Mason Hawkins of Longleaf Partners' 2012 Annual Report
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 investment would turn, but we felt confident that over five years, our companies' unit sales 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 permanently lower rates have exacerbated skepticism over future equity returns. We are not macro-based investors, but we have a different view. First, higher profit margins are sustainable in the U.S. even as world-wide regression occurs, 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, reported margins should be higher due to a larger portion of foreign earnings being accounted for as "equity affiliates." (Equity affiliates represent a net operating profit number which is 100% profit margin on the income statement.) Third, 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, so earnings power can grow as revenues increase, even with steady margins. In both the U.S. and Europe, revenues remain far below peak with additional capacity available to support growth. Finally, 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 shareholderoriented 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.
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.
O. Mason Hawkins, CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.
February 13, 2013