Longleaf Partners: Valuation Principles

“You do eliminate a lot of interference by being in Memphis as opposed to Manhattan.” —Mason Hawkins

This post contains a discussion of the valuation principles followed by Longleaf Partners. In it Mason Hawkins and his colleague Stanley Cates discuss the valuation approach underlying Longleaf Partners daily work in valuing businesses.

Letter To Our Shareholders

The first quarter of 2015 saw a continuation of the themes from the second half of 2014. Almost all of our individual businesses delivered solid operating performance, and our management partners pursued productive ways to build long-term per share values. This activity produced strong excess returns in Longleaf Partners Small-Cap Fund,“which helped the Longleaf fund earn the No. 1 ranking among small-cap U.S. equities funds.” (1) By contrast, the Partners, International, and Global Funds’ relative performance remained challenged as solid company results could not overcome three ongoing broad headwinds: the fall in energy prices, the U.S. dollar strength, and the Chinese government’s pressure on Macau gaming. While these challenges affected only a handful of our holdings, they were large enough to offset the good results at the vast majority of our companies.

The steady upward climb of the S&P 500 has intensified the debate over active versus passive investment approaches, and given this, we want to detail the reasons we are confident that our portfolios can outperform relevant benchmark indices and deliver on our absolute goal of inflation plus 10% over the long term. Our current underperformance is the exception. The three Longleaf Funds with a greater than 5-year track record have since inception returns well above their benchmarks.

Our history aside, future performance is all that matters to our shareholders and to us as the largest collective shareholder in the Longleaf Funds. Normally, we discuss future performance in terms of our price-to-value ratio (P/V), an indicator of our absolute return opportunity. Today, the P/V is above our long-term average, which is not surprising given the bull market run. A more objective and simple comparison to address the current focus on relative returns versus the indices is price-to-free cash flow (P/ FCF), which measures the multiple being paid for the cash earnings coupon that businesses will generate over the next twelve months. The free cash flow coupon is a better reflection of cash profits than are stated earnings. That P/FCF multiple translates into FCF yield (the inversion of P/FCF), which is the FCF return that an investor will earn over the next year if the stock prices remain the same, assuming the 12-month FCF estimates are accurate. That yield can be enhanced if the FCF coupons grow. We can distill our investments’ and the indices’ future return prospects down to the following objective formula:

Going-in free cash flow yield

+

Organic growth our companies can generate without spending that cash yield

+

Any excess returns our managements generate from reinvesting those cash coupons.

=

Expected cash return for shareholders

We believe comparing the FCF yield and prospective coupon growth in the Longleaf portfolios to those in the relevant indices indicates how well our current holdings are positioned and why we are confident in our ability to deliver long-term outperformance with low risk of permanent capital loss.

Going-in free cash flow yield:

FCF yield is the primary source of expected cash return. Today we are paying, on average, 11X forward free cash flow (P/FCF) for the Funds’ common stocks. If none of our companies grew, and they simply earned cost-of-capital-type returns on what they reinvested, we would expect a 9% return from the FCF earnings yield (the reciprocal of 11X). Admittedly, this number is based on our next 12-month cash earnings estimates, which may be no better than Wall Street’s estimates for any given company. In aggregate, however, our estimates for the whole portfolio generally even out any single- company misses and prove to be conservative.

Organic growth our companies can generate without spending that cash yield:

In addition to our estimated 9% FCF yield, the quality of our businesses and operating skill of our management partners will largely determine organic earnings growth. Beyond FCF coupons, returns will be powered by owning high quality businesses that can grow revenues and margins without substantial spending. We mostly own companies we believe are competitively superior like Aon, adidas, and Vail Resorts, where pricing power and other advantages enable organic growth that requires virtually no capital. Additionally, margin improvements can further boost organic earnings growth. We own companies like FedEx and Philips, where margins are nowhere near peak, and where the predominant sell-side descriptor is “self-help” – meaning they can raise margins even without an economic or revenue tailwind. Oil and gas companies, which are hurting performance right now, are the noted exception to our FCF profiles, but in the face of depressed energy prices, our partners are finding other ways to build value.

Any excess returns our managements generate from reinvesting those cash coupons:

Wise capital allocation by our management partners can create additional return beyond the sum of our FCF yield and earnings growth from organic revenue and margin gains. We own companies like Level 3 and Lafarge that are using capital to grow revenues with huge IRR (internal rate of return) expectations on the amount they invest above depreciation and amortization. Melco opening a new Macau casino, Chesapeake picking among millions of acres and thousands of possible well sites in an effort to drill the most profitable projects, and Scripps buying stock back far below private market value are representative of the high IRR projects our management partners are undertaking to grow value per share and thereby increase our ultimate returns.

If the three listed FCF return components perform as we expect, we should achieve our absolute return goal of inflation plus 10%. The yield is based on a constant stock price, but ultimately Longleaf’s performance should also benefit from the gap between stock prices and intrinsic values closing. Contrasting our companies’ metrics with those of the indices highlights the strength of our relative position. Our P/Vs range between 70-80%, while we believe the indices trade close to or above full value. The S&P 500, MSCI EAFE, and MSCI World indices sell for 21-22X next year’s estimated FCF, and the Russell 2000 is at 30X. This translates to a 4.7% yield (the reciprocal of 21-22X) for the first three and a 3.3% yield for the Russell 2000.(2) Earnings growth is limited with margins of the S&P and MSCI World indices near peak levels. Even if margins can stay at these highs, earnings growth is confined to organic revenue growth in a universe where most economies expect low single-digit growth. Conversely, if margins regress to the mean, the outlook for earnings growth is poor. Nor is capital allocation likely to generate growth, because the collective group of CEOs at index companies is not earning excess reinvestment returns. The most telling example is the recent manic stock repurchasing within the S&P 500. Ironically, we are huge supporters of share buybacks when a stock trades at a big discount to intrinsic worth; it de-risks capital allocation while boosting our value per share. But most companies tend to do just the opposite. When stocks had a fire sale in 2009, S&P companies repurchased $138 billion, but as the index was approaching historic highs in 2014 with many stocks trading above intrinsic values, these companies bought back $553 billion, close to their entire FCF coupon after dividend payments.

