Vulcan Value Partners letter for the first quarter ended March 31, 2016.
Vulcan Value Partners - Portfolio Review
We are pleased to report that all strategies produced positive returns and beat their respective benchmarks during the first quarter. Much more importantly, all five of our investment strategies have produced exceptional long-term results. In fact, Large Cap, Small Cap and Focus are in the top 1% of their peer groups since inception, and Large Cap is literally number one. Focus Plus is in the top 2%, and All Cap rounds out our strategies in the top 6%. These results are detailed in the table below.
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.
Noise. Short-term noise. Our excellent first quarter 2016 results should not influence your evaluation of Vulcan Value Partners any more than our poor fourth quarter 2015 results. Instead, we encourage you to focus on our long-term results, the consistent execution of our investment philosophy, our outstanding team, and our conflict-free, fiduciary structure. Our compliance department does excellent work and has an enviable operating environment. Everyone at Vulcan Value Partners is required to invest in publicly traded equities exclusively through Vulcan Value Partners. This policy eliminates a lot of conflicts and focuses energy on where it should be focused – you, our client partners. These characteristics are what drive our long-term results, which is all that we care about. Now, please re-read the paragraph above this one.
2016 started with increased volatility but ended with generally rising markets around the world. We were able to take advantage of the downturn, but it did not last long enough or decline enough for us to materially improve our price to value ratios. In fact, our price to value ratios rose slightly during the quarter. Small Cap remains the highest, in the mid-70’s, with every other strategy in the mid to upper 60’s.
The lower our price to value ratios, the higher our margin of safety. Our goal is to reduce risk. Returns will take care of themselves over our five-year time horizon. It is very important to understand that market volatility is not risk. We define risk as the probability of permanently losing capital over our five-year time horizon. Our investment discipline requires us only to invest in companies that we believe have inherently stable values. As a result, market price volatility creates opportunities for us to lower risk by improving our price to value ratios.
This counterintuitive result is possible because of our dual discipline. One critical variable is our ability to find the few businesses with stable values and to have the discipline to avoid the many that do not have stable values, no matter how “cheap” they might be at a point in time. Most of the businesses that qualify for investment at Vulcan Value Partners in terms of value stability are overpriced most of the time. So, the second critical variable is to be disciplined about the price we are willing to pay for these outstanding businesses.
Ironically to some, but not to us, when markets are volatile and when our short-term results are at their worst, we are reducing risk and planting the seeds for exceptional long-term compounding. Your stable, long-term capital allows us to take advantage of sellers who confuse stock price volatility with risk and/or do not have our long-term time horizon. Together, we form a powerful partnership that gives us a sustainable advantage over other market participants.
Increasingly, these market participants include mindless index funds and ETF’s, and factor-based approaches such as “smart beta.” To paraphrase my business partner Adam McClain, smart beta reminds us of someone who thinks they have discovered something wonderful when they smell bacon cooking and then eat the grease instead of the meat. Thank you very much, but we prefer to do the real work and enjoy the bacon. With more capital being deployed based on flavor of the week factors instead of a coherent investment philosophy based on a comprehensive set of fundamentals, our opportunities to find mispriced companies should improve over time.
We have no idea where markets will head over the remainder of the year, but we hope they will decline. Please rest assured that if they do, we will rigorously follow our investment discipline and redeploy capital into companies with stable values at more attractive price to value ratios. For a real world example of this process taking place, keep on reading about Hilton in the Large Cap section below.
In the discussion that follows, we generally define material contributors and detractors as companies having a greater than 1% impact on the portfolio.
Vulcan Value Partners Large Cap Review
We bought one new position and sold five positions during the first quarter.
There were two material contributors and no material detractors to performance in the first quarter.
Hilton Worldwide Holdings is a company that I have followed and owned numerous times over my career, making very attractive returns each time over several decades. Shortly after Vulcan Value Partners was formed, Blackstone took Hilton private at a price well in excess of our estimate of fair value. Since it was private, it was no longer available to us. A little over two years ago, Hilton did an IPO and was available again. Hilton came public at a price too high to be of interest to us but we continued to follow it as we do with the relatively small number of companies we have found with stable values. Following these sound but over-priced companies is a big benefit to us. Our values are based on a set of fundamental assumptions about the companies we follow. If the companies we follow exceed our expectations, then our assumptions are conservative as are our values. Hilton’s results were much better than we expected, and yet the stock price declined, particularly during the fourth quarter of 2015. When markets declined in January, Hilton declined more. With a steadily rising value and a declining stock price, we were able to purchase Hilton at a substantial discount to our conservative estimate of intrinsic worth.
Please note that nothing changed about Hilton’s business except that its value grew. Stock market and stock price volatility created an opportunity for us to reduce risk and improve our long-term prospects. Because we limit ourselves to companies with stable values like Hilton, stock price volatility is not risk. Instead, stock price volatility is a tool that can be used to lower risk for disciplined, long-term investors like Vulcan Value Partners and you, our client partners.
We sold Carlisle Companies, Honeywell International, Microsoft, MSC Industrial Direct, and Verizon Communications. All are outstanding businesses. We have owned some of them more than once and hope to have the opportunity to purchase them again at more attractive price to value ratios.