(copyright 1998 by Martin J. Whitman)

        The appreciation in market prices for the common stocks that make up the leading indexes have, in recent years, so far outstripped the growth in book value and earnings for the companies whose common stocks make up indexes that these market prices seem now to be grossly out of line with corporate reality.  Thus the possibilities for disaster.  Here, excellent past performance seems likely to be a harbinger of future under-performance insofar as one believes that over the long term, market prices for passively owned common stocks will have a relationship to underlying corporate fundamentals.

        The managers of Third Avenue Funds do not predict the future but rather deal in probabilities.  Probabilities are driven by securities prices as they relate to underlying corporate realities.  It is our strong belief that the higher the current market prices relative to corporate fundamentals, the greater the investment risk; and the lower current market prices are relative to corporate fundamentals, the less the investment risk.  We also believe that for an index, or almost any general aggregate for that matter, corporate fundamentals can be measured by accounting earnings and accounting net asset value per share, i.e., book value.

        A principal reason why Third Avenue Funds deals in probabilities rather than in predictions is that predictions are so difficult to make.  To predict that the prices represented by the S&P 500 Index will crater at a specific time, one has to visualize what the precipitant for such a scenario might be and when that catastrophic event might occur.  Third Avenue is not very good at foreseeing precipitants, especially if timing is involved, and we doubt anyone else is much good at it either.

        Who could really have forecast the timing of the Asian collapse in 1997? Who could really have forecast the timing of sovereign defaults in Russia in 1998, the Mexican Peso devaluation in 1994, the US. Savings and Loan debacle in the mid to late 1980's, or the plunge in oil prices in 1982 and again in 1998?

        The Third Avenue Funds use a balanced approach to analysis, initially measuring the quality of resources in a business as well as the quantity of resources acquired relative to market prices.

        Quality and quantity of resources translate into return on equity.  In using financial accounting as a tool to analyze individual companies, no particular number is emphasized by Third Avenue, but rather each accounting number is a function of, modified by, and derived from, all other accounting numbers.  Thus book value is intimately related to earnings, and vice versa.  Both are joined at the hip so to speak, in the concept of return on equity, or ROE.  R is the earnings figure; E is the book value figure.

        Financial accounting in the analysis of individual companies is always subject to adjustment.  The most GAAP figures can represent in the analysis of an individual company are objective benchmarks, which the analyst uses as a tool to reach opinions about economic reality, either in terms of flows, whether cash or earnings; or asset value, or both.  However, financial accounting in the aggregate tends to be highly meaningful.  It measures changes over time, the amount of resources in existence and flows, whether cash or earnings.  For the aggregates, statistical errors that might exist for individual companies tend to even out.

                        The Statistical Case Demonstrating That Prices for
                        S&P 500 Industrials Have Outrun Corporate Reality

                                 Market Price as a Multiple of:

        It is hard to justify a 6x multiple of book unless one can postulate that either ROE for the index companies will increase to a number greater than 25%, or that companies in general will be able to issue massive new amounts of common stocks, either for cash or in merger and acquisition transactions, at prices related to 6x book.

        From 1982 through 1998, ROE's for the S&P 500 ranged from a high of 22.2% in 1996 to a low of 10. 6% in 199 1. The average ROE for the 17 year period was 15.7%. However, for the 5 years through 1998, the average ROE was 21.0% and in no year was below 20.0%.

        Assuming a market price of 6X book, PE ratios are as follows based on various ROEs:

        It seems unrealistic to suppose that on average the companies making up the S&P 500 would have such attractive access to capital markets that such a large amount of new equity capital could be raised at those prices.  Alternatively, it seems questionable that companies in the aggregate would be able to maintain existing ROEs if massive new amounts of capital were injected into their businesses.

        It is always possible that securities pricing for the common stocks that make up the S&P 500 have entered into a new era where greater capitalization rates will be given to earnings, and greater premiums will be assigned to book values, than historically has been the case.  These enhanced valuations might persist, or even be improved upon, on a permanent or semi-permanent basis.  Such a new era pricing scenario seems to be a possibility rather than a probability.

