The funds seek to achieve superior long-term performance by acquiring equity securities of financially strong, well-managed companies run by capable managements at market prices significantly below our assessment of their business value. We sell stocks when they approach our appraisal. Equities purchased at prices substantially less than their intrinsic worth protect capital from significant permanent loss and also appreciate substantially once the market recognizes the company's economic value.
A company's market price generally must be 60% or less of our appraisal to qualify for investment. We appraise businesses by studying financial statements, regulatory information, trade publications, and other industry and corporate data, and by talking with corporate managements, competitors and suppliers.
We use two primary methods of appraisal. The first assesses the company's liquidation value based on the current economic worth of assets and liabilities. The second method determines the company's ongoing value based on its ability to generate free cash flow after required capital expenditures and working capital needs. We calculate the present value of the projected free cash flows plus a terminal value, using a conservative discount rate. Our appraisal should represent the price that rational, independent buyers and sellers would negotiate in an arm's length sale. We then check our appraisal against our database of comparable business transactions.
We generally sell a portfolio holding for one of four reasons:
1. The price reaches our appraisal and no margin of safety remains.
2. We can improve our risk/return profile substantially, e.g. we can replace a business selling at 80% of its worth with an equally attractive company at 40% of its value.
3. The future earnings power of the company becomes severely impaired by threats to the business, poor capital allocation, or other reasons.
4. We no longer believe management can build shareholder value and efforts to find new corporate leadership would be unsuccessful or too costly.
The Funds invest under the IRS diversification standard and we generally own 25 or fewer stocks in each portfolio. We hold concentrated portfolios for two main reasons. Concentration lowers our risk of losing capital because we limit the portfolios to our very best ideas, and we know the companies we own and their managements extremely well. Concentration also enables each company to have a meaningful impact on our results when the market recognizes value.
We are long-term owners, not traders or speculators. Our time horizon when purchasing a company is generally three to five years, which our historic portfolio turnover rate reflects. There are no limits on portfolio turnover, however, and we may sell portfolio holdings whenever we believe that sales would benefit shareholders.
Period: Q1 2013
Portfolio date: 31 Mar 2013
No. of stocks: 17
Portfolio value: $6,469,860,000
|Stock||% of portfolio||Shares||Recent activity||Reported Price*|
|hist||L - Loews Corp.||9.44||13,853,000||$44.07|
|hist||CHK - Chesapeake Energy||8.65||27,410,576||$20.41|
|hist||DTV - DIRECTV Group Inc.||8.06||9,211,800||$56.61|
|hist||FDX - FedEx Corp.||7.73||5,094,606||Add 3.50%||$98.20|
|hist||DELL - Dell Inc.||6.84||30,878,000||$14.33|
|hist||CNX - CONSOL Energy Inc.||6.54||12,583,000||$33.65|
|hist||TRV - Travelers Companies Inc.||6.24||4,794,000||Reduce 8.20%||$84.19|
|hist||PHGFF - KONINKLIJKE PHILIPS||6.22||13,590,360||Reduce 8.69%||$29.59|
|hist||AON - Aon Corp.||6.21||6,529,700||Reduce 1.81%||$61.50|
|hist||BK - Bank of New York||6.17||14,258,600||Reduce 3.57%||$27.99|
|hist||MDLZ - Mondelez International||5.65||11,947,000||$30.61|
|hist||ABT - Abbott Labs||5.29||9,696,076||$35.32|
|hist||LVLT - Level 3 Communications Inc.||4.71||15,026,565||$20.29|
|hist||BRK.B - Berkshire Hathaway CL B||4.71||2,926,000||$104.20|
|hist||VMC - Vulcan Materials||4.10||5,125,450||Reduce 28.20%||$51.70|
|hist||MUR - Murphy Oil||2.22||2,251,400||Buy||$63.73|
|hist||PHG - Koninklijke Philips Electronics NV||1.23||2,686,500||$29.55|
* Reported Price is the price of the security on the portfolio date. This value is significant in that it indicates the portfolio manager's confidence in the stock at that price and suggests at least some level of undervaluation and/or margin of safety.
Sector % analysis
Articles & Commentaries
We are pleased to report that each of the Longleaf Fund’s 2012 return exceeded our annual goal of inflation plus 10% and outperformed its relevant benchmark index. We also posted strong fourth quarter gains in all three Funds. Our business appraisals, combined with the quality of our companies and our management teams, anchor our investment decisions and provide the foundation for our confidence that market prices will reflect corporate worth over time. At the outset of 2012, we highlighted the investment cases and free cash flow yields at the Funds’ largest holdings, noting that we were “highly confident future returns should be exceptionally rewarding because of the quality of the businesses we own, their prospects over the next five years,and the compellingly low prices we are paying for them.” Over the year,intrinsic values built,and the gap between prices and values started to close.
Most holdings posted solid 2012 returns. The largest contributors were among our most disdained in 2011. In particular, our cement and aggregates companies illustrated why conservative business appraisals, not short-term price movements, should dictate investment decisions, as these stocks sharply rebounded without improvement in global GDP growth or overall industry volumes. In the third quarter of 2011, when macro fears about global growth and sovereign debt caused stocks to tumble, cement companies were among the worst performers as the timing of a construction rebound grew more uncertain. We did not know when infrastructure, housing, and commercial building would turn, but we felt confident that over five years, units and pricing would improve. We could adopt a longer time horizon because we had a meaningful margin of safety in the discount placed on cement plants and rock quarries – they sold for far below replacement cost and recent comparable sales. Had we waited for more certainty about recovery and less recession fear, we would have missed the 66-90% gains in our core cement holdings and 30+% appreciation in our aggregates companies over the last year as prices moved to more fully reflect asset values.
Even after the good results of 2012, our compounding opportunity over the next 3-5 years remains compelling. Broadly, yields on the growing, after-tax, earnings coupons of businesses are over four- and-a-half times the fixed, pretax yields of 10-year Treasuries, and within our portfolios, free cash flow yields are even more attractive.* Our price-to-value ratios offer attractive upside with the Partners and International Funds in the mid-60%s and Small- Cap in the low-70%s. Much like cement companies a year ago,
a few of our core positions are excessively discounted and have yet to receive market recognition for addressing their challenges and successfully repositioning. Beyond our opportunity to close the gap between price and value, corporate worth should grow because of our holdings’ competitive advantages and our corporate partners’ competence. Any tailwind from top line growth, anemic since 2008, can provide additional value upside.
The beliefs that U.S. profit margins will decline to their historic mean and that earnings will grow at rates in line with permanently lower future GDP growth have exacerbated skepticism over future equity returns. We are not macro-based investors, but we have a different view based on two permanent structural changes as well as top line growth prospects over the next five years. First, higher profit margins are sustainable because many low margin businesses have migrated from the U.S., leaving an era of more profitable companies based on intellectual capital such as Apple, Facebook, Google, and their successors. Second, more traditional manufacturers have improved margins employing the U.S. comparative advantages of lower energy, capital, and labor costs (automated facilities run by a minimal number of highly trained staff have replaced much manual labor). Beyond structural changes, margins should benefit additionally from top line growth providing operating leverage in numerous regions. Given where we are
in the economic cycle, top lines are likely to grow more in the next five years than in the recent past. In both the U.S. and Europe, revenues remain far below peak with significant capacity available. Top lines should also grow as companies earning nothing on corporate cash in many developed countries see interest rates increase.
