Longleaf Partners Fund finished the year up 4.92% after a 1.46% gain in the fourth quarter. These results fell below the S&P 500’s returns of 13.69% and 4.93% for the same periods. During the first half of the year, the Fund kept pace with the Index despite having a greater than 20% cash balance. In the second half of 2014, the Fund lagged the S&P 500’s advance largely due to our energy-related holdings, which were leading contributors in the first half but sold off with the sharp decline in oil prices. We are disappointed in the recent performance, but remain confident in the quality of our businesses and management partners in the portfolio. For the last five years, Longleaf Partners Fund exceeded our annual absolute return goal of inflation plus 10%, despite falling short of the Index. Over longer term periods of 15+ years shown below, the Fund surpassed the Index.
Longleaf Partners: Level 3 Communications
Fiber and networking company Level 3 Communications gained 49% and led the Fund’s performance for the year and the fourth quarter, up 8%. Level 3 provides critical infrastructure that connects businesses and consumers to the internet, allowing them to move voice, video and data. The company’s acquisition of tw telecom closed in the fourth quarter, significantly expanding its network reach in metropolitan markets and providing additional capacity to grow its enterprise customer base. Throughout the year, CEO Jeff Storey and his team delivered solid revenue growth, margin improvement, and higher free cash flow. The stock remains well below our value of its operating networks and non-earning dark fiber and conduit assets and is the Fund’s largest holding.
Longleaf Partners: FedEx
FedEx rose 22% for the year and 28% in the fourth quarter. The company expanded operating margins in its Express, Ground and Freight segments over the year and executed on profit improvement initiatives. EPS (earnings per share) grew as did our appraisal. The company repurchased close to 10% of its shares. FedEx moved to further entrench itself in Ground delivery through expansion capex and the acquisition of Genco, which handles reverse logistics for retailer returns. FedEx expects to benefit over the next year from a healthy U.S. economy and lower fuel prices, which improve the relative cost of faster delivery via planes at a premium versus slower shipping via boats.
Longleaf Partners: Berkshire Hathaway
Berkshire Hathaway appreciated 28% for the year after its fourth quarter gain of 10%. The company’s underlying operating businesses performed well. In insurance, GEICO revenues grew 10% driven 2/3 by units and 1/3 by pricing. Reinsurance endured no major catastrophes and some positive currency impact. BNSF grew 4% with gains in both volume and pricing. In the fourth quarter, Berkshire announced the acquisition of Duracell from Proctor & Gamble in a tax efficient exchange for appreciated Berkshire stock. The stock reached our appraisal, and we sold it. Berkshire rarely sells at enough of a discount to meet our criteria given its quality businesses and management, but we were able to purchase it for the second time in our history in 2012. The stock returned over 89% in our two year holding period.
Longleaf Partners: Cheung Kong
Hong Kong based conglomerate Cheung Kong gained 15% in the year. Over the course of 2014, results at most of the company’s operating divisions were strong. Additionally, management made several value-enhancing asset sales across multiple business lines at low cap rates and used proceeds to opportunistically reinvest in discounted infrastructure deals outside of Asia with double-digit IRRs (internal rates of return). Management also returned proceeds to shareholders in the form of dividends. Most recently, in a joint venture with Mitsubishi Corp, Cheung Kong bought an airplane leasing portfolio. With its strong balance sheet, Cheung Kong can take advantage of Hong Kong land banking opportunities if prices correct.
Longleaf Partners: Aon
For Aon, the world’s largest insurance broker and a leading benefits manager, increasing cash flow and healthy share repurchases helped our position gain 8% in the fourth quarter and 14% for the year. Aon’s private health care exchange business increased its scale, adding more than a dozen clients and aggressively growing the market. The company, led by CEO Greg Case, used $1.8 billion to repurchase almost 7% of shares in the first nine months of 2014, the highest amount since 2008. Aon authorized an additional repurchase plan of up to $6.1 billion, roughly 24% of outstanding shares.
Longleaf Partners: Performance detractors
Four of the five primary performance detractors for the year were energy-related businesses that sold off with the 49% decline in oil in the second half. Our investments do not reflect any special affinity for oil and gas. We own a select combination of companies – Chesapeake, Murphy Oil, CONSOL Energy, and Diamond Offshore via Loews – because we feel they have the asset bases, financial ability, and disciplined managements to reinvest in production at returns well above their costs of capital. Our management partners are controlling costs and making value additive divestitures. Our conservative appraisals use the lower of the marginal cost of production or the futures strip to price oil and gas. Because the strip has fallen below the marginal cost, we lowered our assumptions, but our adjustments were much smaller than the stock price declines. Over the next few years supply and demand should recalibrate and cause commodity prices to settle near the cost of production. The timing is unknown, but the upside from the current strip pricing combined with the proactive work of our CEO partners presents a compelling opportunity for long-term investors.
Chesapeake declined 21% for the full year and 14% in the fourth quarter. Since Chesapeake’s heavily vested Board took over in mid-2012, the company has delivered the balance sheet and improved production from its irreplaceable 12 +million net acres of oil and gas fields. CEO Doug Lawler is driving value recognition in ways he can control – selling assets at reasonable prices, reducing debt, and increasing operating efficiencies in both corporate and production activity. In the first half of the year, Chesapeake sold non-core acreage in Oklahoma, Texas, and Pennsylvania and spun-off its oilfield services business into Seventy-Seven Energy, which we sold. In the fourth quarter, Chesapeake closed the sale of Marcellus and Utica assets to Southwestern Energy for $5 billion. This amounted to roughly 8% of Chesapeake’s production for nearly half its market cap. Management announced plans to use $1 billion of the proceeds to repurchase the heavily discounted shares.
Despite being up 1% in the fourth quarter, Loews, the holding company owned and managed by the Tisch family, sold off with energy and was down 12% for the year. The company’s CNA insurance unit generated strong cash flow, but its stakes in energy companies Diamond Offshore (DO) and Boardwalk Pipelines Partners (BWP) declined 30% and 29% respectively. DO has the strongest balance sheet among drilling rig operators and should be able to upgrade its fleet cheaply as distressed sellers seek capital. BWP cut its dividend to invest in additional service points along its pipeline and expand its ability to transport gas from the