Martin Whitman: Going Concerns Vs Investment Type CompaniesVW Staff
Martin Whitman’s letter to investors for the Fiscal Quarter ended October 31, 2015.
Dear Fellow Shareholders:
At Third Avenue Management, companies, the securities they issue, and their managements and/or control groups are appraised from three different angles:
1. As going concerns with perpetual lives engaged in day to day operations, managed as they always have been managed and capitalized pretty much the way they have always been capitalized.
2. As investors buying and selling assets in bulk as well as buying and selling controlled companies and affiliates.
3. As financiers funding going concern operations as well as resource conversions such as hostile takeovers, mergers and acquisitions, going privates, starting up new activities; and also restructuring capitalizations for either healthy or distressed companies.
Virtually all companies are involved in the three activities and combine elements of being both Going Concerns (GCs) and Investment Type Companies (ITCs). Most companies probably are focused on recurring operations, i.e., being GC’s, and in analysis, principal weight is given to the primacy of the income account to determine periodic earnings and cash flows from recurring operations. Such companies include Walmart and Pfizer.
Here most analysis seems to be conventional Graham & Dodd. For other companies the emphasis is on increasing readily ascertainable Net Asset Values (NAVs) over time. Here the emphasis is on analyzing the company as an ITC. Such companies include Berkshire Hathaway, Loews Corp. Wheelock & Company, Brookfield Asset Management, all mutual funds, most other Registered Investment Companies (RIC’s), and virtually all hedge funds.
While Third Avenue Management invests in the common stocks of companies which are predominantly GC’s, it is probable that Third Avenue Management concentrates more heavily on equity investments in companies that are predominantly ITC’s. For this there are a number of reasons:
ITC’s tend to be easier to analyze, especially if the common stocks are available at prices that reflect deep discounts from readily ascertainable NAV, and the company is strongly financed, i.e., eminently credit worthy. ITC type analysis seems especially useful in appraising financial institutions (such as Keycorp and Comerica) and income producing real estate (especially non-US real estate where income producing assets are carried in financial statements at independently appraised net asset values such as is the case in Hong Kong, China, Canada, England and Germany).
An investor in ITC’s usually has less need for diversification than is the case for GC’s, in part because the portfolios of ITC’s tend to already be quite diversified as is the case for Brookfield Asset Management, Loews Corp., and a majority of the portfolio securities held by Third Avenue Real Estate Value Fund. Earnings are not ignored in an ITC analysis. The Return on Equity (ROE’s) for Third Avenue Management’s ITC investments seems to be comparable to the ROE’s for general market investments as represented by the Dow-Jones Industrial Average (DJIA). The DJIA is selling at around 3x book and about 17x latest twelve month earnings. In contrast, the common stocks of most Hong Kong and Chinese income producing real estate companies are priced at least at 30% discounts from NAV and usually around 2x to 6x latest 12 month reported earnings. ITC analysis seems more suitable for long term investors than does most GC analysis. Much of GC analysis, including Graham & Dodd analysis, is not too helpful in appraising long term prospects for four reasons: 1. There is an emphasis on the primacy of the periodic income account rather than on credit-worthiness. 2. There is a concentration on short-termism. It seems impossible to focus on stock price movements without being a short termer or even a trader. 3. There is a concentration on macro factors—the DJIA, Gross Domestic Product, interest rates, employment numbers—with a consequent denigration of important micro factors, —such as appraisals of managements, appraisals of a company’s ability to finance its activities and analysis of a company’s competition, and appraisals of a company’s ability to innovate.
4. There is a belief in equilibrium prices, i.e., there exists an efficient market whose pricing represents a true valuation price which will change only as the market obtains and digests new information.
Graham and Dodd in common stock analysis are not overly helpful for long term investing because of their emphasis on three factors in common stock analysis: the macro outlook, earnings from operations and dividends.
Martin Whitman Third Avenue Funds – Credit-worthiness
ITC analysis however is not very helpful to investors when the entity being analyzed is not credit worthy. Credit-worthiness seems to be a function of three factors:
1. Cash flows from operations
2. Strength of current balance sheet and other credit factors whether disclosed in footnotes or elsewhere or not disclosed at all
3. Access to capital markets ranging from availability of senior credits to an ability to raise equity capital
Access to capital markets seems to be quite capricious. Loss of such capital market access by companies which needed continuous access was the precipitant for a large number of the biggest insolvencies in U.S. history, Drexel Burnham, Enron, Bear Stearns, Washington Mutual and Lehman Brothers.
