The Evolutionary Pressures and Re-emergence of Value Investing
With the recent rotation away from growth stocks due to changing economic conditions, rising interest rates and a growing need to deleverage risk, value investing has come back into prominence. This is a good time to explore the state of value management. An interesting question we discovered was whether the many years of growth style dominance affected and brought changes to value investing methodologies and processes?
To better understand the evolutionary pressures on value investing and where we stand today, we were introduced to Matthew Fine, Portfolio Manager, Global Value and Victor Cunningham, Portfolio Manager, Small-Cap Value of Third Avenue Management – a NYC-based asset management firm founded by legendary value investor Martin Whitman with a family of 40-Act mutual funds, institutional separately managed accounts and UCITs for non-US investors. For more than three decades the firm has consistently pursued a fundamental, bottom-up approach to deep value and distressed investing.
Hortz: How would you summarize the Third Avenue investment philosophy? Does it vary from strategy to strategy within the firm?
Fine: The highly summarized version is that we fall into the camp of long-term, opportunistic, fundamental value investors. We are investing with a three-to-five-year investment horizon, manage relatively concentrated portfolios and tend not to care very much about whether our portfolios mirror a benchmark or not. Unlike other value managers, Third Avenue tends to be an outlier in its emphasis on the price of the security - meaning the size of the discount to a conservative net asset value - rather than that outlook of the business, which frankly can be quite fluid.
Further, given that finding deeply undervalued securities very frequently entails contrarianism and investing in situations where the outlook is challenging, we also place a heavy emphasis on the quality of a company’s financial position. We need to ensure companies can survive until the clouds recede and do so without needing to raise capital in a way that diminishes the value of our ownership interest. This identical approach is applied to each of Third Avenue’s strategies – Global Value, Small-Cap Value, Global Real Estate and International Real Estate.
Cunningham: As an aside, over the most recent decade of falling interest rates and free capital available to anyone, our focus on financial wherewithal has not been a particular benefit to our results, but in the rapidly rising rate environment we now find ourselves in, some younger investors will learn for the first time in their careers why it matters a great deal.
Hortz: From your perspective, what are your observations on how value managers may have been impacted by the extended investment focus and flows to growth investing and what might be some of the consequences investors should be aware of?
Fine: One major consequence of the relative performance dynamic of growth versus value strategies has been that many value managers have struggled to hold on to their clients, and in turn, their jobs. A number have closed up shop. Others have quietly redefined how they think about value in search of a path of less resistance. This is also perfectly analogous to the late 1990s when a number of investing Hall of Famers nearly lost their jobs and the value herd was substantially thinned. I think that a philosophical shift to a path of less resistance over the last few years is on display in the early part of 2022 in the sense that a number of notable value managers have not performed particularly well in spite of value strategies, statistically speaking, showing a strong resurgence.
Cunningham: We feel that growth investing has been in favor so long that a cross-section of historically deep value investors that have been under pressure have morphed from traditional value to more GARPY Growth-At-A-Reasonable-Price orientation. Their definition of value and operating methodology may have morphed from traditional value investing. This is not a criticism, but an observation.
If someone is looking for value investing today, you might want to spend a little more time digging into the processes and operations of the firm to determine where in the more enlarged spectrum of value the firm actually resides or operates from.
Hortz: How would you characterize your position in the spectrum of available value management firms?
Fine: Marty Whitman was the quintessential maverick, not different for the sake of being different, but a genuine independent thinker. Like some other great value managers, he was not born with that inhibiting gene that causes most people to take comfort in being part of some type of herd. In order to be a thoughtful and successful contrarian, you have to be completely comfortable with most people telling you that you are wrong – or even a little nuts – for a while, until they later come around to your point of view. It is for that reason that the current iteration of Third Avenue’s management is deliberately comprised of members of the investment team and decision-making really revolves around working to produce great investment results.
As a result of this heritage of independent thought, avoidance of the herd and seeking investment excellence with a focus on the quality of the results rather than collecting a huge quantity of assets under management, we feel the portfolios managed by Third Avenue today are very unusual in the context of the investment industry. We would point to our active share – a measure of the percentage of stock holdings in a manager’s portfolio that differs from the benchmark index – which stands at over 90% across all our equity funds, including our Value Fund and Small Cap Value Fund being over 98%. Most importantly however, we have been able to demonstrate that our strategy is capable of producing substantial long-term outperformance for clients.
