Dear Fellow Shareholder: Our stock funds enjoyed a good second quarter and an excellent first half of 2013. Both relative and absolute results were strong. The table below summarizes results for the stock funds and the S&P 500 over the past six months, one year and three years. Our Performance Summary shows results for all of our Funds over a number of time periods going back to 1983.
|Period Ended 6/30/13|
|Qtr||1 Year||3 Year|
|Partners III -|
The bond market reacted very negatively to the Federal Reserve’s hints in June that it might slow its purchases of bonds. Our bond funds are positioned very defensively and in contrast to funds which held longer-term bonds, the year-to-date decline in the Short-Intermediate Fund – Institutional Class (-0.2%) was negligible.
The Balanced Fund is designed for investors who want to own both stocks and bonds and who want to delegate asset allocation decisions to us. It earned a very healthy 8.4% in the first half of 2013 as its stocks performed well and its conservative bond portfolio protected it from the bond market decline.
For most of the second quarter, the stock market continued the advance that began last fall. For the last three quarters, our companies’ business values have grown, but their stock prices have risen faster. It seems that the Federal Reserve’s “Quantitative Easing” or “QE” (buying $85 billion of bonds on the open market every month) has created excess liquidity and that some of it has found its way into stock prices.
The rally faltered in mid-June when Fed Chairman Ben Bernanke mentioned that the Fed might begin “tapering” its purchases of bonds. In the ensuing “taper-tantrum,” the S&P 500 declined 6%, the bond market swooned and emerging markets went into convulsions. Fed officials immediately shifted to damage control mode, explaining that they were “not taking away the punchbowl,” but merely slowing the pace of adding liquor to the punch. Richard Fisher, president of the Dallas Fed, quipped, “I don’t want to go from ‘Wild Turkey’ to ‘Cold Turkey’ overnight.” At this point, stocks began to recover, and the bond market settled down, but it is clear that investor expectations are unrealistic—we cannot have both economic growth and perpetual QE.
The world is a messy place. We have catalogued the obvious risks in Europe, China and the Middle East in previous letters. It seems that one could close one’s eyes, spin a globe and insert a pin at random and find a place with a crisis of some sort. Levered speculators are clearly vulnerable to the inevitable shift in Fed policy and other investors who feel insulated may find their good stocks declining as others are forced to sell.
We tend to get excited when the market drops and our favorite stocks get cheaper. This confuses friends, family and clients—“What are you cheering for, anyway?!” We have not gone off the deep end. We only relish these selloffs because we believe they are temporary. Social, political and macro-economic change is usually gradual enough to allow companies to adapt and most crises are manageable. People and businesses are creative and resilient. As long as our companies are growing, generating more cash than they need and finding ways to increase their per share business values, lower stock prices will be temporary and give us the opportunity to buy more shares at reasonable (or preferably, unreasonable) prices.
Having made the brave statement that we would welcome lower stock prices, we would hasten to add that we are not predicting a market decline. We do not believe that anyone is really good at calling short-term market moves, so we do not take extreme portfolio positions. We have sold shares as they approached our estimates of full value, so we hold substantial cash reserves at quarter-end, but we still own a group of companies that we believe have excellent long-term prospects.
What follows is a quick spin through the ten largest holdings among our family of funds. All of these companies will be familiar to long-time shareholders. I will not belabor the case for each, but the point is that we think that each will earn good returns for us from today’s prices and we would be very happy to buy more of each if their prices decline.
Valeant (VRX--$86)(VRX) Valeant Pharmaceuticals continues to make acquisitions (most recently agreeing to purchase Bausch and Lomb), wring cost savings from the combined operations, and grow earnings per share. The outlook for Valeant’s well-diversified portfolio of 1,100 products is relatively predictable. The company has a robust pipeline of acquisition candidates and we expect Valeant to build on its dermatology and eye care franchises over the next few years.
DIRECTV (DTV--$62)(DTV) DTV continues to grow profits in a stable U.S. market and to add subscribers rapidly in Latin America. The economics of the business are very good (subscriptions, growing free cash flow per share) and management’s capital allocation is excellent (careful with acquisitions, substantial share buybacks).
