"Active investing is out of favor; long-term investing (or really, long-term anything) is out of favor; value investing as we practice it is out of favor; and, investing in common stocks is out of favor compared to private equity. Doing all four of these things really makes us the skunk at the party."
-Longleaf Partners Funds second quarter 2018 letter
Mason Hawkins (Trades, Portfolio) and his partners have been value investors since 1975. Their investment philosophy is ostensibly very simple:
A deep discount to their calculation of intrinsic value remains very important. The funds are generally concentrated and weighted towards the firm's best ideas. More about those later. The firm just published its second quarter letter and it's terrific, touching on a few themes that are of crucial importance right now. I'll quote from the letter and reflect on the firm's thoughts (emphasis mine):
"In our view, indexing has gone to a further extreme than is widely acknowledged, threatening its future success. Most indexing proponents agree that passive assets crossing a certain line ironically would make indexing’s future success less likely.
They maintain that indexing is still underpenetrated with a lot of runway before becoming selfdefeating based on the tally of index funds plus the ETFs that are basically passive.
We add to the count the unadvertised and uncounted group of “closet indexers.” We include managers with an active share of 70, maybe even 80. That measure differs from the 60 level that the inventors of Active Share define as closet indexers.
We use 70+ for two main reasons: 1) the range of those managers’ results around the index return is incredibly tight, and 2) a large majority of those managers hold on average more than100 stocks, and we submit that anyone with over 100 stocks is aiming to hug and barely beat the index. Adding the 50% of “active” managers who are closet indexers with 60-80 Active Share to the 45% of assets in passive ETFs and index funds means that the effective indexing percentage today is approximately three-fourths of fund assets, a level that makes future success more in doubt."
Many active managers are now signaling this same problem. The amount of indexed assets is now almost mind-boggling. But it's not just active investing that's out-of-favor but also value investing:
"Just as passive proponents have adopted Buffett to argue against active investing, many investors reference Buffett to dismiss value investing. But, his brilliant 1989 letter discussed lessons learned from the previous 25 years, talking about “cigar butts,” “bargain-purchase folly,” and that “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” His repetition of that theme in the years since has conditioned many to dismiss the price paid as unimportant. Whether or not that is what Buffett meant, it has been the prevalent interpretation. The quality of a business and its ability to grow have substantial impact on our investment outcome, but the price paid relative to value is also critical."
I write about investing on a daily basis and like to believe I'm very much in touch what educated DIY investors are interested in, and I can attest there's some truth to this highly original observation. It never occurred to me to put it this way, but in a sense Warren Buffett is sometimes being used to discredit value investing, a rather interesting irony.
Subsequently, the firm makes a strong case for why it is so important to be disciplined on price and remain a value investor:
"First, the very long-term evidence suggests buying undervalued companies has earned better returns. Value stocks have outperformed growth stocks by almost 3% per year since 1926, even incorporating growth’s dominance in the last decade."
As you know, 3% per annum results is an absolutely crushing difference over a period like that.
"Third, real value investing has a humility not present in today’s more popular method of heavily weighing the qualitative factors of the business and minimizing the importance of valuation. Paying a low multiple admits to not knowing the future. The discount helps guard against a negative outcome rather than banking on the future to turn out as we predict. Conversely, paying a fair or high price based on confidence in a business’s great prospects means more room to suffer if things actually go wrong."
To me this is one of the most convincing arguments for (deep) value investing there are. The true value investor doesn't need to get the moat right or assess a manager's moral compass as accurately. The short-term horizons required to generate a return ensure the random events life throws at us don't have as much impact.
"The number of “wonderful companies” that can sustain moats for that long is small. Unforeseen competitive disruptions make moats vulnerable, especially beyond five years. Seemingly unassailable quality businesses for the long term unexpectedly had moats erode or destroyed within less than ten years in numerous relatively recent examples."
It's been my experience as well that moats don't always last very long. That's also in line with economic theory in general (as competitors theroetically assault margins relentlessly) and backed up by competitive theory by Bruce Greenwald in "Competition Demystified" (I know no better book on competitive theory).
A concept I've also found useful to apply to competitive moats (although not infallible) is that of the Lindy effect as described by Nassim Taleb in his book Antifragile:
For the perishable, every additional day in its life translates into a shorter additional life expectancy. For the nonperishable, every additional day may imply a longer life expectancy. So the longer a technology lives, the longer it can be expected to live.
But it remains a very challenging game to assess competitive advantages into the future. According to Longleaf, those trying have been bailed out:
"Trying to discern the future cannot possibly incorporate all the potential disruptions that can occur. Over the past decade, many qualitative assessment misses were bailed out as all multiples rose because of rates dropping through the floor, making moat or franchise assessments of little importance to successful returns in those industries. Managers who say convincingly today that value does not matter much at their holdings because the outcome is all about their compounding machines probably have lower odds of being right in the longterm than they think, and from this point, they will not get bailed out by rates and multiples."
I'm not sure if I agree qualitative assesment misses were bailed out specifically. Haven't most types of "misses" been bailed out by rate expansion due to low interest rates?
At the end of the day, the Longleaf Funds deeply care about quality as well. It's just that they care much more about price compared to other market participants that they've been forced into names that aren't obviously quality businesses.
"We try to find hidden quality and therefore, a low price. For example, most investors do not consider CenturyLink to be of high quality, nor Park Hotels, nor Hikma. CenturyLink is still covered by ILEC (incumbent local exchange carrier) analysts and compared to ILECS; Park Hotels is treated as just another owned-hotel company near the top of the cycle; and Hikma is viewed as another generic drug company under pressure. Those perceptions allowed us to pay a large discount and low going-in multiples. All three companies own unique, valuable assets that should become apparent over time. The metro fiber assets within CenturyLink are some of the best infrastructure in the world. Park’s Hilton Hawaiian Village is an irreplaceable property of the first order. While Hikma’s generics division will hurt this year’s earnings, the company’s much more important injectables business is a true healthcare franchise with meaningful competitive barriers."
I concur low quality is out of favor, and so is complexity (exemplified in Longleaf's portfolio by a large number of complicated conglomerates that are family or owner operated). Here are the largest 25 positions of the firm's portfolio as tracked by GuruFocus:
Disclosure: No positions.
