Third Avenue Value Fund Q2 Letter: The Case For Regional BanksVW Staff
Third Avenue Value Fund letter to shareholders for the second quarter ended April 30, 2015.
H/T Beren – Reddit
Dear Fellow Shareholders,
In this quarter’s letter we discuss conviction – a key concept for fundamental, bottom up Managers of a concentrated portfolio such as the Third Avenue Value Fund (Fund). We talk about what conviction means to us and what drives our conviction in today’s portfolio. Rather than an academic discussion on the topic, we share with you the main aspects of our theses on a number of investments in the Fund as well as our views on some of the main themes in the portfolio.
Third Avenue Value Fund - Portfolio Activity
We have constructed a Fund that is opportunistic, eclectic and inclusive of individual stocks and credit instruments at substantial discounts from our conservative appraisal of intrinsic value of the companies. The concentrated nature of our portfolio is made possible by building conviction in our individual investment cases through quantitative and qualitative due diligence in our research efforts. We have built this conviction not by trying to prove our investment theses right, but instead by actively trying to prove ourselves wrong. Somewhat like a dentist poking a tooth to seek out decay, we focus our research on where things might go wrong. We start with the balance sheet to assess creditworthiness and systematically move to appraise the other aspects of a company’s financial statements, management strategy, competitive environment and current business results as a measure against these longer term goals.
The long road, including our three to five year investment horizon, is rarely smooth and consistent. As Marty Whitman has opined, consistency on a short term basis is not our primary goal, what we measure is consistent outperformance relative to the relevant index over any rolling three to five year period. With conviction in our investment thesis, we can weather periods where everything does not go exactly right for our investment cases, knowing that we are taking the risk of time as to when our investment case generates capital appreciation, vs. the risk of losing capital if not everything goes according to plan.
As we reflect on the results of our Fund over the first four months of this year, while we have compounded a positive absolute return, the relative return has trailed our primary benchmark, the MSCI World index, and been more consistent with our secondary benchmark the S&P 500. Just as we measure the quarterly results of our portfolio companies as periodic updates to our investment thesis, we take measure of our quarterly portfolio results to measure our portfolio construction and ensure our conviction levels remain high. In the aggregate, we have three major themes expressed in our portfolio construction currently. We own a few positions each in: overcapitalized financial companies, oil exposed exploration and production companies and companies that are levered to a strengthening US housing cycle. Our high conviction in each of these names and themes was tested this quarter, but as we look at our portfolio at quarter end, we can assure you the conviction in both our portfolio names and our overall construction is high. We are excited to watch our companies execute over the next three to five years.
Our investment experience with CK Hutchison Holdings (formerly named Cheung Kong) is a perfect example of why we need to maintain our conviction when our stocks are out of favor. It has been one of our biggest winners in 2015. The Value Fund made its first investment in Cheung Kong in May 2005. Over the ten year holding period, we have discussed it many times because it has had an impact on our performance (both positively and negatively). Despite the volatility of the stock price, the operating performance has been outstanding and consistent. It’s been said a picture tells a thousand words. We think the chart below tells you a lot about CK Hutchinson Holdings.
As the chart and total returns indicate, focusing on wealth creation is the right way to monitor an investment. Although book value per share isn’t a perfect way to measure changes in wealth creation, it’s a pretty good one. Despite two jaw boning stock price drops in 2008 and 2011, book value per share marched ahead, growing every year except one. Even when book value per share declined in 2008, it only dropped 1%. The impressive book value growth gave us the conviction we needed to stick with it despite the volatility. Our shareholders were rewarded handsomely as CK Hutchison Holdings outperformed the relevant indices. CK Hutchison Holdings had 11.7% annualized returns during the May 2005 to April 2015 period, while the MSCI World and the S&P 500 indices had 7.3% and 8.3% annualized returns, respectively.
