A Fund Family with Roots and Wings
08/08/2012 8:30 am EST
A Chinese proverb states that the greatest two things you can give a child are roots and wings. The same could be said of successful mutual funds, observes Gregg Wolper of Morningstar FundInvestor.
In the investment world, seven to ten years is often considered the long term. In April 2012, Longleaf Partners (LLPFX) commemorated its 25th anniversary with its founding manager still in charge.
Continuity is a key theme. Mason Hawkins founded Southeastern Asset Management in 1975, opening Longleaf Partners, its first mutual fund, in 1987. Staley Cates joined Southeastern in 1986, and was named the fund’s co-manager in 1994. Those two remain in place as the only portfolio managers.
Since the beginning, they have used a very concentrated, deep-value strategy, with just 20 or so companies in the portfolio and hefty percentages of assets often devoted to the top holdings. Moreover, this has been the only approach used with any of Southeastern’s portfolios, including its other mutual funds, Longleaf Partners Small-Cap (LLSCX) and Longleaf Partners International (LLINX).
Conventional wisdom says a high degree of concentration increases risk by raising the likelihood that a serious setback in one or two stocks could have a deeply negative effect on the entire fund’s returns. Hawkins and Cates say that, on the contrary, their focused approach reduces risk because they own only companies in which they have absolute faith and that they and their analysts know intimately.
Moreover, the fund’s volatility is often tamed because management will hold substantial cash stakes if it can’t find enough stocks that meet its standards. In recent years, the cash level hasn’t been too extreme, but it topped 30% in mid-1999 and approached that level again in 2004.
Another consistent trait has been a dearth of trading. The turnover rate at Longleaf Partners has typically been around 25% per year, much lower than that of the typical stock fund.
Although Longleaf Partners has often enjoyed success over its history, it has struggled on more than one occasion. The fund endured some of its toughest times in the second half of the 1990s, when investors favored rapidly growing (or potentially rapidly growing) technology stocks and dumped the often-unexciting companies that Longleaf owned.
The fund lagged the S&P 500 in each calendar year from 1995 through 1999, trailing by more than ten percentage points on three occasions. The fund fared better when compared against its mid-value category peers, but in 1999, with a meager 2% gain as the Internet frenzy reached a peak, Longleaf Partners lagged the category by 13 percentage points.
A drastic reversal was around the corner. When tech stocks crashed and the economy slowed beginning in 2000, the worth of Longleaf’s patient value approach showed through, as it topped the S&P 500 by double digits for three straight years.
It wasn’t just the return to favor of value investing that powered these gains. Specific decisions also played a role—the fund also topped the mid-value category average by nine to 15 percentage points in those years.
For example, in 1999, Hawkins, Cates, and then-co-manager John Buford had boosted their stake in troubled Waste Management (WM), whose poor performance that year had contributed to the fund’s exceptionally lousy showing. But their commitment to that controversial stock—they had roughly 15% of assets in it at one point—paid off as it rebounded.
Moreover, in the wake of the September 2001 terrorist attacks, when most investors fled from travel and entertainment companies, the managers not only held on to their stakes in Marriott, Hilton, and other hotel/entertainment groups, they also initiated a substantial position in Walt Disney (DIS). These decisions were rewarded when sentiment turned.
The fund has had similar ups and downs subsequently. What’s noteworthy, though, is that, unlike the experience in the 1995 to 2003 period, when the fund generally lagged during rallies and outperformed when markets crashed, the opposite happened later on.
The fund posted outstanding returns in 2006, gaining 22%, a wide margin over both the S&P 500 and the large-blend category average. (It had been moved to that group in 2005, as its portfolio had migrated in that direction.)
But when the bear market from late 2007 to early 2009 struck, the fund suffered. Shares of Sun Microsystems, Dell (DELL), and some energy and materials companies were the culprits. Longleaf Partners plunged nearly 65%, a far worse showing than the large-blend average or the S&P 500. It shot back upward in 2009 and 2010, though, as investors regained faith in the economy, landing in the top decile both years.
Since then, successes with some stocks such as Disney have been offset by struggles with controversial holdings such as Chesapeake Energy (CHK). The fact that they continue to own Chesapeake, meanwhile, shows that these managers’ willingness to defy controversy and negative market sentiment hasn’t dimmed. They have acted to improve Chesapeake by placing four directors, including Lou Simpson, on the company’s board, and forcing a split of the chairman and CEO roles.|pagebreak|
For some shareholders, particularly those who bought in after the periods of better performance, enduring this ride hasn’t been worth it. For the ten-year period through June 2012, the fund’s 5% annualized return lags both the index and the large-blend category average (along with the average for its old mid-value group).
But from the end of the bear market—March 10, 2009—through the end of June 2012, the fund has handily beaten the S&P and its category. And since its 1987 inception, the fund has crushed those benchmarks.
Those results show both the benefits and drawbacks of its strategy. Hawkins and Cates have built a stunning record over the fund’s full history. But for some shareholders, even those who have held on for a full decade, the deep losses of the 2007-2009 bear market, along with other unpleasant periods, have given them worse returns than they could have received from an S&P 500 tracker.
Thus, to own this fund, one needs to be deeply committed to all aspects of its strategy and willing to hold on for a long time, resisting the temptation to bail out when things look bleak.
Shareholders, in return, get not just a fund with an impressive dedication to a difficult approach and managers with unusually lengthy experience, they receive some of the most detailed quarterly shareholder letters in the industry, an opportunity to hear occasional conference calls that discuss controversial holdings in depth, and the chance to attend an annual shareholder meeting complete with candid Q&A (a rarity among mutual funds).
They’ll also have the knowledge that the managers and analysts are invested heavily alongside them; Southeastern employees generally cannot hold equity investments anywhere except the Longleaf Partners funds.