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.
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Southeastern Asset Management and Longleaf Funds have been around for a while. Could you give us a brief history?
LBH Southeastern 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 out—by prospectus—at 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 to us?”

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 partners.

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 inside work.

One of the interesting things about the Longleaf Funds is the principle, “We 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?
FNS Well, 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.
LBH It 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 sales.

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 about—but the 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 you elaborate?
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 quarterly.

[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 of thought.

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.
JB I think the average turnover in the mutual fund industry is 100% per year, maybe over 100% now. We’re less than 20%.

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 it appealing?
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 medical business.

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 to value.

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 on.

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 sixty-cent dollars.

Those undervalued businesses just aren’t out there?
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.

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