In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Matthew Fine discuss:
- Derating and Lack of Rerating Are Changing the Face of Value Investing
- Mercedes and European Banks Are Leading in Shareholder Capital Returns
- Apperceptive Mass: From Katamari to Cognitive Growth
- The Growing Divide in S&P 500 Valuations: What It Means for Value Investors
- The Impact of Passive Investing on Market Dynamics
- Mean Reversion: How Cycles and Secular Trends Shape Investment Decision
- Subaru’s Unique Investment Opportunity Amid Auto Industry Challenges
- Offshore Energy Industry Set for Long-Term Growth
- EasyJet and the Power of Balancing Asset Valuation and Recovery Potential
- Finding Opportunity in Uncertainty: Buying Gray Clouds, Selling Sunshine
- Marty Whitman’s Legacy: Surviving High Rates
- Fixed Liabilities as Hidden Assets: Real-World Examples
- Seven & I: Why Resistance to Change Could Hinder Value Creation
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: This meeting is being livestreamed, which means this is Value: After Hours. I am Tobias Carlisle, joined as always by my cohost, Jake Taylor. Our special guest today is Matthew Fine. He’s portfolio manager at Marty Whitman’s old Third Avenue Value Fund. Welcome, Matthew. How are you?
Matthew: I’m great. Thanks, guys. Nice to see you. Thanks for having me.
Tobias: I think I had a quick look at your bio, and the two things that really stood out to me, one is that you’ve been with Third Avenue since the year 2000, which I’m incredibly envious. You got there straight out of college?
Matthew: I did. I did– [crosstalk]
Jake: Elementary school, it looks like.
[laughter]Matthew: That’s flattery, and I’ll take it. But I graduated from college in 1999. It’s actually been an amazing ride. The most formative years of my career, I think, were the earliest ones right in the heat of the dot-com. It was an incredibly confusing time to start working at a, what was then, a very sleepy fundamental value firm. Some not so flattering things were being said about the principal of this firm, Marty Whitman himself. I was too young to realize that the same things were being said about Bob Rodriguez and Jean-Marie Eveillard and every other famed value- [crosstalk]
Tobias: Buffett.
Matthew: -out there.
Jake: Yeah.
Matthew: Yeah. Frankly, it’s a miracle that I ended up here. I knew that I wanted to be an investor. I studied economics in college. All I knew that was that I wanted to be an investor. It was the heat of the dot-com bubble. I didn’t know anything about investing, but I wanted to invest. I was interviewing in New York. I was staying at a friend’s apartment. My family’s not connected to finance. I went on to all these interviews. I basically had two weeks to get a job, because I had two weeks of availability to sleep on their couch.
Jake: [laughs]
Matthew: I came back to their apartment after having interviewed at Third Avenue. I weaseled my way into an interview here, and I told my friend’s father whose apartment it was, where I had been that day, and he said– He took me aside, very seasoned investor himself and said, “If you want to be an investor and those people are willing to give you a job, you’d be an imbecile not to take the job.”
Tobias: [laughs]
Matthew: So, I knew nothing, but I knew enough to take his advice and I started working at Third Avenue. But I didn’t think I’d be there very long, to be honest. [Jake chuckles] I saw these guys, and it just resonates with me today. I remember it like it was yesterday, but these people who graduated from college a year or two ahead of me from Hamilton College, and some were working at Excite@Home or Pets.com or whatever else it was, or even capital markets groups of investment banks, making a lot of money, driving fancy cars, making tons of money very quickly.
I thought that was the way the world was going. Everybody was criticizing the principle of the firm I work at. It was very confusing for somebody who doesn’t know anything about investing. And then, obviously, the dot-com bubble crashed in March of 2000. It’s an anecdote. But just a few months before that, one of the very first experiences I had at Third Avenue was at the Annual Investor Conference. The keynote speaker was Sam Zell.
Just minutes before it was time for Sam to speak, he bursts through the door– He’s got two of his lieutenants with him. He’s on the fly. He hasn’t been in the room. He just marches straight up to the dais and he delivers this speech to the crowd called the “Emperor has no Clothes” addressing the dot-com bubble. Explains to the crowd, “Trees do not grow to the sky.” And then, literally, three months later, the dot-com bubble crashes. It’s just incredibly prescient and– Value strategies really prove their metal in that environment. It was just so exciting to me and so interesting. The world really changed, and I ended up staying for 25 years.
Tobias: And more to come, hopefully. In one of the letters that you sent through, I had a look at the Third Avenue Value Fund is the flagship for Third Avenue. It was launched in 1986 and run by Marty initially. That’s right, isn’t it?
Matthew: 1991.
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Marty Whitman’s Legacy: Surviving High Rates
Tobias: 1991? Okay. So, you’ve showed the 10-year under Volcker peaking and then– So, the Third Avenue Value Fund has only seen declining interest rates. So, how do you think it’ll go if you go into a rising rate environment?
Matthew: That’s what the point of that letter was, was to contemplate what life might be like in a rising rate environment. So, if you really want to understand this investment philosophy, which is where I was coming from with the letter and really understand where Marty was coming from the way he created this philosophy, you have to understand where he was coming from.
He spent most of his career as a distressed debt investor, a bankruptcy expert, restructuring expert in the US in the 1960s, 1970s and 1980s. So, he’s in a rapidly rising inflationary environment, rapidly rising interest rate environment, and went through episodic periods of incredibly scarce access to capital. So, he’s a guy, both by virtue of his exposure to distress and by virtue of that interest rate environment, who really understood the incredible power and value of having financial wherewithal at the corporate level, having solvency and a good balance sheet, frankly.
And then, in 1981, rates peaked. Five years after that, he started the fund. 10 years after that– He lived through a decade of declining rates from the peak. But he couldn’t possibly have known that you’re going to see the next 30 years of declining interest rates very steadily, and you basically can’t find a rolling five-year period of rising interest rates over that 30-year period. So, we created this philosophy– he created this philosophy and then basically went into an environment where it had, I don’t want to say that it’s not valuable because it absolutely is, because there are areas in the world and areas for industries and periods where capital becomes very scarce. And we have definitely experienced that. But less helpful than it should have been.
