Some institutional investors allocate capital to private-equity firms to take advantage of mispriced assets, under the theory that private markets are less efficient or less costly than public ones. But theory meets practice at New York-based Third Avenue Management, where mispriced stocks and bonds are sifted out of the public markets, not private ones.

On a day in late October 2010, in Manhattan, Third Avenue's chief investment officer and small-cap fund manager Curtis Jensen sat down to discuss Third Avenue Value Fund's value-investing approach to E&P and oilfield-service companies. With $5 billion in assets, its record is legendary.

A glass case adorning the firm's 32nd floor lobby displays books on value investing authored by Third Avenue's founder, Marty Whitman, including one with an introduction by Gene Isenberg, chairman of Nabors Drilling. In the late 1980s, Whitman bought up the debt of Anglo Energy, took control of the company and brought in Isenberg to run what is now known as Nabors Industries.

Whitman has adapted Graham and Dodd principles of value investing to his vast experience in bankruptcy and distressed investing. He emphasizes diligent analysis of financial strength, business soundness and underlying asset value in relation to market prices.

The fund's quarterly reports are laden with rigorous applications of Whitman's rules of value investing. And the rules are many.

Safe and Cheap

"'Safe and cheap' is one of our investment rules," says Jensen, "and our ownership of Cimarex Energy Co. provides a good example of putting this rule into practice." Cimarex represents one of the few E&P equities in the portfolio. The fund bought Cimarex when its public-market value had fallen below its intrinsic value. Fund managers define this measure of cheapness using numerous metrics, including public-equity-market value versus reserves, cash flow and daily production. They also measure it against a variety of private-market transactions; the fund keeps an extensive database to discern value in the market.

One might assume that public stock investors would not keep close track of private-market activities, but here such measures of value provide essential guidance for investment success. The concept of safety applies to the quality of a company's assets, its management team, the underlying business and its potential for growth. Cimarex met all these criteria at the time the fund bought it, though lately it has reduced its position, and the market's recent disappointment with production levels has further trimmed some remaining unrealized gains.

"Safe and Cheap' is one of our investment rules," says Curtis Jensen, chief investment officer and small-cap manager of Third Avenue Management.

The fund sold most of its energy stocks after their representation peaked at 20% to 30% of its total holdings between 2004 and 2008, a heavy overweighting that paid off. Jensen thought that E&P stocks were becoming attractive in 2002 and 2003 due to an improving commodity-price outlook, strengthening E&P companies' balance sheets, and the fund management's increasingly dim view of the U.S. dollar value. He began buying energy stocks in 2003, including Whiting Petroleum, St. Mary Land & Exploration, CNX Gas, Rosetta Resources, Pogo Producing, Suncor, Comstock Resources and Encana, among others. Of these, only Cimarex, Encana and Cenovus remain in its client portfolios today.

Why the change of heart? Jensen says that balance sheets of E&P companies have weakened since the overweighting period and the increasingly heavy use of derivatives by these companies became inconsistent with Third Avenue's value investment principles. He observes, furthermore, that some of the companies the fund owned have gravitated toward a business model of flipping assets rather than growing them, and the change in focus to shale plays, rather than conventional reserve growth, has manifested as a deterioration in balance-sheet quality. If anything, he says, a focus on conventional oil and gas plays has grown more interesting to the fund, though it hasn't yet acted on this observation.

Owning equity in companies with access to capital on a "super attractive" basis is another investment tenet. For example, a New York commercial-real-estate owner, who recently visited the fund, discussed his 10-year, 3.5%-fixed-rate refinancing of a midtown office building. He planned to use proceeds to invest in higher-return opportunities.

While such inexpensive capital can accrue to the benefit of equity owners, cheap capital can also present challenges. Judging by the terms of some recent shale-development transactions, notes Jensen, a capital provider's desire to access technology and know-how can trump its desire to earn a return, particularly compared to the purchase of low-yielding U.S. government treasury bonds.

