Dear Fellow Shareholders,
We are pleased to welcome Chip Rewey to Third Avenue’s Small Cap team as a fellow shareholder and Co”Lead Manager, working closely with Curtis Jensen. As outlined in Third Avenue Value Fund’s letter, Chip has also joined that team as Lead Portfolio Manager. These appointments not only speak to Chip’s decades of successful experience at like”minded investment firms, but also to his embracing of a collaborative, team approach to investing, as well as to Marty Whitman’s time”tested deep value philosophy. Chip evidences all the characteristics we seek in our teammates: an independent and curious mind; a high level of energy and a sense of urgency in a job that we are privileged to do every day. Chip’s addition will help us to build on the terrific momentum that this team has developed.
Portfolio Performance and Activity
The Third Avenue Small”Cap Value Fund (Fund) generated a 0.6% return over the last fiscal quarter, and a ”0.5% return year to date, significantly outperforming its benchmark during both periods.1 The Russell 2000 Value Index returned ”1.27% and ”2.1% for the quarter and year to date, respectively.
Fund Management added four new positions during the quarter, the three most significant of which are discussed below. We added opportunistically and selectively to several existing Fund positions and exited eight holdings, the largest of which are also detailed below.
The fully invested portfolio ended the period with seventy eight holdings. The largest new positions included Patterson Companies Common Stock (Patterson), Standard Motor Products Common Stock (SMP, Financial) and Cooper Tire and Rubber Common Stock (Cooper).
Patterson (PDCO, Financial) is the second largest distributor of dental, veterinary, and rehabilitation supplies in the U.S. Together with its chief competitor, Henry Schein, Patterson enjoys leading market shares across its served markets. By virtue of its scale, Patterson brings value to its customers by providing turnkey office solutions and by delivering high levels of service. The combination of an aging demographic, a growing pet population, more physical and occupational therapies, with international expansion provides a stable growth backdrop for the company. We also believe there is room for operational improvements that can enhance the return on the company’s assets. Management has, steadily returned capital to shareholders, both through significant share repurchases as well as a growing dividend. With the shares yielding 5% to 6% based on free cash flow, the current share price reflects an estimated 20% upside to our conservative estimate of Net Asset Value (NAV).
Founded nearly one hundred years ago by a Lithuanian immigrant whose grandson is the current CEO, SMP (SMP, Financial) today is an aftermarket auto parts manufacturer and distributor specializing in engine management and temperature control products. Longer term, we believe that the increasing number of older model cars on the road with ever more complex electronic and digital systems create a defensive and growing revenue base for the company. Management augments SMP’s growth by acquiring smaller competitors to expand its product portfolio and has steadily improved the company’s margins and returns through various cost initiatives. Like Patterson, SMP has returned capital to shareholders via share repurchases and growing dividends – without sacrificing the balance sheet. The Fund’s entry point approximated a free cash flow yield of 8%, reflecting a potential upside to our estimated NAV of at least 20%.
Cooper, the fourth largest light vehicle tire maker in the United States, had been the subject of a failed takeover bid by India’s Apollo Tyre, a deal that unraveled late last year owing to the parties’ inability to resolve a dispute related to Cooper’s Chinese joint”venture. Cooper appears to be well managed; in the past 10 years operating margins have more than doubled, returns on capital have spiked and the balance sheet has been steadily de”levered. The business should benefit from improving tire replacement trends, a growing business in China and a supportive raw material price environment. Recently Cooper announced its first Original Equipment deal to supply certain Ford Motor models.
Based on the Fund’s initial purchases, equating to about five times EBITDA, we estimate that the public market had discounted the company’s shares by as much as 25% or more from our conservative estimate of fair value. As another point of reference, our analysis suggests a replacement cost for the company’s capacity ($75 to $100 per tire) that is more than twice that value implied by the company’s current market price, enhancing the downside protection of the investment.
Notably, a resolution to the dispute in its Chinese joint venture is likely value”enhancing and is expected before year”end. Several parties expressed interest in buying Cooper (COO, Financial) last year, opening up the possibility that the company becomes an attractive partner for a global tire company looking to gain scale either in the United States or China.
The Fund realized a number of favorable outcomes among its major dispositions during the period. These include Big Lots, Compass Minerals, Sensient Technologies and Susser Holdings, each of which were among the best contributors to performance in recent periods. The outperformance led us to harvest gains in these positions where valuations got either in line with or ahead of our fair value NAV estimates.