        In contrast to this statistical picture for the S&P 500, many common stocks, especially well-capitalized small caps currently seem to be priced at bargain prices relative to long term earnings prospects and current book values.  This type of pricing in markets for passive, minority investments seems to occur frequently at times when the immediate earnings outlooks are poor.  The semi-conductor equipment stocks Third Avenue Funds are currently acquiring seem to meet these criteria.  As a long term investor, Third Avenue is betting that the probabilities are for most of these companies that the next peak in earnings will be well in excess of historic peaks.  Relevant statistics for these issues are as follows:
 
 

1. The passive investor seeks to maximize a risk adjusted total return consistently.  Consistently means all the time.  The concepts are good for day traders, not for buy and hold fundamentalists.

2. The securities being examined can be analyzed by reference to a very limited number, of computer programmable variables.  These instruments seem limited to credit instruments without credit risk; derivatives, including options and convertibles; and pure risk arbitrage situations such as publicly announced mergers.  EMH tools are not helpful at all in the analysis of most common stocks held by investors.

        Academic finance in general, and EMH in particular, seems discredited in many financial arenas.  The recent Long Term Capital Management debacle is an outgrowth of academic finance where supposedly sophisticated people relied exclusively on quantitative considerations unleavened by any qualitative considerations.  Academic finance also seems to bear primary responsibility for flawed concepts such as portfolio insurance in 1987 and giving 100% weight to marks to market for portfolios of performing loans in 1998.

        The basic assumption underlying Index Funds is that fundamentals such as financial strength, a large quantity of available resources, and a favorable long term earnings record, count for naught.  It is assumed that such fundamentals are already reflected in market prices for common stocks.  This seems a ludicrous assumption.  For example, if passive market players emphasize any corporate data, it seems to be the near term earnings outlook.  Financial strength is almost completely ignored.  The failure of passive investors to put all corporate fundamentals into the information mix upon which they rely, seems to contribute importantly to making current investments in the S&P 500 so dangerous.

        So far index investing has been a great game even though its basic concepts seem flawed.  Some of the basic assumptions of index investing are as follows:

        Active management cannot outperform a market.  This seems true for day to day trading.  It just does not hold either for buy and hold fundamentalism or control investing.

        New information is immediately reflected in market prices.  This is probably not so outside of a minute-to-minute trading environment but, in any event, the concept is irrelevant for fundamentalist buy and hold investing.  For fundamental analysts, the key issue is not to obtain superior information, but rather to use the available information in a superior manner, e.g., good fundamental analysts tend to focus on financial strength rather than near term earnings outlooks in the analysis of the vast majority of securities most of the time.

        There is something basically illogical about academic finance's views of the amount of knowledge, or degrees of analytical sophistication, available to passive outside minority investors.  Academic finance assumes that the individual passive investor cannot be particularly well informed but that collectively, all investors appraise accurately and determine a real value for all purposes.  This view of equilibrium pricing seems utterly unrealistic, certainly for anyone who has ever been actively involved in Merger and Acquisitions, Take-overs, Initial Public Offerings or the Restructuring of Troubled Companies.

        So far academics have been right about index investing.  The gravamen of this article is, "How Long Can Their Luck Hold Out?"

        Both Index Funds and Third Avenue Funds share two advantages relative to most other mutual funds.  Because turnover is low for Index Funds and Third Avenue Funds, costs, including trading costs, tend to be low.  Also, because of low turnover, both Index Funds and Third Avenue Funds tend to be tax efficient from the point of view of their shareholders.

        The Managers of Third Avenue Funds are strictly bottom up.  We bring no special expertise to discussions of macro issues and predicting market prices for securities over the near term.  We value businesses and then stop.  We do not predict securities prices; we deal only in probabilities.  Occasionally though, our observations about macro things such as the S&P 500 have been prescient and sometimes we are lucky in our timing.  A good example occurred in May 1997 when the following appeared in the Third Avenue Value Fund semi annual report:

        "Even though I have no specific evidence, I am more convinced than ever that massive securities frauds have to be taking place in a number of largely unregulated stock markets in emerging countries.  In those countries direct investments with local partners is tough enough.  Passive security investments without regulatory controls has to be impossible.  Note that it was securities fraud that precipitated the recent revolution in Albania. Because of this distrust of emerging markets, the Fund sold its position in Emerging Markets Infrastructure Fund common stock."

        We recommend to investors that they switch holdings in the S&P 500 to Third Avenue Funds or other funds that concentrate on Value Investing.  Value investors, by definition, are conscious of the relationship of securities prices to corporate fundamentals.  In value investing, asset allocation is driven more by price considerations and less by predicting outlooks.
 

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