Does Thematic Invest ingHave A Place In Value Investing?
Dear Fellow Shareholders:
One of the questions we are frequently asked by our clients is how do we see our sector positioning in the markets. Our answer at Third Avenue has always been that we are fundamental bottom up investors and sector agnostic as to where our ideas originate. We look to invest in securities of companies that meet the Third Avenue philosophy of creditworthiness, compounding book value growth and significant price undervaluation. We don’t think the sector index weightings in the indices in any way represent either portfolio construction or risk control guidelines as to how we should invest our fund. The Third Avenue Value Fund has always been an opportunistic and eclectic collection of well-researched investments constructed with the aim of superior long term returns matched with a balance sheet first focus on risk control.
However, we do hold long term high conviction beliefs on some sub-sectors of the economy, and as a result, we have high concentration positioning in groupsof companies that we believ ewill collectively outperformover the long term. But, just as we will not invest in companies or industries that we do not find attractive along the Third Avenue philosophy of creditworthiness, compounding book value growth and significant price undervaluation,we will hold concentrated weightings in sectors where we see favorable investment dynamics over the next three to five years.
One of the areas of greatest concentration for the Fund over the past three yearshasbeen in banks,namely Comerica (NYSE:CMA), PNC Bank (NYSE:PNC), Keycorp (NYSE:KEY) and the trust and processing company, Bank of New York Mellon (NYSE:BK). Our collectiveweighting in these four positionson June 30th was approximately 18%. These four banksadded 118 basis pointsof positive attribution to the Fund in the second quarter. Post theworst of the financial crisisand post the institution of programsby the US government to strengthen the financial sector (e.g.,Troubled Asset Relief Programor TARP), market sentiment on the bankswas very low despite the fact that banks balance sheetshad been bolstered. They had charged off problemloansand addressed any balance sheet concerns (TARP and equity) — and thus the companies were set up to generate cost saves,build capital,generate loan growth and had asset sensitivity to interest rate hikes.
Under the new post crisis financial regulatory regime, these banks indeed built significant excess capital, far beyond their needs to reserve for tepid loan growth,which in our opinion left them dramatically under-earning a normal economic recovery pace. While the profit acceleration of these banks took longer to develop than we initially foresaw,we believe their excess capital position protected our downside risk, effectively allowing us to risk time and not capital over our holding period. In fact,we continued to add to our positions on stock market weakness. The late June 2017 resultsof the Federal Reserve’s capital plan reviewsof all these banks allowed a significant step up in share buybacksand dividend increasesyear-over-year to a level that washigher than still skeptical market expectations.
Beyond the next twelve months accelerated share buyback schedule,we see loan growth maturing with the economic cycle,moving away from Commercial Real Estate and growing in areas like consumer mortgage and business lending. Ratespaid for deposits remain stubbornly low from a depositor perspective,but are providing an increasing spread for these banksas the Federal Reserve has raised its benchmark lending rate 4 times for 100 basispointsoff ?generational lows.’
While thisoverarching financial theme doesapply tomany banks,our specific investment thesison the Fund’sportfolio positionsare individually fundamental with strong self-help and potential resource conversion attributes. Comerica is engaged in a significant cost reduction effort termed GEAR-Up, that istargeted to drive down itsefficiency ratio and increase earningseven in a flat interest rate environment. PNC Bank, too, is engaged in continuing cost reduction through technology implementation and branch consolidation,while it also has the hidden asset of its 21.29% ownership of Blackrock Corp.,where themarket value of $14.3 billion of this stake isapproximately $15.30 per share over the valuation represented in PNC’s March 31, 2017 Book Value of $86.14 and Tangible Book Value of $67.47. Likewise, CEO Beth Mooney of Keycorp in early June indicated the acquisition of First Niagara hasbeen a tremendoussuccess froma cost reduction and geographic expansion perspective,and that whileKeycorp will remain vigilant on costs, it isnow looking to resume both itsorganic andM&A driven growth strategies. Finally, Bank of New York Mellon (NYSE:BK) isdramatically reducing costs,which include rapid adoption of Block Chain and Artificial Intelligence software modules, that should also improve customer service. While these have driven strong returns for the Value Fund, we believe all four companies remain well positioned to drivemarket leading book value growth over the next three to five years.
Another significant industry weight for the Fund is in the US housing sector, as we have high conviction that the housing market will continue to recover fromover a decade of new home ?starts?below a sustainable trend line of roughly 1.2-1.4 million unitsannually. Our housing sector exposure is comprised of Lennar (NYSE:LEN),Cavco (NASDAQ:CVCO),Weyerhaeuser (NYSE:WY), Masco (NYSE:MAS), and Canfor (CFP). They represented a combined 15.13% weighting for the Fund on June 30th, 2017 and returned 101 basispoints for the second quarter 2017. Our thesisagain startswith theBalanceSheetsof our owned positions,which are all strong and indeed improving asbuilding activity continues to recover. Housing startsand building permitsare continuing their long-termtrend of improvement,which should continue asjob and wage growth continue sbroadly as well. Lumber and building product priceshave improved with stronger activity, favoring Weyerhaeuser and Canfor, while Cavco, Masco and Lennar have been very successful in passing along higher priceswhile still drivingmargin improvement. For the sector asawhole,andmore importantly for our portfolio investments,we see these factors continuing and even strengthening over the next few years.
