January 23, 2010
It was a terrific year for the owners of the Longleaf Partners Funds. Each Fund posted another positive quarter and ended 2009 with strong absolute returns that materially exceeded our annual goal of inflation plus 10%. The Partners and Small-Cap Funds produced the best results in their 20+ year histories. They also beat their respective indices meaningfully with Small-Cap having its best relative year ever and Partners having its second best. Although headlines describe the “lost decade,” over the last ten years the Funds generated positive returns that were substantially greater than the relevant benchmarks. The table below shows cumulative returns over both the long run and the more recent periods.
Lessons of 2009
After the market meltdown of 2008, the most frequently asked question we received was, “What have you learned?” In previous shareholder communications we have elaborated on the things we learned including painful lessons from mistakes that cost us a few permanent losses.
In addition to that oft asked question, the most discussed topic has been macroeconomic forecasting’s importance. The macro environment dominated everything in 2008. For those doing solid bottoms-up corporate analysis, the credit crisis overwhelmed individual company analytical conclusions. “Micro” work seemed practically irrelevant, generating suggestions that macro issues should become a greater focus for Southeastern to better protect our investment partners. An understanding of how the macro will affect those names that we own or are considering always has been important. In a vacuum we would not follow Mexican macroeconomic statistics. But as a shareowner of Cemex, we must have some grasp of the Mexican economy’s drivers to properly assess intrinsic value and understand appraisal risks.
Interestingly we have not been asked about the “lessons of 2009.” The first answer to that unasked question is that bottoms-up fundamental company analysis matters quite a bit. If it were probable that every year could be like 2008, every investor should try to monitor the global banking system and engage in macroeconomic prognosticating. However, if it were highly probable that the worldwide economy, banking system, and equity markets would not look like 2008 in most years, then we should not abandon lessons from Graham, Buffett, and our 35 years to become macro driven “generals-fighting-the-last-war.” Simply stated, 2009 reminded us that 2008 was anomalous.
A macro oriented investor could have logically decided on January 1, 2009 (or in March when stocks were meaningfully lower) that with the horrible global economy, the teetering banking systems across multiple countries, and the extremely weak stock markets, it was a good time to sit on the sidelines until some economic clarity emerged. By contrast, an intrinsic value investor who focused on the free cash flow that certain well-run, competitively advantaged companies generated – even in a severe recession – would have purchased those cash flow streams at incredibly low multiples, i.e. high cash flow yields. Those who chose the macro route and parked in cash missed what was the best purchase point for equities in our lifetime and earned virtually nothing on their liquidity.
This leads to the second lesson of 2009: comfort comes at a very high cost. Buffett made this point in an August 6, 1979 Forbes article entitled, “You Pay A Very High Price In the Stock Market For A Cheery Consensus.” Selling stocks in 2007 would have been uncomfortable; in retrospect we all should have done more of that. Buying or even holding stocks in early 2009 was very uncomfortable; investors should have done that. Many investors feel most comfortable when the consensus confirms their view. Making the same investment choices as a large number of other intelligent people mathematically almost insures doing the wrong thing at the wrong time because security prices reflect the collective action of the consensus group.
So where are we now? We believe that we are between the valuation extremes of the mid-2007 highs and the early 2009 lows. With global markets having risen rapidly since March, bargains are less plentiful, and free cash flow yields are less attractive. However, valuations are still compelling when compared to the past. Our price-to-value ratios remain at or below the long-term average. Also, the “comfort gauge” still appears favorable given the excessive quantity of cash people are holding in lieu of equities. This cash on the sidelines constitutes significant future buying power that will someday make its way back to attractive, growing corporate free cash flow yields that almost always find their long-term recognition either in the stock market when overall psychology shifts or from corporate M&A. Today many macro mavens are comfortable owning the taxable, fixed coupons of 10-year Treasuries at yields of 3.7%.We much prefer the after-tax, growing free cash flow coupons of dominant businesses at yields of 9-10%.
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(c) Longleaf Partners
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