What’s This Business Worth?

What exactly goes through your mind when you’re actually making an investment? Warren Buffett got this question during an interview and talked for a moment about a few of the things that come to his own mind when he’s trying to evaluate a certain business and it’s future economic potential.

“Well, if I drive by a McDonald’s stand or a Kentucky Fried Chicken stand I will automatically think to myself “What is this business worth?” You know, how many customers can walk in the door? What kind of gross margins can they have? How many people do they need? How likely is it that another chicken stand opens across the street? I mean, all of those things. And that’s true of the chicken stand and it’s true of Google or you name the business. I mean, it’s all about evaluating the economic potential, the economic future of a given business. And most of them you don’t know the answer on. But every now and then you run into one where you know the answer. But that’s all business is. It’s what Aesop said a long time ago: “A bird in the hand is worth two in the bush.” You know, that was said in 600 BC and that’s now what’s called discounted cash flow and all that sort of thing. But he saw that and figured it out, you know, twenty-six hundred years ago. And all I’m trying to figure out is if I could take that dollar in my hand: When do I get the two dollars out of the bush? How sure am I of getting it out of the bush? Is there some other bush where I can get three dollars out of it instead? I mean, it’s very basic stuff. And a lot of times you look at it and you say “I don’t know how many birds there will be in the bush.” So you go in to the next one until you find the answer.”

(Source: 56:55 into Warren Buffett with B-School Students Interview from India)

Masters in Business: Aswath Damodaran

“Your value should not be a function of knowing the price.”

—Aswath Damodaran

New MiB Episode: Aswath Damodaran

Yesterday saw the release of a brand new episode of Barry Ritholtz’s Masters in Business, this time an interview with Aswath Damodaran. Some topics discussed are Tesla, Amazon, value investing, Warren Buffett and Benjamin Graham. I have transcribed the parts containing the discussions about Tesla and Amazon, both displayed below and ready to get read.

Tesla: Stories and Valuations [8:49 — 10:30] 

Ritholtz: Let’s talk about two of the hottest companies out there, both of which seem to have a somewhat ambiguous valuation; Tesla and Amazon. So let’s talk about Tesla. You’ve done so much work on that. What is the bottom line with the valuation of Tesla?

Damodaran: I mean with all young companies it’s a story that you tell about the company that drives your valuation; the narrative. And with Tesla the narrative can lead you to different places. I mean, I’ll give you an example. When I first valued Tesla it was about three years ago I valued them as a luxury automobile company. I gave them the margins of luxury automobile companies and I gave them the growth you could get as a luxury automobile company, and came up with about 100 dollars per share. The problem with Tesla is you’ve got, for lack of a better word, a delusional CEO who kind of keeps expanding the story on you, right. Cause in a sense today he’s an automobile company, tomorrow he’s an clean energy company and the day after tomorrow god only knows where. So the story for Tesla, I call it the ultimate story stock. People have stopped talking about numbers, and numbers really… and that’s why Tesla’s stock price can take all this punishment of deliveries not being on time, and still hang in there. Cause the people that invest in Tesla have bought into Elon Musk’s story

Ritholtz: Is there an Elon Musk premium?

Damodaran: I think there’s an Elon Musk fandom. Which essentially… Tesla investors are not investors like other companies. They don’t invest in the company for the earnings and cash flows. They are not worried about the delivery schedules not being met. They are buying the Elon Musk story.

Ritholtz: So there was just an article out the other day that Bloomberg released that showed among luxury auto makers; BMW, Audi, Mercedes, and others plus Tesla in terms of sheer volume last quarter Tesla’s beating everybody. Is that a fair statement?

Damodaran: And I think Tesla has some incredible strengths, I mean, can you imagine another automobile company telling the world that they are going to come out with a new model in 2018 and 400,000 people signing up today and putting down… nobody else would do it.

Ritholtz: And how about just the idea of someone saying; “I have an idea. Let’s make a new automobile company.” That hasn’t been done, in how many years, decades?

Damodaran: And that’s why I feel frustrated with Tesla, because at the core it has something very powerful; this connection to customers that no other automobile company does. And the reason I’m frustrated is I want them to build this incredible great automobile company, I want focus here. Instead, what do I get? I get them acquiring Solar City and telling me that they are building  battery panels and solar power.

