Southeastern: The Exceptional Opportunity in Small-Cap Value

May 22, 2020 it good for existing clients, of which By Robert Huebscher we are a very large one ourselves, it’s when you get the best new cli- On April 9, 2020, Memphis-based ents. Small-cap value has not been Southeastern Management a hot place to be in recent years. announced that it was re-opening For people who join us now, we its Longleaf Partners Small-Cap will be setting things up for a great Fund (LLSCX). It closed the fund -term relationship, instead of to new in August 1997 to having performance chasers come manage its size against any poten- in at the top. tial liquidity constraints that would limit the opportunity set and to We designed this reopening in a avoid diluting its shareholders, thoughtful way. We are only tar- given rising at that time. The geting $2.5 billion of AUM. If we get fund remained closed to new in- there quicker with a performance vestors for more than two decades bounce-back, that’s great. We’ll over the course of various market close again. We’ve shown over the conditions. years that we focus on doing the right thing for those clients who I interviewed two of the fund’s are already with us. managers, Staley Cates and Ross Glotzbach, on May 18. I previ- Staley Cates ously interviewed Staley in 2015, Bob: You did not open the fund when we discussed Southeastern’s following the dot-com or finan- methodology and approach to val- cial crisis market downturns. Why ance-sheet strength, combined ue investing. Please reference that now and not then? with great price-to-value. Other- interview for information on those wise, we wouldn’t open it. Staley: It’s a function of better topics. quality and better balance sheets Bob: As of March 31, the fund had Bob: Why did you reopen the fund compared to those two events. We approximately $2 billion in after 23 years? are not sure why this is the case. and 20 holdings—an average po- Maybe it is because the financial sition size of approximately $100 Ross: First and foremost, it was the crisis was more centered on all million. Do you plan to increase right thing for existing clients. It things financial, mortgages and the number of holdings, the posi- will lead to a better portfolio, both derivatives. Maybe its focus was tion size or both? quantitatively and qualitatively. narrower. But for whatever reason, There are new we want to when we looked at our on-deck Ross: We don’t plan a radical buy. There are existing list, which we handicapped for the change in what we’re doing. We’ve we want to add to. Historically, balance sheets we were looking at, always been concentrated. We’ve when the price-to-value ratio in the market caps and quality were always been long term. When we our fund has been below 60%, it’s not good enough that we felt com- can use something like this as an been a great time to add. It’s been pelled to open the fund back then. opportunity to upgrade the quality below 50% at times over the last of the portfolio, we’re going to do two months. We have a low price- This is so broad-based because that. The 20 positions could look to-free-cash-flow ratio, in the sin- of the pandemic. Maybe it’s in different depending on how things gle digits, as well. combo with active and value un- shake out. There’s nothing wrong derperforming for so long. We with going to 19 or to 21 at any giv- Another key thing about making can’t be sure why. We have an en moment. But we definitely have this decision now is that not only is on-deck list with quality and bal- some that we would like to add to,

1 and we have been adding to, as DCF model, it’s a manageable im- is a mix of franchise and manage- well. Overall, we don’t expect our pact. We think it will come out of ment fees. That’s more than half concentrated long-term approach this stronger. of its value, and it has a bunch of to change. owned properties. What’s unique One of the things that was holding is the two bullies of the industry, Staley: We’ve talked about still back the , even before Feb- Hilton and Marriott, have turned having that cap—$2.5 billion dol- ruary, was the risk around these their companies into pure-fee en- lars makes sense, instead of indefi- new low-Earth orbit constellations. tities compared to Park and Host, nitely opening. They could be a new competitor. which are pure plays on the owned We were watching those closely. properties. Bob: Please discuss a few exam- ples of stocks that have emerged As the virus has as attractively valued since impacted the mid-February, when the coronavi- use cases for Within its valuable overseas rus crisis unfolded. some of those business, Hyatt has some incredibly ventures, it’s Ross: I will start off with one that also made mon- high-quality, high-value per key we haven’t talked about too much ey far less free properties in overseas gateway cities.” publicly. It’s extremely compel- than it was for ling, and that is ViaSat. We always those who want think of things in terms of business, to launch billions of dollars in small Part of the reason Hyatt falls be- people and price. On the business satellites. We’ve already seen one tween the cracks is because it’s a side, it provides satellite broad- of those competitors, OneWeb, go hybrid. It’s not a simple company band to a variety of customers. Its bankrupt. It will be interesting to to screen. Starting with the busi- most important business is with see what happens to some of the ness quality, we love the fact that the government, where it has the other ones, but this is a very posi- more than half the value is from best mouse trap in many places. tive long-term development in the fees. Even having invested in the These are often little mini duopo- competitive landscape for ViaSat. past as very large owners of both lies or monopolies. It has been Marriott and Hilton, we still believe This gets to the people and what growing strongly in double digits. that Hyatt’s reservation system they’ll do. Its CEO, Mark Dankberg, It has a strong backlog. This is a and points program are superior, is an owner. It has had a little bit good, steady growing business but you can make the argument of insider buying. Baupost has a that doesn’t have much to do with that the Hyatt fee stream could be board-observer and it the virus. worth even more because it should has been a long-term shareholder. grow more off of a lower base. If It also has a strong residential We feel good about the upcoming you talk to hotel developers, which business, where often it is the only capital allocation at this company. we do often, they not only have a way that people in rural areas can When we add up all the parts, we lot of respect for the brand, but get broadband. As broadband has get to a price over $100, and it’s there are many more ways it can grown in importance through this trading under $40. This is a deep- grow, even if it’s not quite the same pandemic, that’s another good ly discounted growing stock that bully on the points and the reser- place to be. can come through this pandemic vation system. stronger in a variety of ways. There are two things it has had in Within its valuable overseas busi- the crosshairs that brought it down Staley: I’ll talk about Hyatt. Be- ness, Hyatt has some incredibly over the last several months. First cause I’m old as dirt, I’ve followed high-quality, high-value per key is that it had what it calls its “in- a lot of hotel companies for South- properties in overseas gateway cit- flight business,” where it provides eastern going back to Holiday Inn, ies. In terms of its U.S. properties, broadband on airplanes. It’s far su- Hilton, Marriott and Belmond. But the big ones are actually poised to perior to GoGo, which a lot of peo- Ross has done the most work on do better than a lot of U.S. prop- ple know. But with fewer planes Hyatt. erties by their nature because the flying and fewer passengers on biggest territories are Orlando and them, that’s going to knock that Everybody is familiar with its flags. central Texas, which includes San business out for at least a few What’s interesting about how the Antonio and Austin. Those prop- years. But when we put that in our company is constituted is that it erties will be drivable and the first

