26 Jul 2010 Longleaf Partners - Q2 2010 Letter
Macroeconomic concerns continue to dominate market sentiment, which in the last two months has grown considerably more pessimistic. In late June at the Morningstar Conference where many investors gathered, the overwhelming participant focus as described by a Morningstar panel moderator was the “three D’s” – debt, demographics, and doom. We would add a fourth “D” – double dip.

As our investment partners might expect, the widespread angst and concomitant volatility have helped us find new opportunities. A number of high quality businesses have become discounted enough to meet our criteria.

Equities offer a superior opportunity for investors today, particularly compared to fixed income. The earnings yield of the S&P 500 based on 2011 projected EPS is 9.4%. If adjusted for the approximately $100 of cash imbedded in the S&P, the operating earnings yield increases to 10.4%. The numbers are slightly more attractive overseas. Based on 2011 estimates, the EAFE Index earnings yield is 9.8%. If earnings grow organically from today’s depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor’s five year average annual return will be in the mid-teens.

By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce. When stocks have been at their lowest levels, earnings yields have been an average of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks’ relative attractiveness to bonds at bear market lows. We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one. In spite of the short-term market noise that the “D’s” are creating, over the long run equities will reflect the value of the free cash flow streams that businesses produce.

20 Apr 2010 Longleaf Partners - Q1 2010 Letter
We have emerged from the seventh and worst bear market in Southeastern’s history. Unique to the 2008 meltdown was the availability of so many best-in-class industry leaders at severely discounted prices. As we wrote in the third quarter of 2008, “the Funds hold the highest quality businesses in Southeastern’s history.” We have noted that the corporate managements at our holdings are the best collective group of partners with whom we have co-invested. The competitive advantages of our companies have grown, and our management partners’ abilities have been demonstrated more clearly over the last eighteen months. In addition to superior qualitative characteristics, the Funds’ quantitative attractiveness is equally strong. We believe the return opportunity that remains in the Funds even following the appreciation over the last year is substantial.

• The price-to-value ratios for all three Funds are in the low to mid-60%s, below our long-term averages.
• The return opportunity could be much higher than our P/Vs imply because our current appraisals are calculated assuming low secular growth from a depressed 2009. If the cyclical economic recovery is normal, our value assessments will prove to be low.

• Appraisal acceleration is likely to be greater than in previous post-recession periods due to the substantial cost cuts that occurred at our companies. Modest top line increases will generate much larger free cash flow gains due to the operating leverage.
• Meaningful cash on hand combined with growing free cash flow coupons will enable our owner-operator partners to make capital allocation decisions that will further build value and/or return more capital to shareholders.
• Market participants and asset allocators remain skeptical of U.S. and developed non-U.S. equities as measured by the direction of fund flows into fixed income, emerging markets, and alternatives over the last 15 months. A great deal of liquidity sits on the sidelines. These observations do not pertain to our appraisals, but do imply that prices within our universe have not been driven by speculation but predominantly by fundamental improvements at our companies.

We find that many investors currently have little interest in hearing about our company valuations, P/V ratios, the great businesses we own, or the terrific managements with whom we have partnered. This lack of interest in our fundamental research corresponds with ongoing macro concerns. Many believe that another shoe will drop from government intervention, monetary and fiscal policy mismanagement, a second leg to the recession, or some combination of these. Didn’t 2008 show that such negative macro scenarios will overwhelm our appraisals and our “margin of safety?”...

27 Jan 2010 Longleaf Partners - Annual Report
Lessons of 2009
After the market meltdown of 2008, the most frequently asked question we received was, “What have you learned?” In previous shareholder communications we have elaborated on the things we learned including painful lessons from mistakes that cost us a few permanent losses.

In addition to that oft asked question, the most discussed topic has been macroeconomic forecasting’s importance. The macro environment dominated everything in 2008. For those doing solid bottoms-up corporate analysis, the credit crisis overwhelmed individual company analytical conclusions. “Micro” work seemed practically irrelevant, generating suggestions that macro issues should become a greater focus for Southeastern to better protect our investment partners. An understanding of how the macro will affect those names that we own or are considering always has been important. In a vacuum we would not follow Mexican macroeconomic statistics. But as a shareowner of Cemex, we must have some grasp of the Mexican economy’s drivers to properly assess intrinsic value and understand appraisal risks.

Interestingly we have not been asked about the “lessons of 2009.” The first answer to that unasked question is that bottoms-up fundamental company analysis matters quite a bit. If it were probable that every year could be like 2008, every investor should try to monitor the global banking system and engage in macroeconomic prognos- ticating. However, if it were highly probable that the worldwide economy, banking system, and equity markets would not look like 2008 in most years, then we should not abandon lessons from Graham, Buffett, and our 35 years to become macro driven “generals-fighting-the-last-war.” Simply stated, 2009 reminded us that 2008 was anomalous.

A macro oriented investor could have logically decided on January 1, 2009 (or in March when stocks were meaningfully lower) that with the horrible global economy, the teetering banking systems across multiple countries, and the extremely weak stock markets, it was a good time to sit on the sidelines until some economic clarity emerged. By contrast, an intrinsic value investor who focused on the free cash flow that certain well-run, competitively advantaged companies generated – even in a severe recession – would have purchased those cash flow streams at incredibly low multiples, i.e. high cash flow yields. Those who chose the macro route and parked in cash missed what was the best purchase point for equities in our lifetime and earned virtually nothing on their liquidity.

