Mason Hawkins' Longleaf Funds Q1 2013 Letter
Stock prices increased faster than values over the last three months. As price-to-value ratios (P/Vs) and portfolio weights rose, we trimmed a number of holdings. We sold several companies that approached our appraisals. Cash levels increased as few new qualifiers met our requisite discount. Not surprisingly, with an S&P return double that of EAFE, we are finding more opportunities in companies based outside the U.S.
Our approach to activism
Almost all of our holdings positively contributed to our good returns, including two widely publicized names, Dell (DELL) and Chesapeake (CHK), which have received much of our clients' attention. Our work to make changes at these two companies, combined with efforts at HRT outside of the U.S., have generated questions about how Southeastern decides to become active in a name, and if our approach has changed. "Activism" is not part of our normal process, nor is it our preferred avenue. When we make an investment, we believe that we have management partners who will run the business well, prudently allocate capital to grow value per share, and ultimately seek paths to value recognition. In the large majority of our investments, our partners prove capable. Assessing humans, however, is more difficult and less reliable than analyzing the quality of a business or appraising value. Nothing can measure people's future actions, no matter how good their previous work may have been or how strong and shareholder-aligned their incentives might be. Becoming active generally indicates that we made a mistake in assessing our partners.
Activism is not our only recourse when we make a research error. Most of the time, we exit the position. Because we have moved on, people easily forget that exiting is our normal path. Although automatic selling might be easier, we have a responsibility to evaluate the investment case before deciding our next step. When the company's underlying assets remain strong, the stock's undervaluation is compelling, and the primary "fix" relates to people, we will generally become active if we believe we have good odds of successfully improving our clients' outcome.
This approach to activism is neither new to Southeastern, nor does it happen often. Figure 1 summarizes our 13D history (an SEC filing that changes our status in a stock from a passive investor to active) and shows Southeastern's number of U.S. holdings per year, shading those where we became active. Figure 2 demonstrates that in the last twenty years, we have owned 255 U.S. names and filed just twenty-six 13D's. While activism outside the U.S. is not subject to a clear 13D-type designation, and thus is harder to track, a subjective review shows a similarly low level of activity in non-U.S. names. Fighting for our clients has been worth the effort. In over three-fourths of the cases where we filed 13D's, the stock price rose from the filing point through our holding period.
Figure 1 and Figure 2 demonstrate that:
• Becoming active is not a recent tactic,
• Making management assessment mistakes that warrant activism has been infrequent, and
• Standing up for our clients via activism has been worthwhile.
In the first quarter, our efforts at Dell and Chesapeake began to pay off, although we believe that significant upside remains in both stocks. We also have worked productively in the last year with HRT and Level(3) to improve governance and ultimately results, though the stocks do not yet reflect our progress. Fortunately, at our 47 other holdings across portfolios, management appears to be working hard for the benefit of shareholders. Good partners make our job easier. The operating skills and capital allocation decisions of our capable CEOs should help values continue to increase at our holdings.
At the end of 2011, we expressed our conviction by writing in all caps, "WE OWN SUPERIOR BUILDING BLOCKS THAT SHOULD GENERATE OUTSTANDING FUTURE INVESTMENT RETURNS." Performance since then has been 30% or greater for the Partners, Small-Cap, and International Funds, well ahead of inflation plus 10%. We remain optimistic about our long-term opportunity, but we expect the return pace to slow following the recent sprint. Sentiment is no longer universally fearful. Many who abandoned equities in the "flight to safety" have begun to slowly migrate from cash and bonds to high dividend, low volatility stocks, and very recently, to more cyclical stocks. The timid move back into equities is in early stages with much money still on the sidelines, but flows could occur sporadically. Although earnings yields remain substantially higher than Treasurys, corporate margins will be harder to improve from current levels. Our appraisal values over the next five years will increase more rapidly if GDP in developed economies grows faster than 2% and/or if we have a modest rise in interest rates. Recovery could last for a while, though it easily could be a bumpy path.
We are not macro forecasters, and do not require a broad market tailwind to compound. Even after recent strong performance, we have additional upside in our P/Vs, with most holdings selling between 60-80% of our appraisals and values that are growing. Our appraisals are conservative, with modest assumptions and high discount rates. Our conservatism combined with the strong market positions and the financial strength of our companies also should help protect values in the event of an unexpected economic setback. Our cash positions will allow us to exploit short-term market or company-specific dislocations. Longer term, we believe our absolute return goal of inflation plus 10% remains achievable.
O. Mason Hawkins, CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.
April 25, 2013