Marty Whitman On Value Investing Vs Venture Capital FundingVW Staff
Efficient Market Theorists (EMTs) place a premium value on being ignorant about companies and the securities the companies issue. Such EMTs include most financial academics as well as promoters of Index Funds and Exchange Traded Funds (ETFs) such as John C. Bogle, founder of the Vanguard Group. For these EMTs, research is restricted to studying markets and security price fluctuations. To EMTs the study of companies and securities is someone else’s business.
For EMTs, trying to conduct research on companies and securities is a waste of time and money. They believe that passive investors should hold funds having the lowest expense ratios in the form of ETFs and Index Funds which do not have to bear the expense of having to undertake fundamental research in depth.
To prove that fundamental research is useless for passive market participants, EMTs correctly point out that no active investment vehicles (from Mutual Funds to ETFs) outperform a market or benchmark consistently. Consistently is a dirty word meaning all the time. Consistency is an absolutely phony test because it de facto imposes a short term investment horizon. The most any active investor (or any investor for that matter) can hope to achieve is to outperform (or at least equal the performance after fees) most of the time, on average, and over the long term. Some mutual funds, such as those managed by Third Avenue, are value funds where buy, sell and hold decisions are made based almost wholly on examining in depth companies and the securities they issue. Other mutual funds are run by high volume traders who place primary emphasis on forecasting near term market movements and near term security prices. Many value funds, including most of those managed by Third Avenue Management (TAM), do outperform most of the time, on average, and over the long term as was demonstrated to investors at the October 2014 Third Avenue Value Conference. I do agree that the average mutual fund which concentrates on forecasting markets and security prices probably has a very tough time trying to outperform consistently. But those Funds are not TAM Funds.
An important factor that EMTs seem to miss completely is that the vast majority of Wall Street analysis and Wall Street wealth derives from the fundamental in depth analysis of companies and securities, not from the study of markets and securities prices. These individuals and entities which focus on companies and securities include, beside Value Investors, Active Investors, Control Investors, Distress Investors, Credit Analysts, and promoters of pre Initial Public Offerings (IPOs) of Venture Capital undertakings. Certainly
the vast majority of investment fortunes on Wall Street are made by promoters or investors who focus on the in depth study and understanding of companies and the securities they issue, not by passive traders.
If a passive investor wants to undertake an in depth analysis of individual companies and individual securities, it has never been easier than it is now in 2014. Subsequent to the Securities Acts Amendments of 1964, there has been a disclosure explosion in the US and also in Canada, the United Kingdom, Hong Kong and much of Europe. It is now possible for an outsider to know more about more companies than ever before and have the information be accurate. As evidence of this, just look at the successful take-over of companies in hostile or semi-hostilechanges of control since the 1980’s where having non-public information is a show-stopper.
For Third Avenue today, it is not so much about how we access the information available in the public domain about the companies that we research, it is about our superior use of that information to make buy, sell or hold decisions. Another differentiating factor to be a successful, long term, value investor in equities as an analyst is to pay considerable attention to the credit- worthiness of an individual issuer. This is something that seems alien to most EMTs; for example, Modigilani, Miller and Merton were awarded Nobel Prizes for writing, in effect, about how important it was to be indifferent to the quality of corporate balance sheets. In fact, the future is so unpredictable that the value investor has to rely heavily on strong balance sheets of companies to be able to survive through dangerous and unpredictable periods such as 2008 and 2009.
The problem with most financial academics is that they think efficient markets are all pervasive. That is just not so. Efficient markets certainly do exist for market participants who operate without any knowledge, or any interest, in understanding companies and the securities companies issue. Efficient markets also exist for securities that can be analyzed by referring to only a very few computer programmable variables. These securities are mostly “sudden death” securities such as options, warrants and risk arbitrage where there will be relatively determinatework-outs in relatively determinate periods of time, such as when a cash tender offer exists. The vast majority of securities seem to exist in relatively inefficient markets, such as exist forlong-term, value investors dealing in markets characterized by the extreme short termism of market participants. The basic problem with academics is that they take a special case, “sudden death” securities, and apply the principles valid there to all securities. That is, of course, not unexpected for people trained only to examine markets (not companies) and security price fluctuations (not securities).
While I think the concept of efficiency entails assuming the existence of a logical fair value price, there are ways of explaining why inefficient pricing exists and persists. For example, today many rapidly growing, blue chip Hong Kong listed equities of well financed companies, sell at 40% to 80% discounts from readily ascertainable Net Asset Value (NAV) and two times to six times reported earnings. It seems likely such huge discounts and low price-to-earnings ratios could not exist in the Hong Kong market if there were any prospects in any of these companies for changes of control or going private –two resource conversion events.
One point about low turnover value mutual funds, such as those which are an integral part of TAM: an investor ought to look at more than past performance. Importantly, what kind of protections do funds, such as Third Avenue Value Fund provide against financial catastrophe? I think a lot. First, if the Fund’s portfolio consists largely of the common stocks of well-financed companies, bad times
such as 2008 provide well-managed companies with opportunities to make highly attractive acquisitions of companies and assets such as was the case, among others, for Brookfield Asset Management and Wheelock & Company in 2008 and 2009. Second, most of the time, for most of the common stocks of companies held in the portfolio of any mutual fund, NAV will be higher in the next reporting period than it was in the prior period. This offers no guaranty of favorable market price behavior for the mutual fund, but it may tend to put the long term odds in favor of good fund stock price performance. Third, and most important, the Investment Company Act of 1940, as amended, provides more protection for Fund shareholders than I think does any other set of regulations in the world. To summarize, important investment protections for fund investors in Registered Investment Companies include the following:
o As a practical matter, a mutual fund cannot borrow except in dire emergencies
o The fund has to meet certain diversification requirements
o “Affiliated” transactions are restricted
o Fees are controlled, expenses are limited
o Fund shareholders have the right to receive 100% of net income in annual cash payments
oIf the management of the fund is externalized, a majority of the Board of Directors has to be independent
Note that the actual management of a value fund, rather than a high turnover trading fund, is similar to the management of many non-trading hedge funds. The fees charged by value funds tend to be only a fraction of the fees charged by hedge funds.
Finally, I think our readers might find it interesting to contrast what TAM does as a value manager compared with venture capitalists that finance companies, both start-ups and existing businesses pre IPO.
I shall write to you again when Third Avenue reports for the period to end January 31, 2015 are published.
Martin J. Whitman
Chairman of the Board