More importantly, we believe the companies we own have larger opportunity for earnings growth and stock return than the overall market. First, their prices are trading at a much larger discount to our intrinsic values than the market. Second, a number of companies we own have more potential top line growth than the average business because their industries, such as construction, U.S. natural gas, and non-life insurance, have yet to see much revenue recovery post-recession. Third, many of our holdings based in low-growth GDP geographies have a meaningful portion of their revenues tied to higher growth developing markets. Fourth, our investment returns are not limited to dividends plus GDP-driven organic growth. Because of the quality of what we own and our shareholder-oriented management partners, our free cash flow coupons exceed what is needed to fund growth. Our partners are retaining the excess and redeploying it at higher returns, in particular by buying in discounted shares.
With our positive long-term outlook about the ability of our companies to grow values and compound at attractive rates, we launched Longleaf Partners Global Fund at the outset of 2013. The Fund will generally own a subset of the holdings in our other three Funds via a single vehicle that owns companies of all sizes in any geography. More information about Longleaf Partners Global Fund is available at longleafpartners.com. We are confident that the components of our portfolios should deliver significant returns over the next five years. We are also certain that prices will be volatile, and we will have periods of disappointment. Corporate values are much more stable than stock prices. Our appraisals will continue to anchor us in choppy seas as we embrace volatility and buy at points of pessimism. We then will wait patiently as values grow, and the market ultimately recognizes intrinsic worth.
Our Process to Assess and Engage Management
Great corporate partners can mean the difference between a good investment return and a stellar one. Our investment criteria include having “Good People” at the helm. Our management assessment begins long before we own a company and continues once we are shareholders. If we see ways in which management could enhance value at our holdings, we consider increasing our engagement. Each stage of the process – deciding to invest, monitoring results, and engaging further with management – requires a great deal of time and careful evaluation, but the payback can be substantial.
Before we make an investment, we attempt to ensure that the person running the company will meaningfully contribute to our successful outcome. We conduct our diligence in four primary ways. First, we see how aligned the CEO’s interests are with shareholders. Significant stock ownership on the same terms as other shareholders is the optimal formula, but we also examine the overall compensation structure to fully understand management’s economic incentives. Second, we review the CEO’s operating and capital allocation record, at the current company and in previous roles. Third, we use our vast network of clients, corporate managers, industry experts, and friends to find out everything we can about the CEO, including personal as well as professional insights. Finally, armed with our research, we normally meet with the CEO and CFO not only to ask questions about the business, but also to determine whether management approaches decisions with the passion and orientation of an owner/operator focused on building value per share. The board can also impact our results, especially as it oversees capital allocation decisions. Before investing, we consider whether board members are significant stock owners, have relevant knowledge to assess the CEO’s work, and have a record of strong governance and oversight. We weigh all of our research to determine whether management and the board are committed to improving the company’s competitive position, growing intrinsic value per share prudently, and representing our interests as shareholders.
Once we buy a position, we monitor management through quarterly results, major announcements, yearly or more frequent meetings, and ongoing feedback from our contacts outside of the company, including its competitors and large customers. We evaluate operating progress relative to expected results and capital allocation decisions based on whether they optimize the prudent building of value per share. If shares sell at a large discount to intrinsic value for a persistent time, we assess the actions that management takes to close the gap.
When we believe that management could improve operating decisions, capital allocation, or governance and alignment, we decide whether and how to further engage our corporate partners. In most cases, our engagement takes the form of constructive conversations with management listening to our analysis and often incorporating our perspective into their actions. On occasion, management dismisses our views and continues down a path that is either suboptimal or detrimental to shareholders. At this point, we recognize that our original assessment of management was flawed, and we must determine whether engaging more actively has a likelihood of success using a reasonable amount of effort. If the answer is no, we typically sell the stock. If the answer is yes, we pursue whatever course we believe has the highest possibility of protecting and rewarding shareholders. Over our history, we have not needed to become “active” often, but when we have, our efforts have driven better investment outcomes with few exceptions.
Managements’ Contributions and Southeastern’s Engagement at Longleaf’s Holdings
Faced with an anemic U.S. recovery, a European recession, and slowing growth in Asia and emerging markets, our management partners have had to build and gain value recognition without significant demand-driven top line growth over the last year. Because of the caliber of our management teams, most have taken positive action with little-to-no engagement from Southeastern.
Operational Contributions: On the operating side, a number of our partners have implemented meaningful expense reductions including those at Dell, Disney, FedEx, and Quicksilver in the U.S, and Lafarge and Philips in Europe. HRT and Vulcan, where we have become more engaged, also have lowered costs. Additionally, managements have implemented price increases at the cement and aggregates businesses we own, our insurance holdings, other U.S. companies such as Abbott, Disney, Lamar, Scripps Networks, and Vail Resorts, and in our Asian names – Cheung Kong, Henderson, Melco, and Nitori. Spanish based Ferrovial’s two primary assets, the ETR- 407 toll road and airport owner BAA, have raised tariffs well above inflation rates. In a more unique action, Greg Case strengthened Aon’s strategic proximity to international clients by moving headquarters from Chicago to London, which also significantly lowered the company’s prospective tax rate and freed up excess capital.
Capital Allocation Contributions: Capital allocation decisions such as repurchasing shares and restructuring debt have been laudable. Collectively, of the 55 companies across the three Funds, roughly half have added value by buying back undervalued shares over the last year. Management teams at ACS in Europe, Cemex in Mexico, and Level(3) and Quicksilver in the U.S., have improved their balance sheets by successfully restructuring debt, extending maturities, and/or negotiating favorable covenants. Conversely, several companies with strong balance sheets such as Accor, DIRECTV, Disney, Cheung Kong, Ferrovial, and Henderson, locked in historically low interest rates by issuing cheap long-dated debt.
Value Recognition Contributions: Many management teams have taken steps to remove their stocks’ discounts through spinning out divisions, selling all or portions of their companies, and initiating, reinstating, or meaningfully increasing dividends. Abbott is splitting into two companies, and Liberty Interactive has further simplified by spinning off Liberty Ventures. Cemex plans to IPO a portion of its Latin American business. Energy companies including Chesapeake, Consol Energy, and Quicksilver have sold reserves and other assets at attractive prices. A number of our European management partners have taken action. Ferrovial has sold part of its stake in BAA at a high price. Hochtief has sold its stake in a Chilean toll road at a premium to our appraisal and is selling its airports. Leighton, the Australian construction firm that Hochtief controls, has begun to dispose of its non-core assets. ACS has sold its stake in Abertis as well as numerous infrastructure assets, and has more on the block. Accor has executed on its “asset-right” plan by selling a number of hotels including its U.S.-based Motel 6 properties. Intercontinental Hotels is selling the Barclay in New York. In Asia, Cheung Kong and Henderson have been monetizing some of their low-cost China and Hong Kong real estate at attractive returns. In Small- Cap, DineEquity has sold the last of its owned Applebees restaurants to become 99% franchised; Potlatch has taken advantage of private funds’ interest in timber by selling acreage at attractive prices; and management at Lamar Advertising is exploring converting its billboards into a REIT structure.