Of course, each of these investments has specific fundamental positivesthat aremore important to our ownership criteria than homebuilding exposure. Lennar continues to de-lever itsbalance sheet throughmonetizing its long termland position,and in the second quarter the company completed an important step to show its sum-of-the partsundervaluation with the successful Initial PublicOffering of itsFivePoint Holdingsunit. Cavco maintainsa strong net cash position of $15.19 per share,and in the quarter acquired Lexington Homes Inc., synergistically expanding itsmarket presence to Mississippi, Louisiana and Alabama. Masco continues to drive strong revenue growth, even against the negative impact of walking away fromlow margin cabinet sales. Strong sales leverage and the dramatic impact frominternal restructuring initiativeshashelped Masco post improvedmarginsand raise its long term earnings forecasts. Canfor and Weyerhauser both continue to benefit fromhigher lumber prices,astrade dutieson Canadian Lumber by theU.S.have driven up prices,which greatly benefit theU.S.manufacturing unitsof both companies. Weyerhauser specifically hasunique resource conversion opportunitiestomonetize its higher and better use lands ,aswell aspotentially separating out itsbuilding productsdivision into a separate company.
We have also written about our Bull Pen list of well researched and fundamentally attractive companiesthat we continue tomonitor for a potential opportunity to invest if an appropriate discount to our price target materializes. TheHealthcare sector isan areawherewe have added several new positionsover the last two years, including Cerner (CERN),Amgen (AMGN),and Baxalta (which was subsequently acquired by ShirePLC). Alongwith these positions,we aremonitoring several related companieson our Bull Pen list aswe see the growth in Health Care,which now representsalmost one-fifth of all U.S.GDPspending, continuing for the long term.
One new area that we are intrigued with is the rapid emergence of Artificial Intelligence into the economy and the truly revolutionary opportunities itsapplication can have on lowered costsand improved customer service. Fromour perspective it isa diverse theme that will express itself acrossall industries,with wide ranging examples from autonomousdriving, to improved healthcare diagnosticsand patient specific treatments, to phone systemswhich will have the potential to respond to conversational requests providing an end to frustrating hold times for airlines, banking,cable TV,etc. In our view, this technology will become ubiquitousfor all industries, like the internet itself, providing attractive opportunities that are overlooked and outside the large cap technology sector. Aswementioned earlier,Bank of New York hasbeen an early adopter of this technology, i.e. in systemsthat can recognize simple trade errorslike incomplete addressor name information and fix themautomatically,avoiding human intervention. Almost every company we own should to some extent be able to lower costsand improve servicewith thisembryonic technology. Wewill continue to search for those that can be disproportionatewinnersand for which we can invest at attractive prices.
For the second calendar quarter of 2017, the Third Avenue Value Fund returned 3.30%compared to theMSCIWorld Index at 4.21%.1 The Fund remainsconcentrated with 35 positions.
Top performers in the quarter were: Investor AB (INVEB), Bank of New York Mellon (NYSE:BK) and LivaNova (LIVN). Investor AB, aSwedish holding company, continues to compound value. Its reported NAV, including dividends, increased by 10%during the quarter. The company isnow providing estimatedmarket values for itswholly-owned subsidiaries,which includemedical device company MöInlycke,and partner-owned investmentswithin Patricia Industries. Wewelcome the increased transparency and the resultant closing of the discount in the stock price vs.NAV. Bank of New York Mellon continued to execute on revenue growth in both asset servicing and asset management fees alongwith good expense control.
LivaNova,amedical devices company, continued to focuson operational improvementsand announced the acquisition of Caisson Intervention to expand itsheart valve portfolio.
The top detractor wasDevon Energy (DVN),which declined alongwith the broader energy group asoil prices declined during the quarter. Other detractorswereAvnet (AVT),which iscontinuing on itspath to transforming itself though announced further EnterpriseResourcePlanning (ERP) system transition costs,and Ralph Lauren (RL), which wasnegatively impacted by the tough environment in retail,while continuing on its Way Forward restructuring program. Despite the near termhiccups,we continue to believe that the longer termprospects for growth for each of these companies remain strong.
