The relative underperformance in the quarter came as much from what we did not own as from price moves in our names. The financial sector, specifically banks and life insurers whose leverage is too risky for our appetite, drove a large portion of return in U.S. and global indices as interest rates bumped up. Our cash position built during the first quarter with sales of businesses approaching our appraisals and dampened our performance relative to the rising indices. Various individual holdings detracted from second quarter returns, and most of those were retreats from recent strong rallies. No common denominator impacted our primary performance detractors.
Any single quarter usually indicates little about our long-term results. Rarely in Southeastern's 38 years have our 1, 5, and 10 year returns simultaneously lagged the benchmark, but currently the Partners Fund is in such a period. Longleaf International faced this same challenge within the last twelve months before its relative returns improved. While absolute returns are our primary focus, underperforming the market over these periods is disappointing and unacceptable, but not unprecedented. When we had a similarly tough stretch in 2000, the Partners and Small-Cap Funds fell behind their benchmarks for 1, 5, and 10 year periods by a much wider margin than today's Partners Fund lag. Then and now, the combination of a few stock-specific challenges and an extreme market environment that rewarded a narrow segment of stocks caused our underperformance. In 2000, the high-flying growth and Internet stocks selling at nosebleed multiples propelled the market, while we owned high quality businesses that sold at attractive discounts because they were part of the "old economy." A few troubled visible names also hurt our performance (Waste Management, Host Marriott, SafetyKleen). During the last five years, higher yielding, stable "safe stocks" became overvalued and led the market in an environment plagued by fear and volatility. We own steeply discounted, more cyclical companies with high quality assets and/or entrenched competitive advantages. A few troubled, visible names have caused a large portion of our longer term underperformance both in the U.S. (Dell, Chesapeake, Level 3) and outside the U.S. (HRT). Within five years of the 2000 period, the Partners and Small-Cap Funds had dramatically outperformed their indices with 5 and 10 year numbers far higher than their benchmarks. Today, we believe our absolute and relative return opportunity for the next five and ten years is equally as bright across all four Longleaf Funds for several reasons. Continue Reading »