Third Avenue Value Fund - Overcapitalized Financials: Our Inclination toward Regional Banks
In our October 2014 letter, we profiled three of our top financial companies, Bank of New York Mellon, Comerica and KeyCorp. The macro environment for these positions could not have been tougher over the last six months. The yield on the ten year US Treasury moved from 2.17% at year end to 2.03% at April 30th, touching a 50+ year low of 1.64% in the interim as the Fed most likely postponed its long anticipated first rate increase of this cycle from June to at least September and the US economy fell victim to a soft patch this winter with slower employment and GDP growth measures. While we could debate whether this weakness was due to a deep freeze that left us hoping for some localized global warming impacts as we stood in the wind on a cold train platform, we instead look at the individual developments of each of these investment cases over the last six months, and we do like what we see.
Bank of New York Mellon was a solid contributor this past quarter, recovering from weakness early in the year. In March, it passed the Federal Reserve stress tests and was given permission to repurchase up to $3.1 billion in stock. This is a credit to Bank of New York Mellon’s strong financial position and the soundness of its business model. The activist activity surrounding the company also began paying dividends. Trian Fund’s co?founder, Edward Garden, was added to the board of directors and specifically went on the Human Resources & Compensation and the Risk committees, where he will likely effect constructive changes. Cost control at Bank of New York Mellon has been a constant challenge since the completion of the Mellon Financial Corp. acquisition in 2007, but the past two earnings reports have shown disciplined cost management and better than expected results. In this case, the heightened scrutiny on costs from two activist investors is resulting in shareholder friendly actions. We are monitoring this activist situation closely.
Our conviction in Comerica held throughout the quarter, and the stock recovered from earlier in the year weakness to be a solid contributor for the Fund. The Wall Street community is very good at myopically focusing on issues 7% of Comerica’s loan book is comprised of energy loans. In its first?quarter earnings release and on its investor call, management gave supporting evidence showing its energy loan book credit metrics remain solid and performing within management expectations. Looking beyond the energy fears, the company grew book value, maintained a clean balance sheet, grew loans 7% year over year and noted positive trends in California (its largest market), Texas and Michigan, all three of its significant geographies. Comerica also passed the Federal Reserve “stress test” in March, expects equity repurchases of up to $393 million over the next 12 months and recently approved a 5% dividend increase.
KeyCorp recovered throughout the quarter as its operating results showed the benefits of strategic acquisitions made over the past few years and its non?interest income continues to grow. Loan growth in the first?quarter was a positive 5%, and expenses were well?controlled. It also passed the “stress test” and implemented another $725 million stock buyback as a result. Book value continues to march ahead as it has for our other bank holdings.
PNC is a new position initiated during the most recent quarter. Like the regional banks mentioned above, PNC has been operating with one hand tied behind its back for the past few years in having an excess of capital, an economy that has produced tepid loan growth and new federal regulations restricting the return of capital to shareholders. As we have said many times, the problems regional banks face today are the complete inverse of 2006. Banks today have stellar credit performance, too much capital and limited options to deploy capital.
The persistently low interest rate environment, coupled with a slow and competitive lending environment, has weighed on PNC’s top line growth, not to mention its ROA. During the first calendar quarter of 2015, after reports of a slowing US GDP and consequently a more dovish outlook from the US Fed, the broader market took a more cautious stance on the pace of interest rate hikes for the remainder of the year. As interest rates fell, so did regional bank shares, opening an opportunity for the Fund to acquire PNC shares. We view the opportunity a bit differently. What we see is an opportunity to buy a business that is currently under?earning for reasons that should begin to dissipate in the near future, such as low interest rates and soft US economic growth. We believe that higher interest rates and continued economic growth in the US are likely persist over our initial three to five year targeted valuation period. Clearly, the speed and starting point of rate increases are still in question, but the valuation that we are paying for shares of PNC does not seem to have any future growth or increase in profitability priced into them. The bank is very well positioned to continue to grow its book value at high single digit rates and generate an ROE of roughly the same. Any steepening to the interest rate curve should further propel PNC’s ROE, as its excess capital is effectively yielding nothing in today’s flat as a pancake interest rate environment.