Ritholtz: Well, you’re gonna buy a battery pack, put it in you garage, put the solar cells on your roof, and now we’ve made you completely independent of the grid. Look what we’ve done for you as an automobile purchaser.

Damodaran: And in a sense I think, once you’ve established yourself as an automobile company, maybe you wanna do this. But you already have enough on your plate. Why would you want to load up more stuff on your plate? Especially because I think Solar City is in a commodity business with a huge amount of debt. So it’s almost like you’re adding three distractions to a company that already has so much to focus on. If I was Tesla I would focus on getting the Tesla 3 delivered on time, because that’s gonna be disastrous cause you’ve got 400,000 people expecting the car to be delivered in 2018. And that doesn’t get to happen.

Ritholtz: And this is the low-cost under 40,000 dollar every person, ever all electric automobile which ironically General Motors turns out to be ahead of Tesla with. First they had the Vault and they’re actually gonna beat Tesla to market.

Damodaran: Yeah, but I think Tesla will win that game simply because General Motors want to go off to the fifteen, maybe the lowest… I mean Tesla will never be a fully mass-marketed automobile company because I think in a sense they will always trade at a premium over a GM car. So, I think they will have that price premium and and a profit margin. But all of that pre-supposes that they make the trades run on time.

Amazon: Insane Capacity to Destroy [13:15 — 16:20]

Ritholtz: Let’s talk about Amazon. I’ve mentioned that there was an Elon Musk premium. Is there a Jeff Bezos premium at Amazon?

Damodaran: And I think it’s deserved. Amazon has been one of my pet obsessions for twenty years. It’s a company that I valued first in 1997, and I’ve valued it pretty much every year since. I tell people I bought Amazon four times, and I sold Amazon four times. Which kind of tells you where I’m at Amazon right now.

Ritholtz: Have you regretted all the sells?

Damodaran: No, because I think in a sense I have to stay true to my sense, which is I buy companies cause I think as an investor. The price has to be less than the value. Amazon is a company where the price can take off and go well ahead of value for extended stretches for years. And I think part of the reason I think people are willing to pay a premium is I’ve never seen a company where a CEO has been more consistent about his narrative. In fact, he’s the anti Elon Musk, right. If you go back to 1997 and you read the letter that Amazon sent to, I don’t know if you’ve ever read the Jeff Bezos… there’s a great letter that’s online where he told people what he would do as a company in 1997. And he’s stayed exactly true to the script.

Ritholtz: And he’s done it all. There have been a handful of pewits but he’s pretty much been fairly consistent. There’s minor shifts of course changes, not wholesale reversals.

Damodaran: In fact I describe Amazon as a field of dreams company, right. Which is, the story he told in 1997 is; “If we build it, they will come.” Basically he said; “Where gonna go after the revenues first. We’re not gonna worry about profits, and once we’ve built the revenues, the profits will come.” He’s stayed true, not just to that story in terms of what he said, but how he acts. You look at the Kindle, you look at… basically he goes product by product.

Ritholtz: So let’s go through it. You have the Kindle. You have the Amazon Fire, Amazon TV, Amazon Prime is… I started the Amazon Prime a few years ago, I was late to the party and it’s just become indispensable. Amazon Music, Amazon Video.

Damodaran: And what they share in common is that Amazon sells everyone of these products are at cost or below. They are open about it. Amazon Prime, they charge it at 99. You go to the 10-K they actually tell you how much…

Ritholtz: It was 79 when I joined it…

Damodaran: It’s now 99. They give you the cost of how much it cost them to service that. It’s about 399. Basically, they say; “Look we’re subsidising it, but it’s okay. Cause if we build it, they will come.”

Ritholtz: Your colleague and NUY professor Galloway has been suggesting Amazon should go out and buy the U.S. Postals Service, cause their shipping costs are now in the billion, soon to be tens of billions of dollars.

