The Found Money Interview: Southeastern Asset Management and the Longleaf
Funds: The Advantages of Getting Away From Wall Street
Morningstar named Mason Hawkins and Staley Cates of Southeastern Asset
Management’s Longleaf Partners Fund and Longleaf Partners Small-Cap
Fund their 2006 domestic equity managers of the year. For this issue, we
talked to three of Southeastern’s vice presidents about how Longleaf
goes about investing.
Lee B. Harper, VP, has a B.A. in history and communications from the University
of Virginia and an M.B.A. from Harvard Business School. She has been at
Southeastern since 1993. Jim Barton, Jr., VP, is a CFA who has been at
Southeastern since 1998. He has a B.A. in history from Dartmouth College.
Frank N. Stanley, III, VP, is a CFA with a B.A. from Georgia Institute
of Technology. He came to Southeastern in 1985.
Southeastern Asset Management and Longleaf Funds have been around
for a while. Could you give us a brief history?
started as a firm in 1975. We managed separate accounts for the first decade
or so, and fished in pretty much every pond that we could find, whether
they were small opportunities or big, local companies or national. After
about a decade or so, the folks at Southeastern had gotten to the point
where they had some investable assets. To prevent conflicts, our policy
at the time was that we could not personally buy or trade in names that
we owned for our clients—however, that
seemed a bit incongruent with being on the same page as our clients,
and we wanted to own those investments because we thought they were great
opportunities. We created the mutual funds as a way to own the investments
that we were buying for our clients and eliminate the conflicts of interest
that could come up. In 1987 we created the Longleaf Partners Fund as a
vehicle for investing our own assets and replicating what were doing for
our separate accounts. Through the mutual funds, we own the same names,
we pay the same fees, we get the same performance as our clients.
And the rest of us get a chance to come to the party.
LBH We have a policy at Southeastern—if
you work here, if you are married to someone who works here, or the dependent
of someone who works here, you can't own any equities or any other mutual
funds outside of the Longleaf Funds. Collectively, the Southeastern employees,
their families, their retirement plan, and their private foundation are
the largest shareholder group in the funds.
A couple of years after we started the Partners Fund, the firm had
grown to a size where we were finding smaller-cap names that were
too small to use in our existing portfolios. Again, we wanted to
own those with our own money, and we created Longleaf Partners Small-Cap
Fund so we could do that. That was in 1989. Fast-forward: The same
scenario developed in the late 1990s. We were finding lots of good
investments overseas, and we got to the point where we were maxed
30% foreign holdings in the Partners Fund and Small-Cap Fund. That
universe was big enough to create a fund to capture those overseas opportunities.
So once again, we seeded the fund with our own capital and began
Longleaf International Fund in 1998.
Thanks for the background on the company. Could we get some background
on the three of you?
LBH I came to Southeastern about 14 years ago,
by way of being involved with some of the folks who work here, through
the same nonprofit organization. I had been in the consulting group
at IBM—nothing to do with investments—and
I was planning a career change. They approached me and said, “If
you're thinking of changing careers, would you be interested in talking
It was a time when the mutual funds were a smaller portion of our
business, and it made sense to focus on them more. We had this great
record, and people were starting to pay attention to it. But we hadn't
ever really developed the funds as a business. That was the genesis
of my coming to Southeastern. We put together a strategy for the
mutual funds, made them more accessible to institutions and high
net worth individuals. Our approach is that, as the largest investors
in these funds, we want other shareholders with whom we want to be
JB That’s a perfect segue to my career path. I joined Southeastern
almost nine years ago, and before that I was working in Memphis for a company
called Louis Dreyfus as a proprietary futures and options commodities trader.
As Lee mentioned, there was an opportunity here at Southeastern in the
International Fund. It was just getting started in ’98, and there
was only one trader, and they were looking for another. It may appear as
if there's a great divide between commodities trading and what we do here,
but my philosophy was very similar to Southeastern’s—contrarian,
trying to buy things cheaply, selling things when they were getting to
be fully priced. So it wasn't such a leap as it might look on paper. I
spent about five years on the trading desk, and then had the opportunity
to move over to this position in client service—getting in front
of the clients, [explaining] what we do, why we do it, how we do it. I’ve
been doing that for about four years.