Investment strategies that employ a lot of leverage, I’m thinking about just levered buyout industry, private equity industry, all kinds of yield co-type of businesses, cell towers, a lot of commercial real estate just feeds off of cheaper and cheaper access to capital. There’s this self-fulfilling relationship between declining interest rates and declining cap rates. So, you get rising asset values. The next buyer can come in, use cheaper financing, bid the asset up, so you get capital appreciation and all kinds of opportunities to cash out ReFi’s and dividend recaps in a falling rate environment. But our approach has been in light of that rate trajectory, very conservative.
In 2022, well, I guess it was in 2021, but in 2021 and 2022, when rates started rising rapidly, the equity market did quite badly. In 2022, we had our best year of relative performance in 35-year history of the fund. I think that tells you a little bit about the power of financial wherewithal and how we might fare in a higher or more normal is a better way to phrase it, a more normal rate environment.
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Fixed Liabilities as Hidden Assets: Real-World Examples
Jake: I still remember reading the Marty’s book The Aggressive Conservative Investor. One of the things he talked about in there that blew my mind at the time was like, “The idea that some liabilities are really almost more like assets.” I conceptually sort of understood it, but it didn’t really sink in and hit home for me until 2021, 2022 when I had a fixed rate mortgage on my house that was quite low– The rate of inflation being what it was three times as much. And I was like, “Uh-oh, that’s what a liability that really looks like an asset feels like. Okay, I get it now.”
Matthew: Hang on to that mortgage for dear life.
Jake: Yeah. Well, you don’t have a choice, do you?
Tobias: [laughs]
Matthew: In my personal experience with him, when I heard him invoke that concept, although it’s in the books too, quite familiar with it, but when he really invoked a lot was around restructuring of Kmart. This is in the early 2000s, and we were the second largest creditor behind Eddie Lampert in restructuring Kmart. Kmart, at the time, had a whole bunch of way below market leases that were potentially monetizable and theoretically one of the most valuable assets in the restructuring. That’s just another example.
We have an investment today in a company called Harbour Energy that just did a very big deal to buy a bunch of assets from effectively from BASF in Germany. This is an upstream oil and gas producer. Part of the deal was that they would port over all of the indebtedness of the BASF subsidiary assets which had long duration, super low-cost financing. You brought this capital structure over with, it was super attractive. And it’s just another example.
Obviously, a lot of Japanese companies that do cross border business– We no longer do, but had an investment in Seven & i. When they bought the Speedway business from Marathon, it was a huge deal. They financed it with borrowings in Japan basically on a drive by for 80 basis point financing. Talk about a carry trade. It was incredible.
Jake: Yeah.
Matthew: Yeah.
Jake: And now, ACT is trying to buy them, like going the other direction. That’s interesting, huh?
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Seven & I: Why Resistance to Change Could Hinder Value Creation
Matthew: We don’t own it, so I don’t have a horse in the race, but I would be very surprised. The Seven & i Speedway transaction was not approved by the DOJ. They closed it anyway without DOJ approval. The DOJ did not want to allow that to go through. That was to take them from about a 6% market share to an 8% market share. This is talking about taking–crosstalk]
Jake: The two biggest, yeah?
Matthew: -8 to 15, you know, 14, 15. Maybe with a ton of concessions, they get it done. Obviously Seven & i. One of the reasons we sold it was that it became clear– Value Act was very active in Seven & i trying to get them to do a lot of the things that were obviously should have been done to create value. We very much agreed with Value Act. It became clear through that process and through the AGM, the general meeting and the proxy contest, that the company was not willingly going to do the right things.
After that process, we moved on. And now, when ACT wants to engage them and they’ve resisted any kind of engagement, they’ve resisted disclosure, they’ve resisted all proper governance, and they actually went running for cover from the Japanese government asking for core status, which is basically like you’re of national interest and sought protection from the government to excuse them from even having to run a process, and that tells you a lot about their mentality.
Jake: Core 7-Eleven’s, it’s a [chuckles] national security.
Matthew: Honestly. Exactly.
Jake: National security slurpees?
Matthew: They’ve got a card business and they’ve got a bunch of consumer data which is undoubtedly true what they mean. Run the process, engage with them, anyway.
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Tobias: Matthew, let me give a quick shoutout and then let’s talk S&P 500 quartiles.
Matthew: Mm.
Jake Taylor: I’d rather not.
Tobias: Petah Tikva, Israel. [chuckles]
Jake: [laughs]
Tobias: Bellevue. Santo Domingo, Dominican Republic. Boise, Idaho. Valparaíso. What’s up, Mac? Samson’s in Greece, on a break. Andhra Pradesh, India. Encinitas. Cromwell, New Zealand. Early stuff for you. Brandon, Mississippi. Tallahassee. Knoxville, Tennessee. Toronto. Wollongong, New South Wales. Good job. Nashville, Tennessee. Durham, Connecticut. Colorado. Lawrence, Kansas.
Jake: Put St. Louis on the map here for me.
Tobias: Rochester. Malta, Montana and St. Louis. Where are you coming in from, Matthew?
Matthew: Where am I right now?
Tobias: Yeah. Right now.
Matthew: In New York, Midtown East. I’m on Third Avenue.
Tobias: Nice.
Matthew: Yeah.
Jake: Makes sense. The math checks out.
Tobias: It’s becoming clearer.
Matthew: No, we could re-thought that when we named the firm. It’s very limiting.
Tobias: Hard to move.
Jake: Yeah.
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The Growing Divide in S&P 500 Valuations: What It Means for Value Investors
Tobias: One of the little charts that you had showed the S&P 500 quartile spreads most expensive to cheapest. It’s a topic that we discuss regularly on this show. What did you, guys, deduce from your analysis of the quartiles of the S&P 500?