Since the outset of 2011, many of our corporate partners have returned capital to shareholders through higher dividends. Disney, Ingersoll-Rand, Nitori, Scripps Networks, and Vail Resorts have raised their dividends by 20% or more. Dell has initiated a dividend. Numerous companies have paid a special dividend or plan to by year-end including Accor, Ferrovial, Franklin Resources, Intercontinental Hotels, and Vodafone. While spins and dividends have not created additional value for shareholders, they have helped close some of the gap between price and corporate worth. In cases where management has sold assets for more than our appraisal, we have benefitted from value growth as well.
Southeastern Engagement: We have been actively engaged at several holdings, primarily to improve governance. With pressure from Southeastern as well as Carl Icahn, Chesapeake replaced six of nine directors, split the CEO and Chairman roles, and restructured board and CEO compensation. From the stock’s low in May, the price has risen 39% following these changes. Going forward, the directors, who collectively own meaningful shares, will seek to insure financial discipline in capital expenditure and debt decisions. At HRT we have pushed the company to expand the board and replace directors to gain a majority of independent members and enough industry expertise to impose prudent operating and capital decisions. With the acquisition of Global Crossing at Level(3), the board added three representatives from Temasek which owns approximately 26% and is focused on shareholder value growth. Just after quarter-end, the company announced that Mike Glenn, whom we have known for many years as EVP of Market Development and Corporate Communications at FedEx, is joining the board. Mike brings not only an understanding of he value of an infrastructure network (whether logistics or data), but true expertise in the disciplines of pricing and sales that are critical to Level(3)’s future success. At Texas Industries, where we suggested three new board members, the company successfully has managed costs and capex through the cement industry depression, and is now growing in its primary Texas market. Our public engagement over Martin Marietta’s offer to buy Vulcan has created pressure on Martin Marietta’s management to exercise price discipline while focusing Vulcan on substantial cost cuts. In each case where we have become more actively engaged, we believe we have positively impacted shareholder interests.
We Are Well Positioned for the Long-term
We expect our investments to do well over the next five years without a tailwind from meaningful economic growth. Most of our companies are market leaders with competitive advantages that should enable some degree of pricing power as well as unit growth. Just as important, almost all of our management partners have the operational skills, capital allocation discipline, and proper incentives to drive value per share growth. Many have increased their shareholder alignment by buying shares personally over the last year. To the extent needed, we will push as hard as is feasible to insure that managements and boards remain focused on their obligation to act in the best interest of owners. We will move on to better opportunities if we believe our engagement will not produce positive change. We are using modest assumptions in our appraisals. To the extent that economic growth returns to a more normal level, natural resource supply and demand becomes more balanced, or modest inflation adds a few hundred basis points to interest rates, the values of our businesses should rise much faster than we are anticipating.
Broad uncertainty about economic growth – in the U.S., China, and most prevalently in Europe – weighed down global stock markets over the last three months. The S&P 500 was down 2.8%; the Russell 2000 lost 3.5%; and non-U.S. markets took a bigger hit as EAFE declined 7.1%. While the Small-Cap Fund appreciated in the quarter, Partners and International declined. These results reversed the relative standing of each Fund for the year-to-date, leaving Small-Cap ahead of the Russell 2000 but Partners and International behind their benchmarks. Within the indices and Southeastern’s portfolios, stocks tied to broad economic expansion such as commodities, materials, and industrials suffered. However, most of our holdings’ appraisals grew or were little changed, because our models already assumed slow growth over the next few years and revenue declines in Europe through 2014.
With the recent market schizophrenia, we trimmed holdings that had approached their values or become overweight. Conversely, as certain stocks declined relative to their appraisals, we added, as did a number of our management partners. We also identified a few new qualifiers, primarily in names we have previously owned, where we typically have a deeper knowledge.
Portfolio Discussion Norms
Volatile quarterly performance often accompanies concentrated investing. Over Southeastern’s almost four decades, the twenty or so positions we have owned at any given point have fallen into three categories in client discussions. The first are those holdings that are rarely mentioned because their gains make them obvious winners such as DirecTV, FedEx, DineEquity, tw telecom, Fairfax, or Vodafone today. Most names fall into the second category, which also receives little attention. These companies generally are meeting operating expectations, but their stocks have not appreciated significantly. The large majority of discussion focuses on the third category, the few names that are in the penalty box at the time either because of real or perceived business challenges or management issues often highlighted in headlines. We expect and welcome discussing holdings that are most out of favor. We think it is important, however, to put those names in the context of what is normal within our investment approach. We will not be right on every investment. Over the long run if we are right on two-thirds of our picks, and wrong without losing substantial permanent capital on the other third, we can achieve our inflation plus 10% goal as long as we adhere to our margin of safety discipline. Given portfolio discussion norms, we will not elaborate here on Disney, Travelers, Abbott, Texas Industries, tw telecom, Vail Resorts, Scripps Networks, and Henderson Land – the largest contributors to second quarter performance. Instead, we review the recent events, investment case, and broader lessons from our most controversial name. Although Chesapeake Energy is only in the Partners Fund, its recent visibility has generated discussions with shareholders across the three Funds.
Chesapeake Energy (CHK)
Summary of 2Q: Chesapeake is an exploration and production company with a leading acreage position in three of the top U.S. gas plays and four top U.S. liquids plays. The stock fell 20% in the quarter. As natural gas declined in April to its lowest price since 1998, below $2.00/mcf, the media raised questions about CEO Aubrey McClendon’s potential conflicts, board oversight, and CHK’s ability to meet its 2012 cash flow needs. At its lowest point, the stock fell 42% from the end of March. Almost all of what was reported was previously known, but the rapid onslaught of stories blurred the lines between perception and reality. To best represent our clients’ interests, we became more active to push the board and McClendon to focus on what mattered – de-risking the balance sheet, managing costs and reducing discretionary spending while gas prices stayed at uneconomic levels, and focusing on operating the company rather than convincing the world of the long-term case for natural gas. The stock’s decline, pressure from Southeastern and Carl Icahn, and a looming proxy vote brought the most significant governance changes that we have ever witnessed at a company.
• They split the chairman and CEO roles;
• They ended the controversial Founders Well
Participation Program (FWPP) early;
• They reduced board compensation and benefits;
• They replaced four board members, with three nominees
from Southeastern and one from Icahn, and replaced a
fifth member with a new chair;
• They vetted the new, independent chair with
Southeastern and Icahn;
• They will replace an additional director at the conclusion
of a current audit committee investigation.
In total, the nine board members will consist of seven nominees pre-approved and/or submitted by Southeastern, including Lou Simpson who joined in 2011. The board fully embraces its duty to represent shareholders’ interests. Each member has a record of overseeing corporate assets and holding management accountable for value growth and recognition. Most have indicated their view of CHK’s upside by significant share purchases since their appointment.
Our process and case: Throughout the controversy, nobody has questioned the quality of the company’s assets. McClendon has done an excellent job building a portfolio of some of the best oil and gas acreage in the U.S. at attractive prices. Given the headlines, however, many have asked how CHK meets our “good people” criteria. As a first mover in leasing many shale plays and in pioneering horizontal drilling and fracking, McClendon has long been controversial. From the outset of our investment, we required even more due diligence than normal. Through our multiple industry, client, professional, and personal contacts, we gained insight about McClendon and arrived at a different conclusion than the image currently portrayed by CHK short sellers and much of the media. Also ignored in the criticism is that in 2011, McClendon was recognized as one of only eight public company CEOs who have been in place for over two decades and have earned a 20%+ yearly return for shareholders over that time.
