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[Enterprising Investor]

Can Third Avenue Get Back on Track? (5/09/15)

Marty Whitman’s fabled value shop is struggling to regain its performance edge. A new manager with an eye on risk could help.

Legendary investor Marty Whitman, 90, is holding court in his office, wearing a blue sweatshirt and khakis, with his feet up on the coffee table. When the discussion turns to a topic he likes—how his form of value investing differs from the classic style of Benjamin Graham and David Dodd, say—his eyes flash and his whole face lights up. But he’s known as a curmudgeon for a reason, and when the subject is something he’d rather not discuss, he practically growls.

There has been a lot to growl about lately. Third Avenue Management, the mutual-fund firm Whitman founded in 1986, has struggled with management turnover and poor performance. Assets have shrunk to $10.2 billion from a peak of $26 billion in 2006. The firm’s flagship fund, Third Avenue Value (ticker: TVFVX), which Whitman ran from its 1990 inception through 2012, now rates a meager two stars from Morningstar. It has just $2 billion in assets, and is on its second manager since his departure. Third Avenue International Value (TVIVX), which was already shrinking when longtime manager Amit Wadhwaney departed last year, lost more than 60% of its assets thereafter; it now has $269 million.

Third Avenue, which runs five funds and associated separate accounts, offers a look at how greatness can erode—and a study in how it might be reclaimed. All deep-value investors, including Third Avenue competitors Wintergreen (WGRNX) and Tweedy, Browne Value (TWEBX), have faced an uphill battle as money has flowed to zippier growth stocks. But Third Avenue’s portfolios are concentrated in just 30 to 65 stocks, leaving them particularly vulnerable to investment mistakes and client departures. Much more important, it may be impossible to transfer Whitman’s investment genius to the next generation.

That doesn’t have to mean Third Avenue’s days are numbered. But success—and longevity—could require the firm to operate differently in the future, becoming more of a collaborative, process-driven enterprise instead of the “cult of Marty.”

The job of transitioning Third Avenue has fallen, in large part, to Chip Rewey, 46, hired last June from value manager Cramer Rosenthal McGlynn to run Third Avenue’s Value strategy and re-energize the organization’s culture. He has concentrated on breaking down barriers among investment teams and managing portfolio risk. Rewey’s strategy seems like a sensible start, but has yet to bear fruit.

“Businesswise, we’re a very, very modest success,” Whitman says. “I don’t know if you could even call us a success after the 2008 redemptions. We never really came back. It’s been tough.”

WHITMAN SCOFFS at the idea of retirement. While he has stepped back from his roles as chief investment officer (in 2010) and manager of the Value fund (in 2012), and now says he spends most of his time managing his family money, he continues to take the subway to his Manhattan office almost every day. He’s an outsize presence at the firm’s Tuesday research meetings, and, as chairman of the board, continues to write the firm’s widely read quarterly letters. “My wife would rather shoot me than go to Florida,” he says.

Whitman, a Bronx native, Navy man during World War II, and graduate of Syracuse University (thanks to the G.I. Bill), started on Wall Street as an analyst at Shearson, Hammill—and hated it. Looking at stocks based on short-term earnings really got his dander up. “I saw it was a terrible waste,” he says. So he joined the family office of William Rosenwald, son of a founder of Sears Roebuck, where he developed the cornerstone of his investment approach.

That approach—spelled out in his books, including his most recent, Modern Security Analysis, published in 2013—starts with the balance sheet, as befits an investor who made his name by buying bonds of bankrupt railroad Penn Central. He looks for stocks that trade at a deep discount to his estimate of the company’s net asset value. None of Third Avenue’s funds resemble their benchmarks. Diversification, Whitman says, is “a damn poor surrogate for knowledge, control, and price consciousness.” There’s no argument from anyone at the firm. As International Value manager Matt Fine puts it: “We’re all Marty acolytes.”

Whitman has never cared much about running a business. The operations side of Third Avenue is overseen by CEO David Barse, 52, a former bankruptcy attorney who has worked at the firm for nearly a quarter-century. He’s been president since 1994. Their relationship, after so many years, is symbiotic. “He’s my consigliere,” Barse says.

While Whitman’s name is indelibly associated with the firm, he is no longer the majority owner. In 2002 he sold 60% of Third Avenue, most of it his family’s stake, reportedly for $100 million, to Affiliated Managers Group (AMG), whose stable of asset managers now includes Tweedy, Browne and Harding Loevner. Third Avenue’s employees kept the remainder, and under the terms of the agreement, Barse says, AMG pledged not to interfere with Third Avenue’s investment decisions or hiring.