2 ones back from the pandemic. formance. We’re a lot closer to the end than its continuation. But we We look at trailing numbers as a need to acknowledge the reality proxy and reconcile that by look- that a lot of the parts of this crisis ing out a few years, not assuming have really played out to the bene- things come all the way back, but fit of those stocks that were riding discounting back some level of re- high going into it. covery. Those are metrics you can compare to its public peers, both Sectors that we’ve been under- fee and owned peers. Hyatt has a weight include IT and healthcare. value approaching $100 a share. Those just got more important It bought stock back in the $80s and have held up best, even in the before the pandemic, telling you downward market swings this year. what it thought it was worth then. Among some of the lower volatil- The stock’s now around $50. ity-type stocks—the Steady-Ed- dies of consumer products and The Pritzker family controls it. We utilities—we were underweight as do discount our appraisal since we well. Those were all bottom-up have non-voting stock, but they’ve valuation decisions going into this been great partners. Mark Hop- pandemic. We’ve updated those lamazian is the CEO. He’s been companies in our appraisals as a there a long time, and he’s done a result of this. We still don’t find Ross Glotzbach great job. them attractive. In many cases, they’re less so because their val- groundwork to do. Even if you project more debt ues have not grown dramatically for this year’s difficulty, it still has as a result of this. They have just debt-per-share in the mid-teens. Without opening a Pandora’s Box hung in there better due to their of macro considerations, this is This is an incredibly strong balance perceived “safety”. sheet going into and coming out of how macro affects a micro DCF. The free money since GFC has this pandemic. We look at what we own from the factored in several ways. With bottom up. We think our fund is rates almost zero, it makes growth We don’t need a recovery in much more attractive than many of and thematic investments, where months for this to those growth strategies that have there’s no time value of money, do work. Hyatt has close to two and been working. But we’re ready for well. It also leads to a “ hog” a half to three years of liquidi- the market, after this high-correla- mindset, where investors bid up ty, because it was able to raise tion panic over the last few months, stocks because of their yield, even bonds even after the pandemic to start sifting through the winners if it makes them incredibly overval- hit. It came into this with an indus- and losers. We think we’ve built a ued. That’s not great for value. try-best position. We’re interested good bottom-up portfolio to come to see what it can do that doesn’t out of this pandemic. show up initially on a spreadsheet, After this crash, we may all look while it is in defense mode. But we back and say that the government Staley: We would have loved to did the right thing. But whether we think it can shift to offense quicker have held our ground and per- than some others. do that or not, it definitely contin- formed far better going into the ued the free money deal. It’s hard crash; we’re not happy with how to see that as permanent, but that Bob: Value strategies have suf- we did. However, that is a typical still suppressed value returns. I fered relative to growth since the pattern during crashes because, don’t think it will take a reversal of financial crisis, and have not pro- when there’s that flight to quality free money for value to come out vided defensive buffering during as correlations went to one, that’s of this okay. But it delayed some of the recent . Why has that usually not when Mr. Market fa- our payback. been the case and what will cause vors value or finds the econom- that to reverse? ic truth. Once things settle down Bob: I realize that your invest- and you come out of that period, ment process insulates itself from Ross: We’re 13 years into the time- we usually come roaring back. macro considerations. But sure- line of value’s relative underper- That’s what we’re trying to lay the ly the coronavirus has affected