PNC also has a tremendous resource conversion opportunity lurking in its balance sheet to which the market ascribes little if any value. PNC owns significant stakes in Blackrock (21.15% ownership; $25 per PNC share) and has a $900 million investment in Visa ($1.70 per PNC share) that are likely to be monetized over time. Similar to our views on holding companies, we see the value creation in the compounding of these two substantial stock holdings as building a valuation disparity that will be addressed by management, or perhaps an activist, over time. In the meantime, given our entry point at just over book value, we feel our downside is solidly protected and an improving business environment offers nice book value compounding with a mid?teens or better IRR potential.
Third Avenue Value Fund - Opportunities in Energy: Exploration and Production Companies
In our January letter, we focused on our Energy holdings –Apache Energy, Total and Devon. Happily, all three had a strong quarter performance wise, as oil rallied from lows. More important to us is that all three made strategic moves to bolster their already strong balance sheets and stand to prosper from not only a likely gradual long?term recovery in oil prices, but also from opportunistic portfolio and acreage acquisitions as they look to secure drilling inventory well into the future. Apache closed its sale of Kitimat and Wheatstone, for $3.7 billion, and announced the expected related exit of Australian E&P acreage for $2.1 billion. Devon executed a drop down of midstream assets to its Enlink MLP subsidiary and sold 26 million EnLink LP units (ENLK) which represented 22% of its LP units, netting $870 million in cash for future fire power. Total divested a portion of its Nigeria onshore operations for $1 billion, bolstering its balance sheet with more excess capital, while we are paid a 6% dividend.
During the quarter, we took advantage of the chaos in energy related credit by adding a credit position to our portfolio. We purchased Senior Breitburn Energy bonds at roughly 71 cents on the dollar, a price that will deliver a 14.6% yield to maturity on a bond we think is worth par. The bond is performing and our analysis shows there is a very high likelihood it will remain a performing bond. Breitburn occupies a unique area of the US energy space because of its MLP structure. MLPs are not taxed and pay out most of their earnings in dividends, similar to a REIT. In order for Breitburn to pay out consistent dividends in a cyclical industry such as oil and gas exploration, they employ a strategy of acquiring long?lived assets and hedging aggressively. Said differently, Breitburn is structured to produce cash flow from producing properties and does not engage in more risky exploration activities.
At the time of our investment, the market was concerned about the company’s leverage because the company was almost 90% drawn on its revolving credit line, as it had just completed its acquisition of peer QR Energy at year?end 2014. As a result, Breitburn’s senior debt traded at a 200 to 300 basis point spread to its closest MLP peers. Through our due diligence, we became comfortable that Breitburn’s assets and hedge values more than covered our position in the capital stack. Even if oil prices fell further, we had confidence that the offsetting hedges would produce strong cash flows after interest into 2019 and if oil prices remained low, we would own the fulcrum security.
Subsequent to our investment, and as we expected, Breitburn raised capital and restructured its credit facility. The company received a $1 billion investment from an energy?dedicated private equity fund, EIG Partners. EIG invested $650 million in senior secured debt, senior to us in the capital structure, and $350 million of convertible preferred equity with 18% equity voting rights, securities that are junior to our unsecured notes. This capital structure refinancing significantly increases our notes’ probability of performing for several reasons. First, the $1 billion of proceeds from the capital raise will be used to reduce the drawn portion of the revolver from over $2.2 billion to $1.24 billion. The $1.8 billion of capacity on the new revolver will leave $560 million of capacity the company can use to make cash flow accretive acquisitions. Second, the total debt senior to our unsecured notes was reduced from $2.2 billion to slightly under $2.0 billion. Third, a significant portion of EIG’s investment was invested in the capital structure below us with a convertible feature. We are also pleased to see a strategic investor commit funds below us in the capital structure, and receive a newly created board seat. We believe we have locked in a 14.6% yield to maturity into 2022, a return we find attractive taking into account risk.