In ITC investing there is an emphasis on guarding against investment risk, i.e., something going wrong with the company or the securities it issues. Market risk – securities price fluctuations – is pretty much ignored in ITC investing. Thus using borrowed money, i.e., margin, to be an ITC investor is dangerous: too much market risk is entailed if an investor is on margin.
In a sense, GC analysis is distinguishable from ITC analysis by what the analyst is seeking to learn. GC analysis concentrates heavily on forecasts of results for the immediate future and the intermediate future. These forecasts are quite subject to error, sometimes gross error. In ITC analysis, the concentration is on acquiring “what is” safe and cheap, an activity much less prone to error than forecasting future profitability or future resource conversions.
GC analysis has to have major weight in most analysis (albeit Third Avenue Management as an investor has available a myriad of ITC securities in which its funds might invest). NAV tends to be a not very useful tool for investors when individual assets of the GC are not separable and saleable; or where assets are hard (or impossible) to value. Industries where NAV tends to lack importance include retail, most manufacturing companies, most service companies, transportation companies and many natural resources extraction companies.
Diversification is a surrogate, and usually a damn poor surrogate, for knowledge, control and price consciousness. At Third Avenue Management, its concentration, whether GC or ITC, is exclusively on outside minority passive investing with deep knowledge of companies and the securities they issue, and also price consciousness in trying to buy at big discounts from intrinsic value for companies with good outlooks. Thus Third Avenue Management has less need to diversify than finance academics and traders, most of whom study only markets and security prices, and have little or no knowledge about companies and the securities they issue. Also, Third Avenue Management, as an outside passive minority investor, has more need for diversification than do control investors and most active investors.
For financial academics and Efficient Market Theorists, their intellectual appeal is to traders, an almost non-existent activity at Third Avenue Management. Most activity on Wall Street, however, involves not trading, but knowing much about companies and the securities they issue. Those activities encompass the following:
1st and 2nd Stage Venture Capital Investing
It is hard to think of efficient market theorists as knowledgeable about important matters. Indeed, when it comes to understanding companies and the securities they issue, these people seem to place a premium on being ignorant.
Martin Whitman Third Avenue Funds – Market efficiency
Most markets are efficient in one sense or another, and the same markets are inefficient in one sense or another. For analytical purposes, there are three types of efficiencies for securities markets:
Value efficiencies reflect that price and other terms, that would be arrived at in transactions between willing control buyers and willing control sellers, each with knowledge of the relevant facts and neither under any compulsion to act.
Transaction efficiency exists in markets for “sudden death” securities and the analysis involves a relatively few computer programmable variables. Sudden death exists where there is to be a final disposition of the situation within a relatively short period of time. Sudden death includes trading strategies, options, warrants, exchange offers, tender offers, merger arbitrage and certain liquidations.
Process efficiency (or lack of process efficiency) exists in markets where there are prospects (or no prospects) for changes of control, going private, mergers, massive recapitalizations and some liquidations. Process efficiency can also exist in the markets where there is a lack of trading volume and/or a lack of compensation for securities salesmen and securities promoters. Here the process efficiency price may only be a fraction of the value efficiency price. Third Avenue Management invests in GC’s and ITC’s where there is a belief that a wide discrepancy exists between the value efficiency price and the lower process efficiency price.
While most ITC’s sell at large premiums over readily ascertainable NAV’s, many are not only priced at meaningful discounts from readily ascertainable NAV’s but also are the common stocks of quality companies with good outlooks. Third Avenue Management is invested in many of the best ITC’s which are both blue chips and steadily growing. Such investments include the following:
Hong Kong –mainland China real estate Companies
Brookfield Asset Management
Credit-worthy companies almost never repay debt in the aggregate. While individual debt instruments mature, credit-worthy companies are able to refinance, and expand their indebtedness as they become more and more credit-worthy. This seems true for most Third Avenue Management equity investments. Never repaying debts in the aggregate ought to be part of the underlying assumption in financial accounting which bottoms on the fact that most corporations are going concerns with perpetual lives.
Best wishes for a Happy Holiday season. I shall write you again when the quarterly report for the period to end January 31, 2016 is issued.
Chairman of the Board