Weitz Funds' First Quarter Letter
The first calendar quarter of 2012 was a very good one for the stock market. Our stock funds earned total returns ranging from +7.8% (Partners III) to +11.9% (Research). The market has rallied very strongly from its lows of last October, and we have become more cautious as the average price to value of the stocks in our portfolios has risen from roughly 60% to 75-80%.
When our stocks approach full value, we trim our positions. As we sold into rallies, our cash levels rose from 10-15% last October to 20-25% at quarter end. In a strong market, cash dampens returns, and we trailed our benchmarks in the quarter. We would prefer to beat all the market indexes all the time, but we are content to celebrate the good absolute returns and wait patiently for our chance to redeploy our cash reserves.
The Balanced Fund turned in excellent results for the quarter (+7.5%). The Balanced Fund invests in both stocks and bonds. A "neutral" allocation would be 60% stocks and 40% bonds. Brad has shifted Balanced to a more defensive posture and still generated a return that would be pretty good for a full year.
Our bond funds remain very defensive. Short-Intermediate has eschewed the "fear trade" in Treasuries and has kept quality high and duration short. Yet Tom managed a +1.5% return for the quarter for the Institutional Class. Going forward, as we have said every quarter for some time, the environment for bond investing is very negative. We will remain very cautious and while we believe we can deliver positive returns over time, bond investors should keep their expectations low. For additional performance information, please review our complete Performance Summary which presents investment results and includes relevant market indices and related disclosures. "Uncertainty" is a Permanent Condition
The U.S. economy continues to recover slowly. The problems of excess housing supply and unserviceable mortgage debt are slowly being resolved. Companies have been slow to rehire during the recovery as they have found ways to increase productivity among their remaining workers. Depressed tax receipts have led to austerity measures at the state and local levels while highly stimulative national fiscal and monetary policies seem to be losing their effectiveness. Investors are impatient for growth but also concerned about future inflation.
Europe is struggling with similar issues of excess private and public sector debt and over-built real estate markets. Problems are distributed unevenly among European countries and the Euro Zone's hybrid governance structure—a common currency but separate, and often conflicting, fiscal policies—makes it very difficult to devise good solutions.
Asian and Latin American "emerging markets" are generally growing much faster than U.S. and European markets. A number of our U.S. based companies are earning a growing share of their profits in emerging markets. Dynamic changes in these rapidly growing markets inspire both hope and anxiety among economists and investors.
Global economic cross-currents always make it difficult to make broad generalizations and sweeping predictions. Investors hate "uncertainty" and both individuals and professional investors are anxious for definitive answers. The financial press confuses the issue, as usual, with its cacophony of pronouncements based on isolated data points.
Uncertainty will always be part of investing. However, sensible and creative management teams are aware of the political and economic trends that affect their businesses. They can develop strategies to avoid serious disruptions and can sometimes take advantage of the situation. For example, Wells Fargo has made bulk purchases of European bank loans secured by U.S. assets at bargain prices. As conditions change, companies with global businesses make adjustments as to where they source raw materials and sell finished product. As citizens, we have serious concerns about the state of the country and the world, but as investors, we feel reasonably confident that we own companies that can generate good returns on our investments under most conditions.
A Short Look at History Human nature leads investors to focus on the recent past when making current investment decisions. The mortgage crisis and severe bear market are fresh in investors' minds. Many are fearful—especially if they had a similar bad experience with the technology stock bubble and 2000-2002 bear market. They observe that bonds performed better than stocks over the past 10-12 years and have shifted hundreds of billions of dollars from stock mutual funds to bond funds.
To put the current period in better perspective, it might be helpful to look at a much longer period of stock market history. Between 1932 and 2000, the S&P 500 index rose from about 5 to 1550. This period can be divided into four periods of 16-17 years each during which the S&P alternately (a) moved erratically sideways and (b) rose sharply in a major bull market. This period saw war and depression, deflation and inflation. We would assert, though, that GDP growth and the growth in corporate earning power generally rose over the entire period in a path that was much less volatile than the stock market.
