Mason Hawkins Q2 letter to shareholders is out, below is the full thing.
The relative underperformance in the quarter came as much from what we did not own as from price moves in our names. The financial sector, specifically banks and life insurers whose leverage is too risky for our appetite, drove a large portion of return in U.S. and global indices as interest rates bumped up. Our cash position built during the first quarter with sales of businesses approaching our appraisals and dampened our performance relative to the rising indices. Various individual holdings detracted from second quarter returns, and most of those were retreats from recent strong rallies. No common denominator impacted our primary performance detractors.
Any single quarter usually indicates little about our long-term results. Rarely in Southeastern’s 38 years have our 1, 5, and 10 year returns simultaneously lagged the benchmark, but currently the Partners Fund is in such a period. Longleaf International faced this same challenge within the last twelve months before its relative returns improved. While absolute returns are our primary focus, underperforming the market over these periods is disappointing and unacceptable, but not unprecedented. When we had a similarly tough stretch in 2000, the Partners and Small-Cap Funds fell behind their benchmarks for 1, 5, and 10 year periods by a much wider margin than today’s Partners Fund lag. Then and now, the combination of a few stock-specific challenges and an extreme market environment that rewarded a narrow segment of stocks caused our underperformance. In 2000, the high-flying growth and Internet stocks selling at nosebleed multiples propelled the market, while we owned high quality businesses that sold at attractive discounts because they were part of the “old economy.” A few troubled visible names also hurt our performance (Waste Management, Host Marriott, SafetyKleen). During the last five years, higher yielding, stable “safe stocks” became overvalued and led the market in an environment plagued by fear and volatility. We own steeply discounted, more cyclical companies with high quality assets and/or entrenched competitive advantages. A few troubled, visible names have caused a large portion of our longer term underperformance both in the U.S. (Dell, Chesapeake, Level 3) and outside the U.S. (HRT). Within five years of the 2000 period, the Partners and Small-Cap Funds had dramatically outperformed their indices with 5 and 10 year numbers far higher than their benchmarks. Today, we believe our absolute and relative return opportunity for the next five and ten years is equally as bright across all four Longleaf Funds for several reasons.
First, equities should have a strong tailwind with earnings yields still much more attractive than 10-year government bond yields. We presented the information on the attractiveness of equities in mid-June of last year at the Morningstar conference (see following page). The essence of our presentation was that 1) investors would prefer 8-9% aftertax, growing free cash flow coupons from business ownership to the 1.6% taxable, fixed coupons from 10-year treasuries; 2) equities would significantly outperform fixed income; and 3) investors would lose money in intermediate to long-dated bonds. Since that time, spreads have narrowed, 10-year treasuries have fallen 5%, stock market gains have been over 20%, and the Longleaf Funds have delivered strong absolute and relative results, despite the weak second quarter.
Second, those qualities that guided our successful historic results and attracted you to Southeastern and Longleaf remain firmly in place. A disciplined, long-term, concentrated partnership approach has defined our firm since 1975. Our core investment criteria remain good business, good people, and good price, and our research-intensive, team-driven process is intact. The leadership team who created our successful multi-decade record remains fully engaged and committed. Few firms can boast a consistent culture and stable management for almost four decades. Even fewer are as aligned with clients given our unique ethics policy mandating that, unless granted an exception, all of our public equity money be invested in the Longleaf Partners Funds.