Cunningham: Although Marty is no longer with us, his legacy is carried out in our research processes today. Two distinctive attributes are Third Avenue’s reliance on net asset values and the written word. We value companies differently than most peers. It is one of the reasons our portfolios have high active share measures.
Many peers use static metrics such as Price/Earnings ratios when valuing companies. We add up the assets (which includes a conservative independent assessment of each business unit) and subtract all liabilities (off balance sheet and on balance sheet) to determine net asset value. This approach requires a deep dive into each of the businesses and often leads to different investment conclusions versus the crowd.
Marty’s affection for the written word was underappreciated. Our investment team is required to write concise memos when presenting an investing idea. There are compounding benefits to this approach. First, it forces the lead analyst to clearly articulate the thesis to readers with diverse backgrounds. Second, the investment team is required to read the memo before each investment meeting which leads to highly productive dialogue when a new investment is presented. Finally, each memo is submitted to a corporate database which provides a paper trail that memorializes the original investment thesis and analysis and helps minimize many behavioral biases.
Finally, as a general matter, Third Avenue is much more price conscious than outlook conscious. That concept leads us into very different areas of the equity market than the vast majority of investors. That concept is a critical component of contrarianism.
Hortz: Are there special situations or areas of the market that you explore for unique value opportunities to capture? Can you give us a few examples?
Fine: While Third Avenue is primarily an equity investing firm today, we continue to draw upon our firm’s distressed investing roots. We have a number of senior investment professionals with experience in distressed credit and restructuring situations. In that area of the investment world, you are generally trying to identify good businesses or assets with a bad balance sheet that can be fixed through financial restructuring.
In recent years we have taken the same approach by investing in the equity of several companies that have just emerged from bankruptcy. We can go get the reorg plans and read bankruptcy documents and possibly provide liquidity to debt holders who are not interested in owning the equity they just received in the reorg. In cases like Tidewater, an offshore oil service company, and Warrior Met Coal, a metallurgical coal company, the companies came out of bankruptcy with net cash balance sheets at a time when their respective industries were at cyclical lows and with assets that were among the very best in their industries. In the case of Warrior, the company was also bestowed with a huge tax loss carryforward that would ensure the company would not pay any taxes for years.
There is also a concept deeply embedded in the Third Avenue investment approach we refer to as “resource conversion.” It is an acknowledgment that, while Wall Street generally models companies far out into the future based on the business lines as they exist today, in practice, it is the norm for companies to change in structure over time by buying or selling lines of business, spinning off assets, recapitalizing, merging or being purchased. Our approach explicitly embodies the mentality of a long-term owner of the entire company in order to envision the means by which the company’s resources might be converted to the benefit of shareholders.
For example, Vapores is a Chilean holding company that has a substantial stake in one of the world’s largest container shipping companies. The company itself is essentially a pass-through entity with some valuable tax shelters. Because the container shipping company pays such a substantial dividend at these levels of profitability, and it trades at such a large discount to the value of its stake in the container shipper, we expect to receive dividends from Vapores over the next year or so that roughly equate to our purchase price of the stock. The company is essentially going through a recapitalization every couple of quarters.
Cunningham: Investing on behalf of the Third Avenue SmallCap Value strategy, special situations are investments where we can find value in out-of-favor industries, complex corporate or capital structures, and other unique scenarios.
One recent example is an investment we made in conjunction with Third Avenue’s real estate team in Q4 of 2021. InvenTrust Properties Corp (IVT) is a grocery-anchored, open-air retail REIT located primarily in the Sun Belt region of the United States. Our Fund Management was attracted to the company not only for the strength of its balance sheet and discounted valuation, but also the special situation quality of the investment thesis. The investment in that company fits nicely into the Fund’s special situation bucket.
