Friday, October 06, 2006

From Third Avenue Funds

The following is an excerpt from the Third Avenue Funds letter to shareholders for their third quarter ending 7/31 and received by shareholders in the last few days. It is written by Martin J. Whitman, the 80+ year old co-chief investment officer of Third Avenue and portfolio manager of the Third Avenue Value Fund.

"Ernest Jones, in his three volume biography of Sigmund Freud, describes Freud's genius as an abhorrence of looking at people as irrational or 'off the wall'. Rather Freud sought to understand the underlying reasons for why people acted the way they acted, and why they thought the way they did. Were Freud to be describing the 1998 to 2000 high tech bubble, he probably would have described it as 'Rational Overexuberance' rather than 'Irrational Exuberance'. And so it is with the question of, 'So what are earnings anyway.

Earnings for Third Avenue Value Fund(TAVF) purposes are something quite different from what earnings are deemed to be in conventional, plain vanilla, market analysis. Rather, both the Fund and the conventional analysts tend to be rational; they just approach the problem from different places. The fact is that in conventional security analysis, predicting market prices over the very near term is crucially important. In contrast, TAVF ignores near-term market prices for individual securities. Third Avenue tries to buy long-term value safely and cheaply; and allows market prices of individual securities in the portfolio to take care of themselves...

Unlike TAVF, many market participants are, in fact, affected vitally by day-to-day price fluctuations in markets for individual securties. For these people, it is important to predict near-term target prices. For them, therefore, there actually does exist a 'Primacy of the Income Account' and a need for GAAP to tell them the truth. After all, it seems quite valid to conclude that market prices for most securities will be influenced more by earnings as reported under GAAP than by any other single factor. These market sensitive participants include margin buyers; people and institutions relatively uninformed about the securities and companies in which they are interested; participants holding junior securities in companies that are not well financed; and participants who have to strive to outperform benchmarks consistently(such as many research department analysts who want to keep their jobs and get promoted). There are also market participants with both near-term predictions and fundamental analysis-to wit, short sellers and risk arbitrageurs.

The basic problem is that this market sensitive group seems to be the only group that is studied by academics. This group also seems to be the primary concern of securities regulators. However, this group seems to be a small factor in the overall economy, and may even be a minority of Wall Street. Most value investors, control investors, distress investors, and venture capital promoters think and act more like TAVF than like market participants affected vitally by near-term securities price fluctuations. Like TAVF, most sophisticated market participants look at market prices not as something you predict, but rather as something of which you take advantage.

Stealing from Sigmund Freud, it is not that some financial participants are irrational and others are rational. Rather, almost all participants tend toward rationality. It is just that what is rational for those affected by immediate market price impacts tend to be irrational from the point of view of those involved with long-term fundamentals. Those involved with immediate market impact are involved with market risk, i.e. securities price fluctuations, while those focusing on underlying fundamentals are involved with investment risk. For most fundamentalists, like TAVF, market risk, both for individual securities as well as for macro factors affecting general markets, are things that can be ignored safely."

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