There are many reasons for the differences between the "facts" of gradually increasing company earnings and the "opinions" that drive wildly volatile stock prices. We believe the most powerful single factor is investor psychology. Unfortunately for investors, they always seem to get more enthusiastic about buying stocks as prices move higher. Conversely, when prices fall, making good businesses cheaper to own, they tend to become fearful and sell more shares.
Each of the four periods provides a similar lesson, but we will focus on the most recent. As the S&P 500 index rose from about 100 in 1982 to 1550 in 2000 (+1450%), company earnings roughly tripled, but the price-earnings multiple (P/E) placed on S&P stocks more than quadrupled from a low of 7 times to a high of 31 times. In short, the companies' values increased, but their stocks' valuations increased even more.
This illustrates the core concept of our investment approach—stock prices fluctuate widely around a company's business value. Ideally, we buy at a discount to business value, the business value grows, and we sell at or near business value. Easier said than done, but success depends on measuring value and being price-sensitive in our buying and selling—NOT on waiting for ideal macroeconomic conditions or an absence of "uncertainty."
Back to the Future So where are we now? The market peaked in March of 2000 (with the S&P 500 at about 1550) as tech stock valuations reached absurd levels. During the intervening twelve years, many of the growth favorites of the day, both tech-oriented and others, have experienced strong business growth while their stock prices have languished. Microsoft (NASDAQ:MSFT), Dell (NASDAQ:DELL) and Wal-Mart (NYSE:WMT) have each roughly tripled earnings per share, but their stock prices have nothing to show for it. Value rose, but valuation (the price people were willing to pay for those earnings) shrank.
Five years ago, the S&P 500 peaked again around 1550. This time the most extreme overvaluations were to be found in housing and mortgage finance. It turned out that we had over-built the housing stock—borrowing demand from future years—and over-borrowed to finance the houses. Demand for houses, construction materials and furnishings evaporated and triggered a serious recession. Liquidity issues in the financial sector triggered by the devaluation of mortgage related assets compounded the problem.
The revaluation process for stocks in general that started in 2000 may have about run its course. The deleveraging of personal and bank balance sheets may have many more years to run (although we would guess that the worst is over). It would be too much of a coincidence to expect that the current sideways market which is twelve years old would end in exactly 4-5 years to conform to the 16-17 year pattern of the last eighty years, but it may very well continue for some time. A few more years of subdued stock market behavior does not have to be a terrible thing for investors. It would be nice to enjoy the double-digit annual returns of the 1990's—and from the right valuation base—that can happen again. In the meantime, over the past twelve years, while the S&P produced a total return of 1.4% per year, Value, Partners Value and Partners III have earned average annual total returns of 4.6%, 5.4%, and 10.6%, respectively. These are not sexy numbers, but thanks to compounding, they mean shareholder capital has grown by 71%, 87% and 234% in the Funds vs. 18% for the S&P 500.
An Improving Value Equation In spite of the muted recovery and the various headwinds affecting global economic growth, we are still finding interesting investments for our Funds. Volatility of prices of existing positions allows us to buy extra shares on dips and earn trading profits when the shares rebound. This is not our primary focus, but it can add some incremental return in a sideways market. The more interesting additions are companies our analysts uncover and that appear to be cheap for temporary reasons.
FLIR Systems (NASDAQ:FLIR)($25) makes infrared and thermal imaging equipment for military and commercial use. It is a leader in a secularly expanding industry and earns high returns on capital. It has a history of thoughtful capital deployment and sells at a 35% discount to our current estimate of its business value ($39). Fears of cutbacks in defense spending (which we think are over-stated for FLIR's products) and underestimation of the prospects for FLIR's commercial business caused the stock to decline sharply last summer and to tread water ever since. The combination of future earnings per share growth (which we expect to average at least 15% per year) and a higher valuation for those earnings could make FLIR an excellent long-term holding for several of our Funds.