Matthew: Well, very candidly, originally, when I started looking at things like that. We’re bottom-up fundamental people. We’re not top-down quant people trying to carve up the market in that way. But when we were in 2017, 2018, 2019 and you felt as a fundamental value manager, like you’re beating your head against the wall, I don’t understand the relative performance. I don’t understand why these businesses I own have not been rerated even though, in some of those years, the absolute returns are pretty good, the relative were quite poor.
So, the first value for looking at something like that is to get me personally back off the ledge. Like, “What am I doing wrong? Is it me? Is it the world’s gone mad?”
Jake: What did you come up paraphrase that like, “You’re not interested in flows, but the flows are interested in you.”
[laughter]Matthew: Yeah, it’s absolutely right. But I thought it was absolutely fascinating. The more I think about that chart, the more important I actually think it is. There’s a lot of information in there. We could probably devote an entire call to it. But what I saw in 2017, 2018, 2019 was this spread just growing and growing and growing. It had been growing basically since 2012 or 2013. So, now, here we are a decade plus of expansion of that spread where expensive companies, meaning, that the most expensive quartile, the S&P 500, have just become relentlessly more expensive.
What’s also interesting about that chart, is if you have to look a little more closely, but the bottom quartile, the cheapest, has actually gotten cheaper over that time period. So, this notion, one side note or one piece that came out of it, this notion that low interest rates were driving long duration growth companies with cash flows way out in the future is what makes them long duration in people’s minds. Low interest rates should favor them disproportionately.
Maybe that’s true mathematically. I actually put that math in a white paper at one point looking at that, but low interest rates and shrinking discount rates inflate the value of all cash flows. But you can see in that chart, that’s not what’s happening. The cheapest stocks are actually becoming cheaper. They should inflate too, even if the most expensive should inflate more. But that didn’t happen. So, it’s not an interest rate phenomenon.
That chart, I believe is 35 years that you’re referring to, it goes back to basically 1990 and you saw it explode into the dot-com bubble, so harking back to my earliest days. I think we got to like a spread of like 16, so that could be 12 for the cheapest, 28 for the most expensive, something like that. And then, dot-com bubble burst and value strategies, the spread compressed.
While the spread is compressing, that’s very favorable for value strategies. A normal number for that spread is about 9. It went to 16 in the dot-com bubble, compressed. And it kept compressing, all the way right up to before the GFC. It got very low by historical standards, where there’s an argument to be made actually that in 2007 that cheap companies were not cheap enough on a relative basis or cheap was too expensive, if you will, on a relative basis.
I do suspect there’s something in there related to why a lot of value managers didn’t actually do quite as well in the GFC as some people had expected them to. That spread compression tells me a little bit about that. And then, it’s blown way out, got past the dot-com bubble by 2021, 2022. We reconciled about a good portion of that, but 2023 and 2024 has gone even wider. So, it just tells you a ton about why it’s really difficult for value managers on a relative basis, if expensive just keeps getting more expensive and if there is very little if any rerating happening in the cheaper end of the spectrum.
I know I said a lot there, but it’s mostly a US phenomenon. When you look at other markets, you see a little bit of it. When you look at an index for the world, you see a lot of it. But that’s just because the index– MSCI World, for example, is 2/3rd the US maybe even as high as 70%. So, you get a ton of influence from the US market in MSCI World. But on a foreign market basis, you really don’t see a lot of that, which does make me suspect, which I wrote in a recent letter, that the flows from active to passive $3 trillion in the last 10 years does probably have something to do with that. Although I just want to be careful, it’s hard to prove that and correlation does not equal causality. Yeah.
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The Impact of Passive Investing on Market Dynamics
Tobias: If it is in fact flows and there’s no stopping passive, then does this just continue on? Is Michael Green’s thesis right that we have the crack up boom and then the next day, we have the crack up collapse?
Jake: Trigger warning, Toby.
[laughter]Matthew: Find your safe space, everybody.
Tobias: Yeah.
Matthew: Yeah. Look, I think Mike Green does the best work I’ve seen out there. There are others who do great work too. I find Rob Arnott Research Affiliates, very interesting. Cliff Asness said, AQR is extremely insightful on a lot of these topics too, if you guys are looking for other sources of information.
Look, at the end of the day, the entire reason for being for passive strategies is to free ride. It counts on active managers competing against each other, trading against each other, creating price discovery, and therefore, market efficiency. If the markets are largely efficient as Academia has declared, I don’t particularly disagree, but has declared, then you need some portion. It just has to be some portion of equity markets that are comprised of active management.
Today, we’re in the US fund management assets are like 50/50s, numbers that I see passive, active. $3 trillion has gone from active to passive. I don’t know, maybe it’s another 25% of the market that goes to passive and 25% is comprised of active. I don’t know frankly if there’s a level.
In other words, I think that the market could function okay, if half of the assets are inactive and half of the assets are passive. I don’t particularly see that as a problem. What I do see is problematic is the $3 trillion taken from active moving to passive, because what ends up happening is that the entire active space is on average getting redeemed every day on average.
Price discovery does not come from somebody’s fundamental opinion. It comes from a transaction. If you’re getting redeemed every day, on average, you’re selling, your net seller as an entire active management industry. So, the things that you think are cheap and attractive and undervalued, because no active manager deliberately buys overvalued securities. It’s deemed to be undervalued. So, it’s the flows, I think as you said a minute ago, that seem to really matter as opposed to the mix. Maybe we get to 75/25, and the flow stop and maybe that’s functional. I really don’t know. I would defer to Mike.
Jake: I think another issue is the corporate governance. When you have, call it, three firms that are half the market really, like huge index providers and they don’t really take an active interest in what’s happening at the firm, I think you just have a lot of chance of management doing things that are beneficial for them or making decisions that might not be in the best long-term interest of shareholders and maybe more shorter-term decisions. There’s less ownership mentality in the markets when half of it is being run on the passive side. I think that, eventually, there has to be some consequences for that.
