Longleaf Partners Funds’ letter to shareholders for the fourth quarter 2014.
After strong returns across all the Longleaf Partners Funds in 2013, only the Small-Cap Fund in 2014 exceeded its benchmark index and our absolute return goal of inflation plus 10%. We are not pleased with the results in our Funds outside of Small-Cap over the last twelve months, but we do welcome the increased volatility and opportunity created as broad markets and stocks within those markets began to diverge in the second half of the year.
We are seeing strong parallels in current markets versus the late 1990s that lead us to believe we will be returning to an environment where the merits of individual holdings are more likely to be properly weighed by the market and value investment approaches are more likely to be rewarded with solid absolute and relative returns. Based on the underlying fundamentals at our companies, the actions our management partners are taking, and the broader investing environment, we are confident that our portfolios are positioned for successful long-term compounding.
Longleaf: Drivers of 2014 Results
Over our nearly 40 years of investing, Southeastern has built the Longleaf Funds’ portfolios from the “bottom up” as we find stocks that meet our criteria of strong businesses, good people, and deeply discounted prices. In 2014, our fundamentals-based approach was rewarded in the Small-Cap Fund, which benefited from merger and acquisition activity that helped drive double-digit returns in spite of average cash of more than 30%. In our other Funds, various individual holdings gained more than 15%, including Level 3, FedEx, Berkshire Hathaway, and Cheung Kong, as investors began to appreciate how our management partners had positioned their companies for value growth. Unfortunately, three broader portfolio exposures – cash, international exposure to both currency moves and emerging market challenges, and energy – overshadowed strong individual stock returns. In spite of the macro pressures, however, we have rarely been as universally pleased with the activity at our underlying companies.
The first detracting exposure – cash – impacted all of our Funds. We held higher-than-normal liquidity at the outset of the year after we sold fully valued equities and found few qualifying new opportunities. In the Partners Fund, cash averaged more than 20%, impacting relative results as the S&P 500 rose 13.7%. In our other Funds, the first half cash drag was somewhat offset after small cap and non-U.S. indices tumbled in the third quarter. As we’ve written previously, while a higher cash balance can be a drag on returns in the short term, over the long term the benefits of avoiding lower quality investments and having the flexibility to take advantage of buying opportunities during market dislocations are, we believe, key drivers of outperformance.
Second, our exposure to businesses operating outside of the U.S. weighed on our results primarily due to the strong U.S. dollar (USD) and increased regulatory and economic controls in China. In 2014, all four Longleaf Funds contained companies based outside of the U.S. given the more deeply discounted, high quality opportunities currently available in other parts of the world. The Global Fund held more than 60% outside of the U.S., the Partners Fund held European domiciled global businesses such as Philips, Vivendi, and CNH, and the Small-Cap Fund held OCI, Hopewell, and Fairfax. The strength of the USD versus the euro negatively impacted all four Funds. In the Global Fund our returns based in local currencies were positive but fell below zero when translating performance into USD. Likewise, more than half of the negative return in the International Fund was attributable to currency translation into USD. Separately, increased government scrutiny and regulation in China hurt all Macau gaming companies indiscriminately and made our stakes in Melco and Galaxy via K.Wah primary performance detractors in the International and Global Funds. Even in the storm of worry that labeled 2014 a disastrous year for Macau gaming, overall revenues fell less than 3%, the number of visitors rose, and mass (as opposed to VIP) revenues grew double-digits. The Chinese government has demonstrated its long-term support of Macau with massive infrastructure projects. We are excited to own these businesses as increased accessibility and additional room supply should enable mass revenue to continue to rise at healthy levels. China’s slower growth in 2014 also hurt iron ore prices negatively impacting Manabi in the International Fund. Lower ore prices combined with the weak Australian dollar, caused our position in Mineral Resources, held in both the International and Global Funds, to suffer even though the company’s services revenues usually increase with lower iron ore pricing.
Energy was the third broad exposure that hurt the Partners and Global Funds. 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. When oil prices fell 49% in the second half of the year as increasing supply began to exceed demand, stock prices did not discriminate. Low cost producers, higher quality assets, proven management teams, and even energy companies without oil properties such as CONSOL experienced similarly correlated declines. In a year where M&A activity and announced spinoffs massively benefited the Small-Cap Fund, brilliant, value additive divestitures by our energy companies – Chesapeake’s sale of Marcellus and Utica assets, Murphy’s partial sale of Malaysia, and CONSOL’s announced IPOs (initial public offering) of multiple segments – were not only unrewarded in the market, but seemingly punished.