As with every investment, from the outset we had to weigh CHK’s positives against its negatives. We fought against the FWPP behind the scenes well before it dominated headlines. Other negatives were not nearly as dramatic as recently characterized and had been available for years in the public domain to those who took the time to do their research. All of the leadership controversy is now moot. We go forward at CHK with one of the best and most vested independent boards that we have seen. They will be well informed and will make decisions only in the best interests of owners. Combining the new governance with some of the best physical assets we have owned makes us enthusiastic to have CHK as a core holding in the Partners Fund.
Lessons learned: Our conviction about CHK does not mean we are complacent about our path of ownership. We have learned two important lessons as our investment has unfolded. First, we recognize that in commodity businesses, being a low cost provider is not enough of an advantage for an overweight position since the commodity price is subject to going below the cost of production for an unpredictable period of time. Second, we learned a lesson that reinforces the importance of being a long-term investor who tries to work productively with management when change is warranted. We had much more influence in the tremendous governance transformation than we would have otherwise had if we had initiated our investment with guns blazing. The board and management listened to, trusted, and addressed our views knowing that our only agenda was to benefit long-term shareholders.
Context Beyond the Quarter
The second quarter serves as a microcosm of the much broader and longer lasting safety bubble that began inflating in the 2008 bear market. Whether measured by net flows of $1.2 trillion from U.S. equity funds into bond funds over the last 4.5 years, or the fact that dividend yields are materially higher than 10 year U.S. Treasuries for only the third time post-World War II, the flight to safety has had a dramatic impact on equity valuations. Investors are avoiding volatility at an arguably high cost. They prefer U.S. or German bonds yielding less than 2% to corporate earnings yields at 6-9%, as measured by S&P 500, Russell 2000, and EAFE P/E estimates. They are paying large premiums for long-life stable income via owning toll roads or airports in private infrastructure funds. They have pushed stocks with high dividend yields and stable earnings to or through fair values and abandoned the margin of safety priced into competitively entrenched businesses with high returns on capital but with more cyclical earnings and/or any debt. As with all investment bubbles, while it lasts, participants are rewarded, but when it collapses, which is always unexpected but predictable, the capital losses can be tremendous. This may be particularly true when investors think they own safety. If bonds begin to migrate to their 50 year average yield-to-maturity of 6+%, the bond price devastation will be substantial.
Many Longleaf shareholders have been our partners long enough to remember other periods when our intrinsic value investing approach was out of favor, causing disappointing relative returns. Those clients’ patience was rewarded by the strong outperformance when these periods reversed. When the current safety bubble bursts, our holdings should again greatly benefit. Our investment philosophy and rigorous discipline have been the mainstays that enabled us to generate our long-term successful results. We believe our unwavering investment process is more relevant than ever.
• Require investments to qualify on business, people, and price.
• Constantly test our assumptions and investment cases, making any necessary adjustments to appraisals and portfolios.
• Take advantage of macro market movements to improve the risk/reward profile of portfolios by trimming more fully valued holdings and investing in more discounted names or holding cash until we find qualifiers.
• Be introspective and analytical about the world around us and our experience at each company to make future decisions better informed.
• Maintain our commitment to client alignment via our substantial investment in the Longleaf Funds. (In addition to our normal personal inflows, the portfolio management team invested a substantial amount
into Longleaf Partners International Fund in the second quarter.)
Audio excerpts from May 1, 2012 Annual Presentation including investment thesis on Chesapeake, Cemex, Abbott, Dell and Level 3.
Mason Hawkins, whose $34 billion mutual fund firm is Chesapeake Energy Corp's largest shareholder, is best known as a Warren Buffett-style value investor who takes big stakes in companies and holds them, often for years...
Since 2008, investors have become increasingly paralyzed by trying to avoid risk as defined by stock price volatility. But short-term market fluctuations tell nothing about long-term investment outcome or business worth, which is determined by assets and free cash flow generation. Over the long run, corporate intrinsic values determine stock prices. For long- term investors in businesses, risk is not volatility but the probability that they may not get their capital back and earn an adequate return after taxes and inflation. Those who fear stock price swings are beholden to the notion that risk and return are highly correlated. The two are actually inversely related – prospective returns rise and risk of loss falls as a stock declines in relation to a company’s underlying worth. Over Southeastern’s 37 year history, we have built our investment process, disciplines, and criteria to protect the assets of our clients as well as our ownership stake in the Longleaf Funds from the possibility of incurring permanent capital loss and to generate adequate returns. The following discussion contrasts Southeastern’s approach to risk management with the predominant view that avoiding price volatility makes investing less risky.
Reducing Risk by Owning Quality Businesses
As equity investors, we own a percentage interest in businesses. Our analysts consider the five primary risks to business ownership in determining whether we are likely to get our principal back plus an acceptable return within a reasonable time period.
1) Business or competitive risk: We assess a company’s threats, competitive advantages, and their sustainability. The Porter model (see Competitive Strategy by Michael Porter) provides a helpful framework for analyzing an industry and an individual company’s position therein. We want to own companies impervious to the risk of business decline and obsolescence.
2) Pricing power risk: Related to competitive strength is a company’s ability to maintain margins by increasing prices at least as much as costs escalate. We want businesses capable of maintaining profitability in the face of increasing expenses.
3) Financial risk: We want companies that have financial flexibility and limited exposure to creditor obligations. We review the amount of financial leverage, who the lenders are, coverage ratios, maturity schedules, borrowing limits, restrictions, and covenants. In addition, we evaluate a business’ operating leverage to understand how much a top line downturn could impact balance sheet stability and our position as owners.
4) Regulatory, government, or control risk: If regulators can dictate profitability, rulers can nationalize a company or its assets, or someone with an objective other than earning an adequate return can alter the investment outcome, the chance of losing permanent capital may be too great for us to become shareholders.
5) Case-specific risk: A company may have unique challenges beyond its control such as legal liabilities or complete industry overhaul via legislation. Because forecasting the impact generally presents too much uncertainty around whether investment principal will remain intact, Southeastern tries to avoid these companies.
Reducing Risk by Partnering with High Caliber People
Capable, ethical, shareholder-oriented management stewards mitigate against capital loss because they prioritize prudent growth in value per share. Study, due diligence, and meeting with management teams prior to an investment and regularly once we own a company are important parts of our process. We consider numerous factors before we entrust our capital to a management team – properly aligned incentives, good historic operating results, high returns from capital allocation decisions, and personal integrity.
Reducing Risk by Paying a Deeply Discounted Price
The prices of public equities fluctuate, but the values of underlying businesses normally accrete steadily. Waiting for a stock to trade at a big discount to the underlying value of the free cash flow or assets of a business provides a margin of safety that helps protect against permanent capital loss in the case of an unexpected event or analytical mistake. Insisting on a margin of safety also leads us to sell fully valued stocks. In addition, we preserve capital by being patient and disciplined, and hold cash when no investments meet our criteria.
