Longleaf Partners International Fund outperformed the MSCI EAFE Index in the first half of 2016, with a 0.00% return compared to the index’s loss of -4.42%. In the recent quarter, the Fund fell -2.76% while the index lost -1.46%.
Over the last three months, we saw various benefits of Southeastern’s distinct approach—intelligent, concentrated, engaged, long-term, partnership investing. Among our largest positive contributors, including adidas, Great Eagle (HKSE:00041, Financial), BR Properties (BSP:BRPR3, Financial), and SoftBank, returns were enhanced by the productive activity of our management partners with whom we have engaged constructively over time. While the cancellation of acquisitions at OCI and CK Hutchison weighed on those stocks, our heavily-aligned management partners pursued the interests of shareholders.
Intelligent, long-term investing also was relevant in the fearful environment that developed following the Brexit vote. In the short-term aftermath, a strengthened dollar detracted from our performance as local returns of our European-domiciled companies held up better than U.S. dollar based returns. Our businesses have small direct exposure to the United Kingdom, but we saw knock on effects from the decision in stocks with ties to weaker European Union countries such as Italy and Spain. Given our time horizon and valuation discipline, we view the U.K. and EU uncertainty as prospective opportunity for both our companies and our portfolio. The strength of our businesses with European exposure should help them weather the eventual changes from Brexit, and our management partners have the skills, incentives, and balance sheets to take advantage of the upheaval. We were prepared with a target list of companies in the unexpected event that Brexit passed, but in the end, few of the quality businesses we targeted became discounted enough. We did initiate one new investment, however, and our target list still could become amply discounted as countries determine how to move forward.
To us intelligent investing is also about holding cash in the absence of qualifying long-term investments. Our cash position benefitted the Fund’s relative results, as did our disciplined focus on business strength which generally keeps us out of financial institutions. The Financials sector was the index’s biggest detractor with the heavily weighted banks suffering, whereas it was the Fund’s largest positive sector because our holdings classified as such consist of less risky holding companies and real estate firms.
In addition to our one new purchase, we added to two of our more discounted stocks, sold three investments, and trimmed several stocks whose prices and portfolio weights had grown.
Contributors/Detractors
(2Q portfolio return; 2Q Fund contribution)
adidas (XTER:ADS, Financial) (+23%;+1.2%), the German-based global sportswear and equipment brand, remained the Fund’s largest contributor as the company reported stronger-than-expected results. Overall revenues rose 22%, operating profits gained 35%, and net income was up 38%. Earnings per share (EPS) grew 50%, helped by buyback activity during the quarter. The company increased its 2016 organic revenue growth outlook to 15% from the previous 10-12% range. During the quarter the company announced it was actively seeking a buyer for its golf segment, including the TaylorMade, Ashworth, and Adams brands. Additionally, two highly qualified investors, one of whom we proposed, joined the company’s board.
Also a positive contributor for the quarter was Great Eagle (20%; 1.0%), a Hong Kong real estate company that invests in and manages high quality office, retail, residential and hotel properties around the world. In addition to an over 60% stake in publicly listed Champion REIT, Great Eagle also owns hotels branded under the Langham name, the Eaton hotels in Hong Kong and Shanghai, and Chelsea Hotel in Toronto and trades at a significant discount to intrinsic value. With a strong net cash position, the company announced a 2 Hong Kong Dollar per share special dividend which, combined with the regular dividend, equated to an almost 10% dividend yield. In June, the company announced the sale of its 28 story office building in San Francisco at a 3% net operating income (NOI) cap rate. Our partners, the Lo family, own 60% of the company and bought more stock during the quarter.
Ending the quarter as the Fund’s largest detractor was Melco International (HKSE:00200, Financial) (-33%; -2.7%), the Macau casino and hotel operator. Although the company’s $3.2 billion Studio City project (relative to Melco’s market cap of $9 billion) opened in late 2015 and is now generating positive cash flow, construction activity near the property has adversely affected customer traffic flow in the short term. As the construction ends later this year, we anticipate that Studio City’s location and non-gaming attractions will draw more highly profitable mass visitors. Shuttle service to Studio City from other Macau casinos began in June and should boost revenue. In May, Melco Crown Entertainement, the joint venture that owns Melco International’s Macau properties, purchased $800 million of its shares from James Packer at a steep discount, increasing Melco International’s ownership of Melco Crown to 38% and placing Melco International CEO Lawrence Ho firmly in control of the Macau properties. The stock market value of Melco International’s stake in Melco Crown is worth more than 150% of Melco International’s market cap. Ho again increased his personal stake in Melco International.