Our third reason for confidence is that the quality and accuracy of our research continues to improve. We have gained knowledge, experience, and an expanded network of contacts over the last 38 years, and, more importantly, we have addressed where our investment execution has fallen short. Since Southeastern’s inception, we have focused on Ben Graham’s imperative that every investment should qualify quantitatively and qualitatively. We believe few investment organizations have more thorough quantitative appraisal methodologies, more extensive comparable transaction data bases of business sales, mergers, buyouts, and liquidations, or more significant “margin of safety” requirements for value over price. However, any appraisal incorporates critically important qualitative assumptions about a company’s future competitive position and management’s ability to effectively operate and wisely allocate capital for prudent building of intrinsic value per share. When we have assessed these mandatory qualitative factors well, we have had huge investment success as with DIRECTV (DTV), Disney (DIS), Yum! Brands (YUM), Texas Industries (TXN), Dillard’s (DDS), Philips, and Fairfax (FFH), which have been among our strongest performers over the last decade. Where we have been wrong on our qualitative inputs, our returns have suffered, as with Dell (DELL), Chesapeake (CHK), Level 3, and HRT. To further improve our investment execution and results, we will be laser focused on whether a company’s competitive advantages are strengthening; management is operating effectively; and the board and CEO are wisely deploying the business’ financial resources. If an investee falls short on any of these critical necessities, we will move with alacrity to rectify the shortcoming or exit the investment.
As with all of our investments, the companies we highlighted as disappointments initially met our quantitative hurdles, had competitive advantages versus peers, and were led by CEOs with histories of building value for shareholders. What separated the winners from the losers over time was not the quantitative, but rather management’s ability to overcome challenges and generate value growth over time. As we analyze what has worked and what has not, we have enhanced our process in various ways to emphasize the qualitative and more quickly identify shortcomings in our cases and management teams. We have taken an even more skeptical view of managements without ownership and/or heavily aligned incentives (particularly in Japan), companies with substantial debt/enterprise value (limited flexibility in adversity even with great assets), and asset-rich businesses that produce little cash flow (too reliant on things going right). The team tracks monthly values to emphasize value growth in addition to the P/V discount. Analysts present a formal reassessment of at least one existing holding at every weekly research meeting. We have broadened the devil’s advocate role to identify risks to what we currently own as well as to new ideas. We will not add to a position when value is declining or a case is uncertain. We will avoid being seduced by more attractive P/Vs if generated by lower prices without higher values. As indicated by our recent actions to improve governance at Chesapeake, Level 3, and HRT, and to fight the Dell buyout, we are holding CEOs and boards more accountable for doing what they promise and delivering what we expect in a timely manner. We believe in a long-term time horizon for stock returns – we are less patient about value growth. We will exit more quickly – as we did within a few quarters at Republic Services, Leucadia, Vivendi, and Anglo American last year – when competitive advantages or values appear at risk and we do not believe becoming more active would yield results.
The fourth and most important determinant of our future returns will be the investments we own. Most of our holdings and CEO partners remain low profile because they deliver results over time. Our portfolios contain a collection of high-return franchises, at attractive multiples of free cash flows and/or deep discounts to asset values, with capable partners at the helm. In addition to the aforementioned proven winners that we own, the Longleaf Funds’ investments include companies that meet our qualitative hurdles such as the number one global insurance broker, the world’s dominant logistics and package delivery business, a top provider of corporate financial services, market-leading snack and coffee brands, several cement and aggregates leaders, topperforming non-life insurance underwriters, the strongest set of ski resort properties in the U.S., premier global engineering and construction firms, one of the world’s largest agricultural equipment manufacturers, and the most successful Asian gaming companies. Most of our corporate partners are properly aligned and are growing value per share as they successfully manage in a slow-growth environment and reinvest capital at attractive rates of return. Where results are not meeting expectations, we are engaged with management to evaluate their action plan and whether the case still meets our investment criteria. At the companies where we have successfully sought changes, we believe that new leadership has the skills to increase returns on capital and free cash flow from the best-in-class assets they oversee. They have the owner-orientation to build intrinsic value. Both Southeastern and their boards will hold these leaders accountable.
Our investments should succeed if we buy businesses that, in addition to having a margin of safety in the price, also have competitive positions that will be stronger three years out and have leadership with the ability and commitment to prudently grow value per share. We are on track to deliver strong absolute results this year and are highly confident that our disciplines and current investments will post future relative returns that meet your and our long-term expectations.
Sincerely,
O. Mason Hawkins, CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.
July 30, 2013
