Vulcan Value Partners letter for the fourth quarter ended December 31st, 2015.
Vulcan Value Partners - Portfolio Review
We materially re-positioned our portfolios into more concentrated positions in more deeply discounted businesses during the third quarter when we experienced meaningful market volatility for the first time in years. These decisions impacted our results in the third quarter and continued to do so in the fourth quarter. We are not pleased with our poor short-term performance, but, 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% to 5% of our peers since inception. In fact, Large Cap, despite a challenging 2015, is in the top 1% among its peers since inception.
A more detailed discussion of our results follows the table below.
Our investment philosophy is designed to lower risk and produce exceptional returns over our five year time horizon. It is not designed to perform well in all market environments, and it is not designed to perform well over shorter periods of time. In fact, accepting poor short-term results is necessary to produce superior long-term results.
The current market environment reminds us of 2007. Then, as now, our short-term performance was poor. Then, as now, valuation levels were stretched, and what was working we simply did not want to own. In 2015, a narrow group of over-valued companies led the S&P 500 higher. Without the so-called FANG stocks (Facebook, Amazon, Netflix, and Google), the S&P 500 would have had a negative return. What else worked in 2015? The most expensive stocks trounced the cheapest stocks. The 50 highest P/E stocks in the S&P 500 returned 5.4%, while the lowest 50 P/E stocks returned -10.9%. Growth worked well too. The top quintile fastest growing S&P 500 stocks returned 12.9%, while the slowest growing returned -5.13%. The largest stocks did well, while smaller cap stocks did not. The fifty largest stocks in the S&P 500 gained 5.6%, while the smallest 50 declined 5.3%. Momentum worked while mean reversion produced awful results – the exact opposite of what has happened over the long-term. Over the last ten years, mean reversion, which is fundamental to value investors such as ourselves, produced a 7.2% annualized return versus 3.1% for momentum. In 2015, mean reversion produced a loss of 28.6%, while momentum produced a 2.4% gain.1
So, if we had thrown out our investment philosophy and bought the fastest growing, most expensive, largest companies that had gone up the most in price, we would have had a pretty good year. Instead, we methodically executed our investment philosophy, reduced risk and improved our long-term prospects. We allocated capital away from more expensive companies and added capital to more discounted companies with higher margins of safety. We responded to second half volatility by becoming more concentrated in our most discounted companies. The values of the underlying businesses we own grew even though prices declined. As a result, we have deferred returns, not lost them, and our prospective returns come to us with less risk because our price to value ratios have improved materially over the past twelve months. Said another way, our margin of safety improved, not just because of price declines, but also because of rising values.
In last year’s year-end letter we wrote:
“As we enter the New Year and compare our expectations over our five year time horizon to the previous five years, we are virtually certain that our returns will be lower. In the short run, anything can happen. In the long run, our returns are a function of two primary drivers. The first determinant is the underlying growth in the value of the companies we own. The second determinant is the discount to fair value that is available to us, which is the same thing as our margin of safety.
On the first count, the underlying growth in the value of the businesses we own has been consistently higher than the assumptions we use to value our businesses. Our estimated values have compounded at a mid-teens rate compared to our expectations of low double-digit value growth. Our companies are extraordinary, so it is not surprising that their value growth would be extraordinary as well. Our companies have produced large amounts of free cash flow, which has been reinvested wisely; they have grown their top lines, and margins have expanded. Going forward, we expect them to continue to produce ample free cash flow and to continue to reinvest wisely. In the aggregate, however, margins are closer to a peak than a trough. Top line results will muddle along with growth shifting from one region of the world to another, but the global economy is not firing on all cylinders and there is little prospect that it will be over our five year time horizon. So, the growth in the value of the businesses we own, while still positive and very attractive compared to inflation or bonds, will have to moderate over the next five years.
On the second count, we do not enjoy as wide of a margin of safety today as we did five years ago. Today, our weighted average price to value ratios across all strategies average in the mid-seventies. Five years ago, it was in the low sixties. As you know from our previous letters, our primary concern is reducing risk and protecting capital; not returns. As the margin of safety available to us has shrunk, we have reduced risk through greater diversification in our diversified strategies. Our returns are a by-product of reducing risk. A qualifying sixty-cent-dollar2 has a larger margin of safety and less risk than a qualifying seventy-five-cent-dollar. Stated simply, a seventy-five-cent-dollar that moves to a dollar, or fair value, generates less return than a sixty-cent-dollar that does the same thing.”
As this letter is being written, global equity markets are off to their worst start in recent memory with the S&P 500 down 9.0%, the Stoxx Europe 600 down 11.9%, and the Shanghai composite down 15.9%.3 The global economy remains weak. Europe is improving slightly, the U.S. is muddling along below its potential, the developing world is slowing sharply with some large economies such as Brazil in recession, and China is not only slowing but its headline growth is overstated. The dollar remains strong, and the Federal Reserve has begun raising interest rates in the U.S. Primarily due to the strong dollar, value growth for our portfolio companies was mid-single digits in 2015, better than the average company, but well below trend. 2016 looks like more of the same in terms of subdued value growth. Valuation levels, while improving, are a long way from cheap.
The silver lining to this somewhat glum outlook is that increased volatility and market declines give us the opportunity to continue to improve our