Longleaf Partners Funds 2013 Letter to shareholders
Almost every investment positively contributed to performance in 2013, and the importance of good partners and strong businesses was evident. New leaders quickly improved operations and sold non-core assets to strengthen the balance sheets at Chesapeake, Hochtief , and Level 3. At Philips and Wendy’s, managements focused on the most profitable parts of their businesses while implementing successful programs to increase revenues and margins. We had major asset sales at premiums to our appraisals at Vodafone (VOD) (Verizon Wireless stake) and Graham Holdings (GHC) (The Washington Post).
Competitively advantaged holdings continued to demonstrate the value of moats at FedEx (FDX), Melco, and Texas Industries (TXI). These holdings were among our largest contributors to performance, and they exemplify activity prevalent across most of our holdings throughout the year.
Two years ago, when fears about global uncertainty over sovereign debt and economic recession caused stocks to decline significantly in the third quarter, the final paragraph of our year-end letter contained an emphatic message about the opportunity embedded in our portfolios and that we anticipated exceptional returns.
The subsequent two years were outstanding for equity markets in general and for the Longleaf Funds with returns that far exceeded inflation plus 10%. The Partners Fund gained 54%, Small-Cap 60%, and International 55%. It is rare to generate absolute returns of this magnitude over such a short period, and we are pleased but not surprised at this outcome given our message at the end of 2011.
Today we face an interesting contrast in our performance outlook. While we believe that our returns will continue to meet our goal over the next decade, we expect shorter-term absolute results to be more measured than those indicated in our previous “all-caps message.” Our businesses are not nearly as discounted as they were two years ago, and new investment opportunities that meet our deep-discount criteria are more limited than normal. We do expect, however, to deliver solid absolute returns and compare favorably to the indices going forward. Two years ago we expected large absolute returns without regard to expectations about relative performance. But from this point, assuming stock price correlations trend lower toward long-term averages, we would normally perform better in relative terms. The following factors are the foundation for why we believe we should outperform the indices.
•We own a collection of competitively advantaged, industry- leading companies that produce large amounts of free cash flow (FCF);
•We have more financial strength and flexibility across our holdings to potentially capture future opportunity after significant deleveraging over the last few years from a combination of our portfolio sales and our corporate partners’ divestitures and restructurings;
•Our portfolios are trading for a meaningful discount to our conservative business appraisals;
•We believe the values of our holdings should compound faster than the worth of the collection of businesses in the indices due to anticipated FCF retention and share buybacks at discounts to values;
•We believe we are partnered with superior management teams who are good capital and operating stewards intelligently redeploying FCF;
•We are committed to good governance and will engage with management should the need arise;
• We have the flexibility to invest our portfolios where discounts exist, and are not handcuffed by geographic boundaries or index sector weights.
As we have during previous times when qualifying investments were scarce, cash was elevated, and P/Vs were higher than normal, we will exercise patience and discipline rather than add risk of capital loss by chasing prices for the sake of being invested over a short-term period. Our analysts are doing their homework, appraising businesses and assessing management teams to ensure that when an individual company disappoints, a stock stagnates against a rising value, or the market has a downdraft, we are ready to opportunistically take advantage of volatility and stock mispricing. We never know how the next qualifiers will come our way, but they do show up. The combination of what we own now and what will qualify in the future will determine our relative and absolute return success going forward. A broad market pullback could provide our next qualifiers. We are not market prognosticators, but few markets around the globe can claim undervaluation, and many have pockets of overvaluation. In the event of a correction, short-term performance is likely to decline. Our long-term results, however, will benefit from a lower P/V as we are armed with a vetted wish list of businesses and ample cash to be liquidity providers when new opportunities or existing names are offered at less than 60% of our appraisals. Additionally, lower prices will allow management teams at our current holdings to use their balance sheet strength to execute repurchases at deeper discounts that build values per share more rapidly. An addition to our research efforts planned for 2014 may enhance our list of names that meet our qualitative requirements. We will access investment ideas generated by Pat Dorsey, who developed the “Economic Moat” analysis at Morningstar. In return, Southeastern will provide operational support for his new investment firm. With this partnership, Pat gains Southeastern’s back office expertise, and we expand our idea generation using a method more suited to our criteria than any black-box quantitative screen we could buy. Because Pat’s research fits with only the “Business” part of our “Business, People, Price” criteria, to the extent he surfaces companies with moats that are not already on our on-deck list, we will conduct the same diligence we would with any type of screen or new idea: perform a deep-dive analysis of the business, determine a conservative value, and rigorously assess management.
