Third Avenue International Value Fund's Letter Part 1

Investing is a marathon, not a sprint

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Sep 10, 2015
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Dear Fellow Shareholders,

Investing is sometimes analogized to long distance running. People say things like "This is not a sprint; it’s a marathon." While I do not care much for clichés I do enjoy running. I ran the New York City Marathon in 2010, and I do believe there are a number of parallels to be drawn between investing and this type of endurance sport.

As I reflect upon the performance and positioning of the Fund, I frequently remind myself of the concept of “pace,” meaning the pace at which a marathoner can consistently run the length of a grueling race, ideally finishing the latter half of the race with faster per mile times than the first half (referred to as split times). Concentration and discipline throughout the race are critical. Running through New York City with 50,000 people under the watchful eyes of enormous crowds, helicopters and news crews is heady stuff and similar in several regards to Fund management. It is extremely easy to get excited, lose concentration and succumb to the urge to adopt the pace of the runners around you or accelerate to pass runners in front of you, which of course result in a break from one’s pace and strategy.

Through July of this year, the Third Avenue International Value Fund (Fund) returned negative 3.86%. In the most recent fiscal quarter, the Fund returned negative 8.62%.1 The Fund’s benchmark, the MSCI ACWI ex USA Index, returned 4.08% year to date as of July and negative 4.43% for most recent fiscal quarter. It feels far worse than that as a result of the maelstrom surrounding select parts of the portfolio. Structural flows into equity ETFs continue to pose challenges for managers with high active share and, throughout this year, the capital exodus from emerging market and commodity ETFs, and funds otherwise dedicated to those categories, have created a gale force headwind for those classes of assets.

We continue to steer the Fund in the direction of value, in the extreme in some cases. We find neither safety nor prospect of attractive return in the vast majority of widely held securities. We have certainly not been paid for our effort at this point but continue to unapologetically believe that buying dirt cheap securities while protecting one’s capital from risk of permanent impairment is the path to success in this endurance race. It is critical that we tune out the pace of other runners in the field and continue to run our style of race.

Personally, I have used the recent period of weakness to add to my holdings in the Fund. In the pages that follow, we will discuss the drivers of the Fund’s performance and delve into several of the philosophical underpinnings that dictate the Fund’s approach and activity. Our letter concludes with a discussion of the Fund’s investment activity during the quarter.

Performance

The strongest positive contributions to Fund performance year to date have come from Hutchison Whampoa (HUWH, Financial), which has executed on several important resource conversion activities, and a number of our European holdings including Telefonica Deutschland (TELDF, Financial), Nexans (NEX, Financial), BinckBank (BINCK, Financial), Daimler (DAI, Financial) and Vivendi (VIV, Financial). Negative impacts to the Fund’s performance during the quarter, and for the year for that matter, have resulted, in large part, from three categories of investments held within the Fund. Firstly, our exposure to base metals and oil services. Our copper mining companies continued to negatively impact performance as global sentiment towards the metal and this class of company continued to deteriorate in this fifth year of cyclical downturn. With similar sentiment surrounding them, our oil and gas related investments were also poor performers during the quarter. We will return to where the concept of sentiment fits into the team’s activities shortly noting though that several of our investments in other commodity-related industries, such as timber and agriculture, have performed reasonably well of late. Secondly, our investments in Brazil have suffered from an increasingly challenging macroeconomic and political environment which has affected each of our three investments in ways specific to each business. In no case has the long-term value of any of our businesses been diminished, i.e., suffered a permanent impairment, and in each case the impact from the depreciating Brazilian Real has been the primary source of negative investment returns. We will return to the matter of forecasting currencies shortly as well. Finally, our two investments in less liquid New Zealand small-cap companies — Rubicon Ltd. (RBC, Financial) and Tenon Ltd. (TEN, Financial) — have been a drag on performance during the quarter and year to date. The depreciation of the New Zealand dollar is the primary source of negative returns more so than the stock prices. Meanwhile the two businesses derive their value almost exclusively in U.S. dollars, which makes the decline in the New Zealand dollar nearly irrelevant to the value of the business as denominated in U.S. dollars. This value dynamic has failed to “flow through” to be reflected in the equity prices. We have written extensively on this topic in past letters and thus will speak to our investment philosophy more broadly with regard to our assessment of how efficiently the market prices securities in subsequent paragraphs.