OCI (XAMS:OCI, Financial) (-31%; -1.4%), a global fertilizer and chemical producer, also detracted from second quarter results. The two main pressures over the last three months were weakness in urea commodity prices (a key nitrogen fertilizer) and uncertainty around the CF Industries merger. Despite attractive strategic rationale for the combination of CF and OCI, the increased crackdown on tax inversions in the U.S. made the deal untenable. OCI’s European domicile further pressured the stock in the last week of the quarter, even though the Brexit vote should not impact fertilizer demand and could create some currency translation benefits to OCI. Globally, nitrogen fertilizer demand increased, helping to deplete excess supply. OCI’s plants have an advantage by being located near low-cost natural gas, a primary feedstock in fertilizer. Our investment case incorporates demand for nitrogen fertilizer continuing to grow at a couple of percent annually and supply tightening. Beyond 2016, no major additional plant capacity will be added for at least five years. Despite the current decline in nitrogen fertilizer prices, the company is generating significant free cash flow. CEO Nassef Sawiris and his team are working to grow value per share and are exhibiting a disciplined approach to monetizing assets at prices that reflect longer term intrinsic values.
Among other noted detractors for the quarter was CK Hutchison (HKSE:00001) (-14%; -1.1%), a global conglomerate comprised of five core businesses (retail, telecommunications, infrastructure, ports, and energy). CK Hutchison’s plan for its Three mobile phone network to acquire U.K. telecom company O2 was denied by the European regulator. While CK Hutchison is Hong Kong-based, the stock also fell with the Brexit vote because of fears of the impact on its European and U.K. operations which generated over half of its pre-tax earnings last year. However, Chairman Li Ka-shing and his son, Victor, have demonstrated a compelling long-term record of building businesses, compounding net asset value at double-digit rates, and buying and selling assets at attractive prices, and their history includes intelligent capital allocation during previous market dislocations. We are confident our management partners will continue to grow and unlock value.
Portfolio Changes
We sold BR Properties, Brazil’s largest commercial office real estate landlord, following the stock’s rise after GP Investments raised its bid for the company. In spite of high quality properties and a solid partner in Claudio Bruni, the highly challenged Brazilian environment and concurrent currency depreciation resulted in a dollar loss over our full holding period. We also sold Mineral Resources, the Australian-based mining services company, on the strength of a surprisingly strong upward move in iron ore prices. Although the company’s iron ore crushing revenues are driven primarily by the volume of the ore crushed rather than the price of the commodity, the stock’s high correlation with iron ore price hurt our results over the time we owned the stock. Following price gains during the year, we trimmed adidas, K. Wah, and EXOR to manage our position weights.
In the last week of the quarter as reaction to the Brexit vote pushed down stocks, we added one new Spanish based company to the portfolio.
Outlook
The International Fund sells for an attractive price-to-value ratio in the low-60s%. We own companies whose leaders are building long-term value and pursuing ways to drive prices closer to intrinsic worth. While cash stands at 17%, we believe we will continue to find new qualifiers. Our wish list includes companies with strong underlying businesses that may become overly discounted as the futures of the EU and Great Britain get sorted out, questions continue about China’s growth prospects, and Japan struggles with its economy and currency. Over the long run, we and our fellow shareholders have been rewarded for adhering to our investment discipline, and we believe our distinct, advantaged approach will continue to deliver strong results, especially from this point in a world of uncertainty.
See following page for important disclosures.
Before investing in any Longleaf Partners Fund, you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. For a current Prospectus and Summary Prospectus, which contain this and other important information, visit longleafpartners.com. Please read the Prospectus and Summary Prospectus carefully before investing.
RISKS
The Longleaf Partners International Fund is subject to stock market risk, meaning stocks in the Fund may fluctuate in response to developments at individual companies or due to general market and economic conditions. Also, because the Fund generally invests in 15 to 25 companies, share value could fluctuate more than if a greater number of securities were held. Investing in non-U.S. securities may entail risk due to non-US economic and political developments, exposure to non-US currencies, and different accounting and financial standards. These risks may be higher when investing in emerging markets.
