Third Avenue Value Paring Concentration

Russ Kinnel: Hi, my name is Russ Kinnel. I'm director of mutual fund research for Morningstar, and I'm joined today by Ian Lapey, manager of Third Avenue Value. Thanks for joining us.

Ian Lapey: Thank you for having me, Russ.

Kinnel: You've just recently been named lead manager, though you've obviously been with Third Avenue for a while. Can you give us a little bit of background on when you joined Third Avenue and what you have done up to this point?

Lapey: Sure. I joined Third Avenue 11-and-a-half years ago. Prior to that, I had been a sell-side analyst at Credit Suisse First Boston following the housing industry. I was really driven to Third Avenue, by reading an interview with Marty Whitman, in which we talked about the Third Avenue safe-and-cheap investing philosophy, and that really resonated with me. And fortunately for me, Curtis Jensen, who is the chief investment officer now, went to the same college that I attended, Williams College, so I was lucky enough at the time, 11-and-a-half years ago that they were looking for a senior analyst, and I joined by initially contacting Curtis.

At Third Avenue, over 11-and-a-half years, I have been a generalist. I have managed several subadvised funds. I have been comanager of the Third Avenue Value Fund since mid-2009 and now started managing as a sole manager in March.

Kinnel: Third Avenue made it clear that you are going to be taking over the fund. So obviously you had some long preparation time for that, and you made some changes to the portfolio pretty early on. Can you tell us a little bit about that?

Lapey: Sure. The strategy and really I planned to manage the fund using the same long-term, bottom-up, buy-and-hold, safe-and-cheap philosophy that Marty developed. The one difference is that the fund will be and already is a little bit less concentrated. So, the top 10 holdings in the fund in the beginning of March, when I took over, accounted for about 70% of the fund. Now it's about 61%.

Most of that has been in modest reductions in Hong Kong exposure, where we had a couple positions bigger than 10%, and we've brought those down to 10% or lower. Hong Kong is now about 36% of the fund compared with 50% beforehand. The area we have been adding to is actually in the United States. Really it's four areas: energy, where we have been adding to a position in Devon Energy; property and casualty insurance, where we have been adding to White Mountains Insurance and Allegheny; regional banks where we have been adding to KeyCorp and Comerica; then finally high tech, where we have been adding to our Applied Materials position.

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Kinnel: It's interesting, too, that for recent years, Third Avenue Value has been relatively light in U.S. equities. Is there a particular reason why you are finding them compelling today?

Lapey: Well, we are seeing attractive valuations. I would say that the discounts are not as wide as what we are seeing in Asia, but there is an advantage obviously to investing in the market that we know best where we do have the best disclosure or the best corporate governance. So, we are making somewhat off a trade-off. For example, the regional banks and the P&C insurers trade at sort of 8% to 10% discounts to tangible book value. KeyCorp is more like 20%, but those discounts compared with those of Hong Kong companies are not as wide but we still find those to be very attractive.

Kinnel: I wanted to ask a little bit about the records, the recent performance. The three- and five-year numbers on the fund on a relative basis are weak. The longer term is still strong, and people naturally are curious why is that and why should they believe that that the fund can return to that stronger performance of years past. What's your take on that?

Lapey: Well, if we look at the five-year performance, and as you said the performance has been weak, it really is three things. The first is our investments in bond insurers, MBIA, Ambac, and Radian, which cost us about 1,000 basis points during that period. In those cases, those investments were permanent impairments where because of a much more severe housing crisis and our misassessment of the management teams, we suffered massive losses in those investments.

Another area is St. Joe and Forest City. These are real estate operating companies that five years ago--looking back today, of course it's always easier in hindsight--were significantly overvalued, should've been sold. We are out of St. Joe. Forest City is a much smaller position today.

And then the third area actually are Asian investments, although they've been positive contributors, the growth in the business value has been tremendous, and the stocks are only up modestly, so you've actually had a massive widening of the discounts, and I think that's where we see the great future potential because the portfolio today, which sells at only 69% of book value is very, very attractively valued. And we don't have companies like Ambac and MBIA in there. So that if we do have a significant, say, weakening global economy, I think their positions in the portfolio today are much better-financed to weather that type of a slowdown.

Kinnel: Of course, I think with a fund like yours where you are fairly concentrated by individual stocks, sectors, and countries--and obviously, not only are you completely different from any kind of benchmark but also different from the category--I think, to a degree with those kind of funds you have and some of that baked into the process that because you are fairly different, you are going to have different returns in both directions.

Lapey: Absolutely. We try to generate long-term capital appreciation and with minimal investment risks, and we really don't pay attention to benchmarks. So, what we've done and you alluded to this with your earlier question, since 1990 when the fund was launched, we've done 11% a year. Now that includes some bad years and obviously some good years, and I would expect that to continue. We're not going to track any benchmark, and we will make big bets when we find great value.

Kinnel: Ian, thanks so much for joining us.

Lapey: Thank you, Russ. Thanks for having me.