Sentiment and its importance

It might seem odd for fundamental corporate finance-fixated, value-investing people like ourselves to exert energy in considering squishy psychological matters like sentiment. Many Wall Street banks “measure” sentiment using fund manager positioning relative to indices as a proxy or some other similar method. In recent weeks the world has been awash with articles describing historic net short positioning in the futures of various metals. It is not remotely surprising that measurements of poor sentiment are nearly off the charts for a variety of commodities today. Commodity ETF (out)flows are another glaring indication of sentiment.

Which brings us to one critical element of the Third Avenue investment approach: the refusal to accept today’s received wisdom as gospel. Fundamental analysis and valuation inform long-term value investors, not prevailing sentiment though I suspect short-term traders are justified in caring more about current sentiment and shifts thereof. Our firm’s founder and chairman, Marty Whitman, sometimes speaks to the issue of sentiment with the mantra “we buy when the near-term outlook sucks.” The philosophy compels us to deliberately seek out and analyze areas of potential opportunity where sentiment is at its worst, or is at least quite poor, knowing full well that sentiment and valuations may get worse before they get better.

Our presence in areas of controversy is deliberate. These are the hunting grounds in which one finds exceptional long-term value. I offer the Argentine Crisis of early 2000s, the Tech, Media and Telecom bubble implosion of 2000, the Greater China SARS outbreak, the global financial crisis and the European Sovereign Crisis as historical examples of areas where the Fund found opportunities with sentiment at its worst and the near-term outlook quite dire.

David Swensen (Trades, Portfolio), legendary manager of Yale’s endowment, has offered some jewels on the topic of building idiosyncratic portfolios “which frequently appear downright imprudent in the eyes of conventional wisdom.” Idiosyncratic portfolios will, almost by definition, produce periods of underperformance. Indeed, virtually all of the investment industry’s great track records bear scars from periods of material underperformance. Still, this approach is so uncommon because an unconventional approach to any task tends to invite skeptics, and flying in the face of conventional wisdom requires considerable fortitude.

To forecast or not to forecast

Let me skip directly to the punchline: we do not make economic forecasts let alone identify or value businesses based upon them. In our last quarterly conference call we exhumed the often quoted John Kenneth Galbraith quip that “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” I think it’s an honest assessment to say that we know we don’t know, meaning we are guilty of one sin rather than two. Let’s take the matter of forecasting exchange rates as a topical example. Having spent the last year managing an international fund in an environment of unmitigated U.S. dollar strengthening, with the resultant performance headwind, the topic of currency forecasting and currency hedging has been a near constant and continues on today.

The discussion regarding the future of exchange rates tends to be wide-ranging, including (but not limited to) the interrelationship of central bank policy, economic growth rates, inflation rates, interest rates, trade balances, indebtedness, foreign exchange reserves and all manner of national idiosyncrasies such as political will. Bear in mind that we are talking about an exchange rate determined by the future balance of all of these variables not for one country but two, to say nothing of the unknown unknowns and inherent dynamism of the environment in which the relevant actors make critical decisions. I remain extremely skeptical that these varied factors can be accurately predicted over time across many currency pairs. Further, for currency forecasters an equally important and complex question is whether the future as they forecast it is accurately reflected in the exchange rate today, which is what would inform one as to future changes in exchange rate (in other words, are those future developments currently priced into the exchange rate?).