Matthew: Yeah. I like what you said very much. I actually think that I’ve read that the SEC is taking a look at how proxies get voted from passive strategies, and has taken an interest in exactly that topic. But if you carry it out to its end, it does become a dystopian version of capitalism, where price discovery is completely absent, where there is no fundamental view being expressed. It’s just passive flows. This is a secondary market for equities, the stock market that we know. The primary market is IPOs and capital raisings. This is a secondary market. It’s incredibly important to the entire capitalist system. You need a functioning secondary market.
Maybe it’s blind faith, but I have enough faith in the capitalist system to believe that there is some end point, where price discovery must be allowed to function. Maybe it’s not just blind faith, maybe there’s a path for that. As active management has been hollowed a little bit, value investing in particular has been, in my personal opinion, hollowed a lot. Meaning, a lot of firms have closed, a lot have been consolidated, you’ve had a lot of retirements, there aren’t a lot of new people coming into the value investing industry. So, the whole thing is shrinking in assets and people, which fundamentally makes it less competitive.
In my long experience and in reading hundreds of years of financial market history, the less competitive the market is, in which you’re operating, the better opportunity for outsized returns. So, maybe we don’t have this rerating phenomenon, maybe we don’t have capital flows, but maybe we have outsized returns. Eventually, those outsized returns auto attract attention, and capital and make it clear that this is a cycle rather than something secular, frankly. But when that will happen, I can’t tell you.
Tobias: Yeah, I think on a– Sorry, JT. You go.
Jake: I was just going to say, it’s a lot easier to index when it’s just keeps going up into the right.
Tobias: Yeah.
Jake: Like, you haven’t been really tested to see like, do you really believe in this as a strategy of own all the businesses and have booked minimal expenses, which I can’t argue that it doesn’t make a ton of sense on an individual basis. But when it treads water for 10 years, are you still as gung ho? We shall find out, maybe. Sorry, TC.
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Derating and Lack of Rerating Are Changing the Face of Value Investing
Tobias: This is a related question, but I tend to agree that if everything gets too cheap and all the competition for investing in this sector goes away, then you should– It’s not an iron law, but it’s an emergent effect of markets, so that’s where you get all of the returns that you get outsized returns if there’s nobody hunting around in super cheap stocks, because the companies themselves should be able to earn and perform.
David Einhorn has been a little bit vocal about this, talking about, the two sources of return are essentially reinvestment in the business and the flows that you get, the capital returns, buybacks, and dividends, whatever else it might be. And he said he was focusing more on the capital returns, because the market wasn’t giving any credit for reinvestment. That certainly seems to be the case, if you look across many of these portfolios you see, compressing multiples, book earnings, cash flows, whatever the case may be. I think that’s one of the topics that you addressed too. You looked at reinvestment versus capital returns. Do you want to talk about that a little bit?
Matthew: I do. Before I get into that, David has said one of the most insightful and thought-provoking things I’ve heard in my career. Recently, he was asked– I guess it’s maybe a year and a half ago or so at this point, so maybe not that recent. But he was asked when value investing comes back, and if your viewers have not heard that, he said it at a Robinhood event and you can find the original version. But basically, what he was saying is that in the old days– This mirrors my experience so closely is why it resonated with me.
But in the old days, you used to find some diamond in the rough. It would be cheap and bombed out. But you would see that the business quality was higher than other people. In your estimation and your judgment, you would buy it very cheaply, the business would perform, and eventually, other people would come in and see that it was a pretty good business and rerate the business.
So, you would get two pieces of return to your point. One is, the value being created from the operations of the business, and then you get the rerating and then you get a really good investment outcome, if that’s the case. But his point was value investing may never come back, because that rerating is not happening, because there aren’t young people coming into this industry. It’s becoming less competitive, not more competitive. So, there’s nobody coming to rerate your business.
To my point, everybody’s getting redeemed, the capital base is shrinking. That rerating phenomenon is not happening. You can actually see that in that S&P, PE spread chart. The rerating is just not happening. In fact, it’s derating still. So, I thought that was so insightful. His approach has been to focus on companies that are returning a lot of capital to you, because you’re not getting that credit for reinvestment and you’re not getting that rerating.
I like that approach. I’m not sure as maybe you heard a minute ago, I’m as cynical about value never coming back. I do still think that it is a cycle. I remember being here in 1999 when it was a very sleepy place and probably very undesirable place to work. Five years later, there was a stack of Ivy league MBA resumes [Jake laughs] waiting at the door for people to–
Jake: Yeah. That’s how you know it’s going to stop working here at any moment.
[laughter]===
Mercedes and European Banks Are Leading in Shareholder Capital Returns
Matthew: Yeah. Maybe that’s the side of the top. I haven’t explicitly focused the way that he has on companies that are returning a lot of capital. But it’s happened almost accidentally. And I nowhere close in my career have I managed a portfolio that’s returning as much capital as exists in the portfolio today.
I think that it’s a combination of a couple things. One is the investment philosophy itself. So, we start with cheap companies and we start with super well financed companies. We try our best, although this is probably the hardest part of the process, but try to align ourselves with management teams that are going to act sensibly, do smart things, not destroy the capital.
So, when a company makes a dollar of profit, it’s got a choice about what it can do with that dollar of profit. It can reinvest in the business at some rate, or it can go dividend it out and buy back shares. When the shares are trading at something like five or six times earnings, which is really common in the Third Avenue Value Fund today, you’ve got whatever that is, 16% to 20% earnings yield on your reinvestment in the buyback.
It’s very hard. There aren’t a lot of businesses that offer 20% return on invested capital to put that money back into the business. If you’ve started already with companies that are super well financed and have already have excess resources, you’re going to get a lot of capital return. So, it’s happening all over the place.
