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Europe Crisis No Reason to Avoid Region Altogether

Bridget B. Hughes, CFA

Bridget Hughes: Hi. I am Bridget Hughes. I am one of the analysts here at Morningstar, and I am here this morning with Matt Fine, who was recently named as a comanager on Third Avenue International Value. Matt, thanks so much for coming and joining us.

Matthew Fine: Thanks for having me.

Hughes: So, you've got a promotion and have been added as a comanager on International Value. So, maybe you can just give us a really quick summary of your experience at Third Avenue and then talk a little bit about the relationship with Amit Wadhwaney, who has been the lead manager on the fund since its inception, how that will change, if at all?

Fine: Sure. First of all, thank you for having me. Second of all, I think the most important thing I would mention is that we believe that our shareholders in the fund, in Third Avenue International Value, need a clearly articulated succession plan, and that's really what this is all about. We would like people to know that if for some reason, God forbid, Amit wasn't able to come to work, they would know who will steward the fund.

Secondly, I've been with the firm since January of 2000, so I am now in my 12-year anniversary this month, as we speak, and I think this is, to some extent, a recognition of my contribution to the fund over that time. I've been working specifically with Amit for approximately nine years, and increasingly the fund has reflected my influence on the process, on security selection, and on the management of the portfolio.

Hughes: I thought it was interesting you told me earlier that the relationship with Amit started closely because of the Argentine crisis.

Fine: That's true.

Hughes: And you never went back.

Fine: That's true. It was an auspicious start. I was working as a generalist for the entire research department for, what was then, about 15 or 16 people. Argentina, of course, imploded, and the peso peg was broken. Argentina remains the largest sovereign default in history to this day and provided us with some very interesting fodder for the portfolio. Some of our great portfolio returns came out of that period, and as you said, I never looked back.

Hughes: So, as an opportunist obviously, as you mentioned, there was lots of activity after that crisis. People are talking about Europe today and have been for a couple of years. You have seen the portfolio sort of migrate toward some of those European companies but maybe not still the obvious ones as is typical of this portfolio. Can you talk a little bit about where in Europe you're seeing those opportunities?

Fine: Absolutely. You're exactly correct. So if you looked at our portfolio five or six years ago, you would have seen a much larger representation in Asia, whether it'd be Singapore, or Hong Kong, to some extent, in Australia and New Zealand. And with an economic boom during half a decade in that part of the world, you've seen us being largely priced out of a number of securities where we have historically been active. It's much tougher for us to find opportunities.

On the flip side, though Europe has gotten a tremendous amount of press of late, what you've really been seeing is a much slower deterioration over a number of years, such as a deteriorating credit quality and an inability to generate growth at the macroeconomic level. I'm talking about a number of eurozone countries, in fact that would describe most, have been creating a tremendous amount of opportunity for us, where at present, including the United Kingdom, Europe-wide, we would be at about 40% of the portfolio. So, there really has been a significant migration.

One of those companies is Daimler, one of our newest investments that we wrote about in our quarterly letter, which is a bit unusual for us and at the same time illustrative of the severity of the pricing dislocations that are taking place because of the European crisis. This is a class of company that we don't normally get the opportunity to buy. Daimler, by most measures, is rated one of the top five brands in the world. It has an absolutely rock-solid balance sheet with about EUR 11 per share in cash and a wildly profitable business that's actually having its record year as we speak. But currently, we're looking at a valuation based on its record year, which we need to seriously discount in our analysis, but based on this record year, it's at about 2 to 3 times earnings before interest, taxes, depreciation, and amortization. So, it's below book value and is the type of opportunity in that quality of company that we don't typically get.

Now as a final point, Daimler is a very global business. Less than half of its business is in Continental Europe. It is listed in Continental Europe; it's headquartered in Continental Europe. But I think we are living in a world today where people are reluctant to take the time to understand the actual underlying business factors and actual underlying business exposures and are happier to shoot first and ask questions later.