Over the past few years, InvenTrust has been undergoing a transformation that was orchestrated by the current CEO and former CFO, DJ Busch. Actions taken included spinning off non-core assets, improving the balance sheet and focusing on locations in the high growth Sun Belt region of the United States. The transformation was punctuated in October when the company went public, converting from a private to a public REIT. The public listing was followed by a tender offer for private shareholders in November. It took time for the market to better understand the transformation story and the confusion created by the tender offer provided our Fund Management an attractive entry point to initiate a position.
Management’s actions have culminated in a well-capitalized (net leverage of 20%), well-positioned (grocery-anchored, Sun Belt focused) REIT trading at a discount to our conservative Net Asset Value estimates. We believe the company has multiple avenues to grow NAV over time and as investors learn the story and strategic actions take hold boosting the NAV growth, the NAV discount could shrink over time.
Lastly, IVT could be a resource conversion candidate given its low leverage, attractive footprint and tenants, as well as the vast amounts of capital that have been raised by private real estate funds looking for attractive assets.
Hortz: How would you characterize the current shift in the markets from growth to value investing and the prospects for value investing going forward?
Fine: Enormous distortions have been built up within equity markets, particularly in the U.S. large-cap, high revenue growth companies, which came to be ludicrously valued. This is true in an absolute sense and even more true relative to slower growing, but highly profitable companies.
These distortions that were built up during recent years, especially between expensive companies and cheap companies, were among the greatest on record. The reversal of those distortions during the last twelve months has been powerful but has only just begun to return to a normalized relationship of “cheap” and “expensive” and more traditional fundamental value strategies remain in a position to produce considerable additional outperformance as distortions continue to normalize.
Hortz: What are your observations with regards to U.S. small caps?
Cunningham: Small cap stocks have woefully underperformed large caps over the last five years. For the five-year period ending 9/30/22, the S&P 500 returned over 9% which is in line with historical averages. Small Caps have not kept up as the Russell 2000 returning just 3.55%. In addition, small caps now account for just 4% of U.S. equity markets which is far below the historical average of 7.4%, and except for a brief period during the Covid crisis, is at the lowest level since the 1930’s. A reversion to the mean could result in above trend for performance for the small cap asset class.
Looking across the broader small-cap universe, we have witnessed the deteriorating quality of small-cap indices. Leverage levels and the percentage of non-earners in the Russell 2000 Index are near all-time highs. Specifically, 42.3% of the companies counted in the Russell 2000 as of June 30, 2022 are non-earners on a trailing twelve-month basis, compared to the historical average of 29.6%.
Similarly, debt levels across small caps are near all-time highs. By taking a creditors perspective and balance sheet approach to security selection, our portfolio has a net debt-to-capital less than half of the index. With tighter financial conditions in 2022 and beyond, patience, discipline and risk management should be rewarded. Additionally, we are aligned with management teams that not only avoid excessive risks but are also prepared to take advantage of dislocations when they occur.
With deteriorating quality of small-cap indices, the challenge for value-oriented investors has been that valuations of indexed companies have grown due to healthy inflows into passive index funds vehicles (passive is now to 47% of the small-cap market [source EPFR; Jefferies] despite worsening fundamentals.
With recent trends that appear to be reversing course, we feel that small-cap value stocks could be set up for potential outsized future returns. Third Avenue believes the best way to capture the inherent value gap between small/large cap companies is through fundamental security analysis, to focus on underfollowed opportunities and to prudently concentrate on your highest-conviction ideas.
Hortz: Any recommendations on the key areas or elements to consider when positioning value investing in client portfolios today?
Fine: There are three broad areas of global equities that look unusually attractive today – non-U.S. stocks relative to U.S. stocks, smaller capitalization companies and cheap companies relative to expensive ones, i.e., value relative to growth. What we are doing in the Third Avenue Value Fund, as an example, is entirely driven by bottom up, fundamental considerations but virtually all of our recent activity has fallen right into the overlapping sliver of the Venn diagram of cheap, non-U.S., and small-cap companies.
Cunningham: We would also pound the table on the aspect of our investment approach that demands that the companies in which we invest have financial wherewithal. Refinancing is going to be tougher and more expensive in a new interest rate environment. Companies with strong balance sheets will be far less impacted and may even have some opportunities to pick off weaker financially leveraged competitors.
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