The auto OEM space is a great example. Mercedes is the extreme example, actually, where they said, “We’re going to pay out this ordinary dividend, which is a high single digit number, like 7% or 8% yield.” I don’t have a current number in front of me, but 7% or 8% yield, something like that on a current basis. And then, after that dividend, they’re going to take 100% of the free cash flows from its automotive business and distribute those back to shareholders, because they have like 30 billion euros of net cash at the automotive business already. They have more money than they know what to do with. So, they’re going to return basically 100% of the free cash flows.
The European banks, there’s a lot of that going on where you’ve got super well financed companies paying it back, dividends, share buybacks, Bank of Ireland, Deutsche, which both of them which we own are doing exactly that. And then, in Japan, you’re seeing a lot more capital return, although it’s by force and it’s not enough. It’s probably enough to move the meter from a valuation perspective, but it’s nowhere near what it ought to be. So, there’s just a ton of that going on in the portfolio today for all of the reasons that we’re talking about.
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Apperceptive Mass: From Katamari to Cognitive Growth
Tobias: We are right at the top of the hour, which means that it’s JT’s vegetables. Market for everybody who’s looking for the timestamp just wants to [Jake chuckles] skip straight to the veggies.
Jake: Yeah. So, I’m on the road, so we got to set the bar a little lower than normal. So, this week we’re exploring a concept from a 19th century psychologist, which was actually wasn’t even a term yet back then, but he didn’t know that. We’re going to connect it with a Japanese video game. And so, the psych term is something called apperceptive mass. Have either of you had any experience with the term, apperceptive mass?
Tobias: I have not.
Matthew: I have not. No.
Jake: Okay. Well, eventually, as you’ll see, we’ll be able to even tie some of this back to Charlie Munger. It’ll get pretty self-evident by then. But my interest in the term came about, because I was relistening to the 2022 Berkshire AGM. Buffett brings it up explicitly. It was the first time I’d ever heard that term.
We’ll first rewind the clock back to the early 1800s, and we’ll meet this guy named Johann Friedrich Herbart, H-E-R-B-A-R-T, German philosopher and psychologist. Again, before that was even a thing. He was one of the founding figures of modern educational theory. He coined this term, apperceptive mass. So, what does it mean? Apperceptive means having the ability to understand something new by relating it to past experiences. It’s like this body of knowledge and experiences that you carry around in your head. It’s like this network of ideas that you’ve built over time, frameworks, models that help you connect with new information that’s coming in.
So, for example, let’s say you’re a student who’s learning physics. If you’d already understood basic maths and some scientific principles, like if you drop an apple, it’ll fall back to the earth, you’re then much more equipped to grasp increasingly advanced concepts, because you have this existing context in which to fold the new information into. So, your apperceptive mass, your pre-existing knowledge base, acts as a scaffolding for learning. Maybe even you might call it a lattice work. But if you lack that foundational knowledge, you’re likely to struggle. That’s because you don’t have these cognitive hooks to hang the information on.
So, onto the video game side of this. Have you guys ever heard of this video game called Katamari Damacy? Damacy? I’m not sure how you say that, but Katamari–
Tobias: Oh, I’ve played with my son. I’m one of the top two American players. No, I’ve never heard of it. [chuckles]
Jake: I knew it. All right. You’ve probably seen it before at some point. Katamari means clump in Japanese. It’s this game where you control where this ball rolls around, and objects then adhere to the ball and it becomes increasingly bigger. As more and more things stick to it and as the ball gets increasingly bigger in diameter, it’s then capable of grabbing increasingly larger objects and sticking them together. And so, eventually, the ball becomes big enough to grab entire buildings and eventually reaches galactic proportions. You start off with like this little tiny ball. I’m not sure what it is. I don’t know if it’s the compounding nature of it or what, but it’s incredibly satisfying to play for some reason.
So, you can probably already see where I’m going with all this. Like, you have this app perceptive mass, which is really like a cerebral Katamari. You could pick up increasingly large intellectual objects as the mass increases. The more massive it becomes, your toolbox gets more full and you’re more prepared to then see problems from different angles, tackle more complexity with nuanced solutions. This new information is just easier to assimilate bigger chunks of it, because you have this big mass that’s already rolling around.
So, obviously, lots of advantages to having a healthy apperceptive mass, but it can also lead to pitfalls if we aren’t careful. So, cognitive defects like overconfidence bias or confirmation bias can cause us to interpret new information in a way that already aligns with our existing beliefs, even if that interpretation is actually flawed. No doubt, social media amplifies this problem. We’re talking on the eve of the election. We don’t need to go into to how much I– [crosstalk]
Tobias: There’s an election on?
Jake: Oh, yeah. Well, that’s what I heard. So, some new study, some anecdote, some chart, it fits right into your apperceptive mass wheelhouse, and it just strengthens your confidence that you really know what’s going on. Maybe that’s true, maybe it isn’t. It’s like, “Uh-huh, I found the smoking gun that proves what I’ve always believed.” Being smart, you’re actually sometimes at a disadvantage because it’s easier to talk yourself into a really good narrative and find these facts which support your priors. You’re that much better at it.
So, I think it’s key to maintain an open-minded approach, regularly try to update your knowledge base. I think as Ted Lasso said like “Be curious, not judgmental,” which I think is one of really beautiful phrase. I think he stole that from, what was it? Some, I can’t remember, was it Wordsworth or somebody. It’s probably not that. And then, Darwin also would famously write down a fact which contradicted with his previous understanding within 30 minutes of finding it out, because he knew that his mind would then actively work to reject whatever it was that he [Tobias laughs] just learned, because it didn’t fit in with the previous apperceptive mass that he had.
Of course, all this know ties together with Munger’s concept of the lattice work of mental models and emphasizing interconnected knowledge is much more powerful than the man with the hammer. So, to close things out, let’s just take a second to think about this, what the size of Munger’s intellectual Katamari would look like. Imagine it’s rolling up entire planets together or solar systems, it’d be pretty impressive.