Range Resources (NYSE:RRC)($58) is a domestic natural gas exploration and production company. Its "crown jewel" is in the Southwest Pennsylvania portion of the Marcellus field. New techniques for producing oil and gas from shale have led to a several-fold increase in the U.S.'s estimated gas reserves and a temporary glut in available gas across the country. As a result, gas prices have plunged to 10+ year lows and gas producers' stocks are out of favor. Range has a very low cost of production, is increasing its natural gas liquids and oil production, and can continue to reinvest at attractive returns, even at today's very low gas prices. For a variety of both supply- and demandrelated reasons, we would expect gas prices to rise from today's depressed $2.15 per mcf in future years. Change happens slowly for both producers and consumers of energy, but over the next 5-10 years, we believe Range can produce very good returns for us. (We also own Southwestern Energy (SWN—$31), a stock with a similar investment thesis.)
Americans and American businesses are pretty resilient. We think there are reasons to be hopeful that the current period of consolidation and revaluation in the stock market in general will give way to a more positive market environment.
(1) Housing starts in the U.S. fell by 73% from 2005 (2.073 million) to 2009 (0.553 million) and were only 0.611 million in 2011. Starts had been greater than one million each year for the past 50 years, until 2008. But, household formation continues, some of the housing stock needs to be replaced each year, and personal interest in home ownership is alive and well. Eventually, the number of homes being built (and furnished) will rise significantly. Aside from the direct impact on the economy and employment, stabilizing of home prices should have a positive impact on consumer confidence;
(2) A stronger economy should revive tax receipts at all levels. State and local governments should be able to relax the austerity measures that have been a drag on the economy. At the Federal level, higher tax receipts and lower demands on safety net programs should decrease the quantity of new government bonds that must be sold (leaving more capital for investment in stocks). We could hope that Congress addresses the longer-term issues of funding Medicare and Medicaid, but that would be an unexpected bonus;
(3) Some years ago, the price of natural gas fluctuated wildly as supplies were just slightly too big in a warm winter and just slightly too small in a cold one. Many industry observers believed that the supply of gas was in secular decline in the U.S. Now, thanks to new (albeit controversial) technology, gas is being produced from sources previously considered inaccessible. Some think we now have a 100-year supply of natural gas and that it could bring the U.S. a measure of energy independence. There are problems of production, distribution and conversion of facilities to use gas, but most individuals and thousands of companies will be direct beneficiaries of this cheap and abundant fuel; (4) Finally, as investors' memories of recession and collapsing home prices fade, we may find that some of the hundreds of billions (trillions?) of dollars that had been "hiding" in U.S. Treasuries and other "safe" assets may find their way back into the stock market. The incremental demand could make a significant difference in stock valuations.
Great! But When? We are optimistic about the long-term outlook for our stock portfolios. Human nature does not seem to change over time and the reasons that assets are sometimes mis-priced are rooted in human behavior. We still need to do our part in analyzing and measuring value and in exercising the patience and discipline to take advantage of investment opportunities—that is, keeping our own "human natures" under control.
The 28+ year history of our Firm has spanned most of the 1982-2000 bull market and all of the 2000-March 2012 period of consolidation. The two Funds which (including their predecessor partnerships) span our entire history, Partners Value and Partners III, have returned 12.4% and 13.2% per year, respectively, on an annualized basis (after deducting fees and expenses) vs. 10.5% for the S&P 500. These 2% and 3% margins sound insignificant, but on a cumulative basis they make a big difference. Ten thousand dollars invested on June 1, 1983 would have grown to $178,496 in the S&P 500, $295,119 if invested in Partners Value, and $361,967 if invested in Partners IIIInstitutional Class.
We live in an uncertain world, but having learned some lessons and having added several bright young people to our investment team over the years, we are hopeful that we can build on this record.
Wallace R. Weitz
Bradley P. Hinton
Investors should consider carefully the investment objectives, risks, and charges and expenses of the Funds before investing. The Funds' Prospectus or Summary Prospectus contains this and other information about the Funds and should be read carefully before investing. Portfolio composition is subject to change at any time and references to specific securities, industries, and sectors referenced in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. See the Schedule of Investments included in the Funds' quarterly report for the percent of assets of each Fund invested in particular industries or sectors.
Weitz Securities, Inc. is the distributor of the Weitz Funds.