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Third Avenue 2nd quarter shareholder letter

Here are some comments from me on Martin Whitman's Third Avenue Funds' 2nd quarter shareholder letter, released about a month ago.


Bonds, Bonds, and More Bonds

Whitman had been increasing his positions in debt or debt-like instruments. Unfortunately, on top of being almost impossible for small investors to purchase, these securities are difficult to understand. People like me have very little legal knowledge and can't consider these investments even if I had access to them. Just about the only thing that can be done is to either make a bet on a macro thesis or turnaround potential. For instance, one can easily invest in, say, GMAC bonds with an expectation of a turnaround in the future. But trying to figure out which class of bond is best, or whether a term loan is better than a senior bond, or whether a junior unsecured is just as good as a senior unsecured, is quite difficult for those who don't work in the field.

Someone with telecommunications knowledge and an interest in bonds may want to consider the Nortel bonds that Whitman has purchased. I personally have no opinion on this security.

The Nortel Seniors, which were acquired at around 17%
of claim, are workout securities. Nortel is undergoing a
court-supervised reorganization, principally under the
Companies’ Creditors Arrangement Act (“CCCA”) in
Canada. Fund Management believes it likely that much of
Nortel’s various telecom assets will be sold at prices
representing substantial premiums over the Fund’s cost
basis.


Whitman also points out an important thing about bonds: they are taxed at higher rates (ordinary income). Anyone investing in bonds should keep this in mind. As I have suggested in the past, a bond with a yield of 20% is sort of like a stock with a yield of, say, 15% (this depends on the tax jurisdication, your income bracket, etc so it's just an example.)

Whitman vs MBIA

Whitman, for those who follow the monoline bond insurers, made big news a few months back when he sued MBIA over its split. It's a weird situation for Whitman given how he owns shares in the company, as well as surplus notes issued by the insurance subsidiary. He is basically suing in the interest of the surplus holder.

On February 19th, MBIA announced as a
fait accompli an asset stripping transaction under which
MBIA Insurance Corporation, the issuer of the MBIA
Surplus Notes, transferred without any consideration over
$5 billion of assets and all the profitable going concern
activities of MBIA Insurance Corporation to a second tier
subsidiary of MBIA’s parent company. If this asset
stripping transaction stands, the MBIA Surplus Notes
surely will have suffered a very material permanent
impairment. Third Avenue has brought suit in Delaware
Chancery Court seeking to undo the asset stripping
transaction and policyholders have brought suit in Federal
Court in New York’s Southern District with claims not
dissimilar from those of Third Avenue. Litigation
outcomes are always hard to predict, but Third Avenue
seems to have a strong case.

...


A final word on MBIA… In addition to the $362,167,000
principal amount of Surplus Notes, Third Avenue also
owns 19,349,845 shares of MBIA parent company
common stock. Probably the toughest thing we do as Fund
Management is appraisals of portfolio company
managements. Generally Fund Management seems to do a
good job, but this is an area of our “safe and cheap”
approach where Fund Management probably screws up
more than in any other single area. MBIA management
certainly is a big disappointment to TAVF. Aside from the
legal ramifications of the asset stripping, it seems to us that
the transaction sullies the MBIA name in a field where it
is utterly important to be viewed by potential policy
holders as a company run honorably and with integrity.
Understandably, MBIA wanted to separate its sound,
profitable, domestic municipal bond business from its
unsound, unprofitable structured finance business. There is
no question in Fund Management’s mind that through
consultation with the relevant parties, adequate protections
for this separation could have been accomplished, and still
can be accomplished, without the asset stripping; and with
leaving adequate protection for the policyholders and
creditors of MBIA Insurance Corp. Without apparently
ever contacting any policyholder or creditor, MBIA
management chose to proceed with its asset stripping ideas.


If the lawsuit fails, Whitman concedes that his surplus notes have the possibility of not being a performing loan.

Hong Kong Real Estate Companies

On page 3 of the letter, he also details his thesis for owning Hong Kong real estate companies and conglomerates. Almost 39% of the portfolio is in these companies (as for April) and I think he is highly vulnerable to a real estate bust in Hong Kong and China. His low purchase price probably provides some margin of safety but there is still potential for damage. I'm a concentrated investor who holds huge stakes in a few firms so I'm not criticizing the diversification; all I'm saying is that the portfolio is vulnerable to a real estate bust (and I do think Chinese and Hong Kong real estate may be overvalued, but not sure by how much.)

A big risk with bottom-up value investing is that the estimate of intrinsic value may look good but can change due to macro events. Martin Whitman relies heavily on NAV (net asset value) and this will get marked down if the market turns bearish on real estate. This is no different than value investors who overloaded on oil companies and ended up losing money when the market re-priced the underlying asset (Warren Buffett, whom I think will ultimately break-even, temporarily "lost" billions when ConocoPhillips' underlying value turned out to be much lower due to decline in oil prices.) Value investors get around the ignorance of macro issues by trying to buy way below NAV.

If China does well, Whitman's portfolio is set up to do really well. Anyone bullish on China may want to check out some of Whitman's holdings. Whitman has suggested in the past that these companies allow exposure to Chinese growth without the risk of owning Chinese companies (many Chinese companies, including those incorporated in the Carribean and listed on the NASDAQ, have dubious corporate governance or questionable accounting.)

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