Third Avenue Value Fund - US Residential Housing: A Slow but Steady Recovery
We’re a patient bunch at Third Avenue, and although the current data on residential housing starts remain weak, we do not expect our investments in this sector to be in vain. Again in the first quarter, perhaps due to weakness in the yield on the US 10 year Treasuries or a longer than normal, and unusually sustained, deep freeze winter in the Eastern US, the speed of the upturn in residential home starts tested the markets’ resolve. Bears have noted the persistently high unemployment, low wage growth, a tepid economic recovery, low mortgage availability due to tighter Federal standards and Generation X and Y burdened by high student debt as reasons that housing will never recover to past trend levels. The word “never” for us is usually a sign of an investment opportunity, especially when used in context of a cyclical industry.
We believe that the combination of favorable demographics, nine years of below trend housing starts, loosening financial constraints and better general economic trends have historically been positive drivers within the housing market, and the slow but steady improvement in these metrics today are visible, and will play out as in the past over our investment horizon. The chart on housing starts below illustrates our point quite clearly, current levels are incredibly low relative to trend.
Rental prices have rebounded strongly since 2009 and in many markets it is now more economical to buy than rent. We feel that this, along with the fact that Millennials, which is the largest generation in US history and now makes up 34% of the US workforce, are moving out of their parents’ houses (finally), will soak up the current housing inventory which in turn will drive new housing starts and increase the demand and price for timber and lumber. As Millennials enter their peak home buying years there could be a surge in home sales, simply as a function of the group’s size. To put this in perspective, there are 92 million Millennials compared to 61 million Generation X and 77 million Baby Boomers.
With this positive thematic view, we would like to comment briefly on our housing investments, all of which offer creditworthiness from a balance sheet perspective, the likelihood of continued book value compounding and through the beginning of 2015, an even greater discount from our conservative estimates of net asset value. Many of these names are familiar to you as fellow shareholders, e.g., Cavco Industries, Weyerhaeuser and Canfor. We took advantage of group weakness in the quarter to add to our holdings in Weyerhaeuser and Canfor, and we are excited to discuss two new positions in Masco and Kingfisher.
Cavco is a long?time holding of the Value Fund, but was an under?performer in the quarter due to the weak housing sentiment. Although revenue is growing, margins are expanding and cash is building, the market decided to take a negative view for the quarter. We have many reasons to maintain our conviction on Cavco. Joe Stegmayer is a savvy, contrarian CEO who is positioning the company for better times while maintaining a solid financial position ($6 per share in net cash and investments on balance sheet currently). Stegmayer is building capacity and expanding Cavco’s geographic footprint. Manufactured housing industry sales are down 40% from levels achieved just before the financial crisis, but have high potential for growth. As overall housing sales improve, manufactured housing will be pulled along with it (and may gain share) given the low costs to purchase a manufactured home and lack of dependence on government subsidies. Cavco is well managed and has ample opportunity to grow operating earnings as sales rise.
Weyerhaeuser, the largest investment across Third Avenue and a position we continue to build for the Fund, is led by the strong management of CEO Doyle Simons, our “internal activist”. Weyerhaeuser has continued to make great progress on material cost reduction initiatives across its enterprise and continues to return excess cash flow to us as holders through increased dividends and buybacks. While Pacific North West log prices fell this quarter due to seasonally higher inventory, we see this move as normal short term noise, and we are confident that both volume and pricing will improve as housing activity picks up and mill inventories come back into balance. Additionally, we are very pleased with the progress that the company has made in its wood products division – a perpetual under earner for years, which is showing signs of real progress and in the future may be monetized at valuations higher than the market currently ascribes. Finally, we expect the Company will likely take advantage of the recent weakness in pricing to complete the $244 million remaining on its buy back authorization. Jason Wolf and Ryan Dobratz, two Portfolio Managers on Third Avenue’s Real Estate Team recently met with senior management at the company’s Washington state headquarters, and toured their Pacific Northwest operations. Our partners returned from the trip with the reinforced opinion that Weyerhaeuser common remains one of the most compelling securities in global real estate today.