Today it seems hard to believe but in January of 2014 Goldman Sachs' currency strategy group put forth its 12-month euro forecast for a rate of 1.40 U.S. dollars per euro. The euro was then at 1.36 U.S. dollars per euro, meaning they were looking for a modest strengthening of the euro relative to the U.S. dollar throughout 2014. That is of course not what happened. Fourteen months later in March 2015 with the euro now costing only 1.05 U.S. dollars, the same team forecast that six months forward the euro would be at 1.00 and 12 months forward would be at 0.95. Declines have a way of eliciting forecasts for further declines. The 2015 low for the euro was within days of that report, and the euro has since strengthened roughly 7%, ECB bond buying onslaught and Greek Crisis notwithstanding. For your records, they forecast the euro to be at $0.85 by the end of 2016.

My purpose is certainly not to call out Goldman’s currency team but rather to draw attention to the near impossibility of the forecasting job, even for sophisticated and experienced people who make it their life’s endeavor. In my experience as an investor and, more generally, as a human, forecasts are frequently extrapolations in drag. What I am describing can be seen in countless corners of the financial world. As in the currency example above, it is easy to find forecasts that are heavily derived from the current price and recent price movements. The futures curve for oil gave no indication of the late 2014 oil price crash even as the crash had already begun. Earlier high prices had led to predictions for more high prices. Likewise, current low oil prices tend to be extrapolated in forecasts that look a lot like current prices.

To be clear, I don’t personally have a strong view about the future price of oil. Nobel Prize Laureate and Yale professor Robert Schiller recently produced a long-time series showing a similarly poor ability of the market to accurately predict future inflation rates, as seen through TIPS pricing. The conclusion was conceptually identical to the oil futures example –expectations of future inflation tend to be extremely similar to the recent inflation experience. It is no wonder that as an investment community we are prone to economic surprises on a grand scale.

In practice, the implications for our team are several-fold. First, the companies in which we invest must be able to maintain, and hopefully increase, value across a range of economic conditions. Second, we tend to spend the preponderance of our time attempting to understand what an informed cash buyer would pay for the business or assets in question across a range of scenarios and further develop a sense of the probabilities that this underlying value will grow over time. Third, we must make sure that the company’s business model and financial position will enable it to endure the unexpected.

We are certain that we will be surprised (we know we don’t know). Our goal is to be as prepared as possible by paying cheap prices for companies with high degrees of financial and operational durability, for which underlying values are highly likely to endure, if not grow. The Deficient Market Hypothesis I will spare readers another lengthy invocation of Black Monday and instead refer readers to our chairman’s brilliant writings on the invalidity of the efficient market hypothesis. Additionally, I will attempt to make a contribution from my own personal investment experiences which preclude me from having any faith in the efficiency of securities markets pricing.

Factors exist pervasively in financial markets that are the enemy of efficiency. Markets for illiquid or less liquid securities immediately come to mind. As discussed above, sentiment (in its extreme form known as hysteria) also has a habit of creating nasty divorces between price and intrinsic value. Earlier in this letter I referred to Rubicon Ltd., and the New Zealand dollar in which it is listed, as a drag on Fund performance. Over the last 12 months, the U.S. dollar denominated intrinsic value of the security has grown meaningfully as a result of the improved operating performance of one if its two subsidiaries and through gradual nearing of a known resource conversion event for the other, all of which is publicly available information. In each case the values are almost entirely derived in U.S. dollars.

Meanwhile the price of Rubicon stock has declined 32% in U.S. dollars (13% from the stock price and 19% from the New Zealand dollar decline) over that last 12 months. There is no efficient market for the equity of Rubicon. Investment returns will come the old fashioned way, from actual corporate events, rather than market efficiency. More broadly, securities with high degrees of price volatility, due to low liquidity or any number of reasons, tend to produce inefficient securities pricing and on occasion extraordinary opportunities to buy or sell. Poor sentiment, extrapolated forecasts for a continuation of poor operating conditions, and heightened price volatility are today conspiring to provide exceptional long-term opportunities in many of the areas described above. This type of investing rarely provides immediate gratification but has historically been very rewarding.