Tobias: Yeah. Good long runway. Good one, JT.
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Finding Opportunity in Uncertainty: Buying Gray Clouds, Selling Sunshine
Tobias: What’s the process at Third Avenue? Is the Value Fund is run separately as a silo by itself? Is that how it works?
Matthew: The Value Fund is a standalone fund. I am the portfolio manager, and ultimately responsible for all of the blame and/or credit associated with the fund. Yeah.
Tobias: What’s the process? You have analysts and–
Matthew: I do. We have two senior research analysts who work with me. Larry Hedden has about 20 years of experience and Ryan Korby about 15 years of experience. So, between the three of us, that’s 60 something years of experience. Doing exactly this type of investment philosophy. It’s a good amount of horsepower and quite happy with the team.
We also work within the entire Third Avenue Research Department. So, we’ve got a small cap team that I think you’re aware of. We also have a very, very good real estate, two strategies, one team here at Third Avenue. So, we’ve got a 10-person research and portfolio management team. We meet twice together, twice weekly for 09:00 AM research meetings, Tuesdays and Thursdays. We all sit here in our New York office, and a couple guys in the Texas office. Yeah, it’s a good group.
Tobias: How do you surface ideas and due diligence on ideas and ultimately size?
Jake: Ideas.
Matthew: Yeah. I think you got to go back to the philosophy, a little bit. So, essentially, what we’re trying to do is buy businesses at a significant discount to a conservative estimate of net asset value. What that basically means is that we need to seek out areas where other people have become pessimistic. People are not stupid. They need a reason to become pessimistic and become sellers, and create pricing inefficiencies and significant discounts between some reasonable value of the business and the security price. So, we go looking for trouble, basically. Sometimes we use the phrase that “We buy gray clouds and sell sunshine.”
Some of the trouble can take the form. It could be at a macroeconomic level, it could be an industry crisis, or it could be something idiosyncratic to a single company. So, you get a lot of different things in there. One is that the near-term outlook for the businesses in which we invest is usually, admittedly poor. So, we are much more price conscious than outlook conscious.
It’s clearly a contrarian approach, where most people are pessimistic. We see some path to redemption. It’s definitely opportunistic rather than prescriptive, because we don’t really know where the next crisis is going to develop. I can’t tell you where we’ll be investing a year from now.
So, opportunistic. But also critical to the investment approach is what I mentioned a few minutes ago about financial wherewithal and the balance sheet quality, because we don’t know we can make estimates. We generally think in three-to-five-year time horizons for recovery. But the world is full of surprises, right? Timelines get stretched out, things that you never contemplated enter the picture, COVID. We’ve never contemplated what does it look like for an airline when the entirety of the global air fleet is grounded all at the same time. That’s a scenario that we had never– [crosstalk]
Jake: You’d have zero revenue in your model?
[laughter]Matthew: Zero revenue. But not only that, zero revenue for one airline would be one thing, because then you could fall back on liquidation value, because it could sell off all the aircraft. But zero revenue for all aircraft, that’s a whole different thing. Speaking of the apperceptive mass, you try to figure out in the moment a scenario that you have never even contemplated before, and you try to put that in the framework and related to things that you’ve dealt with in the past. COVID was certainly a hard one, even with a lot of apperceptive mass.
Anyway, Tobias, you’re asking about how we find ideas. But that’s a core of it. We’re reacting to things that go wrong in the world at the macroeconomic level, at the industry level. A lot of what we do comes from the reps and the experience. We’ve owned a lot of companies. At Third Avenue, we have a proprietary database that houses every single investment memo that’s been written at this firm for the last 20 something years. So, it’s a couple thousand investment memos in a proprietary database. We have, within our team, watchlists of securities that we have owned in the past that we really like for some attribute that we’re attracted to management team, balance sheet, asset quality, whatever it is, and we’re waiting for some kind of shoe to drop.
So, for example, in 2022, the UK had been six years into Brexit, things were terrible already. And then, Liz Truss announced this budget which created the gilt’s crisis. The stock market went down, the pound went down and all kinds of things were going on. So, that’s the kind of thing that gets our attention. We’re going to marshal resources. We’re going to go look at all the companies that we’ve been attracted to in the past in the UK. We’re going to go to research database. We’re going to run screens for all kinds of different things, but certainly balance sheet quality is among them. We’re going to try to figure out how to prioritize our admittedly limited resources, experienced people, but only a few of us.
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EasyJet and the Power of Balancing Asset Valuation and Recovery Potential
Jake: What does it look like for balance sheet quality? Is it just liquidity or is there something else that attracts you?
Matthew: It’s a whole mosaic, honestly. Liquidity certainly lack of encumbrances, lack of financial liabilities on or off the balance sheet, salability of assets helps. So, in this particular case in the UK, we bought easyJet. So, we’re looking to pile a lot of misery on when possible, in order to get that kind of discount. So, it wasn’t all just the macro. They were still recovering from COVID for easyJet. In 2022, we were not fully recovered, but they had done a major REITs offering only about a year prior, so the balance sheet was terrific.
And then, they had the summer of lost luggage with Heathrow Airport catastrophe, which sounds silly, but it’s a major issue when it starts rerouting aircraft in the peak season, which is their entire money-making season, they lose money in the shoulder seasons. It was a mess, but great balance sheet, highly salable, young fleet, all A320s. Narrow body aircraft. I don’t exaggerate, but trading cards. They’re highly salable assets. We bought the company at a discount to liquidation value in 2022.
We talk about a concept called readily ascertainable net asset value. It’s a perfect example where I can take the whole aircraft fleet, what is the second-hand value, take off all the liabilities, deduct all the liabilities from that gross asset value, come up with a net asset value and pay a big discount to that number. And then, obviously, we’re looking at valuation from a bunch of different perspectives also, what does it look like if the business normalizes and fully recovers and let’s create return on assets in a reasonable multiple for that.