FNS I started at Atlantic National Bank in Jacksonville, Florida—with
Mason Hawkins—in 1972 or so, in the investment department. It was
a great little bank. Eventually he came to Memphis and I went to
Atlanta to work at an investment counseling firm, but we kept in
touch. He kept trying to get me to come over here. It was a great opportunity
to get in on the ground floor of a new company, so I accepted. Eventually
I started doing more outside work, and Mason concentrated on the
One of the interesting things about the Longleaf Funds is the
will concentrate our assets in our best ideas”—although in
so many of the investment discussions that we hear and read in various
media, the emphasis is on diversification. Could you talk about the
values that you find in concentration?
if you don't know what your businesses are worth, you'd better own plenty
of them. I'm smiling when I say that, but when I listen to some of these
people on TV, you'll notice that they never say what the businesses that
they like are worth. They talk about the trends in the economy that might
hurt [those businesses] or help them, or why they would avoid them or buy
them, but they never say what [those businesses are] worth. We think we’ve got a pretty good idea of what businesses are
worth, as a private market value or a going concern. When [we think] they’re
very well managed and very good businesses that are selling for half what
we think their intrinsic value is, we want to concentrate our money in
those businesses because they’re very difficult to find. No one’s
ever been able to convince us we should be out there buying the fiftieth-best
business when we’ve identified the tenth-best, and the tenth-cheapest,
and the tenth-best run.
I understand you look for three things: “good businesses, good people
and good price”—which are some interesting hooks.
sounds a little like “motherhood
and apple pie.” I mean,
who doesn’t want those things? Of course, the devil is in the details—finding
the opportunities and executing the strategy. Good business means
characteristics that, if you or I were to put our money in a business across
the street, we’d want it to have: not heavily leveraged; understandability,
so that we can understand the products they have now and what the
business will look like five years hence; generating free cash flow, so
at the end of the day, there is money left to reinvest. We want businesses
that have pricing power, so if their costs go up, they can pass that
along to customers, rather than have to eke it out of their margins
Another thing that we talk about is the competitive advantage or
the “moat” that the business has around it. Can competitors
throw things against it, and the business will remain intact? A great example
of that is Gatorade. Coke and Pepsi had tried everything they could to
take share from Gatorade, and in the end Pepsi had to buy it to take share.
Gatorade had such a competitive advantage, such a strong brand name, that
they still got the shelf space, still got the pricing—share just
couldn’t be taken away.
Great brands, dominant market shares, low-cost producers—the things
that really build a moat around the business are the things we want
to understand and find in the companies that we want to own.
JB Good people—we laugh because it does sound like “motherhood
and apple pie.” If you can have good people, why would you ever even
consider bad people? The way we assess people is very similar to the way
we assess businesses. If you were to partner in a private enterprise across
the street, what would you look for in the people that are running that
business? We’re giving these companies a vote of confidence with
your capital and our capital. So we go and meet with management teams.
We want to know whether or not they’re owners whose interests align
with shareholders, and [whether or not] they’re good operators—we
want to look them in the eye, talk to them about their business, understand
their business, find out what concerns them and keeps them up at night—such
as their competitors’ advantages.
Then we want to make sure that they are good allocators of capital,
because the companies that we buy generate a lot of free cash flow—earnings
per share, plus or minus working capital and non-cash charges and maintenance
capital expenditures. We want to know what they’re going to do with
that capital, and we want to make sure there’s a shareholder-oriented
answer—that they’re not going to make acquisitions that don’t
make sense, or for which they’re overpaying. We want to be sure they
understand the value of their underlying business. If they’re going
to buy back shares, we want those shares trading at significant discounts
either to our appraisal or their own appraisal.
We are in partnership with our investors in the form of a mutual
fund. Similarly, we partner with the management teams of the companies
that we buy. That’s the “people” part. I’ll let
the third part of the triumvirate take over from here.
FNS I guess the good price part is almost where we started a few
minutes ago [with the subject of worth]. No matter how good the business
or how good the people, we want to pay a cheap price in relationship
to the value. We need an adequate return and safety of principal.
A great discount of price relative to value gives you both. If you
can buy a stock for half what it’s worth, which is our target, you’ve got a
long way for it to rise. [That] comprises most of your return, and you’ve
also got the margin of safety—it’s unlikely the price is going
to go down to 25% of what it’s worth. We look for that [value] in
three ways: discounted free cash flows, net assets, and comparable
As Lee mentioned, discounted free cash flow is the cash that a good
business gives us back each year, minus what we have to pay to keep
[the business] up to speed.
Second, what are the real assets minus
the real liabilities? For example, real estate is often worth more
than the historic cost recorded on the balance sheet. We determine the
current liquidation value of the company’s assets and liabilities.
[The third way to appraise value is through] comparable sales. For
20 years we have tracked transactions in different industries to
understand the range of multiples that businesses have traded for,
and we use this as a check on our longhand appraisal methods.