Hughes: Just real quickly, when you talk about discounting this record year, what exactly do you mean by that? How do you do that?

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Fine: Sure. So, let's assume for a second that auto sales in most parts of the world don't continue to roar ahead unabated. You've seen tremendous growth in Asia, particularly China, which has become the largest passenger-vehicle market in the world. Auto sales in the U.S. are even in terrific health; Europe has really not been that bad in terms of auto sales. So, when you came out of 2009, which was a terrible year for most auto manufacturers, they had a record year in 2010, at least in the case of Daimler, but for most a terrific year. 2011 has handily beaten 2010's records.

So you have in a three-year period, an unusual situation where you have the full spectrum of operating performance. In 2009, the worst year in recent memory, and 2011, a record year, and I'm going to analytically throw out both of those as data points, and believe that somewhere in between might be a much more normal operating environment for Daimler. In doing so, let's take those types of assumptions and demand a double-digit cash flow yield from each of its industrial businesses and pay book value for its financial business. And to that type of value, we believe we are paying about a 25%-30% discount to net asset value.

Hughes: One of the things, I think, scares people right now about Europe in particular are the financials. You do own insurance companies. You don't own the banks. Can you contrast the two, and why the insurance companies meet your safe-and-cheap criteria and the banks don't?

Fine: Sure. You're drawing a very, very important distinction, and Europe itself is not homogenous, meaning Germany and France are not Italy and Greece. So, within the eurozone, you have a tremendous amount of heterogeneity. In financials, similarly you have a tremendous amount of heterogeneity also. Banks in the simplest sense borrow short and lend long, and this is clichéd and well-documented at this point, but most banks go out and collect deposits. They gain access to the wholesale financing market and they lend long and profit from what is effectively a duration mismatch. And that business model, while profitable in most periods of time, can subject banks to tremendous liquidity crises, and we of course saw that in 2008, 2009, even 2007.

In contrast, insurance companies tend to collect premiums upfront. They invest assets typically in a way that matches the liabilities, but very often their assets are even shorter-duration than their liabilities, so you have the reverse of the duration mismatch in many cases. These companies operate with an entirely different business model. But if you can identify something in the insurance realm, with a lack of financial leverage, with a historical underwriting track record that makes you comfortable and evidences the underwriting skill of the business and if you can get comfortable with the asset side of the balance sheet--mind you, those businesses have been tarred with this European financials brush--you might have something very interesting on your hands. And we believe that's the case in Alliance and Munich Re.

Hughes: If European banks, are scarier, or kind of raise a red flag, then Greece probably does, as well.

Fine: Right.

Hughes: You own one company, a fairly recent purchase, in Greece. Can you talk about that one?

Fine: Yeah. We have a single investment in a Greek company called Titan Cement, which is a heavy building products company, a cement manufacturer. Titan is a fabulous example of one of these companies that outgrew its own market and expanded across the globe, not to encompass the entire globe, but selectively into Southeastern Europe, into the Eastern Mediterranean, meaning Turkey and Egypt, and in the 1980s, 1990s, and the 2000s into the U.S. market. So, today, maybe 25% or 30% of the value of the business is actually attributable to the Greek market. So, to call it a Greek company, yes, it's listed in Greece, but I don't quite see it that way.

What's even most interesting in my part is this U.S. business, where people tend to value these types of companies on a multiple of current operating performance or a multiple of EBITDA you'll commonly see, cash flow. What's interesting is this U.S. business which cost the firm an amount roughly equivalent to the entire market capitalization of Titan is producing no cash flow at the moment. This is a break-even market for most competitors in the U.S. market. Their specific operations are in the Atlantic Coast, meaning from Virginia down through the Carolinas and into South Florida. And South Florida, while declared dead as one of the epicenters of the housing crisis, might not be quite dead yet. You are seeing some interesting rumblings coming out of the heavy building products world in the U.S. at this point.

Hughes: Well, Matt, thank you so much for coming in, and good luck with International Value Fund.

Fine: Thank you so much. Great to be here.