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Mean Reversion: How Cycles and Secular Trends Shape Investment Decision
Jake: Matthew, would you say that the general overarching theme is– How you’re going to win is reversion to the mean, which could either be the business can revert to a longer historical mean, because it was just a temporary issue, it wasn’t an actual existential crisis or the valuation– At some point, it used to be multiple would– There was some mean reversion in multiples as well. Maybe not as dependable now.
So, if that’s true and mean reversion is the implicit thesis on a lot of the investments, is there anything about technology that might call into question, being able to bank on reversion to the mean as a reliable phenomena? I’m thinking of Brian Arthur’s paper on returns to scale, as opposed to diminishing returns, which has been economic history. Therefore, then they’re not reverting to a mean. Some of these companies, they’re getting better the bigger they get, which defies the previous space rates.
Matthew: I don’t do a lot of investing in the technology sector which– I recently read a pretty interesting book called The Platform Delusion by Jonathan Knee, which I would recommend. It discusses some of the topics you’re talking about, just out of curiosity. But I don’t know the paper that you’re referring to. I think historically, we’ve been pretty good and it’s really important to what we do, but pretty good at deciphering what is a cycle and what is secular. When you’re buying businesses where the near-term outlook is poor and people are really pessimistic about the outlook for the business, a lot of times, that topic is right at the heart of what you’re doing, like what is secular.
When most people are interpreting the current circumstances as secular or permanent, they’re extrapolating the difficult times long into the future. That’s what creates the discounted valuation of the security. You’ve got to be right about the cyclical aspect of it. So, that’s the heart of the mean reversion. Historically, that is a very big part of what we do as contrarian fundamental bottom-up investors.
Although, I will say, this period of time right now is a little bit different. There seems to be and has been for maybe the last five or six years, a lot of cheapness and distressed valuation in companies that are actually performing really, pretty well. I mentioned European banks, I mentioned automotive industry, a bunch of Japanese companies where the returns, the economics that the businesses, the underlying businesses themselves are generating would be sufficient for you to earn a pretty good return. So, we categorize that. I haven’t thought of a better name yet. So, forgive me, but attractive as is.
Marty used to say, [Jake laughs] “We’re good enough business.” But if you can buy a business with a bunch of headwinds that are depressing its operating performance– The operating performance is basically accruing to you and some shareholder yield, however you measure that, earnings or free cash flow or whatever it is, book value compounding that will be that you estimate to be market beating even with the headwinds, that’s a really good starting point.
If you can assess the probabilities for the direction of travel, not to be so abstract about it. Like, we bought Bank of Ireland in the middle of 2019. So, ECB rates were negative at the time. So, all these bank deposits that are with the ECB are producing a negative return. It’s very, very difficult to earn a reasonable net interest margin as a bank with that kind of environment. And they weren’t.
For Bank of Ireland, that meant that they were producing a return on equity of about 5%. I’m talking about full equity, not necessarily tangible. But 5%, and it was trading at about 40% of book. So, if you just do that inverse math, so you’re getting basically a 12% earnings yield, something along those lines, 12% or 13%. It’s not going to make you rich. But if that’s the status quo and it’s super well financed and it’s got staying power and durability and it never gets better and those returns of 12% or 13% accrue to you, because the management team is reasonable, that’s okay. Not great, but okay.
If you’ve assessed that you’re at a starting point from an interest rate perspective that is once in ever, I don’t know what the right phrase is, but multi-hundred years, it’s reasonable to assume that the pendulum is more likely to swing the other way than even further negative, although I guess it could in theory. So, you try– [crosstalk]
Jake: Don’t speak that evil into the world.
[laughter]Tobias: I was going to say, haven’t you seen that 6,000-year chart?
Jake: Yeah.
Tobias: 6,000-year trend. It’s going negative.
Matthew: Yeah.
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Subaru’s Unique Investment Opportunity Amid Auto Industry Challenges
Tobias: I had this Marty Whitman quote ringing in my head as you were talking before about– He says net-nets inventory and those things are hard to sell sometimes. He said he’d much rather sell a AAA rated building fully tenanted. He had this great quote where he said that was easier to sell. So, he preferred that to net-nets.
One of the places where that debate is going on most closely about cyclicality versus a secular change is in auto EMs and electric vehicles supplanting the existing. And so, you’ve got three interesting ones that I just wanted to highlight, BMW and Mercedes Benz. You did a write up of Subaru in the last– I hadn’t realized how cheap Subaru had got. Can you discuss Subaru a little bit?
Matthew: Yeah. So, Subaru is the most recent purchase in the Third Avenue Value Fund. That is disclosed in our most recent quarterly letter which is available on our website, if anybody else would like to read that. But during the quarter, there was a lot of volatility with the Japanese Yen, and a lot of volatility related to that in Japanese equities in general and Subaru got to a negative enterprise value during the quarter. Meaning, it’s net cash on the balance sheet was greater than its entire market capitalization, which gives a negative value assigned to the business which produced, I want to say close to $5 billion US of EBITDA in the trailing 12 months. This is not a– [crosstalk]
Jake: It doesn’t make a lot of sense.
Matthew: It does not make a lot of sense. I don’t want to get too down in the weeds unless you want me to, but what was lost in the whole topic was that at the beginning of the year, Japanese companies generally make forecasts for the year ahead. Many of them have cross currency exposure of some kind, US dollar, whatever it is, foreign business. So, they have to make a Japanese Yen forecast. Most of them look back at the year prior, and they look at investment bank forecasts, so they end up in a very tight band, 140 to 145. We’re all of the forecasts. We called every company that we own. We looked at a bunch of other companies forecast 140 to 145.
What happened at the beginning of the year is that the yen got much weaker, which is more beneficial to all of these companies than they had even forecasted. And then, the yen strengthened very sharply, which is what caused all of the turmoil. But it was still well below being more helpful than they had even anticipated at the beginning of the year. This is a pretty well-run business, Subaru. Very, very profitable, been around for a very long time. They don’t have as much effects, cross-currency mismatch as many people think they do because they manage a lot of the North American production out of Indiana. 21% owned by Toyota.
