Concentrating on value
“Believe it or not,” says David Barse, president and CEO of Third Avenue Management, “I think we’re boring. Our portfolio might look interesting, but we never change our style or basic investment philosophy for different markets, or even for different asset classes, market-caps or regions. I once overheard an investor who thought he’d muted the conference phone say, ‘This guy says the same damn thing every time’. I thought that was the greatest compliment.”
What is that philosophy? As befits a firm established by legendary value investor Martin (Marty) Whitman, Third Avenue pursues a long-term, high-conviction, deep value strategy, based on detailed balance sheet analysis, in global large- and small-cap equity and debt instruments, and real estate. High-conviction means concentrated portfolios, and at small-cap level that can mean owning as much as 20% of some portfolio companies. “If you have to sell that stock it’s not going to be easy,” Barse notes. “Marty Whitman once said that diversification is a surrogate - and a very poor one, at that - for knowledge and price control. Third Avenue’s first mutual fund eventually became a single-stock portfolio. We don’t necessarily think that diversification is good risk control. We’d rather buy a security based on knowing as much as we can about it.”
Although that level of conviction may not offer much protection when markets liquidate en masse and correlations head towards 1.0, as happened last October, it does leave you with a coherent strategy when investors panic into taking back their money. If your default position is concentration, it isn’t too painful to concentrate even more while meeting those liquidation demands, “gravitating to some key investment themes and very-best ideas”, as Barse puts it. One of those themes is distressed investing.
Distressed is not new to Third Avenue. Whitman published a book on it this year with management consultant and finance professor Fernando Diz; and Barse spent the 1980s as a bankruptcy attorney working for distressed investment firms.
“It’s really only been this year that we’ve seen opportunities comparable to what we saw back in the 1980s,” he says. “There were businesses, whose common stock we liked, where senior debt was trading at 30% yields. We moved from what was very little of our assets under management to close to $2bn across our platform in distressed, up to around 15% of some portfolios.” Bought as ‘fulcrum securities’ - distressed-investor jargon for the point in the capital structure where a company’s enterprise value no longer covers the claim, and therefore the most senior security that will participate in a restructure and convert to equity - yields have come in to such an extent that they now look like cash alternatives.
“We were OK with taking ownership of equity if these securities failed,” says Barse. “Not only did they not fail - some of those companies that were at risk of failure are now doing IPOs.”
Another, bigger theme, was a little further from the beaten track: Hong Kong property stocks. The firm’s basic global company balance sheet screens suddenly started flagging these when SARS sent their valuations through the floor in 2003. They took a closer look at the one they knew most about - Hutchinson Whampoa - and liked what they saw.
“When we find companies we like from a business-model and balance-sheet standpoint, eventually we look to branch out to find similar opportunities, the competitors that are less well-known,” says Barse. “We spent a lot of time in Hong Kong: meeting management, meeting the real estate brokerage community and talking to economists to understand the China dynamics.”
Eventually that led to a Singapore research office and a portfolio of four stocks - Hutchinson Whampoa, Henderson Land Development Co, The Wharf Holdings and Hong Leong Group - which, through price appreciation and firm-wide portfolio concentration, make up close to one-quarter of Third Avenue’s AUM. “These are wonderful companies,” says Barse. “Super-strong balance sheets and sophisticated billionaire management teams with their entire net-worth tied up in their companies, disclosure in English audited by Big Four firms, busy building platforms to create development pipelines into mainland China. Furthermore, these management teams have become an invaluable network in the region, and they like us because we are a long-term shareholder.”
Last autumn’s liquidity-driven sell-off and renewed question around Chinese growth prospects drove them lower, but Barse was undeterred: “These guys still had Class A office buildings in Hong Kong, fully-leased with tenants paying rents, and at the end of the day, if Chinese growth is 6% rather than 12%, that’s still six times what we’re going to see in the US.” This year has seen the stocks double - “and we still don’t think they are at fair values”.
Value has clearly enjoyed a stellar 2009 since March, and while few people now expect a similar, sudden style rotation, the sheer force of the market rally in the face of continuing economic uncertainty is causing many to tilt towards growth. But here again is another advantage to Third Avenue’s high-conviction style and willingness to concentrate when necessary. For a start, it avoids ‘value traps’: Third Avenue’s philosophy didn’t think much of this year’s short-termist ‘dash for trash’. “That’s going to result in some very quick turnarounds in pricing,” Barse predicts. “The safety of a balance sheet, on the other hand, will help companies distinguish themselves and their fundamental value creation from what has been momentum value creation.” In addition, Third Avenue is not forced to find 200 value stocks in this environment.
“In 2006, inflows exceeded our ability to put capital to work, and, so we closed a couple of funds, but even in those headiest days for growth there were industries suffering near-term dislocations,” Barse observes. “US auto suppliers, for example, were having a depression that rivals what happened to financial services in 2008, but there were still interesting opportunities around that sector. You just have to be a little more creative. Outside of distressed and Hong Kong property, there are energy themes: natural gas is at historical lows, for example, and you have to wonder how long that can go on - we find opportunities along the entire value chain there.”
Within the long-only equity world this is high-alpha, idiosyncratic stuff, and Barse admits that it has been a difficult sell into more consultant-led pension communities, where advisers “tend to want to place you into a nine-quadrant box”. “We’re not appropriate for everyone,” he concedes. “We tend to appeal to real students of investing who are charged with finding people like us with distinctive investment processes: endowments or family offices where investment committees are populated by professionals, or high net worth individuals who have worked in investing. We can’t afford to be in a position where a client’s adviser frets about underperforming a benchmark by 50 basis points and threatens to terminate if it happens for another quarter.” However, he senses that the consulting community wants to evolve into an “absolute return-minded, value-adding business” which would have a friendlier ear for Third Avenue’s unconstrained style, and that is why the firm has invested in its first head of consultant relations.
So, ‘exciting’ in the short-term but ‘boring’ over the long-term? That depends on whether you think the numbers from the firm’s flagship value Fund - 3.6% annualised over five years, 7.9% over 10, 10.4% over 15 and 12.8% since inception in 1990 - are ‘boring’. Volatility is high, but that comes with the philosophy, and unmuted conference phones or not, that is one thing that will never spring any surprises.