Although our minimal exposure to healthcare did not impact absolute results, this major driver of the S&P 500, Russell 2000, and MSCI World indices hurt relative returns. Healthcare companies rarely meet our criteria because of the uncertainties in appraising government control over providers, pharmaceutical pipelines, biotech discoveries, and technological obsolescence in medical equipment. During 2014, acquisitions in this sector heated up, with deal multiples moving well beyond norms, driven in part by tax inversion initiatives. Indicative of the heated environment, the stocks of buyers paying those huge multiples were often immediately rewarded, which is unusual and not likely to remain the case. Similarly, the difficulty in appraising the future of information technology companies kept us out of that sector, which was a strong performer in the U.S. and global indices, driven by a limited number of tech stocks that rose over 25%.
Longleaf: Reminiscent of the late 1990s
Our 2014 results and the environment driving them are strikingly similar in a number of ways to the late 1990s. While multiples have not reached the extremes that developed in the dot.com bubble from mid-1999 through March 2000, we see many parallels in the broad market and in the factors impacting our portfolios. In the latter half of the 90s, the U.S. was in a multi-year bull market with low dispersion, little volatility, and momentum investing sending large-cap stocks ever higher while fundamentals at individual companies mattered little. Consider the following comparisons:
- The S&P 500 was up double digits for five consecutive years at the end of 1999. In 2014, for the first time since 1999, and only the second time in our 40 years, the index posted three consecutive years of double-digit returns.1
- Small cap stocks substantially underperformed large caps, with the gap between the Russell 2000 and S&P 500 at more than 31% in 1998. The almost 9% gap in 2014 was the largest since then1.
- The Partners and Small-Cap Funds contained considerably elevated cash levels in both periods because few stocks traded with the margin of safety to meet our requisite discount.
- Stocks outside the U.S. were dramatically more undervalued. The EAFE Index fell short of the S&P 500 by more than 31% in 1997, the largest disparity until it underperformed by more than 18% in 2014.1
- The U.S. dollar index rose just over 13% in 1997 and just under 13% in 2014.2
- We held 29% of Longleaf Partners Fund in companies domiciled elsewhere in 1998 because of the opportunity set disparity. The Partners Fund today has 25% in foreign holdings.
- Oil prices declined more than 39% during 1998 and 49% in the last six months of 2014 and negatively impacted our energy related holdings in both periods.2
- We delivered strong three and five year absolute returns that surpassed our goal of inflation plus 10% in the Partners Fund, but underperformed the index in 1998, 1999, and 2014.
- Only 14% of U.S. large cap managers beat the S&P 500 in 1997: the next-lowest level was 16% in 2014. Large cap value managers faced even worse odds – fewer than 5% outperformed in 1997 and only 10% in 2014.3
- The market cap weighted S&P 500 rose 28.6% in 1998 while the equally weighted Value Line Index, which is more representative of the average stock, fell 3.8%. Though not as dramatic, the gap in 2014 was meaningful: 13.7% versus 3.1% respectively.2
Much like today, after widespread underperformance in a stock run that distinguished little among company fundamentals, many investors in the late 1990s moved into what had done well, including passive strategies in U.S. large cap equities. The momentum of more money flowing into the largest and most expensive stocks forced the cap-weighted S&P 500 to add more to those stocks, driving prices well beyond the values of the underlying businesses. Although relative returns versus the S&P 500 were worse in the late 90s, today the outcry for passive over active and the strong consensus that active is a waste of time (especially in U.S. large cap) are even louder as fund flows indicate. Passive fund flows grew more quickly than active flows in the previous era, but over the last five years, passive funds, including the expanded universe of ETFs, increased inflows as active funds had net outflows each year.4
The 1990s momentum-driven virtuous circle continued until the dot.com bubble exploded in March 2000. In the multi-year period that followed, individual company qualities and valuations mattered, and the relative performance of proven active managers versus passive indices reversed itself, as we believe it will again. As our long-term partners would expect, at this moment of weak relative performance with active management in disrepute, our optimism about future relative performance is exceptionally high.
The lesson from the 1990s aftermath and from the Small-Cap Fund’s results in 2014 is that underlying corporate values eventually get reflected in stock prices, although nobody knows what the payoff pattern will be in any given year. Our management partners are not simply waiting for a more favorable environment. Where prices are strong, they are selling assets, spinning off segments, or creating high-yielding structures. In the pockets of price weakness, managements are using their financial flexibility to initiate buybacks of their discounted shares, some for the first time. They are opportunistically increasing values per share for a potentially larger ultimate payoff. In many cases, our partners are backing up their corporate conviction with meaningful personal stock purchases.
Similar to the late 1990s, recent returns do not adequately reflect the underlying progress our companies made during the year. We believe the Funds are well-positioned to deliver solid absolute and relative returns over the next five years. We own more competitively entrenched businesses at more deeply discounted prices than the indices. Our management teams are more capable, and our underlying corporate values are growing. As the largest investors across the Longleaf Partners Funds, we are highly confident that our longstanding investment discipline will reward those who are patient as it has done over the long term.
O. Mason Hawkins, CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.
January 20, 2015