Southeast Asset Management 2012 Annual Letter
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.
*Based on the 12/31/12 forward earnings yield of the S&P 500 and MSCI EAFE Indices as compared to 10 Year Government bond yields for the U.S., Germany, U.K., and Japan.
O. Mason Hawkins
CFA Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management Inc.