Vulcan Value Partners letter to investors for the second quarter ended June 30, 2016.
Vulcan Value Partners – Portfolio Review
All strategies produced negative returns and trailed their respective benchmarks during the second quarter. Our disappointing second quarter results should not influence your evaluation of Vulcan Value Partners, nor should our very good first quarter results. As we have often said, we place no weight on short-term results, good or bad, and neither should you. In fact, we have made and will continue to make decisions that negatively impact short-term performance when we think we can improve our long-term returns and lower risk. We encourage you to place more weight on our longer term historical results and a great deal of weight on our long-term prospects.
All five of our investment strategies have produced exceptional long-term returns and, once again, all five strategies are in the top 15% of their peer groups since inception, with Large Cap in the top 1%. These results are detailed in the table below.
The second quarter was dominated by macro concerns. The quarter began with intense speculation that the Federal Reserve would raise interest rates and ended with global market upheaval from the UK’s decision to exit the EU, or “Brexit”. At the end of the quarter, developed nations’ government bond yields were plunging worldwide with the futures market pricing in only a 16% probability that the U.S. Federal Reserve would raise rates again in 2016. Ten-year government bond yields were 1.47% in the U.S., 0.86% in the UK, -0.14% in Germany, and -0.24% in Japan as the second quarter ended. Also, the U.S. dollar rallied again against a steep drop in the pound and euro on the Brexit news late in the second quarter.
Most of the time, the macro environment is noisy and contradictory. We pay attention to outliers, and Brexit is an outlier that few people were expecting. Said another way, it is a real event. As a result, there are greater risks that the EU eventually could disintegrate and that the UK itself could break apart. These are risks, not forecasts. In the short run, several outcomes are likely. The UK should enter into a mild recession with real estate taking the brunt of the pain. Eurozone growth should slow further from its anemic pace, and the strong U.S. dollar should pressure U.S. corporate earnings for the third year in a row. The U.S. economy overall should feel minimal impact from Brexit, but slower global growth and a stubbornly strong dollar should create additional headwinds to earnings growth.
At the portfolio level, Brexit-centered volatility gave us a brief but meaningful window to reallocate capital to more discounted companies, lower our price to value ratios, and become more fully invested. These changes were especially welcome in Small Cap where we have struggled to find qualifying investments at sufficient discounts for some time. As you might expect, we allocated capital to several UK based companies, some of which we have owned in the past. The drop in the pound hurt our quarterly results, but it was not material. More importantly, the majority of companies we purchased in the UK generate most of their profits outside the UK, so the falling pound did not impact our values. Stable values and falling prices create opportunities for long-term investors.
Several companies, including Oracle, our largest position, exceeded our expectations when they reported earnings in the second quarter. A few, including Fossil, reported results that disappointed Wall Street (but were consistent with our expectations). Most of our companies performed as we expected. From an earnings perspective, the post-Brexit external environment overall is more challenging than it was pre-Brexit. Despite a more challenging macro environment, we expect our companies to grow their values in 2016. While we can never predict the timing of returns, growing values and deeper discounts lower risk by increasing our margin of safety. Our long-term prospects are promising as values continue to grow and discounts are materially deeper than they were a couple of years ago. Keep reading for more detail.
As evidenced by extremely low government bond yields, strong results from defensive sectors such as utilities, and very high valuation levels for other defensive sectors such as consumer staples and REIT’s, investors are paying a lot for “less risky” assets. Ironically, the high prices being paid for those assets make them very risky indeed. Their prices can keep going higher in the short run. The 10-year U.S. Treasury yield has declined from 2.27% at the beginning of the year to 1.47%, its biggest rally in six years. With the Federal Reserve targeting a 2% inflation rate, investors in U.S. Treasuries are locking in a negative real return of roughly half of 1% over the next ten years. It could be a lot worse if inflation overshoots on the upside. Investors in UK 10-year gilts are getting less than 1%, and German, Japanese, and Swiss investors in government bonds are accepting negative nominal interest rates. As this letter is being written, $11.7 trillion dollars of sovereign developed world debt has a negative yield.
To repeat, investors in much of the developed world are accepting negative absolute and real returns. They are paying the government to take their money. These statements sound crazy and they are. We have become accustomed to these unprecedented times, so it bears noting that these conditions are crazy and we believe it will end very badly. What rational investor would accept a guaranteed negative return for ten years or for fifty years in Switzerland? Investors placing trillions in yen, euros, Swiss francs and U.S. dollars are doing just that. We are not among them.
In contrast, we own the “risky” assets including financials, technology stocks, U.S. dollar exposed industrials, and more recently, UK based businesses. These “risky” companies sell for extremely compelling valuation levels, especially compared to the prices paid for “less risky” assets. They produce ample free cash flow, which is being used to repurchase discounted shares, pay dividends, and occasionally to make acquisitions. This free cash flow belongs to us as shareholders, and it is being returned to us in one form or another in an intelligent way by our companies’ outstanding management teams. (As an example, please see the following discussion on Oracle in the Large Cap review.) In addition, our companies’ pricing power will serve us very well when inflation inevitably returns. Investors in “less risky” fixed-rate government bonds will see dramatic losses from their “risk free” bonds.
In the short run, the market does not like what we own. Our prices overall are down while “less risky” assets have delivered strong returns. Our values, however, are rising. Consequently, our price to value ratios are improving, which lowers risk and improves our long-term prospective returns. In fact, our price to value ratios have improved roughly 10 points across all strategies (except Small Cap, which has improved 5 points) over the last couple of years. This improvement has occurred despite a lackluster global economy and a strong U.S. dollar. Given this steady improvement and the margin of safety we enjoy, we would much rather own our portfolios than the overvalued “less risky” assets that are working in