Damodaran: And you know what? If I was FedEx or UPS I’d be terrified of where Amazon is going next, right. Cause Amazon has this insane capacity to destroy almost every business for everybody else of the businesses. It’s done it in the retail business already. The reason I will be hesitant to buy Netflix is because Amazon is entering big time into that business. UPS and FedEx, you look at Amazon entering the business, and this is what Amazon does in every business they go into; they sell below cost. They challenge you to match up with them and they can keep going long after you’ve dropped out of the game. So, I think that they’ve got that right. There is change coming to this business.

Hubris and Overconfidence

Damodaran: “There are two things that get me into trouble when valuing business; it’s hubris and the other one is overconfidence. The two are related. Any book that reminds me that hubris and overconfidence historically have been set-ups for disaster, is a good reminder for me. It’s so easy to get caught up in “I know more than anybody else, so I can put stuff into models and not recognise how much of the stuff you don’t control.”

What Are Some of Your Favourite Books? [1:06:35]
  • Security Analysis, Benjamin Graham (I don’t read it for the techniques, but the philosophy of investment)
  • A Conspiracy of Paper, David Liss (a novel about the time in London around the time of the South-See Bubble)
  • Extraordinary Delusions and the Madness of Crowds, Charles Mackay
  • Michael Lewis books
  • James Stewart
  • Barbarians at the Gate, Bryan Burrough & John Helyar
  • When Genius Failed, Roger Lowenstein
Narrative and Number: The Value of Stories in Business

In the beginning of 2017 there will be a new book out from Damodaran called Narrative and Numbers: The Value of Stories in Business. Below the book description from Amazon. Looks like an interesting book, and one I will keep an eye on and catch up as soon as it gets available.

How can a company that has never turned a profit have a multibillion dollar valuation? Why do some start-ups attract large investments while others do not? Aswath Damodaran, finance professor and experienced investor, argues that the power of story drives corporate value, adding substance to numbers and persuading even cautious investors to take risks. In business, there are the storytellers who spin compelling narratives and the number-crunchers who construct meaningful models and accounts. Both are essential to success, but only by combining the two, Damodaran argues, can a business deliver and sustain value.

Through a range of case studies, Narrative and Numbers describes how storytellers can better incorporate and narrate numbers and how number-crunchers can calculate more imaginative models that withstand scrutiny. Damodaran considers Uber’s debut and how narrative is key to understanding different valuations. He investigates why Twitter and Facebook were valued in the billions of dollars at their public offerings, and why one (Twitter) has stagnated while the other (Facebook) has grown. Damodaran also looks at more established business models such as Apple and Amazon to demonstrate how a company’s history can both enrich and constrain its narrative. And through Vale, a global Brazil-based mining company, he shows the influence of external narrative, and how country, commodity, and currency can shape a company’s story. Narrative and Numbers reveals the benefits, challenges, and pitfalls of weaving narratives around numbers and how one can best test a story’s plausibility.

Further Reading

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Fortnox: Visma’s Cash Offer Re-Engineered

Fortnox: A High Growth Small-Cap with High Profitability

Fortnox is, according to themselves, the leading provider of Internet-based applications for businesses, associations and accounting and auditing firms (a big part being their offering of accounting software). The business concept is to offer a wide range of Internet-based applications that are easy to learn and use, yet is powerful and feature-rich enough to meet most needs and wishes. Fortnox has been growing at a fast pace back since it was founded in the early 2000s.

Fortnox_Datapershare

Below a page from the 2015 Fortnox annual report with my own notes (I now see that I made a mistake when I wrote 2016 which is incorrect, should be 2015 and nothing else).

Cash Offer from Visma

On March 14, 2016, Visma made a cash offer to acquire Fortnox for a total purchase price of SEK 1,406 billion, or SEK 24 per share. To read the press release, click here.

In its quaterly report for Januari-March 2016 Fortnox disclosed a non-recurring item of approximately MSEK 1 for consultations, a so-called fairness opinion, in connection with the Visma bid mentioned above. The Fortnox Board of Directors have evaluated Visma’s bid by themselves, and from taking in a fairness opinion, decided to favour Visma’s bid.