[So] comparable sales is one benchmark; the present value of the
free cash flow over the next five to seven years [is another]; and
the real assets minus the real liabilities [is another]. And we want
to pay half of what that [intrinsic] value is.
As we started out by saying, it’s very difficult to find all three
investment criteria [in the same place]. It’s easy to find a good
business; it’s easy to find a great manager; it’s a little
more difficult to find something for fifty cents on the dollar. When you
do [find something that cheap], generally you’ve got a bad business,
or it’s poorly managed. But when all three factors are aligned, you’ve
got all the stars in your favor to make a meaningful investment commitment.
A lot of times, few are available—as is the case right now, which
is why we’re closed to new business. When you can’t do anything,
the trick is to stand pat.
At a recent shareholder meeting your chairman, Mason Hawkins,
laid out six points for successful investing. Three of them were
about a sound technical philosophy, which you’ve just talked
other three were essentially psychological, which is interesting: “the
discipline to say no”; “patience”; and “the courage
to make a significant investment at the point of maximum pessimism.” Could
JB “Patience” refers
to what Frank just mentioned—a
patient investor will stick to his discipline, waiting for an opportunity
that meets his criteria, rather than force an investment and thereby
raise his risk and reduce his return potential.
Those three points [of Mason’s] also highlight a difference in time
horizon. There seems to be an ever-decreasing time horizon for lots of
market participants. Wall Street’s focus—cocktail party talk
seems to push it along—is certainly less than a year, oftentimes
[On the other hand,] we are looking out five to seven years. When
you know what a business is worth, and you’ve discounted it properly
and conservatively, you can be patient. You don’t care what’s
going to happen in the next quarter. Sure, you want things to work out
sooner rather than later, but it doesn’t have to happen that way.
You have the conviction (a) to pass on things that aren’t a good
opportunity, [i.e., “the discipline to say no,”] and (b) to
really step on the accelerator when you find something you like, even though
everyone in the world is telling you it’s a stupid thing to do. It
really does boil down to the time horizon, I think—that, and independence
LBH Price is usually the driver in the
end. If we can’t get [the
investment] for fifty or sixty cents on the dollar, we’re going to
wait. If you accept a smaller discount, you’re eating into your margin
of safety and you’re lowering your ultimate return. Usually companies
don’t sell for half of what they’re worth unless there is some
problem—perceived or real, ephemeral or permanent. There’s
some reason people hate it, [if we can] get it that cheap. That’s “taking
action at the point of maximum pessimism.”
As Jim said, it doesn’t matter what everybody else thinks. That doesn’t
mean we’re stubborn and we don’t understand the case for not
liking [the investment]—because we want to make sure that we’re
objective in our analysis. But if our analysis comes up with something
that’s worth twice what it’s selling for, and the other criteria
are met, it doesn’t matter what everybody else thinks. You’ve
got to have the courage of your convictions and the belief in your
discipline to go ahead and act.
One company that comes to mind in that regard is Level 3 Communications.
LBH The history there is interesting,
because it’s different from
many of our investments. Our initial foray into Level 3, actually, was
into their debt. We bought their senior notes back in ’01. They were
selling at thirty cents on the dollar, with equity-like returns but lower
than equity-like risk. We did all our work as we would normally do on the
company and on the people, both of which we had great confidence in. When
it came to the price, while the equity looked cheap, the debt looked as
cheap and less risky. That was our first foray. Then we participated in
a couple of private placements of convertible debt, which eventually converted
to equity. Then we bought some of the equity outright. Now the only thing
we own in the capital structure is the equity itself, but we’ve gotten
there by various ways.
What was the problem that made it possible for you to get those securities
for thirty cents on the dollar?
LBH Fiber optic backbone across the country was
a marketplace that had way too much capacity. Most was built in the
dot-com boom. Level 3’s
network was the last one built, by Jim Crowe and Walter Scott, who had
done it before and sold a previous network to WorldCom. [They were] experienced
people building the last [network], therefore the technology they built
it with was better than that of the [earlier networks]. So it was cheaper
to operate—a commodity product at the lowest cost. We would argue
it was the best service provider as well, but the fundamental advantage
was the low cost, combined with the people.
It’s a high fixed-cost business, [but] the overcapacity in the marketplace
caused everybody to cut prices, just to get the incremental revenue. Obviously,
cutting prices doesn’t do a whole lot for growing your revenue or
profitability. Almost every other player eventually went bankrupt
and/or eventually was consolidated by Level 3.