Reducing Risk by Portfolio Construction
Owning 18-20 companies across a number of industries provides the diversification to minimize company-specific risk and minimizes the risk of loss by limiting holdings to only the most qualified businesses, managements, and discounts. To introduce significantly more stocks would compromise the best-in-class criteria that are so crucial to preserving principal and generating excess return. We generally keep single industry exposure below 15%, and we manage positions to concentrate more heavily in our best qualifiers. We reduce or eliminate holdings as security prices approach companies’ intrinsic values.
Reducing Risk by Contemplating Unknowable Events
Nobody, including Southeastern, can accurately and consistently forecast future events, but unpredictable occurrences can impact business values. Southeastern protects portfolios to the extent possible in three primary ways. First, corporate appraisals must be conservative, and our purchase prices must be significantly discounted from our values. Second, we stress test appraisals for difficult operating environments and extreme events – how have previous recessions, inflationary periods, terrorist attacks, or investment bubbles bursting impacted a company’s results? Finally, we assess overlapping exposures across a portfolio. Reducing the risk of exogenous and/or macroeconomic challenges is best managed by those factors we can control – owning competitively entrenched, financially sound companies with capable management partners and having a large margin of safety between what we paid and what the company is worth.
Reducing Risk by Embracing Volatility and Benchmark Deviation
One of Southeastern’s biggest advantages is the long-term time horizon that we and our clients share. For those who demand consistent quarterly or yearly returns and determine capital allocation based on stock price movement, volatility defines risk, and material price changes over short periods are terrifying. Intrinsic value investors with an ownership perspective of a decade or more know that market declines create opportunity and reduce risk. Extreme price declines such as those that occurred in the fall of 2008 and third quarter of last year provide the chance to buy great business at rare discounts to intrinsic worth with minimal chance of permanent capital loss.
Those focused on short-term stock price changes versus business values try to minimize volatility via statistics such as tracking error, Sharpe ratio, and beta, which indicate relative price moves but tell nothing about whether capital will be preserved over time. The return for investors who expect to own a business for ten years is not impacted by these statistics. In the market’s “lost decade” that began at the outset of 2000, owners of the S&P lost principal with the so- called low risk of low tracking error. Conversely, Longleaf Partners Fund delivered 68% in the period and Small-Cap and International more than doubled by following our investment discipline and embracing opportunities that volatility offered. Over the long run our high conviction, benchmark-agnostic approach and resulting high tracking error have rewarded clients with superior compounding even though in shorter periods our beta may be high, and we experience intervals of underperformance.
Reducing Risk by Having Secure Operations
Investors have risks beyond security selection and execution. Southeastern maintains conservative operational and financial policies to further protect against capital loss. Securities lending is not done in the Longleaf portfolios except in rare circumstances. The Funds exclusively use U.S. government securities for cash management. We have ongoing reviews by our Chief Compliance Officer as well as heads of key operational areas to identify and ameliorate any potential firm or procedural risks.
Reducing Risk through Proper Investment Manager Alignment
Southeastern is 100% owned by its employees, and employees are limited to Southeastern-managed funds for their public equity investing unless granted an exception. Collectively, we are Longleaf’s largest shareholder and among Southeastern’s largest clients. The long-term viability of the firm and Funds is critical to us. We have built continuity and sustainable business strength through hiring to build next generation leaders across departments, creating an orderly transfer of firm ownership as individuals retire, relying on a team-based research process with individual accountability, and importantly, building a long-term, supportive client base.
Only two questions should matter to equity investors: 1) Did I get my money back, and 2) What return did I make? If the answer to the first is “no,” the second is irrelevant. We know of only two ways to satisfactorily answer both consistently. First, use Mr. Market’s temperamental moves to buy qualifying businesses at deep discounts to their intrinsic values. Second, invest with a long time horizon. Going back to 1970 (1979 for the Russell 2000), the S&P 500, Russell 2000, and EAFE indices have recorded declines in more than 20% of one year periods, while rolling ten year returns have rarely been negative. For holding periods of fifteen and twenty years, performance has been positive 100% of the time. Market volatility is reality, but long holding periods dramatically reduce the possibility of a negative return.
Southeastern combines the benefit of long-term investment horizon with quantitative and qualitative intrinsic value-based investment disciplines to generate a return of capital and a return on capital. As owners of our firm and one of its largest customers, nobody has more at stake in our future compounding than your partners at Southeastern, and consequently, nobody is more focused on reducing our risk of capital loss. Every facet of our approach to investing and to running our business is designed to preserve principal and earn an adequate return over the long run. We are grateful for your partnership in this endeavor.
Members of Southeastern's team review 2011 and current opportunity, and answer investors' questions.
The Great Dichotomy
Never in our investing careers has the prospective return on corporate ownership so surpassed the return on long-term lending. Never has the risk of permanent capital loss from long-term lending been so great. Oft-discussed macro fears and the accompanying market volatility have driven investors from equities into the supposed security of U.S. government bonds and other highly rated sovereign and corporate debt. The January 5, 2012 USA Today headline, “Bonds Outperform Stocks over 30 Years,” highlighted this flight and was reminiscent of the 1979 Business Week “Death of Equities” headline that preceded the high stock returns of the 1980s. Unlike the double-digit yields that 10-year Treasurys offered in the early eighties, today’s below 2.0% government yields are meager competition for the S&P 500’s earnings yield of 7.9%, the Russell 2000’s 6.4%, and the EAFE’s 9.3%. Moreover, and surprising to some, equities are even more attractive vis-à-vis bonds today than at the end of 2008, the worst economic downturn and bear market in our lifetime. Because of the large and unprecedented spreads between “safe” lending and business ownership yields shown above, we believe it is almost certain investors will begin swapping low or no return debt instruments for the much higher returns that high quality equities offer. According to the Wall Street Journal story on January 13th titled “China Reserve Changes Weighed,” China has begun to reconsider its approach to investing its $3.2 trillion in foreign-exchange reserves. The chairman of China’s largest state-owned bank indicated that “China may invest more of its...reserves in stocks, enterprises, and other assets as it looks for ways to boost returns.”
Because our future returns will be determined by the companies in the Longleaf portfolios, we have summarized the investment case for the five largest holdings. These names are representative of the caliber of our portfolio components. The qualified merits of “business, people, price,” including the current free cash flow (FCF) yield at each, will illustrate why we are convinced we should deliver positive, excess performance over the next few years.
Dell: Based in Austin, Dell has transformed its business by offering a combination of servers, services, storage, and software to provide enterprise solutions which now dominate and complement the desktop and laptop computing segment. As the world becomes “unplugged,” demand for solutions to manage hardware, software, and security will grow. With Dell’s product mix change, the company has delivered substantially higher margins and earnings. Michael Dell, founder and CEO, is a multi-billion dollar owner and has been a major insider purchaser over the last year. The market continues to focus on the “dying” PC business even though it is only 35% of our appraisal value, and analysts persist in evaluating the company against the consumer market which represents only about 10% of revenues. In assigning a multiple to the earnings, most analysts also disregard the large net cash that generates virtually no earnings and equals over a quarter of the share price. As long as the market ignores the growing free cash flow coupon, Dell should continue to use much of it to repurchase shares and build value even faster. Using expected 2012 FCF, the company’s FCF yield is 16.2%, but adjusted for the net cash, is over 20%.