Visma’s current bid puts a total value of MSEK 1,406 for the shares outstanding, or SEK 24 per share. On the same day as the bid was made public the share price rose from SEK 18.2 to SEK 23.9, an increase of +32%. With the value of equity at MSEK 1,406, almost no debt (only MSEK 0.5) and cash of MSEK 46 at year-end 2015 (compared to MSEK 52 per March 30, 2016) Fortnox has an enterprise value of about MSEK 1,360.

Re-Engineering Visma’s Cash Offer

Reverse engineering a certain valuation makes it possible to back out what growth is implied in it, as noted by James Montier:

So, if one can’t use DCF how should one think about valuation? Well, one solution that I have long favoured is the use of reverse engineered DCFs. Instead of trying to estimate the growth ten years into the future, this method takes the current share price and backs out what is currently implied. The resulting implied growth estimate can then be assessed either by an analyst or by comparing the estimate with an empirical distribution of the growth rates that have been achieved over time, such as the one shown below. This allows one to assess how likely or otherwise the implied growth rate actually is.

Let’s see what implied growth assumptions we get if we reverse engineer Visma’s cash offer per share of SEK 24, equal to a total purchase price of MSEK 1,406.

I have put together three different scenarios, all starting with earnings per share (EPS) of SEK 0.43 (calculated by assuming 25% growth in revenues in FY2016 and an operating margin of 20% with a 22% corporate tax rate). A discount rate of 10% is used in all the scenarios.

  • Scenario 1. Forecast period of 5 years with a compounded annual growth rate (CAGR) of 25%.
  • Scenario 2. Forecast period of 10 years with a compounded annual growth rate (CAGR) of 15%.
  • Scenario 3. Forecast period of 3 years with a compounded annual growth rate (CAGR) of 35%.

Scenario nr. 1 requires, except for the assumed 25% CAGR during 2016-2020, a terminal growth rate beyond 2020 of 6.76% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 1 valuation is shown in the table below.

Fortnox_S1

Scenario nr. 2 requires, except for the assumed 15% CAGR during 2016-2025, a terminal growth rate beyond 2025 of 6.76% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 2 valuation is shown in the table below.

Fortnox_V_s2

Scenario nr. 3 requires, except for the assumed 35% CAGR during 2016-2018, a terminal growth rate beyond 2018 of 7.20% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 2 valuation is shown in the table below.Fortnox_V_s3

Discount Rates and Terminal Growth Rates

By altering the discount rate used we can solve for what terminal growth rate needed to get an intrinsic value per share of SEK 24.

See table to the right where different growth rates are shown for each of the three scenarios depending on what discount rate is applied, ranging from 8.0% to 15.0%. Depending on the discount rate used the growth rate range between 4.1% to 13.1%. What should be considered a reasonable discount rate as well as growth rate is up to each individual investor to decide.

Fortnox_terminal

The Trade-Off and Where to Go From Here…

I have not, and I do not, own any shares in Fortnox. Clearly, I was too late to the party and didn’t find this gem before Visma made its bid public. Without doing a lot more digging into this case it looks like Visma’s cash offer per share is reasonable. Of course Fortnox could go on and grow even faster. As always, the future is uncertain, but selling and taking the cash received to look elsewhere for new investment cases may be the thing to do. By reverse engineering the SEK 24 per share cash offer from Visma we are at least able to see what kind assumptions give this value.

Before making any further decisions about what to do, one would have to take a look at what levels of revenues that each EPS is derived from and analyze them to come up with an answer to whether they could be deemed reasonable or not. A quick look at revenues from the three different scenarios is shown in the table below. Scenario nr. 2 gives MSEK 395.8 in revenues in 2020, CAGR of 25%. This growth looks to be in line with the underlying growth in the industry (see link to analysis, in Swedish though, that I found that is referring to Statistics Sweden).

Before making any decisions one would likely want to have a closer look at revenues, both for Fortnox but also for the whole industry, to decide what levels could be deemed reasonable.

Fortnox_revenues

See tables below for some historical Fortnox key ratios.

Fortnox_PL2

Links

Disclosure: I have no position in the stock mentioned, and no plans to initiate any position within the next 24 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion, and should not be considered investment advice. Always do your own due diligence and contact a financial professional before executing any trades or investments.

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