This behavior is boosting stock prices for now (and indirectly feeding the index’s outperformance of active managers), but will likely end badly, as all overpriced share repurchases ultimately do.

After the dramatic declines in the global financial crisis (GFC), the Funds’ absolute returns over most periods at the end of 2008 fell below our inflation plus 10% goal. We told our partners that because our P/Vs were below 50% and our P/FCF multiple was 7X, yielding 14%, we anticipated stronger compounding than normal. Over the six years since then, the Partners and Small-Cap Funds have made substantial money for shareholders as our absolute returns have far exceeded inflation plus 10% and we have outperformed the relevant benchmarks. Today, we face a similar end point challenge in the Partners, International, and Global Funds, but it is our relative returns that have underperformed. While we are committed to our absolute goal, given FCF yields, P/V levels and a slim on-deck list, we anticipate lower absolute returns than we did at the end of 2008. We feel as strongly now about our ability to outperform the indices over the next five years as we felt about our absolute opportunity after the GFC. Our portfolios sell on average for 11X FCF, slightly higher than our normal 9-10X, but very attractive against broader markets at 21-22X versus their historic 17-18X (and an even higher multiple in the Russell 2000). Said differently, we own portfolios with 9% FCF yields where we believe the cash coupons will grow versus the markets’ 4.7% FCF yields where the coupons will likely decline in the next few years.

While the payoff pattern may be unpredictable, the transaction activity that helped produce our substantial Small-Cap Fund returns in the past few years is occurring in companies across all of our portfolios. Exceptionally positive corporate activity is generating value growth in U.S. holdings such as Chesapeake, CONSOL Energy, and Murphy Oil. Likewise, our non-U.S. partners at Philips, Vivendi, Exor, CK Hutchison, and Lafarge are involved in transactions that have gone partially unrecognized in their stock prices thus far. In addition to owning quality businesses with relatively high FCF yields, we have partners making superior capital allocation decisions that we believe will further drive excess returns.

Southeastern has followed the same proven investment disciplines under the same leadership for four decades. While our concentrated, valuation- based approach has not outperformed the indices all the time, it has delivered strong relative results most of our history. Ultimately, our partners have been rewarded for owning strong businesses run by good management teams when the discounts between prices and values have closed. The payoffs tend to occur in periodic bursts that do not necessarily correspond with the broader markets. As the largest owners of the Longleaf Funds, we believe our portfolios are positioned to experience a burst of outperformance because they reflect a:

• Time-tested investment discipline rooted in the principles of investors such as Keynes, Graham, Templeton, and Buffett and implemented by a singularly focused, aligned manager,

• Set of criteria that has produced a track record of high rates of outperformance over multiple periods throughout our 40 year history,

• Strong position against benchmarks near historic high levels after a long-winded bull run in what arguably has become a “passive bubble,” and

• Carefully selected set of competitively advantaged businesses that are generating solid operating results with capable, motivated managements driving above average value growth and in many cases, creating catalysts for value recognition. We are grateful for our supportive, long-term partners who share our conviction. If you missed our shareholder webcast on Wednesday, May 6, a replay is available on our website.

Sincerely,

/s/ O. Mason Hawkins

O. Mason Hawkins, CFA Chairman & Chief Executive Officer Southeastern Asset Management, Inc.

/s/ G. Staley Cates

G. Staley Cates, CFA President & Chief Investment Officer Southeastern Asset Management, Inc.

May 14, 2015

(1) Bloomberg Markets April 2015, “Staying Active.” Returns through 12/31/14

(2) Factset

(Source: Letter to Our Shareholders, Q1, 2015 – see link below)

The Cautionary Statement in the quarterly report contains a few definitions that can be useful to know.

Definitions

EBITDA is a company’s earnings before interest, taxes, depreciation and amortization.

EV/EBITDA is a ratio comparing a company’s enterprise value and its earnings before interest, taxes, depreciation and amortization.

Free Cash Flow (FCF) is a measure of a company’s ability to generate the cash flow necessary to maintain operations. Generally, it is calculated as operating cash flow minus capital expenditures.

Free Cash Flow Yield (FCF Yield) equals a company’s free cash flow per share divided by the current market price per share.

The Global Financial Crisis (GFC) is a reference to the financial crisis of 2007-2008.

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows from an investment equal zero.

A master limited partnership (MLP) is, generally, a limited partnership that is publicly traded on a securities exchange.

Organic growth is the growth rate a company can achieve by increasing output and enhancing sales, as opposed to growth via mergers and acquisitions.

P/V (“price to value”) is a calculation that compares the prices of the stocks in a portfolio to Southeastern’s appraisal of their intrinsic values. The ratio represents a single data point about a Fund and should not be construed as something more. P/V does not guarantee future results, and we caution investors not to give this calculation undue weight.

Further Reading

Southeastern Asset Management, Inc. 

Letters to Shareholders – All Years Consolidated(1997Q4 to Present)

Longleaf Partners Funds Quarterly Report, Q1 2015

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