This post has been excerpted from a letter by Chip Rewey, Lead Portfolio Manager of the Third Avenue Small-Cap Value Fund.
In the second quarter, the broader market indices of the Russell 2000 Value, the S&P 500, the Nasdaq composite, etc., all continued to trade at or near all-time highs. While clearly we agree that there are pockets of high expectations in the broader market, The Third Avenue Small Cap Value Fund had an active quarter in new purchases, as our robust, repeatable and definable philosophy and idea origination processes led us to uncover and execute new positions. Given this seeming contradiction of a market reaching new highs and our enthusiasm for several new positions, we thought it would be timely to review our stock idea origination philosophy and process.
Every Third Avenue idea comes from following our core philosophy as originally articulated by Martin Whitman, that is the three pillars of: i) Creditworthiness, as defined by a strong balance sheet, ii) the ability to compound book value growth and iii) purchasing at a significant discount to our estimated Net Asset Value.
Following the Dots to 6 New Investments: PDC Energy, Haynes International, Finisar Corp, Horizon Global, AMN Healthcare, and WesBanco Bank
To implement this philosophy in idea generation, we follow both qualitative and quantitative paths. Most of our ideas originate from our fundamental research on existing or current work-in-progress ideas, where we ‘follow the dots’ of relevant information. Our new position in PDC Energy (PDCE) this quarter is a classic example. As we were continuing to research our current holding Carrizo Oil and Gas (CRZO), and indeed EOG Resources (EOG) in the Third Avenue Value Fund, we continued to become more intrigued and enthusiastic about the tremendous oil resource in a field called the Delaware Permian Basin, and more specifically with acreage located in Reeves County, Texas. As we analyzed production results and finding cost economics for Carrizo and EOG Resources, we followed the dots and analyzed all companies that had core acreage holdings in Reeves County, and this was the starting point for our due diligence on PDC Energy.
Another example was following the dots on our aerospace holding Barnes Group (B), as we analyzed the strength of the Boeing and Airbus narrow body airframe refresh cycle now ramping up, specific to engine components. This led us to take a new look at Haynes International (HAYN), a small cap company with a large market position in aerospace engine alloys.
Finisar Corporation (FNSR) makes optical components and is related to the same food chain as NetScout (NTCT), another holding in the Fund, which provides network service assurance and security. Finisar’s stock price declined due to what we perceived as a more near-term issue. We were intrigued, given its cash-rich balance sheet and leading market position and decided to do further due diligence.
Our other three purchase ideas originated with our robust screening function. Since we search for smaller companies off the beaten paths, many of whom are not often reported in the financial press, quantitative tools allow us to identify these potentially overlooked names. It is important to understand that our screening process is not just a starting point for our fundamental research process, but it is also specifically tailored to our investment philosophy. Put simply, the ability to rapidly access large amounts of both financial and qualitative data in a tailored fashion has allowed us to push forward our idea generation tool kit. In the same way that the cars we drive today are much more advanced than those we drove at Third Avenue’s founding in 1986, our front end processes continually push the envelope for broader vision, efficiency and speed of process, but all within the parameters of our philosophy.
The initial look at Horizon Global (HZN) and AMN Healthcare (AMN) came from a screen that integrates the multiple factors of: strong cash flow, healthy balance sheet, improving business trends, and compelling valuation levels. Lastly, our initial spark to work on WesBanco Bank (WSBC) came from studying a screen of smaller cap bank stocks with healthy Net Interest Margins, strong deposit led funding and controlled charge offs. All six new purchases are described in greater detail later in this letter.
In our opinion, a robust and repeatable front end is a critical factor for success for two reasons. First, as we have discussed, it is essential to identify new ideas regardless of broader market levels. Secondly, the ability to consistently find and execute on new ideas allows for the timely sale of existing portfolio names that have achieved and even surpassed our NAV-driven price targets. Finding compelling new ideas lets us efficiently recycle our capital, and not have cash accumulate beyond desired levels through a lazy belief that there are no compelling ideas on which to work. At quarter end, our cash level was about 3%.
This publication does not constitute an offer or solicitation of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this publication has been obtained from sources we believe to be reliable, but cannot be guaranteed.
The information in this portfolio manager letter represents the opinions of the portfolio manager(s) and is not intended to be a forecast of future events, a guarantee of future results or investment advice. Views expressed are those of the portfolio manager(s) and may differ from those of other portfolio managers or of the firm as a whole. Also, please note that any discussion of the Fund’s holdings, the Fund’s performance, and the portfolio manager(s) views are as of June 30, 2017 (except as otherwise stated), and are subject to change without notice. Certain information contained in this letter constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe,” or the negatives thereof (such as “may not,” “should not,” “are not expected to,” etc.) or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of any fund may differ materially from those reflected or contemplated in any such forward-looking statement. Current performance results may be lower or higher than performance numbers quoted in certain letters to shareholders.
Date of first use of portfolio manager commentary: July 17, 2017.
Past performance is no guarantee of future results; returns include reinvestment of all distributions. The above represents past performance and current performance may be lower or higher than performance quoted above. Investment return and principal value fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. For the most recent month-end performance, please visit the Fund’s website at www.thirdave.com. The gross expense ratio for the fund’s institutional and investor share classes is 1.40% and 1.65%, respectively, as of March 1, 2017. Please be aware that foreign securities from a particular country may be subject to currency fluctuations and controls, or adverse political, social, economic or other developments that are unique to that particular country or region. Therefore, the prices of foreign securities in particular countries or regions may, at times, move in a different direction than those of U.S. securities. Prospectuses contain more complete information on management fees, distribution charges, and other expenses.
Third Avenue Funds are offered by prospectus only. The prospectus contains important information, including investment objectives, risks, advisory fees and expenses. Please read the prospectus carefully before investing in the Funds. Investment return and principal value fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. For updated information or a copy of our prospectus, please call 1-800-443-1021 or go to our web site at www.thirdave.com. Distributor of Third Avenue Funds: Foreside Fund Services, LLC.
Current performance results may be lower or higher than performance numbers quoted in certain letters to shareholders.