Aon ($64)(AON) Aon is a growing insurance brokerage firm whose stock was depressed by its acquisition of HR consultant Hewitt. Aon would be a beneficiary of higher insurance rates and increasing global economic activity.
Berkshire Hathaway (BRK/B--$112)(BRK.B) We and our clients have owned Berkshire continuously since 1976. It is “built to last” and we expect it to continue to compound shareholder wealth for years to come. People have been worrying about a post-Warren Berkshire for decades, but we believe that with management in place at all the subsidiaries, strong successors identified, and an expressed willingness to buy back substantial amounts of stock if it should trade down for any reason, we are comfortable continuing to hold the shares.
Wells Fargo (WFC--$41)(WFC) Wells Fargo was a beneficiary of the financial crisis (though it was hard to tell at the time as the stock price dipped under $10). It avoided serious balance sheet problems and was able to buy (rescue) Wachovia Bank on very favorable terms. It has a great loan underwriting culture, very cheap deposits and is in a very strong position to take advantage of economic recovery and higher interest rates.
Liberty Global (LBTYK--$68)(LBTYK) Liberty Global’s chairman, John Malone, also needs no introduction. LGI has been an aggressive acquirer of European cable assets, having just closed a merger with Virgin Media (UK cable), taken a position in Dutch cable company Ziggo, and expressing interest in making another German acquisition. LGI’s subscription business generates huge amounts of cash flow and management is not shy about using borrowed money to acquire cable systems and buy back its own stock.
Texas Instruments (TXN--$35)(TXN) TI is an analog semiconductor company which makes a huge variety of relatively inexpensive products for electronics and industrial customers. The company took advantage of its financial strength to make opportunistic capital equipment acquisitions during the last recession and over the years has been a prodigious repurchaser of its own shares.
Redwood Trust (RWT--$17)(RWT) We have owned Redwood shares since its founding in 1993. Redwood is a “value investor” in the residential and commercial mortgage markets. We know management well and trust their judgment. The mortgage market was rocked by the recent bond market commotion, but Redwood ought to be able to continue to build its business. Redwood’s current dividend yield is 7.5% and we would expect the company to raise its dividend over time.
Liberty Interactive (LINTA--$23)(LINTA) Liberty Interactive’s QVC continues to grow in the U.S., Europe and Japan. The company also owns 37% of HSN (Home Shopping Network). QVC and HSN employ both video and online retailing platforms that give them significant cost advantages over traditional (bricks and mortar) retailers. We trust management to both grow the business and buy back shares, thus increasing the value per share of our holdings.
Iconix (ICON--$29)(ICON) Iconix is a licensing business. It buys the rights to license brands such as Candie’s, London Fog and Peanuts. The products are manufactured by others and sold through major retailers, usually on multi-year contracts. The result is very predictable licensing revenues generated with little capital investment and thus very high returns on invested capital.
We really like these ten companies and the others in our stock portfolios. You will notice, though, that I did not characterize any of them as cheaply priced. They are fairly priced, and we expect them to sell at higher prices over time, but they are not “bargains” today.
Investing is a marathon. We face an ongoing series of decisions as to which companies to own, what price to pay, and when to be disciplined about holding out for the right opportunity. The fact that several of our stocks have performed unnaturally well this year gives us a measure of “cover” for our defensive positioning. We feel very confident that our patient, conservative approach will continue to serve us well. Believe me, when stocks become truly cheap again, we will follow Warren Buffett’s advice: “When it’s raining gold, go out with a bucket, not a thimble.”
Incidentally, for those who read the Wall Street Journal article about our firm and our “struggle” with ETF’s (passively-managed exchange traded funds), rest assured that the “struggle” is in the minds of the outside world. Passive investing has been around in the form of index funds for years. The ETF craze is the newest manifestation. ETF’s can be useful tools, but they also make it easier for investors to do things that are not in their own best interests. I think there will always be a place for (good) active portfolio management, and some of the structural flaws in the ETF format may even make our job easier.
Thanks again for the trust you place in us by allowing us to invest your capital.