JB About three or four providers are left—there were ten.
LBH Because Level 3 was the lowest-cost
provider, they could take price cuts longer and bigger than their
competitors and still make money.
Our initial analysis assumed that it would not take as long as it
did for the industry to turn and for pricing to start firming up.
In the first few years the stock price declined even though the bonds
we owned continued to provide a solid return. However, as Jim pointed
out, the time horizon is of huge importance to us and we didn’t sell
because the stock went down. We believed the value was still building
and that it would be recognized in time. In fact, that is what has
happened. Level 3 is one of the few fiber optic backbone companies remaining,
and is still the low-cost provider.
We talk about good people. One of the reasons Level 3 was able to
endure the pricing competition longer than we thought they would
have to, was because of the smart, smart people running that company
and how they managed the capital structure. They didn’t have any
bank debt. All their debt was publicly traded. They were smart about
buying in some of their debt that was very cheap, and then reissuing
debt, continuing to move out the maturity dates and manage the cost of
that debt structure. Their wise capital management is part and parcel of
why Level 3 has the high ground today.
When you talk about a five-year time horizon, Longleaf tends
to hold its investments longer than most other mutual funds. It’s
one of the things Palmerston Group loves to see.
think the average turnover in the mutual fund industry is 100% per year,
maybe over 100% now. We’re less than
LBH There are huge advantages for the
taxable shareholder. Plus, whenever you trade in or out of a stock,
there are transaction costs, too. While transaction costs are not huge,
the tax piece is very significant.
Another company that Longleaf has been invested in for a long time
is International House of Pancakes. What is it about IHOP that makes
JB We’ve been invested in them for about six years, and we had been
trying to get [management essentially] to exit the financing business.
They [finally] told their franchisees to go to the banks if they wanted
financing, they weren’t going to get capital from IHOP anymore, that
was a poor deployment of IHOP’s capital. Then they took that unspent
capital, which was in the several hundred million dollar range, and
repurchased their shares at steep discounts to what they were worth.
By the way, their underlying business is terrific, a gross profit royalty
on franchisees’ capital and sales. Comparable sales have
grown consistently, and with fixed costs, margins have improved.
IHOP is a free cash flow machine.
Another recent success for Longleaf is Olympus. A lot of people
paid attention to the camera business and didn’t quite get the message
on the medical imaging business—but Longleaf did. Would you like
to take this opportunity to brag?
JB That’s a good segue into another piece of our philosophy—we
talk about owning businesses at a significant discount to what we think
they’re intrinsically worth, [in the range of] fifty or sixty cents
on the dollar. We also want our appraisals to grow, so that we’re
being paid as we wait for the price to meet the value. For Olympus, our
[appraised] value when we first initiated the position, I guess three and
a half years ago, was well below where it’s trading right now. The
value is up 70% over the last three and a half years. We closed the initial
gap between price and value and we’ve now eclipsed it, and it is
really all due to the medical business.
If you look at the history of analyst coverage, the people who were
covering that company [on Wall Street] were camera analysts. But
in our appraisal, that was only about 10% of the value. [The camera
business] made a huge difference on the year-to-year earnings per
share changes. But if you just looked at it from a private owner
standpoint, and you looked at what the medical business was, which
is primarily endoscope business—they
have a 70% market share in endoscope technology used for procedures such
as colonoscopies. Demographically, people are getting older, they’re
getting more colonoscopies, and there’s a backlog of doctors learning
how to use endoscopes. Then if you look at it from a price perspective,
as Frank was saying before, you just look at our appraisal and compare
that to comparable business transactions for much inferior businesses
in the medical field. [The price of Olympus is] still well below
where that stock would probably trade if someone were to buy the
What you said about Wall Street assigning camera analysts to
Olympus reminded me of something you said earlier about the difference
between your time horizon and Wall Street’s. Is it an advantage
being in Memphis and away from Wall Street?
JB We absolutely,
wholeheartedly believe so. We’re an independent
business, owned by employees here, and it provides us that kind of independence
of thought. When an analyst brings up a new name, there’s no career
risk. If you throw a company into the ring, and are willing to stand behind
it with facts and reasoning that make sense and make it a justifiable case,
and want to buy it—if it doesn’t prove out in six months or
a year, that’s OK. We’re not constantly looking over our shoulders.
Oftentimes we know that businesses are trading below what they are worth,
but we don’t know the catalyst [that will bring the price
up to the intrinsic value]. It seems that Wall Street, when they’re
appraising businesses, may come up with similar appraisals, but if they
don’t see a catalyst, they’ll take a pass. We’re comfortable
with not knowing what the catalyst will be.