Big Lots (BIG, Financial), one of the nation’s largest closeout retailers and operating more than one thousand and five hundred stores in the U.S. and Canada, respectively, initially gained our attention as a turnaround story. Despite weak top line results during the last couple of years, we were attracted to the company’s relatively stable margins, even during recessionary periods, and highly cash generative operations. We believed the “problems” in the business, such as merchandising and sourcing, were likely temporary and fixable, that the company had not lost its core customer and a new CEO had a decent chance of success in the turnaround. Management’s restructuring does appear to be gaining traction this year and the share price has responded accordingly. Skeptical of a persistently difficult retail environment and mindful of what we viewed as a full valuation, however, Fund Management sold its shares, realizing an IRR of 42%.
Fund Management exited its position in Compass Minerals (CMP, Financial), one of North America’s largest and lowest cost salt producers, following vastly improved business conditions from the investment’s inception in late 2011, at a valuation that approximated the high end of our estimate of Net Asset Value. The investment produced an annualized IRR of 17%.
Sensient Technologies (SXT, Financial), a manufacturer of colors, additives, flavors and fragrances to a wide variety of industries, benefited from steady, albeit uninspiring, operational results that eventually came under question from an activist shareholder. Sensient’s share price responded positively to the presence of the dissident shareholder and when the share price reached the high end of our NAV, we exited our position, resulting in an IRR of 23%.
As noted in last quarter’s letter, Fund Management elected to sell its position in Susser Holdings (SUSS, Financial) when that company became the subject of a takeover by Energy Transfer Partners (ETE, Financial). The investment thesis in Susser, a growing convenience store chain in Texas, was based on its unique Laredo Taco food”service operation, exceptional management team, and ownership in a valuable, publicly”listed fuel distribution franchise. Sale of the investment, one with an unusually short tenure, was completed this quarter and resulted in an IRR of 81%.
Outlook
One of the common questions our fellow shareholders have asked recently is whether we are still able to find good value investments given the outperformance by small capitalization stocks relative to other assets and especially in view of their relatively rich valuations. The short answer is absolutely. While current earnings trends are important, they are not our starting point. Our process is rooted in evaluating the entire business enterprise, essentially counting up the assets and ascertaining a fair value NAV. From there we assess the balance sheet and credit profile of a company, to ensure the company has the financial ability to meet its obligations and investment opportunities, and the ability to survive market storms.
Stocks get mispriced by the public markets for various reasons, including, for example, investor short”termism, a perceived lack of ‘catalysts’ or an ignorance of inherent asset values that may not be fully exploited. Our in”depth, fundamental research helps to separate this ‘noise’ from longerterm fundamental value while our focus on the ability to compound NAV provides a distinction between higher quality companies, and those that could be in secular decline or other ‘value traps’.
As the U.S. Federal Reserve’s quantitative easing program winds down, we have seen a decline in correlation within equity markets. Correlations across stocks are declining as dispersion in the performance across stocks is increasing. Equity markets appear to be less driven by the broad ‘risk on’/ ‘risk off’ investor mindset that has been dominant since the onset of the global financial crisis. Instead, over the last few months, fundamental characteristics of companies are having more influence on stock returns. The renewed interest of investors in fundamentals bodes well for the Fund, as our investment process thrives in these environments.
The current global economic and geopolitical situation remains fraught with uncertainty. We recognize this and in doing so focus our efforts on those variables that we can ‘control’, namely the value proposition and quality of the businesses in which the Fund invests. In this vein, we seek companies that are well managed, have a sustainable competitive advantage, sensible balance sheets and a wide gap between stock price and our conservative estimates of NAV.
While we acknowledge that future equity market returns may be more subdued than those of the past five years, we view equities favorably and our differentiated portfolio in particular, where the results we believe will be much more tied to individual company results than to the results of the general market.
We look to the future with confidence, knowing that:
o We have the tightest process and highest quality portfolio ever in the strategy. Chip’s addition brings even more experience, more depth on companies and industries and potential for new ‘best practices’ from a like”minded firm we have known for decades. o Our process transcends any one individual; our system of checks and balances makes sure all voices are heard and questions answered while maintaining efficiency in processing ideas.
o The evidence of our improvements during the past year in our process and portfolio is delivering attractive returns this year, particularly when viewed in the context of the investment risks assumed and the resultant ‘return per unit of risk’ that we believe – and the data supports – is well in excess of the index.
We thank you for your support of the Fund and look forward to writing to you again next quarter. In the meantime please let us know should you have any questions or comments.
Sincerely,
The Third Avenue Small”Cap Value Team
Chip Rewey, Co”Lead Portfolio Manager
Curtis Jensen, Co”Lead Portfolio Manager
Tim Bui, Portfolio Manager
Charlie Page, Portfolio Manager