This leads to the second lesson of 2009: comfort comes at a very high cost. Buffett made this point in an August 6, 1979 Forbes article entitled, “You Pay A Very High Price In the Stock Market For A Cheery Consensus.” Selling stocks in 2007 would have been uncomfortable; in retrospect we all should have done more of that. Buying or even holding stocks in early 2009 was very uncomfortable; investors should have done that. Many investors feel most comfortable when the consensus confirms their view. Making the same investment choices as a large number of other intelligent people mathematically almost insures doing the wrong thing at the wrong time because security prices reflect the collective action of the consensus group.

So where are we now? We believe that we are between the valuation extremes of the mid-2007 highs and the early 2009 lows. With global markets having risen rapidly since March, bargains are less plentiful, and free cash flow yields are less attractive. However, valuations are still compelling when compared to the past. Our price-to-value ratios remain at or below the long-term average. Also, the “comfort gauge” still appears favorable given the excessive quantity of cash people are holding in lieu of equities. This cash on the sidelines constitutes significant future buying power that will someday make its way back to attractive, growing corporate free cash flow yields that almost always find their long-term recognition either in the stock market when overall psychology shifts or from corporate M&A. Today many macro mavens are comfortable owning the taxable, fixed coupons of 10-year Treasuries at yields of 3.7%. We much prefer the after-tax, growing free cash flow coupons of dominant businesses at yields of 9-10%.

22 Oct 2009 Longleaf Partners Funds - Q3 2009 Commentary
If the global economy grows, and 2009 proves to have been a single-year dramatic low in operating results rather than the “new normal,” our appraisals are too conservative. Additionally, given how meaningfully our management partners have cut expenses, values should skyrocket whenever top line growth does return.

We expect most of our companies to gain share, increase pricing, and/or improve their profit margins in the recovery. In a number of cases, they have moved aggressively to strengthen their competitive advantages in this challenging environment.

Our on-deck list of qualifying new investments has shrunk over the last six months with the rally in worldwide markets.

27 Jul 2009 Longleaf Partners - Q2 2009 Commentary
As investors emerge from the shock of 2008, the debates that always accompany bear markets are appearing. We hear low return expectations from the investment community and low profit expectations from the business community. Negative sentiment bottomed out in early March, but uncertainty remains dominant. Numerous CEOs have told us that they are stockpiling the cash flow from their businesses because of current challenges. The June 29th USA Today contained an article about how buy-and-hold investing no longer works. One investor was quoted as saying, “I don’t trust any stock anymore.” Although advisor sentiment has rebounded from a decade low in October, the percent of bullish advisors relative to bearish advisors remains far below its levels over the last ten years. The active versus passive debate has reemerged after many managers underperformed in 2008. Over the six months ended in March, data shows that institutional investors added to passive investments while taking money away from active managers. This much negativism about long-term investing usually makes us optimistic. This sentiment, however, is not the source of our current confidence. We believe that the great returns over the last three months are only a partial reflection of what the future holds.

23 May 2009 Audio/Slides: Longleaf Partners annual presentation
Excellent series of audio commentaries and slides by Mason Hawkins of Longleaf Partners discussing value investing, the current market conditions, and specific stocks in the funds…

17 Apr 2009 Longleaf Partners Funds First Quarter 2009 Commentary
When we discuss the characteristics of the businesses we own, something we can talk about with a degree of certainty, many lose interest. Market commentators’ remarks often imply that the old-fashioned approach of buying and holding individual undervalued securities as a protection against future events is not only antiquated but worthless in this environment. Because macro events indeed dominated all returns in all asset classes in 2008, people illogically are extrapolating that macro events will exclusively dictate all future performance.\

Security analysis not only remains relevant, but is more important today than at any point in Southeastern’s history. Current conventional wisdom, which holds the opposite view, is pricing in an Armageddon macro scenario and driving equity prices to levels that offer huge opportunity to a good business analyst and long-term investor.

Because most have abandoned security analysis and long-term investing, and many have sworn off equities for fear of short-term macro uncertainties, our opportunity to own severely discounted dominant companies has never been better...

15 Apr 2009 A Portfolio of Great Companies at Cheap Prices
Of course, Hawkins, a crusty legend in the mutual fund industry, couldn't care less about short-term results. Operating from Memphis, Tenn., he's run Longleaf since its inception in April 1987 (Staley Cates became a co-manager in 1994), adhering strictly to a bottom-up, value-oriented discipline with an eye toward the long term.

One of Hawkins's favorite measures is to compare a stock's free-cash-flow yields to the yield of Treasuries. ...he says, "stocks have never been cheaper" during his 35-year investment career.

Hawkins notes that many of the holdings in his concentrated portfolio, such as Dell (DELL), Disney (DIS), eBay (EBAY) and DirecTV (DTV), are paying free-cash-flow "coupons" well into the teens. And, unlike the fixed-interest payments of Treasury bonds, these "coupons" will grow over time...

12 Feb 2009 Longleaf Partners - Q4 2008 commentary
...Dell sells for less than 4X currently depressed after-tax free cash flow once one subtracts almost $5/share of net cash and DFS receivables. Over the longer run, worldwide laptop, server, storage, and services demand will grow, even if desktops never do. Dell is uniquely positioned to be the low cost, custom-order solution for commercial customers with its direct sales model, while offering consumers both direct sales as well as off-the-shelf alternatives.

Chesapeake Energy, the largest publicly traded independent natural gas operator in North America, sells for below 25% of our appraisal and less than 2X after-tax discretionary cash flow...

07 Feb 2009 Longleaf Partners Q4 2008 commentary
Throughout the year we followed our long-held discipline of trying to protect capital by buying businesses with competitive advantages, good management partners, and prices below 60% of appraisal. In 2008 many high quality investments went from 60-cent dollars to 30-cent dollars, even after lowering appraisals to account for the worse environment. We believe that prices will return to fair value at some point meaning that returns on our capital are deferred, not lost...