LBH Assuming that it’s a good business
and that good people are running it, over time the earning power of the
business is the catalyst. Again, “patience.”
Longleaf has some exposure to the energy sector. Why do you like
Chesapeake Energy, and what do you think about Pioneer Natural Resources?
LBH From a broad standpoint, we are not sector
buyers. We don’t come
in and say, “We really want to own some energy.” Everything
we do here is a bottom-up process, company by company, specific cases.
Obviously there are times when certain segments are being disdained, and
where you may find more things that look interesting, but we don’t
make a “buy” decision because we want to own a particular area.
Pioneer, we’ve owned for a while; Chesapeake, we’ve owned for
just over a year; and we like them for some similar reasons and for some
different reasons. In the case of Pioneer, they have both oil and a large
amount of natural gas. The company is run by Scott Sheffield, who has been
a good operator and, perhaps even more important, a sound capital allocator.
One of the things that is attractive about Pioneer is that their reserves
are long-lived—what’s the …?
JB Seventeen years.
LBH Seventeen-year reserves, whereas the
average energy company’s
reserves are less than half that amount of time. They don’t get a
lot of credit in the market for the life of those reserves, because the
cash flow may last over a long period of time but may not mean as much
today. That’s a part of the hidden value in Pioneer’s case.
Even more relevant for Chesapeake, the natural gas component is one
that has been more undervalued than the oil side of things. Normally
oil and gas trade at a six times multiple—i.e., if oil is trading at
$60/barrel, the BTU equivalent in natural gas will trade at $10/mcf. That’s
been out of whack in the last several years. Even though we’ve had
$60 and $70 oil, natural gas has not been trading at $10. So you’ve
got some discounts there in the market too, in terms of price relative
The other thing to say is that our investment in those companies
is not a reflection of a belief that oil is going up or oil is going
down, or any kind of play on what we think the commodities are going
to do, particularly in the short run. We use the future strip prices
to determine what price we use on our appraisal. Right now we’re
using $45 for oil, which translates into about $7.50 for natural
gas. In other words, oil prices could actually go down and our value
[appraisal] will still be intact.
Are there any recent ideas that you would like to tell us about.
LBH Nothing that we would tell you about that
we’re still acting
All right, I understand.
LBH In the international arena there are some
things that we’re looking
at and doing— not a lot, but some. On the domestic side of our business,
there’s very little to do right now. We’re not finding any
Those undervalued businesses just aren’t out
FNS The ones that are out there are of such low quality that they’re
not competitively entrenched enough for us to get excited about.
There are some cheap businesses out there, but the quality is not
high enough to get onto our radar screen.
So new investors have to wait until things change
and you open your doors.
LBH The International Fund is open.
What’s happening there?
LBH There is more to do there. The fund has maybe
10% cash right now. Our “on deck” list of companies that are
pretty close to being attractive, price-wise, and that we think meet
the other criteria, has a few more names on it.
FNS We never [said enough about] the ability to say no. The antithesis
of buying when things are negative is of course saying no when everything’s
positive. We’re not just contrarians to be contrarians. We don’t
just buy when things are negative and sell when they’re positive.
We let our calculators tell us the mathematics, but there is psychology
involved in this. [When] we go to meetings with clients and with prospects,
I feel a little like that figure—you won’t remember, you’re
too young—in [the comic strip Li’l Abner], the guy that always
dressed in black and had a rain cloud over his head.
I do remember that character—his first name
was Joe and his last name was unpronounceable.
FNS And I feel like Joe [Btfsplk] when I walk into a meeting. I walk
into the room and it’s always, “What about General Motors?” and “What
about Level 3?”—focused on whatever the biggest negative headliner
is at the moment. But they never say, “All right, you sonofagun,
tell us about Walt Disney. It’s gone from 14 to 35, what do you think
about it?” Or, “What do you think about Federal Express? It’s
gone from 17 to 110, will you explain that?” You never get those
questions on the positive side, although of course when it’s 110
is exactly when you ought to be saying no. That’s just human nature.
And so when I come out of a meeting I kind of feel depressed in some ways,
but then I have to feel sort of happy and say, well some of those investments
that they asked about have to work out—because nobody likes them!
When Disney’s gone from 14 to 35, that’s when you read about
it in the newspapers, and it’s on television, and all the analysts
are writing “buy” recommendations, and it’s selling for
88 cents on the dollar.
But that’s the time to say NO.
Thank you very much for saying “yes” to this interview.