Chesapeake Energy: Based in Oklahoma City, Chesapeake has assembled at low cost the best set of natural gas assets in the U.S. and a rapidly growing portfolio of oil reserves and production. Aubrey McClendon, co-founder and CEO, has been controversial but has consistently monetized assets at far above cost through either joint ventures like the most recent Utica transaction in late 2011 or the full sale of the Fayetteville holdings in early 2011. The stock sells for less than half of our NAV in part because the market doubts McClendon’s willingness to spend less than cash flow on additional lease acreage, but mostly because natural gas has declined to under $3/mcf due to oversupply and the current warm winter. At these prices, drilling is unprofitable, and supply will eventually decline as gas drilling commitments are met and rigs move to much more profitable oil wells. Longer term, LNG (liquefied natural gas) facilities are preparing to export gas to Asia and Europe where prices are over $10/mcf and transportation, industrial, and electricity generation demand is accelerating. Natural gas assets continue to attract large offshore buyers at substantially higher prices than Chesapeake sells for in the market. The free cash flow yield with $3/mcf gas and flat production in 2012 is 7.6%, but if adjusted for a higher gas price a year or two out as the futures curve suggests, the yield is well into the double digits. These numbers are also before backing out $10-15 per share for assets such as drilling carries, oil service company investments, and pipelines that provide little in earnings today but will probably soon be monetized at good prices.
Loews: Based in New York, Loews is a diversified holding company sagaciously stewarded by Jim Tisch and his management team. In addition to $4 billion in cash available to deploy opportunistically, the company’s primary assets are CNA, a dramatically improved property/casualty insurer led by talented Chubb alum, Tom Motamed, Diamond Offshore, an offshore drilling rig operator with substantial cash flow and a history of acquiring, leasing, and disposing of rigs successfully in a volatile industry, and Boardwalk, a natural gas pipeline and storage company with a growing cash coupon. The Tisch family owns approximately 25% of the stock and has intelligently allocated capital and delivered value growth for investors over decades. The company sells for roughly half of appraised value, in large part due to the mispricing of publicly traded CNA and the resulting conglomerate discount on Loews. Not only does insurance remain out of favor, but the results of Motamed’s turnaround have not been given credit, and earnings are highly volatile with the unpredictability of insured events. CNA shares sell for half of book value. As long as Jim Tisch is making capital allocation decisions, whether for large share repurchases at these discounts or for high-return acquisitions, we believe value will grow materially. Using consensus 2012 earnings, the company’s current FCF yield is 9.0%, but adjusted for the net cash, is 11.6%.
Aon: With a planned headquarters move from the U.S. to London, Aon is the top global insurance broker in an oligopoly. The company also is a leader in the investment and benefits consulting business. CEO Greg Case and his team have increased margins substantially and gained share over the last six years. Additionally, they have reinvested the growing cash coupon into Aon’s discounted shares and several successful acquisitions. The stock sells below 70% of our appraisal because of both depressed earnings from low interest on premium float and a substantial difference in reported and cash earnings due to goodwill amortization from acquisitions. As long as the shares remain significantly undervalued, management expects to grow value-per-share by meaningful repurchase activity. Based on 2012 expected FCF, Aon yields 10.1%.
DIRECTV: Based in El Segundo, DIRECTV is the largest satellite broadcaster in the U.S. and has dominant market share in Latin America. Domestically the company offers unique technology and programming that attract high-end customers with little churn. In Latin America, most countries have no alternative because neither cable nor fiber have been or will be laid where there is minimal infrastructure. The market puts a low growth multiple on the entire earnings stream, not accounting for the more valuable emerging market growth. Additionally, SAC (subscriber acquisition cost) is counted against earnings rather than being treated as discretionary capex that provides a return via revenues over multiple years. The stock trades below 70% of our appraisal, and Mike White has done a tremendous job building value by using the substantial cash coupon to buy in shares aggressively at deeply discounted levels. The free cash flow yield based on 2012 expected FCF is 10.3%.
Sentiment is as fearful and irrational as we have experienced. Not surprisingly, your partners at Southeastern are finding the most compelling opportunities we have seen since early 2009.
I think the future of equities will be roughly the same as their past; in particular, common-stock purchases will prove satisfactory when made at appropriate price levels. It may be objected that it is far too cursory and superficial a conclusion; that it fails to take into account the new factors and problems that have entered the economic picture in recent years — especially those of ... the movement towards less consumption and zero growth. Perhaps I should add to my list the widespread public mistrust of Wall Street as a whole, engendered by its well-nigh scandalous behavior during recent years in the areas of ethics, financial practices of all sorts, and plain business sense.” — Excerpt from June 1974 speech by Benjamin Graham, printed in Financial Analyst Journal, September/October 1974
The opportunities created in the equity market disarray of the early 1970’s cited above precipitated the 1975 founding of Southeastern Asset Management. Similarly, uncertainty relating to various global economic conditions has created numerous opportunities for today’s long-term investor. We have endured material stock price declines in the last few months as macro fear around well-known issues of European sovereign debt, U.S. deficit reduction, and Chinese inflation control rendered company fundamentals irrelevant. As evidence of how little the market discriminated among businesses, stock price correlations in both the U.S. and Europe surpassed the level experienced in 2008 after Lehman’s collapse. The closer correlation moves to 100%, the less differentiation there is in how individual stocks trade. Correlation in September reached 85% for the FTSE 100, and the S&P 500 hit 90% compared to its historic average of 30%.
In other previous periods of high correlations, including 1982, 1990, and 2008, Southeastern suffered short-term underperformance. The third quarter of 2011 was no different. Out of favor companies became more disdained, and any perceived challenges became magnified in people’s minds. Similar to past periods, the companies that most negatively impacted results were economically sensitive businesses and/or those with some financial leverage. Following these periods, Southeastern has posted substantial outperformance when company fundamentals return to the spotlight and correlations fall back to normal levels. Severely discounted prices tend to snap back like a tightly compressed spring.
If we know this common refrain, why not alter our investment strategy to avoid the types of companies that suffer when pessimism and correlations rise? Warren Buffett commented on this idea in his July 1966 Partnership Letter.
“I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership... We don’t buy and sell stocks based upon what other people think the stock market is going to do, (I never have an opinion) but rather, upon what we think the company is going to do. The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right... Who would think of buying or selling a private business because of someone’s guess on the stock market?”
We are incapable of knowing what stocks will do in the short run. To make investments based on correlation changes would require two correct calls — when to sell and when to reinvest. Being accurate in either prediction is a low probability, but when the two probabilities are multiplied, the chance of success is remote. Patience and discipline historically have rewarded our partners who believed in intrinsic value-based investing and who stayed owners through full market or correlation cycles. Price declines are painful, but do not equate to capital losses if investors stay long-term and business values remain intact.
Our most important task is to ensure that whatever is causing stocks to decline will not permanently impair the businesses we own. We have assessed what is causing individual security price weakness, what might alleviate this pressure, and where we could be vulnerable to appraisal risk for each portfolio company. A number of our stocks have been under pressure because of the macro unknowns related to economic growth over the next few years and to government actions addressing debt and growth. Across all portfolios, those securities hardest hit have included cement and aggregates companies, economic bell weather businesses such as FedEx (transportation), Accor (lodging), and Lamar (billboard advertising), emerging market energy firm HRT, and companies with a combination of operating and financial leverage like Level(3). The market’s misunderstanding of our businesses also has weighed on certain companies, such as Olympus (not a camera company), Ferrovial (not a Spanish construction business), Philips (not a consumer electronics company), and Dell (not a hardware company).
