This is a great letter from Martin Whitman on avoiding investment risk. It is long and well worth the read.
AVOIDING INVESTMENT RISK
During the quarter, I read an interesting book, The Great Risk Shift, by Jacob S. Hacker, a Political Science Professor at Yale University. The gravamen of the book is that in recent years – the George Bush years – various risks, i.e., job risk, family stability risk, retirement risk and healthcare risk, have been shifted increasingly from corporations and governments onto the backs of individuals. The raison d’etre for The Great Risk Shift is to foster the creation of an ownership society where the beneficiaries of say, pension plans and health plans, take the risks that go with ownership by being responsible for investing funds with no guarantees of minimum returns.
What the proponents of this type of ownership risk fail to recognize is that the most successful owners do not take risks. They lay off the risks onto someone else. Professor Hacker’s thesis got me to thinking about investment risk in the financial community and in American business in general. Put simply, the vast majority of great individual fortunes built in this country, especially by Wall Streeters and corporate executives, were not built by people who took investment risks. Rather, the secret to building a great fortune is to avoid, as completely as possible, the taking of any investment risk. Investment risk consists of factors peculiar to a business itself, or the securities issued by that business. Investment risk is a risk separate and apart from market risk. Market risk involves fluctuations in the prices of securities and other readily tradable assets.
A directory of those in the financial community who build great fortunes by avoiding risk include the following:
• Corporate executives who receive stock options or restricted stock. If the common stock appreciates, the executive builds a substantial net worth. If the common stock does not appreciate, the executive loses nothing. Indeed, he may obtain new options at the lower strike price, or new restricted common stock.
• Members of the Plaintiffs’ Bar who bring class action lawsuits in order to earn contingency fees. The expenses involved in financing such lawsuits are minimal, and it is remote that Plaintiffs’ attorneys ever incur costs for sanctions or for paying defendant’s costs and fees. The fee awards obtained tend to be huge upon settlement of such lawsuits, or less frequently, obtaining a favorable verdict for the plaintiffs after trial.
• Initial Public Offering (“IPO”) underwriters and sales personnel. If you run a promising private company and desire to go public, you will find that many potential underwriters will compete for your business. However, as a general rule they will not compete on price. The price will be a 7% gross spread plus expenses. Thus, on a $10 IPO, the gross spread will be $0.70 per share. In contrast, to buy a $10 stock in a secondary market like the New York Stock Exchange, a customer can negotiate a commission rate of, say, $0.02 to $0.05 per share.
• Bankruptcy Professionals; Lawyers and Investment Bankers. Chapter 11 is now set up so that bankruptcy professionals have to be paid in cash, on a pay as you go basis (with only minor holdbacks), where such payments are given a super priority so that these professionals very rarely have any credit risk at all. Attorneys’ fees billed at up to $900 per hour, and investment banking fees of over $300,000 per month (plus success fees) are not uncommon.
• Money Managers, Mutual Fund Managers, Private Equity and Hedge Fund Managers. Normal fees might range from 1% of Assets Under Management (“AUM”) to 2% of AUM plus 20% of annual realized or unrealized capital gains (after a bogey, of say 6%, paid or accrued to limited partners). These fees are paid to entities which receive the cash fees without incurring any credit risk in business entities which have few physical assets and very little necessary overhead. Most hedge funds are Limited Partnerships (“LPs”) where the money manager is the General Partner (“GP”) and Outside Passive Minority Investors (“OPMIs”) are the LPs. An LP has been waggishly described as a business association where at the beginning the GP brings experience and the LPs bring money. At the end of the business association, the GP has the money and the LP has the experience.
• Venture Capitalists. These people finance a portfolio of start-ups, and then are able to realize astronomic prices on some of the portfolio companies when they occur, as they always seem to do from time to time, IPO speculative booms.
• Real Estate Entrepreneurs, especially investment builders. Two keys to making fortunes in large scale real estate projects are the availability of long-term, fixed interest rates, non-recourse financing, and income tax shelters. In terms of understanding corporate finance, economists have it all wrong when they say “there is no free lunch”. Rather, the more appropriate comment ought to be “somebody has to pay for lunch – and it isn’t going to be me.” Third Avenue is basically an OPMI. As such, it seems impossible to avoid investment risk. The methods by which TAVF attempts to alleviate investment risk are described in the remainder of this letter.
1. Buy Cheap. Warren Buffett, the Chairman of Berkshire Hathaway (BRK.A), describes his investment technique as trying to buy good companies at reasonable prices. Warren, however, is a control investor, and while a reasonable price standard has worked remarkably well for Berkshire Hathaway, that standard is not good enough for TAVF, an OPMI. The Fund has to try to buy at bargain prices, i.e., cheap. The definition of “cheap” for TAVF in acquiring common stocks in the vast majority of cases is acquiring issues at prices that reflect substantial discounts from readily ascertainable NAVs. Further, the Fund acquires such NAV common stocks only when Fund management believes that the prospects are reasonable that over the long term such NAVs will increase by not less than 10% per year compounded.
