Longleaf Partners International Fund advanced a notable 2.83% in the first quarter, far surpassing the MSCI EAFE Index’s -3.01% decline. A number of our stocks had double-digit gains, including several of our most undervalued businesses coming out of 2015. Most of our companies generated solid operating results, and management activity helped drive higher appraisals. Not only were our absolute returns in line with our absolute goal of inflation plus 10%, but our relative results also benefitted from our lack of exposure to health care, which was among the top performing index sectors in 2015 but was among the MSCI EAFE’s worst performing sectors in the quarter.
Stock prices in the first quarter embodied Ben Graham’s description of “Mr. Market,” whose manic short-term swings are driven by investor emotions. The MSCI EAFE fell by -13% at its February 12 low point, but then rallied over 11% by the end of March, a 2440 basis point swing. While broad economic and political uncertainties fostered stock volatility, our appraisals proved much more stable, highlighting the importance of anchoring investment decisions to the long-term cash flows and underlying asset values of each company.
The volatility provided opportunistic points to buy one new business, add to one of our more undervalued companies, sell three holdings, and trim several positive performers as they became overweight and traded closer to our appraisal values. Our on-deck list of new qualifiers was more robust in Asia than elsewhere which is reflected in our 45% portfolio exposure in the region.
Contributors/Detractors
(gross return of the stock for 1Q; impact to Fund return for 1Q) adidas (+20%; +1.8%), the German-based global sportswear and equipment brand, reported better-than-expected earnings, with 16% revenue growth for the core brand, and increased its 2016 expectations to 10-12% organic revenue growth. We have been engaged in productive conversations with adidas over the last year and were pleased with several governance announcements. Kasper Rorsted was named the successor to CEO Herbert Hainer. Rorsted had a strong record at Henkel AG, and we believe he will successfully address costs and increase adidas margins, which are at half the level of key competitors. The company also nominated shareholders Nassef Sawiris and Ian Gallienne to join the Supervisory Board. After the stock’s strong 12-month performance, we trimmed our overweight position, but the company remains discounted relative to both our appraisal and its peers.
Genting Berhad (XKLS:3182, Financial) (+97%; +1.3%), the Malaysian holding company with gaming, property, plantation, pharmaceutical, and oil and gas assets, benefited from progress at several businesses and a rebound of the Malaysian ringgit. There was news of a potential initial public offering of Alzheimer’s drug maker TauRx Pharmaceuticals, which is 20.7% owned by Genting. The Singapore casino business steadied, with the core mass gaming and non-gaming business revenues expected to grow. The duopoly position in the stable Singapore jurisdiction represents a significant competitive advantage. Genting Singapore also began construction on its Jeju project in Korea, which offers potential upside for our appraisal and the stock. Despite the strong quarter, Genting trades at a significant discount to the sum of its parts, but we did trim our stake to reduce the overweight.
Mineral Resources (ASX:MIN, Financial) (+61%; +1.2%), the Australian-based mining services company, surprised the investment community with stable operating results in its crushing business and lower mining costs. Additionally, higher iron ore prices and a stronger Australian dollar were favorable for the stock. Although ore prices did not benefit Mineral Resources’ crushing and processing business since the company is paid a fixed fee per ton, they did help the mining operation produce higher earnings before interest, taxes, depreciation and amortization (EBITDA) per ton. Management indicated the company is unlikely to move forward with the ambitious elevated transport system without a more attractive long-term iron ore pricing environment. The company began to buy back shares, and founder and managing director, Chris Ellison, purchased more shares personally. We trimmed our position.
EXOR (MIL:EXO, Financial) (-21%; -2.3%), the Italian holding company, detracted from the Fund’s results as its share price closely correlated with underlying holding Fiat Chrysler Auto (FCA) despite FCA comprising less than half of our total EXOR appraisal. Most auto stocks declined with concerns about peak demand, easy credit, and the longer term implications of driverless cars. Additionally, the Volkswagen emission test scandal weighed on European car makers. These current industry challenges are likely to delay CEO Sergio Marchionne’s pursuit of a merger for FCA. Additionally, the broader Italian market had the worst performance in Europe, which impacted EXOR’s share price despite the value overwhelmingly coming from outside of Italy. EXOR completed its acquisition of Bermuda reinsurer PartnerRe in the quarter, providing another outlet for Chairman and CEO John Elkann to build value. We believe there are ample strategic and value building levers still to be pulled at EXOR and see the current price weakness as unjustified.
OCI (-21%; -1.2%), a global fertilizer and chemical producer, fell early in the quarter in line with a decline in the underlying urea commodity price, which recovered somewhat by quarter-end. Global excess supply should diminish as nitrogen fertilizer demand grows approximately 2% per year while no additional plant capacity is scheduled for at least five years out. Uncertainty around OCI’s planned sale of its U.S. and European assets to CF Industries also weighed on the stock. A major hurdle to the deal was removed in mid-March, when OCI announced that Consolidated Energy Limited would jointly invest in the methanol plant, Natgasoline, which would fall outside of the scope of the assets going to CF. OCI is trading at a steep discount to our appraisal and even more cheaply assuming the CF deal closes in the second quarter of 2016 as planned.
Portfolio changes
We sold three companies in the quarter and initiated a small position in nitrogen fertilizer manufacturer and distributor CF Industries (CF, Financial), which offered a more discounted way to increase our stake in OCI post deal. CF CEO Tony Will is buying back discounted shares, and OCI CEO Nassef Sawiris will be the largest CF shareholder and join the board when the deal closes.
We sold Australian-based testing, inspection, and certification company ALS Limited (ASX:ALQ, Financial) at a loss after owning it for just over a year. The company announced a rights issue, which we thought was unnecessary, at a steep discount to market price. This decreased both our appraisal and confidence in management’s capital allocation skill.
We exited our small position in British power systems company Rolls-Royce (LSE:RR., Financial) after its price rallied in the first half of the quarter. The business has long-term upside, but the thesis will take longer to play out than we originally expected. We invested our proceeds in higher return opportunities.
We completed the sale of Orascom Construction, which OCI spun out in 2015.
Outlook
We believe the strong absolute and relative returns we posted in the first quarter should be indicative of our expectations going forward. Many of our top performers rallied from unsustainably low levels to a more normal discount range and have substantial additional upside. The portfolio price-to-value (P/V) in the low-60s% offers an attractive buffer between our conservative appraisals and our companies’ underlying stock prices, especially in a market where we are finding limited new opportunities. Volatility could increase in Europe, with continued worries about anemic economic growth, coupled with increasing political risks from the migrant crisis and terrorism, as well as Britain’s potential exit from the Eurozone. Asia remains more undervalued, given persistent uncertainty over China’s future growth rate and additional currency weakness. The Fund’s 7% cash level should enable us to take advantage of the next opportunity wherever it emerges. At many of the companies we own, management teams are pursuing operational improvements as well as strategic alternatives that can build material value.
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