During the year, market disparities widened, favoring momentum investing over a value approach, very large stocks over mid- to smaller market caps, and U.S. dollar-denominated businesses over those in weaker currencies, particularly emerging markets. In addition to these broad challenges, the handful of companies we owned in two specific areas —U.S. energy and gaming companies with significant exposure to Chinese visitors — faced enough pressure to mask otherwise successful investments. This small subset of holdings accounted for over 100% of the Partners, Small-Cap and Global Funds’ negative returns (and about two-thirds of the International Fund’s) and 100% of the relative performance shortfalls for Small-Cap and Global (about 90% for Partners and two-thirds for International) for the year.
In the face of these headwinds, we followed our discipline of regularly re-evaluating our investments to position portfolios optimally. Across the Longleaf Funds, we sold several longstanding holdings that performed well over time and had reached our appraisals, including several U.S. holdings in the first two quarters and a few European companies later in the year. In the second half, we sold a few companies whose prospects for value growth dimmed. We also acquired new opportunities amid the increasingly bifurcated markets: some quickly helped our results while a few became more discounted.
As market volatility increased in the last two quarters, we found new qualifiers in the industrial arena. More recently, in the distressed debt selloff, we found a few interesting opportunities. The Funds’ geographic weightings reflected that the overall opportunity set remained more compelling outside of the U.S., and Asia became relatively more attractive as a number of European stocks rose. The deep discounts in many emerging markets (EM) are reflected in our holdings’ exposure to EM revenues with over 15% in Small-Cap, over 30% in Partners and Global and over 45% in International.
We believe the Funds are well positioned in three important ways and are eager to start 2016. First, many of our companies were positive performance contributors with good results in 2015 and should be able to continue to deliver solid value growth.
A primary driver at many of our strongest compounders, including some of our largest positions, was the announcement or implementation of corporate transactions. This helped drive double-digit gains at a number of holdings. In fact, we owned two of the Standard & Poor's 500’s and MSCI World’s top 10 contributors, and one of EAFE’s top five. Our strong compounders remain attractively discounted, and we believe that additional benefits from corporate transactions as well as strong business operations may help drive continued value growth.
Second, we believe in the strong probability of sizable gains, as has been the case after other big declines in our history. Following large downturns, the payoff patterns can be quick and sizeable, and often can occur when few believe that results can turn. While recognizing a bottom is only possible in hindsight, it is worth showing that following the three oldest Funds’ worst 12-month return periods at quarter ends, future payoffs have been dramatic, with a minimum return of 32% over the subsequent 15 months (see above chart). We think relative performance can shift even more dramatically than in the past because of the emergence of so many momentum-driven investment strategies. More money chasing good returns has pushed high prices even higher, as these funds have bought more of the same stocks and helped create a narrow market. When the tide turns and money flows out, prices of those dominant winners should fall quickly.
Our concentration means our return patterns look dramatically different than the broader indices, usually driven by a few holdings. Historically, many of our most tortured individual stocks had hockey stick-shaped rallies after most investors had given up on them, and we think the same will be true again. Given how far energy and Asian gaming stocks have fallen, we believe our related securities are good candidates for a rapid reversal. In fact, Wynn Resorts and Melco International rose 31% and 23% in the fourth quarter as Macau’s mass revenues seemed to stabilize, new properties started opening, and new infrastructure moved closer to coming on line. Likewise, at the end of the year we saw a small glimpse of how rapidly the energy psychology can change, as gas rallied 33% in the last two weeks following a decline in mid-December to its lowest level since March 1999 when a warm winter start exacerbated U.S. natural gas supplies. As shown in the chart on the following page, price fell below $2/mcf (thousand cubic feet of natural gas) but quickly rallied as it has most other times gas has dipped that low in the last 20 years. Many assume commodity prices will remain this low for at least the next three years, leading to negative cash flow and rendering nonproducing assets worthless at Chesapeake Energy (CHK, Financial) and Consol Energy (CNX, Financial), our two primary exploration and production (E&P) investments. In commodity-based businesses, prices reflect supply and demand dynamics. Gas below $2.50 should reduce supply as drilling becomes uneconomic for most producers. We don’t know when supply and demand will rebalance and adjust prices, and thus far, our energy assumptions have been wrong. Patience is critical because energy prices, along with the stocks of Chesapeake and Consol, can turn rapidly.
While we wait, our management partners are pursuing additional cost reductions, capital flexibility and asset sales. Industry transactions over the last six months indicate that strategic, long-term buyers are paying fair prices for nonproducing assets even as the short-term commodity price is deeply depressed.
Third, we are not dependent on a bounce in energy or a turn in Asian casino revenues to make good returns over the next few years, even though we believe our related holdings are so bottomed out –Â at P/Vs less than 40% for our E&P companies and 50% for our Macau casino operators –Â that they can make a meaningful positive impact in 2016. Our future returns are primarily dependent on the unrelated 75% to 90% of our investments, many of which performed well in 2015 and trade below a 69% P/V on average. Our confidence in strong prospective returns remains grounded in the reasons that helped drive these results and which we discussed during the year:
- The quality of the vast majority of our businesses indicates that values should grow at strong rates. We own many businesses generating growing free cash flow with competitive advantages via market leadership, pricing power, low cost and scale.
- Our management partners are pursuing productive ways to build values beyond organic cash flow and to gain value recognition via transactions, restructurings and share repurchases at discounted levels.
- Our team is engaged with many of our management partners to promote the most beneficial outcomes for long-term shareholders.
- Our companies are deeply discounted with our portfolios trading at P/Vs in the 60% range. Free cash flow yields are compelling.
- Although not necessarily indicative of future results, our similarly large underperformance in the late 1990s was impacted by many of the same factors we see today, especially in the U.S. Coming out of that period, our relative returns were among the strongest in our history.
Much went right at our businesses in 2015, in spite of our final return. When faced with challenged performance, we must be willing to identify, learn from and exit the mistakes we will inevitably make but also willing to be patient and hold businesses which look like mistakes but have prospective value growth and payoff potential that make them opportunities.
Giving up when things look most certain to fail usually means missing the payoff. We are fortunate and appreciative that we are able to maintain our patience and discipline through challenging periods because of Southeastern’s independence, strong financials, passionate investment team, large employee investment in the Longleaf Funds, and most importantly, long-term, like-minded clients.
In 2016, we are optimistic about our potential to deliver strong absolute and relative results. We feel the characteristics of our current investments indicate that our payoff patterns could be quite rewarding from this point forward.
