Mason Hawkins' Longleaf Partners First Quarter Letter
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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 longterm 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 socalled 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.