Low yields on government, municipal and some corporate bond issues stem from the public's understandable fear of revisiting steep equity-market losses, which have not faded from memory. Jensen tags this phenomenon "fixed income fever." Arguably, this fever has contributed to the flow of low-cost corporate funds into oil and gas properties, also spurring the hedging and asset-flipping mode that the fund avoids.

Resource Conversion

"Resource conversion" is another investment tenet at Third Avenue, referring to recycling of assets or capital into a higher and better use. For example, a company with a large working-capital balance may be well-positioned to acquire another company for cash, thus generating substantially more value from assets on its balance sheet.

Jensen points to Encana as an example of resource conversion, with its choice to split into two companies: Encana, the gas company, and Cenovus, the oil company. Some E&Ps have adopted the view that a balanced mix of oil and gas reserves provides diversification to shareholders. But diversification is a much lower priority for Third Avenue than is a strict focus on value. Therefore, when Encana decided to split off oil-concentrated Cenovus, the fund's management recognized it as a terrific example of resource conversion, and capitalized.

Spin-offs have provided additional attractive investment opportunities. Jensen points to the fund's purchase of Comstock Resources a few years ago. He and his colleagues thought that Comstock's 25% ownership in Bois d'Arc Energy was not reflected in the stock's public market price. They bought Comstock under the theory that, if the company needed cash (resource conversion), then it could sell its Bois d'Arc shares (safety), and in any event, the shares weren't fully priced into Comstock's public share price (cheap).

As time passed, Comstock did exactly that, putting its under-valued Bois d'Arc shares to higher and better use and thus benefiting Third Avenue as a shareholder. Similarly, Whiting Petroleum delivered added value by spinning off MV Oil Trust.

"We want to own the equities of well-financed companies," Jensen says, "and the debt of less well-financed companies."

Third Avenue's Focused Credit Fund has a mandate to purchase distressed debt, high-yield debt, and the bonds of companies in special situations. In this corner of the fund, energy represents 10% of the bond portfolio.

It's no surprise, then, that the fund acquired certain Anadarko Petroleum bonds at a significant discount to par in the wake of the BP Macondo blowout. These notes now sell at a premium to par.

In fact, opportunistic credit purchases are another value-investing pattern at the fund. In 2008, the hurricane season presented the opportunity to buy distressed debt, and the fund purchased 8.25% notes of W&T Offshore at a one-third discount to par—notes it still owns today. Third Avenue also bought 10% notes of Energy XXI at a 19% discount to par. Energy XXI then recapitalized, and these notes now trade at a premium, says Jensen.

These bonds are yet another example of resource conversion. The fund's management surmised that a proposed change-of-control covenant in a proposed new Energy XXI bond issue portended asset acquisitions funded with proceeds from a new equity issue. Encouraged by what it discovered during due diligence, the fund bought the discounted bonds and enjoyed subsequent improved credit quality as these higher and better uses of capital became a reality and drove the bonds' value back up to their face amount.

Oilfield-service equities have been a regular holding of the fund for years. It has favored boats and helicopters in the portfolio, with investments in Tidewater and Bristow Group, of which the fund owns 1.5% and nearly 8%, respectively. These businesses present an attractive investment opportunity due to their relatively high barriers to entry, says Jensen. Moreover, Tidewater has consistently earned money through all cycles, even though its share price often doesn't reflect that fact. This disconnect periodically spells further opportunity.

Why invest in small caps? Jensen notes that if you want growth, small caps are more interesting, and the chance of a takeover is ever present. Optionality exists in small caps, either from appreciation of the business, or from the arrival of a buyer, or both. A tenacious focus on cheapness and safety keeps this optionality alive, while a well-run business continues to prosper, regardless of its share price.

Spoken like a true value investor.

Bill Weidner is managing director of New York-based The Rodman Energy Group.

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