Vulcan Value Partners commentary for the third quarter ended September 30, 2016.



Portfolio Review


We are pleased to report that all strategies produced positive results and beat one or more of their benchmarks in the third quarter. 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.

[drizzle]All five of our investment strategies have produced exceptional long-term returns. In fact, three of our five strategies are in the top 1% of their peer groups since inception, one in the top 3% and the fifth strategy in the top 12% since inception. These results are detailed in the table below.

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Record low interest rates engineered by the world’s leading central banks have created an almost desperate search for yield. This monetary stimulus has caused supposedly defensive, higher dividend-yielding stocks to become dangerously overvalued. Until recently, consumer staples companies, utilities, and Real Estate Investment Trusts (REITs) have outperformed the broader market. Valuation and, in the case of utilities, quality concerns have kept us out of those areas. Recently, many of the companies in these sectors have begun to decline in price, but they remain overvalued.

For instance, Campbell Soup, a consumer staple bellwether that is on our MVP list, sold at 30 times earnings at the end of the quarter compared to a five-year average of 22 times earnings. Its earnings have declined roughly half of 1% per annum over that time period. It yields 2.6%. It trades well above our estimate of intrinsic worth. Utilities, as a group, trade at 22 times earnings and yield 3.5%. They do not produce free cash flow and are highly leveraged. Returns are regulated, and growth prospects are poor. Yet they are the second best performing segment of the market in 2016, despite a pullback in the third quarter.

REITs deserve special mention. They just became a separate sector of the S&P 500. In the 1990’s, REITs were attractively priced. While several REITs are on our MVP list, all of them are overvalued today, in our opinion. As a group, REITs’ dividend yield is 3.2%, and they trade at just under 25 times free cash flow so their free cash flow yield is approximately 4%. They are also highly leveraged. Over time, growth in rental income should approximate inflation, which the U.S. Federal Reserve is targeting at 2%. With financial leverage, REITs should be able to grow their bottom line (Funds from Operations in REIT parlance) and dividends at perhaps 4%. One other data point: Post Properties, an Atlanta based apartment REIT, recently announced that they are being acquired at roughly 26 times free cash flow, or for less than a 4% free cash flow yield. While higher quality retail and office REITs have longer leases ranging from 3 to 10 years, apartment REITs generally turn over roughly half of their units annually. So just to break even, they have to resell half of their product annually before they can grow.

So, what if Oracle, our largest position, was a REIT? How might it be valued? Oracle has over 90% customer retention. They have long-term contracts called licensing agreements that have inflation-adjusted escalators. So Oracle’s revenue structure looks a lot like higher quality REITs with long-term leases and much better than apartment REITs like Post Properties. Oracle, however, can add new services such as Cloud computing and acquire more customers without having to build new properties. In real estate terms, Oracle can grow its “occupancy” without physical constraints. We estimate that Oracle can grow its bottom line at a high upper single-digit rate for many, many years, so let us use 8% as an estimate. Moreover, unlike REITs, which are highly leveraged, Oracle has net cash on its balance sheet. So Oracle can grow twice as fast as the typical REIT without leverage. Adjusted for cash, Oracle trades at less than 11.5 times free cash flow, so its free cash flow yield is roughly 8.8%.

So, Oracle, which can grow at 8%, or twice as fast as the average REIT, sells for less than half the valuation of the average REIT and less than half the valuation paid for Post Properties. Why? Oracle only has a relatively paltry 1.6% dividend yield. REITs use most of their free cash flow to pay a dividend. Oracle uses most of its free cash flow, roughly 80% in fact, to repurchase its discounted stock. This capital allocation decision is highly beneficial to us as long-term shareholders because a dollar of dividends is only worth a dollar while a dollar of share repurchases is worth more than a dollar because Oracle’s stock is selling for less than its intrinsic worth. If the market valued Oracle’s free cash flow stream, which is higher quality and growing twice as fast as the average REIT, at the same yield as the average REIT, then Oracle’s stock price would be more than twice as high as it is currently.

Our results over the past year in particular have been held back because we refuse to buy overvalued and extremely risky parts of the market. We instead allocate capital to extremely high quality companies whose valuations are ludicrously low in comparison. As serious, long-term investors who are required to invest in equities exclusively through Vulcan Value Partners, we would not invest our money or yours any other way. We look nothing like an index, so it is reasonable to expect us to perform nothing like an index. In the short-run it can be painful. In the long-run we believe your patient capital, alongside of ours, will be amply rewarded for following our investment discipline instead of following the crowd.

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

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We purchased six new positions in the third quarter and exited five positions.

There was one material contributor and no material detractors to performance in the third quarter.

New purchases included McKesson, AmerisourceBergen, UnitedHealth Group, Qorvo, Skyworks, and Verizon.

McKesson and AmerisourceBergen are both drug distributors. They participate in an oligopolistic industry with high barriers to entry. Route density and scale are very important in the drug distribution business, making it uneconomical to challenge the incumbents. In addition, regulatory hurdles are high because they transport controlled substances. UnitedHealth Group is the largest health insurer in the United States. In addition, it owns Optum, a rapidly growing healthcare information services company. We do not believe the market appreciates and adequately values Optum within UnitedHealth Group. Qorvo and Skyworks make radio frequency filters (RF), power amplifiers, and mixed signal semiconductors. These chipsets are critical components in modern cell phones. As telecommunications technology continues to evolve from 2G to 3G to 4G

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