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By Bridget B. Hughes, CFA | 08-02-2011 11:21 AM

Volatility Can Create Great Opportunities

It's very difficult to generate attractive long-term capital appreciation if you try to protect against short-term market volatility, says Third Avenue Value's Ian Lapey.

Bridget Hughes: Hi. My name is Bridget Hughes. I'm one of the fund analysts here at Morningstar. I am here today with Ian Lapey of the Third Avenue Value fund. He is one of the comanagers. Ian thanks for coming in and chatting with us today.

Ian Lapey: Thank you for inviting me, Bridget.

Hughes: Third Avenue recently created a new role at the company, a chief risk officer, with Tom Gandolfo taking on the role. I know that the safe and cheap investment philosophy sort of lends itself to a risk-conscious investment approach throughout the firm, but what does this new position mean for the portfolios?

Lapey: Well, we are really formalizing the approach of looking at risk, and it is an evolving role. I guess first of all, it's certainly a recognition of Tom Gandolfo's contributions. He has been with us for three years, and I think we have been very impressed with him.

What it's meant so far in terms of the value fund is we have now quarterly risk committee meetings that the portfolio managers, including myself, attend, and we talk about things other than just bottom-up security analysis issues. We actually talk about macroeconomic factors, overall firm exposures, and large concentrations within various portfolios. So, it's nothing really tangible in terms of day-to-day portfolio activity at this point, but as I said, it is an evolving new position for us.

Hughes: Do you envision a time where with the risk officer, Gandolfo says, "You need to make some changes here"?

Lapey: Probably not, but again as I said, it is evolving. We will have to see. I think certainly he would make recommendations, but we don't have, at least to my knowledge, a situation where he would have actual authority to make portfolio transactions, but certainly recommendations. And at these risk committee meetings, it isn't just Gandolfo and the portfolio managers. Our CFO is there, and a number of senior people at the firm are there, as well.

Hughes: So continuing about risk and volatility, let's talk a little bit about volatility and the portfolio. I know that risk and volatility are not exactly the same thing; you don't think of them in the same way. Nonetheless, you spend a lot of time in your shareholder reports talking with investors about the Hong Kong real estate companies and the conglomerates that you have in the portfolio; it's a big concentration.

Lapey: Yes.

Hughes: I am just curious of the kind of volatility that you have endured with those companies. Is that typical of a Third Avenue holding that you have historically held?

Lapey: No, it really isn't, and actually the stocks are more volatile that other areas, particularly in the U.S. in which we have been invested in the past. However, we are really focused at Third Avenue on generating long-term capital appreciation, and we are absolutely willing to live with short-term volatility. In fact, for a value investor, volatility can create great opportunities.

For example in 2008, the businesses of all these Hong Kong real estate and investment companies actually performed very well. The stocks got hammered, and we were able to add to several of the positions at great prices. So, we are willing to live with the short-term volatility because we are invested for the long term, and we believe our investors are as well. And it's very difficult to generate attractive long-term capital appreciation if you try to protect against short-term market volatility.

The other thing I would add is actually it's been surprising because the businesses are actually not all that volatile. If you look at how these companies have done from a business standpoint during the last five years, net asset values have compounded between 10% and 20% per year, almost as if the recession never happened, yet the stock prices went like this.

So it's really been a real divergence between business performance which we focus on and stock-price performance. But we're willing to live with that because we think that this is going to be, in the market today, the best opportunity to generate long-term capital appreciation.

Hughes: And to be clear, I think that those positions over the holding periods have been additive to performance, so, at five-plus years?

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