Longleaf Partners Funds shareholder letter for the third quarter ended September 30, 2015.
In the third quarter of 2015 the Longleaf Partners Funds had significant absolute declines and relative underperformance. As your managers and the largest investors in the Longleaf Funds, we are frustrated that our results have not met your expectations or our own.
As was true in other similarly challenging quarters during the Funds’ long history, most of the underperformance came at the hands of macro pressures indiscriminately weighing on a few holdings rather than company-specific problems. The primary driver in the U.S. remained energy, but China economic fears broadly impacted our companies with direct or indirect exposure. The slowing Chinese economy, collapse in the China A-share market, and an unexpected Renminbi devaluation created a ripple effect of fear across countries with economic ties to China, including many emerging markets, where local stocks were down and currencies also suffered.
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Despite our frustration over recent returns, we believe that the positive fundamentals of the companies we own ultimately should be reflected in their prices. Following previous periods when broad pressures weighed heavily on our returns, we posted strong returns when macro fears subsided. At each of the low end points, the Funds had similar characteristics to today, including price-to-value (P/V) below the long-term average, a growing on-deck list of companies to own, and solid value growth prospects. Our concentrated, bottom-up approach has historically produced strong, long-term results for our shareholder partners, but the path to get there can be volatile.
While the historic performance patterns give us context for viewing this current period, they are neither an excuse nor the basis for our confidence in returns going forward. Our confidence is grounded in three fundamental beliefs:
- The time-tested, value investment approach based on a long-term business ownership mindset and embraced by great investors, such as Keynes, Graham, Templeton, and Buffett, remains valid around the world.
- Southeastern’s investment team has the skill, experience, discipline, and proper alignment to successfully execute the approach.
- In our strongly held opinion, our Fund companies have the competitive strength and management skill to grow value per share, as well as the margin of safety between the stock price and corporate worth to deliver attractive returns from this point.
Longleaf Partners Funds – The Approach
Value investing has outperformed growth over long periods, even though it has been out of favor at points along the way.1 Whether privately held or publicly traded, a business is ultimately worth the cash earnings it generates; the stock market is ultimately fairly efficient at pricing companies over the long term. However, short-term emotions can impact stock prices at any given point, causing them to diverge from the values of businesses. In the post-Global Financial Crisis (GFC) bull market, massive asset flows into index funds and share buybacks near 2007 peak levels have fueled passive investing’s recent success, causing some to question whether investing in undervalued businesses is worthwhile. We note that momentum-driven indexing also dominated in one of our worst relative quarters (4Q 1999), yet within six months, businesses began to be priced on their fundamentals again.
We see nothing that has changed to indicate that values will no longer be reflected in stock prices over time. Until the fear and greed that drive shorter term market swings no longer exist, periods of mispricing will occur, but the large cap value approach that has outperformed growth investing by over 8800% cumulatively since 1927, a five-fold differential, is likely to continue to outperform over the long run, despite allowing for interim periods like this current one when momentum investing has been favored.1 While this data is based on U.S. stocks, we believe the distinction between value and growth as well as price inefficiencies apply equally to the rest of the world.
Longleaf Partners Funds – Our Execution
The data regarding value investing’s outperformance is for a large U.S. universe of stocks that are quantitatively screened, but Southeastern carefully analyzes and selects the 20 companies that we believe can deliver the best returns with the least risk of permanent capital loss. Our stock selection is never perfect. A large part of our underperformance in the Partners, Small-Cap, and Global Funds this quarter was driven by holding energy businesses through a 12-month period when oil prices fell over 50%—something that has happened less than 2% of the time in the last 115 years.2 We do not believe our results over the last quarter and year, which also have hurt our five and ten year numbers, demonstrate our ability to execute.
We have the deepest, most experienced global investment team in our history with the same leadership that has delivered outperformance over the Funds’ history. Our same approach has delivered strong performance since the inceptions of the Partners, Small-Cap, and International Funds. We have not changed our investment beliefs or our execution process that have delivered these long-term returns. We always are learning and looking for ways to improve and increase our information inputs for even higher success rates. For example, we have boosted our quantitative capabilities by adding quantitative talent and implementing new tools to look more broadly at data that may impact our investment cases. We also have worked with an outside firm to review ways to neutralize biases and have made incremental portfolio management improvements to how we buy and sell. Likewise, our cumulative contact network expands and becomes more valuable with time as we engage with our management partners, clients, and others who provide insights for our analysis of businesses.
Longleaf Partners Funds – Our Portfolio
We have high conviction because the companies we own will determine our performance from this point. Looking at their fundamentals, many of which the market does not currently recognize, gives us the confidence that we should more than overcome this past quarter’s downdraft and outperform. The Funds have three categories of companies that we see driving returns.
Between 45–65% of each Fund is a collection of incredible businesses that we believe have the competitive strength and management leadership to compound value per share at high rates for many years. Based on our appraisals, as a group this category of holdings sells for around 65% of our appraisal values and on average, no more than 12X after-tax free cash flow (real cash price to earnings). Prospects for these holdings’ value growth, especially as a diversified basket, are greatly enhanced due to their combinations of pricing power and gross profit royalty status. Their managements’ track records and ownership alignment suggest strongly that these steadily growing free cash flow streams should be reinvested to build even more corporate value.