Selling a stake to AMG was an estate-planning move: Whitman’s three adult children—a Broadway producer, a law professor, and a music professor—had no interest in the business, and institutional investors kept worrying about his age. “If it wasn’t the first or second question, it was the third they’d ask Marty—‘well, Marty, what’s going to happen when you retire?’ ” says Barse. “Mind you, he’s 77 [at the time], and doesn’t think he’s anything other than Superman. He’d say, ‘well, I’m never going to retire,’ and they’d look at him like, ‘you gotta be kidding me.’ The AMG transaction really solidified our succession and comforted clients significantly.”

When Third Avenue and AMG struck a deal 13 years ago, it was a different world. The firm had $4.5 billion in assets; its five-star flagship Value fund was a top performer, and its International Value fund was less than a year old. Assets rose nearly sixfold in the next four years. But its deep-value strategy struggled since the financial crisis, and investors have fled as performance has suffered. For the past five years—with the notable exception of the top-performing Third Avenue Real Estate Value fund (TVRVX), now the firm’s largest with $3.5 billion of assets—its funds are in the bottom half relative to their competitors, and some are really scraping the bottom, according to Morningstar.

YET THIRD AVENUE has stuck to its mission, even as other fund companies expanded their lineups and moved into exchange-traded funds. In addition to the flagship Value fund, International Value, and Real Estate, the firm manages the $451 million Third Avenue Small-Cap Value (TVSVX) and its newest and second-largest fund, $2.5 billion Third Avenue Focused Credit (TFCVX). It launched in 2009, when high-yield and distressed debt were available cheaply. All adhere to Whitman’s investing principles. “If we lose our differentiation, then we lose our business,” Barse says.

Jennifer Borggaard, an AMG senior vice president who has managed the relationship with Third Avenue since 2007, says AMG has a long time horizon and understands that all of its affiliates will go through cycles. While the company generally steers clear of day-to-day involvement, it is always involved in succession planning, she adds. “I feel very positive about the firm, and the people they have in place today, and we’re very pleased that they can continue to have Marty,” she says.

In 2012, a decade after the sale to AMG, the 10-year employment contracts that key employees had signed ran out. That February, Whitman announced his retirement from active management of the Value fund, and said he would hand over responsibility to his co-manager and protégé, Ian Lapey. “For the investment advisors who put money with Marty, it was almost a cult, like the Dead Heads or something,” says Richard Berse, chief executive of Northstar Financial Advisors, which once had one-third of his firm’s assets with Third Avenue, and now has far less.

During Lapey’s two years at the helm, the fund’s performance trailed almost two-thirds of its peers in Morningstar’s world-stock category, and assets fled. Part of the problem dated to Whitman’s tenure: He had bulked up on East Asian property stocks that he believed—and continues to believe—are some of the world’s most undervalued securities. By 2011, those stocks, including Cheung Kong Holdings, now CK Hutchison Holdings (1.Hong Kong), and Henderson Land Development (12.Hong Kong) represented 45% of fund assets. One of Rewey’s first moves was to cut the Asian property stocks to less than 10% of the fund from 16% at the end of June.

Wadhwaney, who had run International Value since its inception, departed in 2014. Fine, 39, who had joined Third Avenue right after college and had worked with Wadhwaney for 12 years, took over. Third Avenue expected an easy transition; instead, assets kept shrinking. “It is shocking what has transpired in such a short period of time,” says Bill Belko, chief investment officer of Roble Belko in Sewickley, Pa., among those selling after Wadhwaney left.

AS WITH THE VALUE fund, issues had been brewing before the transition. For example, Wadhwaney, who had been a paper analyst before joining Third Avenue, made a big bet on Canada’s Catalyst Paper. The bet went south: In 2012, Catalyst Paper filed for bankruptcy. In 2013, the fund returned an impressive 21%, but as competitors soared 26%, it landed at the bottom of its peer group, according to Morningstar.

Fine was stuck trying to manage a shrinking fund, and one with large, illiquid positions, especially Straits Trading (STRTR.Singapore). Last fall, he found a buyer for Straits, and now says he has capital for new investments. But the fund’s performance has suffered: In the past year, the fund lost 8%, while competitors lost less than 1%, according to Morningstar. “Nobody said it’s easy,” Fine says, “and it will make you look stupid at times.”

Focused Credit, like Real Estate, is a winner. Together, these strategies account for $6.3 billion—more than 60% of assets. Focused Credit is typical of Whitman’s distressed approach; it buys cheap debt of all sorts, and often gets involved in reorganizations. It has had ups and downs, returning 16.5% in 2013, landing in the top 1% of high-yield funds, before tumbling to the bottom 1% a year later, according to Morningstar. Manager Tom Lapointe, 45, who joined the firm in 2009 from Columbia Management, says last year was a tale of two halves, with the fund outperforming most high-yield, bank-loan, and distressed funds in the first half, but giving it all back, plus some, in the second.

