In concert with the geographic performance differences over the quarter, investment opportunities also diverged by region. Ongoing pessimism about slower economic growth in China continued to weigh on stocks tied to Chinese demand, including those linked to natural resources. By contrast, European markets benefitted from the combination of low European Union interest rates spurring private equity activity and U.S. companies re-domiciling through offshore acquisitions to secure lower tax rates (“inversion”). The U.S. reflected a more extreme version of Europe with few discounted opportunities. Multiple factors contributed to the lack of qualifying U.S. investments – a five-year bull market, the lowest volatility since 2007, heightened activism, and the substitution of investor complacency for healthy fear. The largest driver of what we see as market overvaluation has been the rise in merger and acquisition activity encouraged by the Federal Reserve’s (Fed) commitment to historically low interest rates combined with the strength of corporate balance sheets, plus the aforementioned inversion driven by the world’s highest corporate tax rate.
Transaction activity has been a double-edged sword. Our performance has benefitted, but new investment opportunities have almost disappeared as stocks have moved from earnings-based multiples toward deal multiples. Some of the Funds’ holdings have participated in full-scale mergers and acquisitions. Additionally, many of our management partners have fed the deal appetite by spinning out pieces of businesses or selling assets at full or premium valuations. The chart below illustrates the large number of transactions involving the Funds’ holdings both inside and outside of the U.S. over the last nine months and is a testament to the positive impact that good management partners can have.
The preponderance of U.S. activity has made finding companies that meet our deep discount criteria much more difficult. Deals have propelled prices more rapidly than intrinsic worth has grown. We have trimmed positions and sold several, leaving cash in the Partners Fund at 26% and the Small-Cap Fund at 47% following the sale of Texas Industries on July 1. The International and Global Funds are more fully invested with 9% cash in each after adding new qualifiers outside of the U.S.
We continue to manage the Longleaf Funds with the same bottom-up discipline that we have followed over four decades. We will seek to buy strong businesses with good management teams at deep discounts even if the overall market appears expensive. Cash levels are a residual outcome of our process rather than a reflection of a bearish market view. With our ongoing analytical work, we are building a robust on-deck list to be prepared to act whenever prices cooperate. A market correction could provide an expedient way to find adequately discounted businesses but is not necessary for us to put cash to work. Increased volatility, individual company idiosyncrasies, and value growth ahead of price gains also could generate qualifying opportunities such as they have outside of the U.S. this year.
Equities remain attractive versus bonds and most other asset classes. For believers in mean reversion, both the ten and particularly fifteen-year market results are well below the multi-decade return averages of the S&P 500, Russell 2000, MSCI EAFE, and MSCI World indices. Over time, the more business-friendly government in India as well as Japan’s push for improved corporate governance could create opportunities in those large markets.
We believe that the Funds are well positioned versus the broader markets over the next five years. First, market correlations have declined since the end of 2011 but remain above their long-term average, setting the table for individual stock picking to perform better than broad market bets. Our bottom-up, fundamentally-based investment approach has delivered strong relative results as correlations have declined over the last two years. Moreover, these results understate how well our stocks have performed since our large cash levels have muted total returns over the last year. Second, because many of our businesses have margin upside and are nowhere near the peak margins many believe are embedded in the broader market, our earnings growth can continue even without improved economic growth, and has the potential to outpace the market’s earnings growth. Third, our calculations indicate the benchmark indices are selling at or above fair value, while the Funds trade at a discount to our value. Although our price-to-values (P/Vs) are higher than the long-term average, the disparity between our portfolios’ valuations and the relevant indices is the same or larger than usual. The margin of safety in our holdings does not make us immune to price volatility, but potentially indicates more upside opportunity and less intrinsic value erosion than exist in the overall market. Additionally, if volatility increases or we have a market pullback, our cash reserves, particularly in the Partners and Small-Cap Funds, can serve as a buffer and allow us to take advantage of lower prices.
Longleaf’s returns depend on results at our individual investments. Based on the quality of our current holdings, we expect to meet our absolute annual return goal of inflation plus 10% over the next five years, although we anticipate lower returns than we generated over the last five years given the dramatically low P/Vs coming out of the financial crisis, especially in the U.S. Value growth at our companies will drive a larger part of return given our higher P/Vs today. Many of our management partners are increasing intrinsic worth through astute capital allocation beyond what organic cash flows are generating. These activities are not captured in our P/Vs, because our conservative appraisals only ascribe credit for normal business operations.
Positive returns on capital allocation decisions represent upside optionality, and we have seen value growth escalate as our partners have been:
- Selling assets above our appraisals,
- Making purchases that are value accretive,
- Investing in growth that delivers high future returns, and
- Repurchasing substantial amounts of shares when they have sold below intrinsic value.
First and foremost, a number of the individual businesses we own and the management partners running them are driving strong value growth. Second, current market valuations have not dampened our long-term outlook for equities. Third, we believe our portfolios have more upside than the broader markets. Finally, we have a ready on-deck list and liquidity to add new qualifiers in the event of more volatility or market fear. These themes play to the strengths of Southeastern as we have the experience and team to take advantage of these opportunities.
O. Mason Hawkins (Trades, Portfolio), CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.
July 11, 2014
From Longleaf Partners Funds 2014 Semi Annual Shareholder Letter.