Common stock holdings which met these standards when acquired by the Fund include Toyota Industries (TM), Forest City Enterprises (FCE-A), Brookfield Asset Management (BAM), Cheung Kong Holdings, Posco and Wheelock. I doubt very much if those discount prices would have existed if any of those issues were likely to be subject to a change of control. That type of cheapness is one of the advantages of being an OPMI. Readily ascertainable NAVs means that the Third Avenue common stock portfolio is, to a large extent, concentrated in financial institutions and companies involved with income-producing real estate. Third Avenue’s portfolio contains almost no common stocks of companies engaged in old-line manufacturing.
Control investors can afford to pay up versus TAVF because control investors are in a position to undertake financial engineering, and to cause management changes. Third Avenue leaves companies as-is, and places particular efforts into buying into well-managed businesses with stable, but clearly superior, managements. This seems to have been achieved in establishing relatively large positions in the companies mentioned in the previous paragraph, as well as in acquiring large positions in Nabors Industries (NBR), Power Corp., St. Joe (JOE) and Mellon Financial. “In terms of understanding corporate finance, economists have it all wrong when they say ‘there is no free lunch’. Rather, the more appropriate comment ought to be ‘somebody has to pay for lunch – and it isn’t going to be me.’”
2. Buy Equity Interests Only in High Quality Businesses. The Fund does not knowingly acquire the common stock of any company unless that company enjoys a super strong financial position. TAVF tries to buy into reasonably well-managed companies. Fund management appreciates the fact that any relationship between al statements. OPMIs and corporate managements combine communities of interests and conflicts of interest; Third Avenue Management tries to restrict itself to situations where the communities of interest seem to outweigh the conflicts of interest. Third Avenue restricts its common stock investments to companies whose businesses are understandable to Fund management and where there exists full documentary disclosure, including audited financing
3. TAVF tries to operate on a low cost basis for its shareholders. The fiscal 2006 expense ratio was 1.08%. Third Avenue has no 12-b(1) charges, is a no-load fund and imposes no redemption fees on long-term shareholders. Since portfolio turnover is low, transaction, i.e., trading, costs, too, are low.
4. The Fund ignores market risk. Fluctuations in market prices are mostly a random walk with changes in market prices not in any way a measure of long-term investment risk, or investment potential. It is as Ben Graham used to say, “In the short run the market is a voting machine. In the long run the market is a weighing machine.” Most competent control investors, again like Warren Buffett, pretty much ignore market risk also in that little, or no, weight is given to daily, or even annual, marks to market for portfolio holdings.
5. Buy growth, but don’t pay for it. In the financial community, growth is a misused word. Most market participants don’t mean growth, but rather, mean generally recognized growth. In so far as growth receives general recognition, a market participant has to pay up. To my mind, Cheung Kong Holdings, Forest City Enterprises, Covanta and Toyota Industries are growth companies. When the common stocks were acquired, none of these issues enjoyed general recognition as having growth potential.
6. TAVF is a buy-and-hold investor. Although our entry point into a common stock is a bargain price, the Fund will continue to hold a security where Fund management believes that the business has reasonable prospects that it can, over the long run, increase annual NAV by a double digit number; and where Fund management does not
believe it made a mistake. Mistakes are measured by beliefs that there has occurred a permanent impairment in underlying value or financial position. The Fund will also sell if there is a belief that the security is grossly overpriced. Finally, the Fund will sell for portfolio considerations; i.e., where there are massive enough redemptions of Fund shares so that the liquidity of the Fund is threatened. As one can see by our sales activity during the quarter, most of our sales occur when a company is taken over.
7. The Fund does not borrow money and, thus, invests without financial leverage. Furthermore, the TAVF portfolio has a cash cushion. Usually 10% to 20% of Fund assets are in cash or credit instruments without credit risk. Obviously, an investment by you in TAVF does entail investment risk. Fund management, however, is doing the best it can to try to minimize investment risk. Toward this end, and as our business continues to grow, we thought it would be prudent to charge a senior member of our investment team with the responsibility of preserving the integrity of our research process. I am pleased to inform you that portfolio manager, Yang Lie, has been named Director of Research for Third Avenue Management. Yang has been with Third Avenue more than ten years, as both an analyst and portfolio manager, and is extremely well qualified to assist Curtis Jensen and me, as co-Chief Investment Officers, in leading the team. Research has always been at the core of what we do here at Third Avenue. Each of the 21 members of our research team is an analyst first and foremost, whether or not he or she also manages portfolios. In this new role, Yang will add structure to the organization, enabling us to manage the assets you have entrusted to us even more effectively.
I will write to you again when the report for the period to end July 31, 2007 is published.
Marin J. Whitman