Vulcan Value Partners first quarter letter.
We will go into more detail below, but the summary of the first quarter is that the market rewarded businesses that we had no desire owning and punished the outstanding businesses that we were happy to own as long-term investors. Our businesses continued to compound their values and their prices fell. As a result, we improved our margin of safety, reduced risk in the portfolios, and improved our prospective returns. The cost was poor short-term performance. It is a cost we have paid in the past (2007) and will happily pay again in order to produce superior long-term risk adjusted returns.
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.
Our results are detailed in the table above. You will note that our long-term performance and peer rankings remain outstanding (Focus is literally #1 among its peers), which proves the point that superior long-term performance can only be achieved by executing a consistent investment philosophy even when it is at odds with “what is working” in the short run.
We are more concerned with risk than we are with returns. We reduce risk by limiting our investments to extremely high quality companies whose values are inherently stable. We further reduce risk by demanding a discount to those stable values. When prices fall and values rise, as occurred during the first quarter, our margin of safety improves and risk is reduced.
Our preference is to reduce risk by lowering our weighted average price to value ratios and thereby improving our portfolios’ margin of safety. When larger discounts are not available, we hold smaller positions in the deepest discounts we can find. That is, we acknowledge reality and hold smaller stakes in admittedly less discounted companies. As a result, we will lower risk through increased diversification¹. In either case, we are lowering risk.
In the first quarter, our values rose and prices fell, which improved our margin of safety. In addition, we became more diversified as we sold more fully valued companies and redeployed capital into companies with larger discounts than those we sold. The deepest discounts available to us today are not as great as they have been in recent years as markets have recovered from the financial crisis. Consequently, we took smaller position sizes, which also reduced risk through greater diversification. This process was more pronounced in Small Cap than in Large Cap. All Cap was roughly unchanged in terms of diversification.
So, what was working in the first quarter that we are glad we did not own? Utilities were one of the best performing groups among both large caps and small caps. We are not aware of a single utility that would qualify for investment at Vulcan Value Partners. In our opinion, the outlook for the industry going forward is relatively poor with stagnant demand, high leverage, and record high valuations. Financials, driven by commercial banks and investment banks, did well while our financials declined. We do not like commercial banks or investment banks because their values are inherently unstable. Instead, we bought three new outstanding financials (one in Large Cap and two in Small Cap) as they were declining in price, which hurt our short term returns. Energy did well. We are not aware of any energy companies we would like to own at today’s prices and there are very few we would like to own at any price!
See full Vulcan Value Partners Q1 Letter in PDF format here.