Dislocations in the credit market have set the stage for what might be the best environment since late 2011, he says. Lapointe is particularly focused on distressed oil names now that prices have fallen and investors are abandoning oil-company bonds, which make up 15% of the high-yield market. “There’s nothing better than people running out of a building with their hair on fire,” he says.

THIRD AVENUE’S MOST successful fund, by far, is Real Estate, which has returned an annualized 13% for the past five years versus the global real-estate category’s 11%, putting it in the top percentile. Its definition of real estate is far broader than competitors’, encompassing everything from Asian property companies like Cheung Kong to timber company Weyerhaeuser (WY). How it approaches its stock selection is something of a prototype for how Third Avenue would like all its funds to operate.

Co-manager Michael Winer, 59, a former real-estate operating executive, convinced Whitman to set up the real-estate fund 17 years ago. Today, Winer has two younger co-managers. This more collaborative approach has become the template across the organization. Management of the five funds now includes 12 portfolio managers and an investment team totaling 27 people.

“Marty Whitman is, and always will be, a star,” Barse says. “We were attempting forever—since the inception of the firm, quite frankly—to create this long-term succession plan, to morph into not one strategy but five strategies, and not one manager but multiple managers. We don’t want to live by a star-power system anymore. That process has altered the whole dynamic of the organization.”

Since his arrival, Rewey has focused on putting in place new processes to manage risk. One of the first things he did, he says, was to replace what he considered artificial barriers between the value team and the small-cap value team.

ACROSS THE FIRM, portfolio managers talk about how the different teams have worked together to analyze companies such as Weyerhaeuser, the giant timber company that is the company’s largest holding, at 3.2% of assets, and one held in multiple portfolios. “The collaboration has increased a ton, and that is great,” says Real Estate Value co-manager Jason Wolf, 45.

At a recent $31, Weyerhaeuser shares trade at a steep discount to their net asset value, which Third Avenue’s managers peg in the low-$40s. But the bigger play is the housing market’s comeback: If housing starts return to their historic levels of around 1.5 million to 1.6 million a year, Weyerhaeuser’s underlying businesses would probably generate enough cash flow to push its shares above $50, says Real Estate Value co-manager Ryan Dobratz, 34.

In fact, Third Avenue’s view of the upside is so great that when Weyerhaeuser spun off its home-building unit last year, the firm chose to keep its shares instead of those of the spinoff.

Even before Rewey’s arrival, Third Avenue had begun implementing processes that can be repeated by multiple people. At Real Estate Value, for example, Wolf and Dobratz designed a shadow portfolio of companies in their universe that they want to own at lower prices. It serves as an on-deck list, and speeds their response to market dislocations. For instance, it helped them move quickly to deploy stockpiled cash in the summer and fall of 2011, when the market sold off on troubles in Europe and gridlock in Washington.

Rewey pays particular attention to concentration risk. During the Asian-flu crisis, he recalls, he had owned shares in a rental-car company, a hotel operator, a maker of jet airplanes, and a company that sold perfume ingredients that wound up on the shelves of Duty Free. The result, he says, was a big travel bet. While that might seem obvious in retrospect, it wouldn’t have been clear by looking at industry categorizations. So Rewey has put in a place a process to check the portfolio for its raw-materials exposure, leverage, and other cross-correlations.

As the market shifts, Rewey says, he’s finding value in stocks like Comerica (CMA), an under-earning regional bank that’s been out of favor with investors. Comerica is currently the firm’s fifth-largest holding.

It’s far too early to say how Rewey’s tenure will pan out. The performance numbers had been moving in the right direction, but then fell back: The fund is now up 5% in the past year, putting it in the middle of the pack of the world-stock category, which has returned 6% on average, according to Morningstar. “I think we can re-energize it,” Rewey says.

WHAT WILL IT TAKE for investors to come back? “Beats me,” growls Whitman.

“Good performance,” says Barse.

“I don’t know,” Whitman says. “I disagree that performance makes all that much difference.”

Dan Michalk, founder of Waterway Wealth Management in The Woodlands, Texas, dropped Third Avenue Value when Whitman left as manager, and says he’d find returning really tough. “That trust has been lost a little bit,” he says. “I don’t have any reason to believe [Rewey] is going to be able to replicate what Marty did.”

Replicating Whitman’s process means putting balance-sheet strength and valuation first, and not giving a damn what fund-holders think. But investors, especially institutional investors, want more process, diversification, and risk control. That’s precisely what could make the firm less like the “cult of Marty” and more like everybody else—which might not be a bad thing.

http://online.barrons.com/articles/can-third-avenue-get-back-on-track-1431136270