We also added to our holdings in Canfor on weakness this quarter. Canfor’s improved lumber shipments have driven better cash flow generation. Operationally, a trend that we expect to continue is the improved productivity and higher conversion costs Canfor has attained as a result of its capital investment program through the downturn. Additionally, recent acquisitions in the US South are being integrated and should be significant cash flow contributors beginning in the near term. Current lumber capacity is split roughly 55% US and 45% Canada, so the material weakness in the Canadian Loonie over the past year (it dropped from parity 18 months ago to US $0.82 today) increases the competitiveness of the Canadian lumber producers like Canfor. All else equal, a $0.01 drop in the Canadian dollar versus the USD, generates $15 million in EBITDA for Canfor.
Pressing our positive housing theme, during the quarter the Fund initiated a position in Masco Corporation, a manufacturer and installer of home improvement and building products, owning a stable of well?known products and brands, most notably Delta / Hansgrohe faucets, KraftMaid cabinets, BEHR paints, and Milgard windows. Masco’s primary end markets are repair and remodeling, representing 71% of sales in 2014. We believe Masco represents a compelling opportunity supported by a strong balance sheet, capital return, internal improvement and resource conversion opportunities and a likely tailwind from a strengthening US residential housing market.
Since the bottom of the housing market in 2009, Masco has undergone significant internal restructuring that cut $600 million in fixed costs and tightened its strategic focus on operations and innovation. In February 2014, Masco named Keith Allman as its new CEO, and he has accelerated these restructuring actions and implemented a compelling capital return initiative, fulfilling the role of what we term “an internal activist”, i.e., a strong visionary leader.
In September 2014, CEO Allman announced several resource conversion activities that we believe are additive to our NAV targets. He announced the spin?off of Masco’s Installation Services segment, to be renamed TopBuild, a lower margin business with heavy exposure to the cyclical new home construction market. We view this move as favorable for shareholders in that it consolidates the majority of Masco’s profits to higher return, cash flow stable businesses exposed to the repair & remodel market. Additionally, he announced several capital deployment actions including the repurchase of 50 million shares of common stock (representing approximately 14% of shares outstanding), increased the dividend by 20%, the elimination of additional $35 million in corporate expenses, and a further de?leveraging of the balance sheet by retiring $400 million of debt by 2016.
We believe Masco will continue to outgrow the repair and remodel market by expanding the product and geographic reach of its leading brands, and will successfully complete the restructuring of its cabinet division, increasing margins to at least 10%. Additionally, it never hurts to have a tail wind and Masco should be a leading beneficiary of a long overdue recovery in the residential housing market. As housing starts approach roughly 1.0 million in 2015, we note that this will be the ninth year below the 1.5 million average start trend since 1959. As such, the TopBuild spin, scheduled for June this summer, is likely to be timed perfectly for investors seeking a more pure play exposure to the housing cycle.
We are pleased to discuss the first new European name we have added to the Fund in almost a year, as we initiated a position in Kingfisher, the largest home improvement retailer in Europe with market leadership positions in the UK, France, and Poland. Kingfisher entered the financial crisis with over £2.0 billion of debt and £3.6 billion of lease obligations.1 Its leverage in 2009 was approximately 5.0 times earnings. Since then, Kingfisher has strengthened its balance sheet by reducing its debt by more than £2.0 billion. Kingfisher is well capitalized with a BBB credit today, a rating that it is committed to maintaining or improving. We believe an investment in Kingfisher at under 8.0 times EV/EBITDAR2 represents an attractive price to pay for such a credit?worthy business with number 1 market positions in its major markets.
