Across the Funds, the primary performance detractors were our U.S. energy holdings and several companies with challenges in specific emerging markets. In spite of the negative impact on our third quarter returns, we continue to have strong conviction in the intrinsic worth and quality of these positions for several reasons. First, our conservative assumptions already embedded the lower forecasts that the market was just digesting. Second, macro-driven pressures that hurt broad industries did not impact the prospects for our specific holdings – our appraisals are not necessarily correlated to the macro factors currently undermining stock prices. Third, those company-specific challenges that emerged were temporary or focused in business areas that were minor parts of our appraisals.

Mason Hawkins

Not only did those companies under the most price pressure meet our operating expectations, but their upside prospects increased due in large part to the actions of our CEO partners. To provide insight into these positions and why we continue to have long-term conviction in their potential to outperform, we discuss them below.

Mason Hawkins: In the U.S.

The worst performing sector in the S&P 500 and MSCI World Indices was energy, down 9.1% and 9.5% respectively. With the unusually cool summer, natural gas prices fell 7%, crude 13%, and coal 13%. Within the sector, exploration and production companies (E&Ps) such as Chesapeake and Murphy, as well as coal stocks, including CONSOL Energy Inc. (NYSE:CNX), suffered more than the average, which was helped by subgroups such as refining and storage and transportation. While lower energy prices rather than company-specific disappointments in our energy names drove declines, they did not impact our appraisals of these three companies because our models already incorporated lower commodity prices based on the futures curve pricing and the marginal cost of production in our various plays. Higher commodity prices would likely lift their stocks, but these three companies do not require a rise in energy prices for intrinsic values to be recognized. At Chesapeake, CEO Doug Lawler is continuing to drive value recognition in ways he can control — selling non-core assets at reasonable prices, reducing debt, and increasing operating efficiencies in both corporate and production activity.

He is building additional upside with $2-3 billion of annual discretionary capital spending that management projects should deliver strong returns on capital, even without higher commodity prices. Neither is Murphy’s CEO, Roger Jenkins, relying on higher commodity prices for value recognition. The company is selling its UK downstream assets and announced the sale of 30% of its Malaysian assets at a price above our appraisal. Moreover, Jenkins built value by repurchasing shares as they became more discounted, a move he properly viewed as buying their proven barrels of oil for much less than it would cost to drill new wells or buy other plays. CONSOL is more than its category of “coal and consumable fuels.” In fact, management has been selling coal assets, and more than half of our appraisal is attributable to gas reserves in the Marcellus and Utica shale plays. To monetize production value in the recent quarter, Executive Chairman Brett Harvey and CEO Nick Deluliis successfully IPO’d a midstream Master Limited Partnership (MLP) at metrics above both our appraisal and the projected price. The company’s variety of assets, including the Baltimore port terminal, provide multiple options for gaining value recognition without reliance on commodity price increases.

Mason Hawkins: Outside the U.S.

At least one of three significant performance detractors outside of the U.S. impacted the Small-Cap, International, and Global Funds. In spite of their stock declines, these companies met our underlying business expectations during the quarter. They are diverse businesses but faced various emerging market uncertainties in addition to currency pressures and company-specific issues. In each case, management is taking the initiative to overcome current market perceptions through discounted buybacks, productive capital investments, and/or value accretive transactions.

Melco International Development Limited (HKG:0200), the Macau gaming company held in the International and Global Funds, fell alongside all Macau gaming stocks. A meaningful drop in VIP visitors has led to lower revenues. The causes include China’s crackdown on corruption causing wealthier people to keep a lower profile away from Macau, slower Chinese economic growth hurting property sales that boosted gambler credit, and liquidity challenges faced by junket operators who organize VIP visits and extend credit to them. Other pressures impacting the stocks are difficult to quantify, such as tighter transit visa requirements, wage inflation and labor unrest, UnionPay credit card restrictions, and a smoking ban starting in October. The negative news flow did not impact our conviction in Melco.

Mason Hawkins

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