Thursday, September 27, 2007

Third Avenue Shareholder Letter

I have money invested in only one mutual fund (actually my son does, in a coverdale) and that is in Martin Whitman's Third Avenue Value (TAVFX). Here is the most recent shareholder letter, well worth the read as it talks about "credit-worthiness".

Portions of the most recent letter are reprinted below.

"At July 31, about 21% of the Fund’s assets were in what are considered cash and equivalents (excluding the 1.3% represented by the investment in Nuveen Common). Of
this 21%, almost 58% was invested in United Kingdom Government issues, and a little over 42% was invested in U.S. Treasuries and similar instruments. Third Avenue has weighted its cash holdings toward the U.K. rather than the United States because TAVF obtains a better yield on U.K. instruments, and because of my belief that important parts of the U.S. economy, including the Federal Government, are likely to face a continued deterioration in credit-worthiness.

Absent violence in the streets (i.e., terrorism) and the continued existence of political stability, the U.S. will continue to be an attractive and relatively safe place for Outside Passive Minority Investor (“OPMI”) investment. But deteriorated credit-worthiness may well mean higher interest rates and a weaker dollar over the
long term. Thus, the Fund’s weighting toward U.K. cash equivalents.

At July 31, approximately 78.1% of Fund assets were invested in common stocks. Within the common stock portfolio, 54% of the market value were in non-North American issues, and only around 46% were in issues of companies whose princcompanies; 10% was a South Korean company; and 8% were Western European companies. An explanation as to
why the emphasis on overseas investments ought to be informative to TAVF shareholders.

Put simply, the Fund has invested in the equities of overseas companies with super strong financial positions for two reasons. First, the overseas common stocks, based
on TAVF’s cost basis, appear to be much cheaper than U.S. issues, measured by estimated discounts from readily ascertainable NAVs. Second, the overseas
common stocks appear to have much greater growth potential than their domestic
counterparts, measured by the probabilities that over the next five to ten years, it will be easier for the foreign companies to increase readily ascertainable NAVs by at least 15% compounded annually.

As bottom-up investors following a “safe and cheap*” approach, Third Avenue Management has always focused on credit-worthiness much more than almost any other
OPMIs. Thus, there exists for TAVF the strict discipline of not investing in any common stock knowingly unless the issuing company enjoys a super strong financial
position. This is in contrast to almost all conventional investors who emphasize a primacy of the income account, i.e., principal weight in an equity valuation goes to earnings from operations and/or cash flow from operations. Almost all other OPMIs seem to denigrate the importance of strong financial positions.

This tendency to downplay the importance of creditworthiness is prevalent also on the macro-level, probably even more so than for bottom-up investors. This attitude has been well summarized by Vice President Dick Cheney who is quoted as saying, “Deficits don’t matter”.

For the vast majority of people, the important economics statistics are Gross Domestic Product, employment and unemployment levels, corporate earnings, and productivity increases. Credit-worthiness is pretty much ignored.

Credit-worthiness is, in the final analysis, a function of two factors. First, how much indebtedness is being incurred via balance of payments deficits, other governmental borrowing, corporate borrowings and borrowings by consumers. Of itself, increasing indebtedness is not a huge problem, provided the use of funds created by the borrowing is used productively, i.e., to create wealth. Insofar as the use of proceeds do not result in wealth creation, or it creates only modest increases in wealth, i.e., there exists a negative multiplier, or a modest multiplier, the borrowing entity, sooner or later, has to face diminished credit-worthiness (except if the entity can sell assets on a massive scale).

The U.S. is incurring massive debts. By and large, the use of proceeds from incurring this debt seems to be only modestly productive or even counter productive. These
uses of proceeds seem to have non-positive, or even negative, multipliers. Non productive uses of proceeds include the following:

• By the U.S. government: massive expenditures in Iraq.
• By Consumers: massive expenditures for consumer
goods that depreciate rapidly.
• By Corporate America: Leveraged Buy Outs where
most of the proceeds from debt incurrence are used to
make cash payments to stockholders, rather than to use
the cash to build or acquire productive assets.

Given the gradual deterioration in U.S. creditworthiness, I think it is important to encourage foreign entities to acquire control of U.S. assets and U.S. companies. Foreigners can use the proceeds from providing finance to the U.S. in three ways:

1) Buy and hold U.S. debt instruments.
2) Acquire U.S. equities or assets as passive investors.
3) Acquire control positions in U.S. equities and

Insofar as increased amounts of debt instruments are held by foreigners, this seems likely to detract from U.S. credit-worthiness, sooner or later. This would not be the
case if the proceeds from U.S. borrowing were recycled into equity investments. Given the massive amounts of U.S. debt held off-shore, passive investing is probably of
limited use to creditors located in China and Japan.

Rather, those creditors ought to be encouraged to acquire control of U.S. companies and U.S. assets. If so, this might prove to be a bonanza for Third Avenue. Many of
the domestic companies in the TAVF portfolio appear to
be ideal take-over candidates.

Again, put simply, the U.S. has so far in the 21st Century achieved prosperity and paid for prosperity with a steadily deteriorating credit-worthiness. Macro factors point to a less optimistic outlook for the U.S. than for, say, Hong Kong or Mainland China. In spite of this, the U.S. remains the best place in the world to invest in individual securities for a bottom-up investor such as TAVF, other things being close to equal. These other things encompass businesses having strong financial positions; prices of common stocks reflecting meaningful discounts from NAVs, and that for the long term, there exists reasonably good prospects that such NAVs will increase by no less than 10% per annum compounded."

Marin J .Whitman


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