Vulcan Value Partners letter to investors for the third quarter ended September 30, 2015.
Vulcan Value Partners – Portfolio Review
General
We experienced meaningful volatility during the third quarter for the first time in several years. While it did not last as long as we would have liked, we took full advantage of it while it did last. We materially re-positioned our portfolios into more concentrated positions in more deeply discounted businesses. We paid a price in terms of poor short-term performance but reduced risk and improved our long-term prospects. As you know, we place no weight on short-term results, good or bad, and neither should you. In fact, we have and will continue to willingly make decisions that negatively impact short-term performance when we think we can lower risk and improve our long-term returns. We encourage you to place more weight on our longer term historical results and a great deal of weight on our long-term prospects. Within this context we are gratified that all of our investment strategies are ranked in the top 1% or top 2% of our peers since inception. In fact, Large Cap, which had a poor quarter, is number one among its peers since inception.
A more detailed discussion of the progress we made follows the table below.
We entered the third quarter with the portfolios defensively positioned. In our second quarter letter we wrote:
“[I]n the current environment our investment discipline results in us having smaller position sizes in our diversified portfolios, which increases liquidity and enables us to respond quickly to better opportunities, should they present themselves.
Unfortunately, near term compounding prospects are below average. Valuation levels are higher than they have been in many years. Applying a consistent valuation methodology, many of the companies we do not own are trading above our estimate of fair value. The companies we do own trade at a discount, but the discounts available to us are not as great as we would like. Moreover, a sluggish global economy, combined with a very strong dollar is causing value growth to be below average for many companies we follow. Volatility continues to be very low, which reduces the number of potential investment opportunities available to us.”
What stayed the same and what changed during the third quarter? Well, the global economy remains weak. In fact, our bottom up work suggests the global economy is weaker than the top down macroeconomists say it is. What did change was an increasing recognition of this fact in the markets which resulted in a spike of volatility around the world. We used our liquidity to take larger stakes in fantastic businesses at deeper discounts than have been available in quite some time. As a result, we materially improved our margin of safety by lowering our price to value ratios, and we became more concentrated in these more discounted businesses. In Large Cap, we went from owning 35 companies to 30. Price to value ratios improved to the lower 60’s from the high 70’s at the beginning of the year. In Small Cap, we went from holding 17% cash (because limit orders we were using were not being filled) to being fully invested. Price to value ratios improved to the upper 60’s. All Cap, Focus, and Focus Plus all became more concentrated and improved their price to value ratios to the lower 60’s.
We were able to improve our margin of safety because we limit ourselves to only owning businesses with inherently stable values. When prices fall and values remain firm, we are able to take advantage of stock price volatility. We exited more fully valued companies in which we had smaller position sizes – our “winners” – and used the proceeds to buy larger stakes in more discounted businesses – our “losers.” Our performance in the quarter would have been better if we had not done so. Our prospects over the next five years would be worse if we had not done so. We will always choose the long-term over the short-term.
If volatility continues, and we hope it does, expect more quarters of poor performance. If we successfully execute our investment discipline, these painful quarters ultimately will result in superior long-term results. You are an important part of enabling us to execute. Your patient capital and shared long-term time horizon allows us to buy competitively entrenched business at absurd valuation levels because sellers are worried about short-term results.
An example is instructive: We own several businesses that are experiencing changes to their business models that are holding back short-term results but should lead to better long-term returns. The most prominent example is Oracle, which we own everywhere except Small Cap (because Oracle is not a small cap company). Oracle and SAP dominate the global enterprise software market. This market is evolving from onsite delivery of software solutions to cloud-based delivery. For the foreseeable future, we expect the market to be a hybrid, whereby some solutions reside in the enterprise and some are delivered through the cloud. Oracle and SAP are the only companies able to deliver comprehensive enterprise solutions onsite or through the cloud or in combination, and Oracle is ahead of SAP in this transition. Oracle’s cloud business grew 34% in their most recent quarter, and it is accelerating. Their results exceeded their own expectations and are well ahead of ours. Ironically, the faster the cloud grows, the more pressure it puts on short-term results because cloud products do not have an upfront license fee, while enterprise products do. However, cloud-based products are more profitable over time. Perhaps as soon as next year, the revenue mix-shift to faster growing cloud products should overwhelm the reduction in less valuable, one-time, upfront license fees. Next year is too long for Wall Street to wait, and Oracle’s stock has been one of our worst performers, down nearly 20% so far this year. Meanwhile, we enjoy a $14B free cash flow coupon that is being used to repurchase discounted stock. With a stable value and improving long-term prospects, Oracle is our largest position firm wide.
In the discussion that follows, we generally define material contributors and detractors as companies having a greater than 1% impact on the portfolio.
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