In spite of global economic uncertainties, the prospects for our companies to grow units and pricing over the next 5+ years are solid. The competitive strength of our holdings combined with rational pricing within many of their industries will provide some protection in a downturn. Weak U.S. and European economies will have less impact than is apparent because at a number of our businesses, emerging markets have become an increasingly meaningful part of value either directly or indirectly. Although U.S. housing starts may not rise to meet new household formations for a couple of years, political leaders both within and outside of the U.S. must address infrastructure needs sooner to maintain their positions. The few companies whose stocks have been penalized because of some financial leverage have no major maturities for over two years and have extremely valuable, severable assets worth more than debt requirements. Those asset values have been affirmed by recent comparable sales at or above our appraisal metrics. To the extent we have had concern about a company’s intrinsic value or its growth, we have sold shares to buy a similar or more attractive P/V with higher quality and predictability.
Much of the fear in the market is a residual of the fresh scars from 2008 causing a “flee first and ask questions later” reaction. Slowing economies and western government debt are real issues, but do not inherently translate into the corporate value deterioration that many businesses experienced in 2008. Then, the burst of the U.S. housing and credit bubbles catapulted much of the world into a deep recession and created a liquidity panic. Most investors did not anticipate an economic interruption, and few had any idea how far it would permeate. The primary challenge today is neither a liquidity shortage nor corporate or consumer excess but government policy related to sovereign debt and emerging market inflation. These same issues have weighed on stocks over the last year, are well known, and seem more than incorporated into our securities’ prices.
As a further contrast, in 2008 businesses were structured for peak operating levels. Companies were geared to expand and meet consumer demand fostered by cheap and abundant debt. When credit was withdrawn, the consumption decline was immediate and widespread. Today, companies have significantly less exposure. Although the global recession officially ended two years ago, slow recovery and caution have tempered businesses’ expansion plans for growth, as unemployment numbers indicate. Cost structures are already sized to recession levels; inventories are lean; balance sheets are strong with almost all of them de-risked; and industry- leading companies have become more dominant over the last few years. A number of our businesses have not rebounded. Property/casualty insurance underwriters such as Travelers, NKSJ, CNA, and Fairfax, reinsurers including Everest Re, and brokers, Aon and Willis, have had minimal pricing gains, and the industry’s overcapitalization still weighs on insurance rates. Additionally, bonds, a meaningful component of these companies’ investment portfolios, are producing minimal yield given current interest rates. Low interest rates also have kept BNY Mellon’s earnings depressed. Cement and aggregates companies such as Cemex, Lafarge, Texas Industries, Vulcan, and Martin Marietta, have seen no U.S. or European recovery. U.S. natural gas prices around $4/mcf have kept Chesapeake’s revenues at recessionary levels. While these companies have tremendous operating profit upside when economic growth improves, our appraisals do not assume a normal GDP bounce will help in the next few years. Adapting to a possible 2012 recession would be like stepping off of a curb rather than falling from a skyscraper for these businesses and their values.
While the market is ignoring positive fundamentals, many of our investees are using the negative sentiment to meaningfully grow value through share repurchases. When stocks completely decoupled from corporate values in late 2008-early 2009, we called on our CEO partners to repurchase as many shares as possible. A few responded, but most were too fearful of how bad the economic damage might become to aggressively use any cash cushion. Today, most of our corporate partners see minimal growth but believe that their strong business prospects over the intermediate term make repurchasing today’s discounted shares the optimal capital allocation choice. Our portfolio companies collectively are shrinking shares at an average 4% annualized rate, with CEOs at DIRECTV, Travelers, Philips, FICO, and Wendy’s repurchasing at a rate in the teens. Warren Buffett has initiated Berkshire Hathaway’s first buyback. Not only have strengthened balance sheets and strong cash flow given companies the arsenal to steal shares, beneficial capital allocation work over the last two years has put our partners in a much improved position. Companies such as Chesapeake, Ferrovial, Vodafone, and ACS have sold assets at attractive prices; Cemex, Liberty Interactive, Level(3), and Dine Equity have decreased and/or termed out their debt opportunistically; a few holdings such as DIRECTV and Disney have issued cheap corporate debt to buy much higher returning shares.
Over time, economic fears and downturns inevitably will occur, but the most successful investors view these periodic events as opportunities. Southeastern’s 36 year experience indicates that the best assurance for both protecting capital from permanent losses and compounding at above average rates is to:
• Have a long-term investment horizon for buying and holding through economic cycles,
• Use conservative assumptions in our appraisal models,
• Own high quality, competitively entrenched businesses that can go on offense in challenging times,
• Partner with management teams who can operate successfully through business cycles and who will always work to prudently maximize value per share, and
• Pay a substantial discount to a conservative appraisal to provide protection against the impact of unpredictable events.
As the largest owners of the Longleaf Partners Funds, we have used the recent price downdraft to meaningfully add to our stakes. Broadly speaking, the return on corporate ownership vis- à-vis the return on lending seldom has been so compelling. With the S&P 500’s growing, after-tax free cash flow yield around 10% and the pre-tax, fixed 10-year Treasury at 1.8%, shareholders receive over five times the return of bondholders, before adjusting for taxes or future growth. More specific to the collection of businesses we own, we have both little uncertainty about how they will fare over the next five years and the rare opportunity to purchase them at half or less of appraised value. We encourage our partners to join us in adding capital at this opportune time.
Analysts describe backgrounds and attraction to Southeastern
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What differentiates Southeastern's research?
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Lessons of 2008
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How macro themes impact company analysis
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What opportunity is most exciting today?
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Corporate management interaction post-2008
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View on Dell
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View on dividends
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How Southeastern adds value to companies we own
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Corporate governance in Japan, NKSJ & Olympus
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Due diligence report on Southeastern based on an on-site visit to the firm and conversations with all 11 analysts.
Instantaneous reaction and speculation dominate stock swings today. In May and June sentiment dramatically changed with more speculation around slower global economic growth and Greek debt default. No significant new developments accompanied the confidence reversal. Market fluctuations are nothing new, but the speed and magnitude of the market’s mood change indicated a reactive rather than reflective environment. Equity funds, which had positive flows through April, experienced outflows every week in May and June, with significantly larger withdrawals in the final three weeks of the quarter. Conversely, bond fund flows peaked in May and were strong again in June. We saw similar movement among institutions as the pace of pension plan “de-risking” increased. The Advisors Sentiment report in Investors Intelligence measured the rapid and dramatic confidence swing. The 57% of advisors who were bulls in early April fell to 37% in mid-June, while fewer than 16% started as bears but grew to 28% over the same period. The difference between bulls and bears, therefore, went from over 41% to under 10% in fewer than three months.
These market observations did not impact our investment decisions, but they provide context for the opportunity change over the last three months. At the end of the first quarter we noted that few new companies met our qualifications and the cash in our portfolios would give us flexibility if markets declined. One of Southeastern’s advantages is our discipline of doing detailed business analysis and generating in-depth company appraisals. Armed with our long-term investment horizon and conservative appraisals, we capitalized on the short-term mispricing created by the market’s rapid reversal. By the end of June we had found five new qualifiers as well as added to nine existing holdings across the three Funds.
