Volatility Can Create Great Opportunities

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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Lapey: Yes, we're up on all of them. What happened is, as I mentioned, the NAVs have compounded at double-digit rates. The stocks have done OK, but actually the discounts have in most cases widened since we first got in. So that's why we even though they're up from our original costs, we still believe they are very, very attractive today.

Hughes: And when you say "long term," what does that mean to Third Avenue? Some of the stocks in the portfolio have been there for more than a decade.

Lapey: Right. I looked at the last decade, and our average portfolio turnover was 14% a year. So that's sort of what we're thinking about seven or eight years. Now, obviously we hope that when we make an investment that it will generate a return before then. But that's historically been our holding period, and I think we'll probably continue with that type of an approach.

Hughes: So shifting gears a little bit, one of the smaller positions in the portfolio that it looks like you've added to Encana. I'm just curious if you can maybe comment on whether that's a broader energy or a natural gas play and whether there is something specific to Encana. Then maybe we can compare it and contrast it with Nabors, which is a much bigger position and a long-term holding.

Lapey: Yeah, well actually we initiated the position in Encana in late 2003, and what's happened since then is the management has done a terrific job. During '05 and '06 when you had very high commodity prices, they actually sold a lot of noncore assets at great prices; they repurchased about more than 20% of the stock. At the end of 2009, they split the oil sands business with the natural gas business. So we now actually own in the fund both Encana and Cenovus.

Now what's happened during the last couple of years is that natural gas prices have been very depressed, so Encana common stock has been a poor performer. Cenovus has actually done very well, but Encana now trades at a significant discount from our estimate of net asset value. Just to give you a sense, although the current outlook is weak, the value of the assets to some degree was recognized by a long-term strategic buyer, BHP, which just bought Petrohawk, which we think is an inferior company to Encana.

But BHP paid $4.40 per Mcfe-approved reserves, whereas Encana trades at about half that at $2.20, so we think there's tremendous value in Encana's assets. The firm does have a very strong financial position. As I mentioned, the management team is quite good; currently they are making a little bit of money. But at $4 and change for natural gas, the business is not robust today.

Hughes: So, the thesis is more about the cheapness of the stock as opposed natural gas prices being the next to shoot through the roof?

Lapey: Well, I wouldn't say next to shoot through the roof, but on a long-term basis, we do believe natural gas prices will be higher. It is very competitive compared with other fuels at their current prices. At $4 it just isn't sustainable because many shale plays are not all that economical; you really need $5 or $6 natural gas for most shale plays to work.

So we do think natural gas prices will be higher on a long-term basis, not necessarily in 2011, but on a long-term basis. At more of a $5 to $6 level, Encana's assets are very, very valuable.

Hughes: The firm is at less than a percentage point, at least as of the end of April, in the portfolio. Given that this is really a very concentrated portfolio, what kind of role is that position serving at that small of a level?

Lapey: Well, I think we would definitely buy more and make it a bigger position at a bigger discount. As I mentioned, the current business fundamentals are pretty weak. It does trade, as I said, at a significant attractive discount. At a bigger discount, we would definitely make it a much bigger position.

Hughes: And then Nabors is a firm that has been held for very long time. Marty Whitman brought that one in.

Lapey: Right, Nabors is actually a supplier to Encana, and Nabors benefits because it's not only natural gas in North America, but it also has exposure to oil as well as international.

So it's business is today doing a lot better than Encana's, and actually the stock price has done well in 2011. We've actually lightened up on the position modestly, so actually the position size is smaller as of June 30. It was no longer a top 10 name, but we do continue to like it.

Hughes: Okay. Well thanks so much for your time.

Lapey: Okay, thank you for having me, Bridget.