In our opinion, among the holdings in this group across the different Funds are one of the world’s two best sports brands in adidas, the world’s best insurance and risk proxy in Aon, China’s dominant internet search engine in Baidu, the highest quality global conglomerate in CK Hutchison, the world’s most compelling real estate company in Cheung Kong Property, the most valuable independently owned animated film library in DreamWorks Animation, maybe the most value-generating holding company in the world since the Global Financial Crisis in EXOR (thanks to its leaders Sergio Marchionne and John Elkann),the world’s best delivery network in FedEx, the world’s largest and best search engine in Google, the most dominant worldwide cement oligopolist in LafargeHolcim, the best global digital network in Level 3 Communications, Macau’s best local mass gaming company in Melco International and best upscale operator with high end U.S. properties in Wynn Resorts, the best U.S. cable channel company with HGTV and Food Network (via Scripps Networks), and the premier collection of mountain resort properties in Vail Resorts. These companies are among those that offer a combination of competitive advantages, business safety, balance sheet strength, and glaring undervaluation that gets lost in the focus on the pressures that have hurt recent results. As the dominant portion of the Funds, however, it is this group of holdings that we look to as the primary driver of potential future outperformance.
The second category of holdings includes companies being led through transitions by strong management partners who are focused on growing and unlocking values by highlighting their competitive business segments and/or reinvesting substantial cash in high-return opportunities. ALS Limited owns a highly valuable life sciences business temporarily obscured by a depressed energy segment; BR Properties is basically liquidating, having sold or contracted to sell more than half its assets; CNH Industrial should eventually become a pureplay agricultural equipment company, second only to Deere; DSM is far down the road in slimming itself into a purer-play nutritionals company; DuPont has multiple ways to refocus and improve, with a leadership change occurring post quarterend; Graham Holdings has sold or spun off numerous assets, with valuable television stations, Kaplan’s strong international assets, rapidly growing internet company Social Code, and a cash-rich balance sheet remaining; Great Eagle holds net cash and securities totaling more than its stock price in addition to many hotels and other properties; McDonald’s has discussed capitalizing on its increasingly valuable real estate and becoming a fee company, while its operating turnaround is beginning to gain traction; OCI is merging most of its assets into CF Industries; Philips is heading toward becoming a leading healthcare company; Tribune Media spun off its newspapers and has numerous remaining assets, including television stations, spectrum, and real estate, that management can monetize; and Vivendi holds the world’s largest music company, dominant French media assets, and significant cash to deploy. This group comprises roughly one-third of the Funds, and should drive performance when the gap between price and value closes as our management partners lead these transitions.
The third category contains our energy holdings which, as a bucket, are down over 60% year-to-date (YTD), constituting a bona fide crash rather than a mere bear market. The momentum-driven heavy selling and shorting of this “crash bucket” has gotten so out of hand that we feel the companies’ recovery is a large part of our comeback potential. Even though qualitatively Melco and Wynn are in the first category above, their severe price declines position them similarly to our energy investments for a big recovery. To be clear, we do not think these stocks will do well simply because they are down. We believe their long-term fundamentals under the stewardship of their capable leaders will drive prices as contrasted to the short term perceptions. In the case of our energy holdings, we are not reliant on an energy rebound to move the stocks higher, as our appraisals are over twice the current stock levels based on current depressed commodity futures pricing. Should oil and gas prices move back to their high marginal cost of production, the values of these stocks would be multiples more. These energy holdings represent less than 10% of our portfolios, and while we put them in their own group, they share many of the same compelling attributes described in the second category above.
Longleaf Partners Funds – Summary
Our collective experience and analysis tell us that the significant underperformance in the quarter and over the last year is not indicative of how value investing in general, and the Funds in particular, can perform going forward. While market volatility like we are seeing now can pressure short-term results, we welcome its benefits. Our most meaningful outperformance has often come following periods of big price swings, and the recent market declines are presenting additional attractive opportunities. All of the Funds reached a high-50s% to low-60s% P/V at quarter-end and, additionally, U.S. bullish sentiment measured by Investors Intelligence’s weekly Advisor Sentiment report just fell below 25%, the lowest level since late 2008. As evidence of the undervaluation in Asia, the Hong Kong market is trading at the lowest Price/Book ratio in over 15 years, including the GFC. We cannot predict what stock prices will do in the short run, but for those with a 5-plus year horizon, this appears to be an attractive entry point for the Longleaf Funds.
As the largest investors in the Longleaf Funds over time, we recognize how difficult being a Longleaf shareholder has been recently. We are constantly learning and pursuing ways to improve our execution and believe that our outperformance periods will continue to make up for times of underperformance. The high level of quality across such a large percentage of our portfolio companies, our extremely capable management partners, and the attractive margin of safety in our companies’ stock prices make us highly confident that the companies we own can perform well and reward your patience and ours.
O. Mason Hawkins, CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.