They’re just being very blunt. There are way too many Japanese auto companies. There’s no purpose for that degree of independence. They do a lot of cooperating together in particular, Subaru and Toyota. They’ve got six different forms of partnership. These should really be one company. I think that, maybe where this goes– I’m hopeful that’s where it goes, because that’s what makes industrial sense.
Toyota is the face of corporate Japan, whether it wants to be or not. So, when the government and the Tokyo Stock Exchange and [unintelligible 00:53:49] and the Japanese pension system say, the Japanese companies have to reduce cross shareholdings. They have to improve returns on capital. They have to create balance sheets that are reasonable and sensible. Toyota has started to move in response to that and they’ve started to divest holdings and take in holdings. That’s really, ultimately what should happen with Subaru.
But in the meantime, they’ve done a great job. There’s a lot of noise about Inventory levels and incentives and all kinds of headwinds in the auto OEM space. But they’re an outlier with how well they’ve managed inventory in the North American market, whereas Stellantis is the other end of the spectrum just cars piled two and three high on Stellantis lots.
Tobias: What do you think about the existential risk of EV to companies like Subaru?
Matthew: Subaru has an EV. They’ve got a huge balance sheet that they can use to produce new electric vehicles, battery electric vehicles. It’s a fast-evolving market. Meaning, the architecture, the models, the technology. They’ve got a bunch of partnerships with the 800-pound gorilla in the Japanese market, which is Toyota on the battery electric side. But BEV has slowed dramatically, essentially all over the world. I think that they will evolve and adapt, but like other Japanese companies, they have deliberately slow plated. It’s actually been quite helpful to them. They have responded to customer and dealer demands, not to government decrees.
Just so everybody knows, this is a business that has 70% of its volumes in North America. North America is a special place from an electric vehicle standpoint. It’s not Europe and it’s not China where things have moved much faster. There’s been a lot of resistance here. So, they’ve slow played it to their own benefit so far. I think that they’ve got all they need to evolve as the market evolves.
I don’t think that’s the problem with the valuation. When you look at something like a BMW, BMW’s battery electric vehicles are growing substantially faster than Tesla today. They have made up enormous ground. They’ve got a techno savvy client base. They’ve got 25 billion euros of net cash on the balance sheet. It’s one of the world’s great engineering powerhouses. They’ve created a product that people really want. The volumes of BEV have grown very fast. It has not moved the valuation of the business. That’s a company that’s trading at two times EBITDA today. I don’t understand. I think it will work out just fine though.
Tobias: They got a Hans Zimmer to do the backup tone for one of those electric beamers. It’s incredible.
Jake: Oh, really? What does it sound like?
Tobias: [laughs] I can’t sing that. I can’t do it for you, but it’s distinctive. I hear them around here every now and again. It’s very cool. I’m a big– Hans Zimmer. I love Hans Zimmer soundtracks. Do you think there’s any sort of cultural– There’s quite a big cultural difference between the Japanese and the Germans for BMW and Merc. How do you think that plays out as we move forward into the EV, whatever the other– What do they call it? What’s that ICE, internal combustion engine?
Matthew: Yeah. I think it’s already shown up in the way that the Japanese companies have largely– I don’t want to say dragged their feet, but they’ve played their cards pretty close to the vest and they’ve waited to see how the market is going to evolve. Toyota was big looking at hydrogen too. There are people working on different forms of batteries, steady state battery, solid state batteries today. So, the technology may change.
I don’t really know, but I do think it’s important to think about the exposures that the individual companies have. Subaru has 70% of its volumes in North America, and call it 20% of its volumes in Japan, and the other 10% is basically everywhere else. They primarily operate in two markets that have been very resistant to BEV adoption, unusually so, Japan and the US from a customer perspective.
BMW and Mercedes are completely different. They’re much more globalized. They’ve got much larger exposure to China, where BEVs are growing very, very fast. They’ve got more exposure to Europe and a handful of European markets, where they’ve grown faster and are competing incredibly well as we had hoped they would and they are. Particularly BMW, more so than Mercedes.
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Offshore Energy Industry Set for Long-Term Growth
Tobias: The other theme that comes out from your last letter is the offshore-energy, which has had a very good run, but it stumbled a little bit more recently. We’ve got very little time, but I was just wondering if you had any thoughts on the direction?
Matthew: Yeah, I think the direction is still up. I think the market’s very tight and I think the industrial cycle will be governed and destroyed when new orders for equipment start being placed for platform supply vessels, drilling rigs, subsea equipment. Today, there is very, very little in the order book. If you place an order today for a piece of equipment, you’re talking about three years out. I think that the market will continue to tighten to the benefit of the asset owners.
Tobias: Yeah, that’s good stuff. Matthew Fine from Third Avenue Value Fund, thank you very much. If folks want to get in contact with you or follow along with what you’re doing, what’s the best way of doing that?
Matthew: Yup. thirdave.com. T-H-I-R-D-A-V-E dotcom. We’ve got a terrific client service team that would love to engage with you. All of these letters and all of this content that we produce to try to communicate with people is available on the website. We would love it if you engaged with us.
Tobias: JT, any final words?
Jake: Well, no matter who wins tonight or if we find out, try to be kind to each other and let’s remember we’re all in this together at the end of the day.
Tobias: When’s [unintelligible [01:00:34] live?
Jake: Oh, Toby, what do you–
Tobias: Did I get it out too early? Sorry, brother.
Jake: Yeah, it’s all right. Not yet. Hang in there.
Tobias: Disregard that. Disregard that.
Jake: [chuckles] We’ll take that out and post. No, we won’t.
Tobias: We’ll fix it in post. Matthew Fine, thank you very much. That was really fun. JT, as always. Folks, we’ll see everybody next week. Same bat time, same bat channel. See you then.
Matthew: Thanks–
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