NewPosition:RelianceSteel &Aluminum(RS) Founded in the late 1930s, Reliance Steel & Aluminum (Reliance) hasgrown to become the largest metals service center in North America. Given the name of the company,one could be forgiven for thinking the company produces steel and aluminum. In actuality,asan operator of service centers,Reliance’s business is providing essential value-added servicesand distribution for thesemetals,as well asbrass, copper, titaniumand other alloys,withmore than 100,000 productsoffered. A few examplesof the value-added servicesReliance providesare slitting, laser cutting and electropolishing. The company operatesa network of more than 300 locationsacrossalmost 40 states in theU.S.and a dozen countries.
Reliance hasbeen on our radar for yearsduringwhich time we’ve had the chance tomeet withmanagement and tour itsoperations. After a decline in its stock price this year, we took advantage of the opportunity to initiate an investment with a belief that the company isvery well-positioned to continue itsprofitable growth,both organically and inorganically. As the domestic and global economy growsover the long term, the need for metal products isever-increasing,and Reliance has carved out a defendable niche for itself serving thisdemand. Specifically,Reliance focuseson smaller customerswith relatively small orders that need the company’s high-quality productsquickly (40% of orders are delivered the next day). Taken together, thisaffordsReliance sticky customer relationships (97% repeat business) with superior marginsand pricing, regardlessof underlying metal prices. AsReliance’s share of itsmarket isstill only in the single-digits, the company should continue growing both with the industry and also through ongoing share gains. Reliance hasbeen able to steadily capturemarket share over itshistory given the breadth of itsproductsand services, itsbuying power and operational efficiency,and the exceptional quality of itsproductsand customer service. Another notable competitive advantage is Reliance’s strong balance sheet,with net debt of approximately 30%of capital,2.2x EBITDA,and strong cash flows for deleveraging. In an industry with a number of poorly capitalized peers,Reliance’s financial position has given rise to lasting partnershipswith its suppliersand customersand istied to the quality of itsproductsas it has allowed Reliance the ability tomake industry-leading investments in state-of-the-art equipment.
The balance sheet isalso a reflection of the high quality of Reliance’s management team. In addition to being judicious financiers, the long-tenured teamhasproven to be exceptional operatorsand capital allocators,having completedmore than 60 acquisitionssince taking the company public in 1994. Thishasbrought about the Reliance Family of Companies, a smanagement insists on acquisition targets with strong leadership teamsand brands that it can keep in place.Reliance isnow becoming the recognized acquirer of choice in the industry and this hashelpedmanagement deliver an outstanding long-term track record,with the company’s retained earnings and dividends compounding at 12%,16%, and 20% per share over the last 5, 10 and 15 years, respectively. Given the still very fragmented nature of the industry,we expect resource conversion will remain a persistent source of value creation for management over the longer term.
Wewere able to purchaseReliance common stock at a discount of roughly 30%to our estimate of NAV. Over the mediumtermwe see the improving economy and renewed push for investments in infrastructure within the US as potentially offering a tailwind to demand for Reliance’s productsand services. Over the long termasReliance continuesgrowing,we expect ongoing compoundingin the value of the company and a closing of the discount to our NAV estimate.
Aswewrote last quarter,despite the broader market indicestouching new highsover the second quarter,our front-end idea generation processisstrong,ashighlighted in our Small Cap commentary thisquarter. We continue to work onmany more names than wewill ever own,and have a robust Bull Pen list of attractive investment ideasthat wewill move quickly on,or Carpe Diem if share price movementsgive usthe patient buying opportunity. Indeed, the RelianceSteel purchase this quarter is an example of a company on our Bull Pen list that we have monitored for several quarters.
In closing, we thank you for your trust and support and look forward to writing to you next quarter.
The Third Avenue Value Team
Lead Portfolio Manager
IMPORTANTINFORMATION Thispublication doesnot constitute an offer or solicitation of any transaction in any securities.Any recommendation contained hereinmay not be suitable for all investors. Information contained in thispublication hasbeen obtained from sourceswe believe to be reliable,but cannot be guaranteed. The information in thisportfoliomanager letter represents the opinionsof the portfoliomanager(s) and isnot intended to be a forecast of future events,a guarantee of future resultsor investment advice.Viewsexpressed are those of the portfoliomanager(s) andmay differ fromthose of other portfoliomanagersor of the firmasawhole.Also,please note that any discussion of the Fund?sholdings, the Fund?sperformance,and the portfoliomanager(s) viewsare asof June 30,2017 (except asotherwise stated),and are subject to changewithout notice.Certain information contained in this letter constitutes?forward-looking statements,?which can be identified by the use of forward-looking terminology such as?may,? ?will,??should,??expect,??anticipate,??project,??estimate,??intend,??continue?or ?believe,?or the negatives thereof (such as?may not,??should not,??are not expected to,?etc.) or other variations thereon or comparable terminology.Due to various risksand uncertainties,actual eventsor resultsor the actual performance of any fundmay differ materially from those reflected or contemplated in any such forward-looking statement.Current performance resultsmay be lower or higher than performance numbersquoted in certain letters to shareholders. Date of first use of portfoliomanager commentary: July 17,2017