In addition to its attractive valuation, Kingfisher has a new and very capable CEO, Veronique Laury, who has accelerated the company’s restructuring plans. During Laury’s 11 years at Kingfisher, she led Castorama, Kingfisher’s largest French retailing unit. Over her tenure, operating margins expanded significantly and are now 9.0% versus 5.5% in the UK. The most important measures she is implementing include reducing B&Q’s retail footprint in the UK and integrating Kingfisher’s supply chain across all of its brands. In the UK, the company over?expanded prior to the crisis and locked in long?term leases that currently have above market rents. Laury announced that Kingfisher would close 60 B&Q stores in the UK over two years, which we believe will increase returns without causing significant market share losses. In addition, because Kingfisher has multiple brands across different geographies, it has not had an integrated supply chain or a modern back end IT system. Laury suggested on the most recent conference call that the implementation of common sourcing and the addition of a sophisticated SAP system to manage inventory could add hundreds of million dollars in cost savings across the system.
At Kingfisher’s current market multiple of ~8.0 times, $100 million to $200 million of cost savings would represent an additional $800 million to $1.6 billion of value that we do not believe the market is fully pricing in. Even without these restructuring benefits, we believe we are paying an almost 20% discount to our conservative appraised NAV, and see a credible path to continued NAV compounding.
Third Avenue Value Fund - Notable Sales
Sometimes, we don’t need to wait to get paid. Happily, this was the case with Target Corporation, a position we initiated in August 2014 at an average price of just over $58. Our thesis was that the market remained too myopically focused on the 2013 credit data breach incident, and was ignoring the positive trends Target was reporting in regaining customer confidence, traffic and sales.
Further, we felt that the bad news of Target’s botched entry into Canada was discounted in the share price, and management would fix or exit this operation. In January, new CEO Brian Cornell announced that Target would exit Canada, and the stock rallied strongly and reached our NAV target. As such, we exited our position and deployed the capital to our newer purchases. The investment generated 42% IRR.
We initially purchased shares of Daiwa Securities, the second largest brokerage firm in Japan, in July of 2012. Our original thesis was that Daiwa was a super well?financed Japanese brokerage firm with a profitable retail business with levers to improve its operations via cost cutting initiatives regardless of the macro environment, and was trading at an attractive valuation, i.e., a significant discount to tangible book which attributed no value to its growing asset management business. We were able to acquire shares at approximately 27% discount to tangible book value and more than a 35% discount to NAV. Since our initial purchase, Daiwa’s business has improved with overall market sentiment related to Abenomics, and along with its cost cutting efforts which have started to bear fruit. During the quarter, we exited this position for valuation reasons, realizing an IRR of around 88%. While clearly Daiwa was a successful long?time investment for Third Avenue, our team is refocused on harvesting gains when discounts are closed and redeploying that capital into better long?term risk vs. reward opportunities.
In summary, we have strong conviction in our portfolio. We have carefully selected a set of investments that share the three tenets of our investment philosophy: strong creditworthiness, consistent net asset value compounders and meaningful discount to NAV. We believe that the portfolio’s exposure to overcapitalized regional banks, select set of exploration and production Energy companies and US housing related companies is well positioned to benefit from a rise in interest rates, a readjustment of the oil industry and recovery in US housing. From our focus on creditworthiness and relentless due diligence focused on an attempt to prove ourselves wrong, we believe we have built an opportunistic and concentrated portfolio, with a high level of conviction to drive positive performance over our three to five year investment horizon.
In addition to the names discussed today, we continue to search for and find new ideas. We look forward to writing to you next quarter, profiling some newer themes and positions.
We thank you for your support and trust.
The Third Avenue Value Team
Chip Rewey, Lead Portfolio Manager
Yang Lie, Portfolio Manager
Victor Cunningham, Portfolio Manager
Michael Lehmann, Portfolio Manager
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