enable ‘over-the-air’ software updates for any connected device, whether a car, or perhaps a turbine or a dishwasher, and thus is an emerging leader in the nascent ‘Internet-of-things’ space. This division now has over $735 million in revenues and 15% EBITDA margins, with mid-teens revenue growth and 20% EBITDA margin targets.
We believe Harman is a compelling addition to the portfolio as it meets all three tenets of our investing philosophy. From a creditworthiness standpoint, Harman has a strong balance sheet with a 21.5% Debt to Capital Ratio, made up of approximately $1.0 billion in debt and $438 million in cash. Harman refinanced its senior debt in 2015 into two tranches, $390 million due in 2022 at a rate of 2% and $400 million due in 2025 at 4.15%, providing long -term maturities at low rates. Debt to expected FY16 EBITDA is .74. Harman is returning excess cash to shareholders with a dividend yield of about 2% and has $463 million remaining on its share repurchase authorization; it is looking to step up repurchases on current share price weakness.
Harman has compounded book value growth over the trailing 5 years at 18.2%, when adding back dividends. More importantly, we see Harman well positioned to continue this growth as it has a $23 billion backlog, revenue growth estimated at 14% for 2016 and likely double digit over the next few years, and continued margin expansion driven by price mix and sales leverage. At our average purchase cost of $77, Harman offers over 30% upside to our mid-case NAV of $100, and as such we look to continue to build the position size opportunistically on market weakness.
Third Avenue Value Fund – Looking Forward
We are investing for the long term with management teams that have an aligned long-term vision and capital allocation strategy. Over time, we believe that strong balance sheets coupled with thoughtful financing and capital allocation will win and create attractive returns for our shareholders. We are taking advantage of the recent volatility in the markets to deploy capital into companies which have the most attractive risk/return profiles. We are also seizing this opportunity personally; the three of us have increased our positions in the Fund over the last quarter.
Finally, Third Avenue has been in the news of late. We refer you to our Management Committee’s letter which discusses events regarding the Focused Credit Fund and importantly the capital strength and durability of Third Avenue as a firm.2 We also note that since our September sale of the Lehman SIPA claim, the Third Avenue Value Fund has no overlapping positions with the Focused Credit Fund. As a firm, we have developed a reputation of open and honest communications. It is your money and we try to help you understand how it is invested. The by-product of our openness is attracting the right types of investors. We have investors who understand our approach and think long term. We are grateful to have a like-minded investor base. We care very much about the Value Fund because we want to reward our shareholders. In addition, a significant percentage of our wealth is invested in the Fund alongside you.
The Third Avenue Value Team
Chip Rewey, Lead Portfolio Manager
Yang Lie, Portfolio Manager
Victor Cunningham, Portfolio Manager
See full PDF below.