Even though returns in 2011 have been positive, the price-to-value ratio (P/V) has grown more attractive in each Fund for three reasons: 1) we have sold and trimmed more fully priced names, 2) we have bought and added to holdings that were trading below 60% of appraisal, and 3) the values of most companies have grown. We believe the Funds contain a great deal of compounding opportunity. Not only are they selling at a large discount to appraisal, but the high quality, competitively advantaged businesses we own and the capable corporate stewards running them should drive additional strong value growth for the foreseeable future.
Holding increased to 5.368 million shares.
The human toll both in Japan and the Middle East uprisings is tragic. The tsunami recovery will take many months as could political and economic stability in Tunisia, Egypt, Libya, Yemen, and the other countries that are in flux. Ironically, the uncertainty has enhanced the longer term attractiveness of several portfolio companies. Middle Eastern oil supply concerns have placed a higher premium on growing reserves outside of the region including Pioneer Natural Resources’ Spraberry field in the US (in Partners and Small- Cap) and HRT’s Brazilian and Namibian exploration rights (in International). The sharp price rise in oil relative to natural gas has also improved the longer term outlook for Chesapeake’s natural gas reserves (in Partners). Gas rigs will decline as more operators move to extract more profitable oil, and demand will increase as the cost to convert from oil to natural gas is more economically attractive. Higher oil prices also should benefit Cemex because the Mexican government’s oil receipts will rise and lead to more infrastructure and housing spending, and the company’s competitive advantage improves because Cemex has the lowest energy costs in the industry.
The Funds’ insurance holdings illustrate one of Southeastern’s major advantages in generating superior long-term returns — time horizon arbitrage. Most analysts make stock recommendations based on the outlook for a company over the next few quarters. For them, a one-year horizon is long-term. Conversely, Southeastern appraises business values which are dependent on multi-year free cash flows. If an industry or a company faces short-term pressures such as a soft pricing cycle, but the strength of the business and its prospects over five years remain intact, we may get the opportunity to buy a high quality company at a substantial discount to its underlying value.
Currently we are finding fewer businesses that meet our required discount given the overall rise in global stock prices over the last two-and-one- half years.
Inflation plus 10% remains a worthy and achievable goal but will be more difficult to deliver over the next few years given the higher P/Vs. As opposed to the recent period when appraisal growth was anemic but returns were huge, we anticipate that most of our performance in the next few years will come from considerable value growth and finding new investments at less than 60% of conservative appraisals. We have begun to see explosive appraisal increases in the last quarter or two at some companies. We anticipate additional substantial gains given the quality of our businesses, the abilities of our management partners, and the conservatism in our appraisals. In contrast to concerns some market bears have about high corporate margins, most businesses we own are still operating well below peak margin and/or revenue levels. Additional margin improvements and revenue gains will contribute to the anticipated value growth. Meanwhile, if the market pulls back, we have significant financial flexibility either to add to existing holdings or to purchase new qualifiers.
Discussing the differences between evaluating U.S.- and non-U.S.-based companies...
For Southeastern, qualitative strength matters a great deal in stock selection at all times, no matter what the macro environment or relative valuations are. “Cheap” is not enough to protect capital and earn adequate returns. Broadly used quality categories and metrics, however, do not adequately capture the strengths of many businesses. In our 35 year experience the following characteristics when purchased at a steep discount (price matters), almost always lead to investment success.
• Distinct and sustainable competitive advantages that enable pricing power, earnings growth, and stable or increasing profit margins.
• High returns on capital and on equity as measured by free cash flow rather than earnings, which are subject to so much accounting gimmickry.
• A properly geared balance sheet that takes advantage of the lower cost of debt versus equity but will not overextend the company in tough times. The debt/equity ratio is only one measure for capital structure prudence. We consider overall leverage versus the sum of the parts value of a company. We also review debt structure, covenants, and major maturity dates as well as operating cash flow/interest coverage to determine whether a company can meet its obligations comfortably.
• Corporate management’s operating skills, capital allocation prowess, and properly aligned, ownership-based incentives. In over three-and-one-half decades our investments that have outperformed most have been due in large part to capable, vested owner-operators who made decisions that increased business quality as well as value per share.
Sometimes investors question the “quality” of our holdings, usually because these companies either do not fit a formulaic definition of quality or because of a recent headline scare that obscures an incredibly strong long-term competitive position. It is not exactly to our benefit to correct this misperception. We can pay far more attractive prices for assets which are of the highest quality though not yet perceived that way compared to the price premium usually built into those companies that have universally achieved consensus as “high quality” based on simplistic measures that may or may not properly reflect the risk of losing permanent capital.
The Longleaf Funds own primarily high quality businesses today, many of which remain misunderstood and therefore cheap. We anticipate solid value growth in 2011 from our companies. In the few cases where qualitative characteristics are in question, we are working internally and with managements and boards to assist in building values. In rare cases where we believe the business might become permanently impaired, we exit.
We strongly disagree with those who equate stock price volatility with low quality and increased risk. Amidst the extreme price fluctuations in 2010, our best performers were some of the highest quality companies we own. None were among the most heavily levered (by any metric). The high returns generated involved little to no risk. (We define risk as the chance of permanent capital loss). Price movements have no bearing on capital loss unless one is forced to sell at a low point. Long-term investors who know the value of their businesses and intelligently take advantage of price volatility increase their return opportunity and lower their risk of loss.
The number of on-deck prospective investments remains higher than normal. Our analysts have presented numerous new ideas for consideration; we are fully invested; our most difficult decisions are choosing between great companies we own and qualified new ones; and we have added ten names across Southeastern’s portfolios over the last six months. Investor fear driven solely by global macro concerns is fueling our research productivity. During the quarter Investors Intelligence reported that the spread between bulls and bears had fallen to the same level as March of 2009. The New York Times noted on October 1 that “fixed income markets have seen greater inflows than equities did during the tech bubble of 2000. Record low interest rates in many developed countries imply macro concerns about a double-dip recession and/or deflation. Conversely, gold’s record highs and the concomitant “flight to safety” indicate macro concerns about inflation. Evidence of the macro obsession and utter disregard for individual company merits comes in various forms – individual stock movements are highly correlated with overall market moves; macro funds have increased in number and net flows; and perhaps most tellingly, the Wall Street Journal recently quoted one research firm as declaring that “Stock picking is a dead art form.
Not only are investors concerned about sovereign debt, growing deficits, and lackluster economic growth, they also extrapolate the “lost decade” as representative of what most developed markets will deliver in the future. Our conservative and growing company appraisals, our long-term time horizon, and that of our clients give us the ability to seize the opportunity created by short-term macro fears and the mispricing of superior global businesses.
We’ve operated through seven bear markets, and what’s been unique about this one is the opportunity it has created in the highest quality stocks. From the third quarter of 2008 through the first quarter of 2009, we were given an opportunity to own best-in-class companies at price levels I’ve never seen in my experience. Coming out of the 1974 bear market, for example, you were lucky to buy one or two industry leaders, because they all went into the bear market so overpriced that they still weren’t cheap enough. Today our portfolio companies have collectively never had as strong com- petitive positions and you can buy them at 55-60% of our conservative appraisal of their intrinsic values. That compares with our long-term average price/value ratio of around 68%.