The Partners fund recently re-opened to investors and Mr. Hawkins agreed to answer our questions.

Across your funds, you rely on the metric of “P/V,” which is the ratio of current price to intrinsic value.  Can you explain how you determine intrinsic value?  Over the last six months, have more opportunities arisen because of changes in the numerator (P) or the denominator (V)?

We use three methods to arrive at an appraisal.  The first and most predominant is determining the value of the free cash flow of the operating business.  For understandable, predictable, competitively entrenched companies, we project the next seven years of free cash flow (net income plus non-cash charges minus required maintenance capex and working capital costs,) put a low or no growth terminal multiple on the business past 7 years, and discount back at a conservative discount rate (9-11% today.) 

The second method calculates net asset value by adjusting book values of assets and liabilities to current liquidation values.  (For example, real estate is rarely worth the original cost carried on the books, particularly if it’s been held for a long period.)

Third, we check our longhand math against a data base of comparable transactions over the last 30 years, taking into account the interest rate environment at the time of the transactions.   We mark our appraisal to the lower of the two values when comparable sales and our longhand math differ.

Over the last six months, most of the improvement in P/V has come from the P, or prices coming down.  Values are not nearly as volatile as prices, which obviously gives us opportunity at times when fear is driving prices.  Most of our appraisals have grown or remained steady throughout the last six months.  At a number of our companies we expect values to grow substantially because management is using the financial strength of the business to aggressively buy in shares at steeply discounted levels.  Buying in shares at half of value grows the value per share of the company materially.

You compare each fund to a benchmark, as well as to an objective measure of inflation plus 10%.  What is the history and rationale behind the choice of this benchmark (inflation + 10%)?

You can’t fund scholarships or retirement or college with relative returns.  For our capital which is 100% invested in the Longleaf Funds, absolute, real returns matter.  A real return of 10% far exceeds the market’s long term average, and recognizes the premium that investors in businesses would require over bonds in order to take on the risks of business ownership.

Relative to your benchmarks, the Partners Fund has not performed as well over the last 5 years as it did during its first 15 years.  What do you attribute this to?  Has the discipline of value investing become more competitive over the last five years?

The primary frustration over the last five years, until recently, has been the lack of volatility in the markets.  Without volatility we get few opportunities to steal businesses and lay the foundation for future compounding.  Obviously that has shifted dramatically since late 2007.  In addition, much of what has done well has been the natural resource and emerging market areas, driven largely by China.  We typically don’t own many natural resource companies because they are commodities without competitive advantage and are often depleting assets.  We believe that the relative returns from here for the next five years will be compelling, and the opportunity set is what caused us to temporarily re-open the Partners Fund.

What tools do you employ for identifying potential candidates for investment, specifically the companies on your “on deck list” for the Partners Fund? 

Each analyst is tasked with finding the best opportunities that meet our qualitative and quantitative criteria.  He can source the ideas from a myriad of places including general business publications or trade journals, the new low list daily, insider buying and share repurchase reports, data screens that indicate things that might be cheap, management teams that we respect, and a “wish list” of great businesses with capable managers that we would like to own at the right price. 

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