Friday, January 28, 2011

Third Avenue Discusses their Leucadia Investment

In the latest annual report for Third Avenue Value, Amit Wadhwaney discusses his fund's investment in Leucadia. Here is the relevant excerpt:

Leucadia National Corp. (“Leucadia”) is a NYSE-listed holding company. Run by Ian Cumming and Joe Steinberg since its founding in the late seventies, Leucadia has compounded the NAV of its portfolio by about 18.5% per annum, on average, over the last 30 years.

Given such a long-term track record, it is hardly surprising that Leucadia’s stock has rarely been inexpensive. There have, however, been opportunities to purchase these shares at attractive valuations following sizable double-digit declines in stated book value, as occurred in 1999 and 2008. In 2008, mark-to-market losses on several of its investments resulted in a decline of over 55% in its stated book value. The company also took sizable accounting write-downs to its deferred tax asset. The resultant negative impacts on reported earnings and book value drew the ire of the market at large, and the company’s stock price plummeted to what we deemed to be unusually attractive levels.

While the mark-to-market declines and writedowns in these various assets conformed to accounting standards, the resultant declines in reported earnings and book value pushed many investors to the exits and provided us with precisely the type of opportunity that we look for – a short-term distraction which allowed us to partner, at bargain prices, with a management team which has proven its ability to grow NAV at truly exceptional rates over the past 30 years.

It was not particularly surprising that Leucadia recognized substantial accounting losses during the depths of the financial crisis, in early 2009. Its portfolio included equity and royalty interests in a large-scale, Australian iron ore mining operation and another base metals mining company, the market values of which had declined reflecting expectations of poor near-term profitability. In addition it held significant investments in a U.S.-based, full-service investment banking and securities firm, which, while its security price declined during the financial crisis,
had employed its strong balance sheet to expand its work force and build its market presence during a period when its competitors closed shop or retrenched. Our conclusion was that these reported losses did not represent a true permanent impairment to the underlying businesses and the long-term fundamentals of the businesses remained attractive.

Additionally, the sizable write-downs of deferred tax assets, which exceeded $1.5 billion in 2008 alone, were prompted by a mechanical interpretation of accounting law; but, had neither any negative effects on cash-flow, nor, we suspected, any longer-term economic repercussions. Presumably, when business conditions were to moderate, these substantial tax assets would once again be available to provide protection from taxes on future realized investment results; and given the aforementioned track record of the company, we believed that the odds of Leucadia delivering value realization in the future were in our favor.

Let us look more closely at these mark-to-market writedowns which helped spark a sell-off in Leucadia’s share price. Did they instill widespread fear in the market? Yes. Would such write-downs be undeniably unpleasant, if not downright scary, for those investors/speculators with shortterm time horizons and/or leveraged portfolios? Certainly. But from Third Avenue’s perspective – that of a long-term, fundamental investor which does not employ financial leverage – these accounting write-downs were merely distractions from the key factors in our analysis, and largely irrelevant to the consideration of economic book values which were considerably longer term in nature.

We find a bit of irony in that last point; specifically, that the environment which scared many investors out of Leucadia stock was precisely the type of environment in which Leucadia has historically been able to sow the seeds of long-term value creation. This point is one that should be clear to anybody who has analyzed Leucadia’s history, but also one which was, to many, drowned out by the noise of reported accounting statistics and general market anxiety. In this case, such noise ultimately lacked relevance to the fundamental, long-term health of the underlying business, and to the key factors which played into our decision to invest. Among these factors were the unusually cheap valuation at which we were able to invest, the longterm track record of value creation and the aforementioned exceptional tax attributes.
As usual, Marty Whitman and the rest of the Third Avenue team not only give you a lot of insight into their own picks but also into the mechanics of good investing. You can read the full report here.