The qualitative strength of the businesses and management partners that drove our 2013 results remains firmly in place and should help us deliver strong relative results going forward as well as meet our absolute return objective over the long term. We believe that the values of our companies will be materially higher in five years. Additionally, we are continually pursuing new opportunities and are prepared to capitalize when qualifiers emerge. We are glad to be your largest partner in the Longleaf Partners Funds and appreciate your long-term investment commitment.
See following page for important disclosures.
Happy New Year,
O. Mason Hawkins (Trades, Portfolio), CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.
January 24, 2014
The Longleaf Partners Funds are subject to stock market risk, meaning stocks in the Fund may fluctuate in response to developments at individual companies or due to general market and economic conditions. Also, because the Funds generally invest in 15 to 25 companies, share value could fluctuate more than if a greater number of securities were held. Mid-cap stocks held by the Funds may be more volatile than those of larger companies. With respect to the Small-Cap Fund, smaller company stocks may be more volatile with less financial resources than those of larger companies. With respect to the International and Global Funds, investing in non-U.S. securities may entail risk due to non-US economic and political developments, exposure to non-US currencies, and different accounting and financial standards. These risks may be higher when investing in emerging markets. The annual expense ratios for the Longleaf Partners Funds are Longleaf Partners Fund 0.92%, Longleaf Small-Cap Fund 0.91%, Longleaf Partners International Fund 1.27% and Longleaf Partners Global Fund 1.65% (1.73% before fee waiver, which is voluntary and expected to continue until average net assets exceed $112 million and expenses fall below the 1.65% cap).
The S&P 500 Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P is designed to be a leading indicating of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3,000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. MSCI EAFE Index (Europe, Australasia, Far East) is a broad based, unmanaged equity market index designed to measure the equity market performance of 22 developed markets, excluding the US & Canada. MSCI World Index is a broad-based, unmanaged equity market index designed to measure the equity market performance of 24 developed markets, including the United States. An index cannot be invested in directly. P/V (“price to value”) is a calculation that compares the prices of the stocks in a portfolio to Southeastern’s appraisal of their intrinsic values. The ratio represents a single data point about a Fund and should not be construed as something more. P/V does not guarantee future results, and we caution investors not to give this calculation undue weight.
As of December 31, 2013, Chesapeake represented 7.2% of the Partners Fund and 4.3% of the Global Fund. Hochtief represented 3.3% of the International Fund and 1.8% of the Global Fund. Level 3 represented 5.8% of the Partners Fund, 7.0% of the Small-Cap Fund, and 10.9% of the Global Fund. Philips represented 4.9% of the Partners Fund, 5.3% of the International Fund, and 1.7% of the Global Fund. Wendy’s represented 1.8% of the Small-Cap fund. Vodafone represented 3.7% of the International Fund. Graham Holdings represented 6.9% of the Small-Cap Fund. FedEx represented 6.9% of the Partners Fund and 2.6% of the Global Fund. Melco represented 7.3% of the International Fund and 4.9% of the Global Fund. Texas Industries represented 12.5% of the Small-Cap Fund. Fund holdings are subject to change and holding discussions are not recommendations to buy or sell any security. Current and future holdings are subject to risk. Funds distributed by Rafferty Capital Markets, LLC