3 your thinking. Have you made any economy has been crushed and if you took the composite of what changes in the fund, for example, the political landscape is uncer- we own, that might’ve looked like based on a belief that certain sec- tain. I realize that you are bot- 11 times free cash flow, which is a tors of the economy may be per- tom-up investors and do not look surrogate for P/E. manently impaired or that other at overall market valuations, but sectors will be structurally stron- does that 9.2% correction ade- The market would typically have ger? For example, the fund has quately compensate investors been 15 or 16 times. You’ve heard had exposure to real estate. Has for the greater risk premium that us forever talk about roughly two- your view on real estate changed they should demand and for the thirds price-to-value as a compos- in a structural way? degree to which corporate cash ite. That composite means a lot flows have been impaired? more than it does for individual Ross: We’ve done a bottom-up stocks. As recently as last year, we review of every single company Ross: You brought up the S&P 500. were at more than nine to 10 times that we own across all of our dif- We think that’s probably one of the free cash flow in our composite. ferent portfolios and strategies. most overvalued indexes as we look The market was 18 to 20 times, de- We looked not just at the quantita- around the world. Even going into pending on the earnings estimate tive of safety and price-to- the pandemic, we thought the S&P and the index. Now, it seems like free-cash flow, but the qualitative 500 was trading richly. Non-U.S. the S&P would be lucky to earn and small-cap $130 in the next 12 months. Yet, stocks were more here it is almost 3,000. interesting op- When you have a fear of a portunities on a Index investors are paying more correction, that’s when it’s great to know bottom-up, price- than 20 times P/E. That has never what you own and to know that you’ve to-free-cash flow, worked in U.S. market history, and and price-to-val- has not led to good long-term re- partnered with great people who can ue-multiple basis. turns. make it through and go on offense in a You can defi- But our composite is down to sev- variety of environments.” en or eight times. This explains why nitely argue that we have underperformed. Part of it there are large parts of the S&P factors that you mentioned. We was active, part of it was value, but don’t want to stick to an old belief 500 where investors are continu- it doesn’t change the fact that we when things have changed. That ing to ride with what’s been work- have these incredibly low historic said, given the sweeping coverage ing or what feels “safest.” We’d multiples. Flipping that over, we about these changes, we would refer back to the Warren Buffett see very fat free cash flow yields caution swinging too hard the oth- adage about how you pay a high on businesses with durable cash er way. We want to be right and price for that cheery consensus, flow. That’s just a giant gap in what get that right middle ground. and the S&P 500 today is priced we own versus the index. That’s the whole case for active versus Real estate is an area where there at a much higher multiple than our passive. Fundamentally, that’s why definitely have been changes. The portfolios. we think that our portfolio will be same is true of stocks tied to oil, compensated for its risk, even if balance-sheet-heavy banks and re- Staley: In a word, the answer is the S&P is not. tail. Our portfolio had some expo- “no.” That decline does not com- sure to some of those. It’ll lead to pensate investors enough. But Bob: Related to my previous ques- some changes on June 30th when to add to what Ross said about tion, how do you respond to in- we file our next 13F. But overall, where we’re searching and buying, vestors who believe it is a matter when we step back and look at I would simplify this into multiples of time until the market corrects, what we have and the moves we’ve instead of how we always normal- and that such a correction could made, it has led to not just better ly talk about price-to-value. This be extreme? quantitative, but better qualitative gets into owning things actively positions. versus the index. I’m just using the Ross: We would remind folks that S&P even though the Russell is our we’re bottom-up value investors. Bob: The S&P 500 is down 9.2% benchmark in small cap. But it’s When you have a fear of a cor- year-to-date. Yet, we live in a world not that different, regardless of the rection, that’s when it’s great to where our lives are in danger, our U.S. index. Over our long history, know what you own and to know

4 that you’ve partnered with great more tilted in favor of active than or another. We can drill down into people who can make it through its normal allocation, as compared what we own and who we part- and go on offense in a variety of to passive. nered with at these companies to environments. That’s what our in- get a bottom-up look at a variety vestor partners, who think and act Ross: We haven’t talked too much of scenarios in which we make it like owners, can do at a time like about just stocks versus bonds. through and grow our long-term this. If you own an ETF in order Lots of Treasury bonds are yielding absolute returns. to have broader market exposure, 1%. That’s paying 100-times earn- that’s when you don’t know what ings for something that can’t grow Staley: The pandemic that led to you own. its earnings for a decade or more, the destruction of the economy at least on longer term bonds. is obviously on the top of every- Often it can lead to an emotional That is very unsafe for the person body’s mind. There is so much sci- decision at the very wrong time. who’s focused on compounding entific talent and so many great It means going to cash at the bot- their wealth over the long term. minds on the case that the first rea- tom because it feels like something It’s a radically different story than son for optimism would be getting that will give you -term relief. stocks, like the ones that we’ve to a vaccine. No matter how long We’re talking to you on an up day. carefully chosen at a 10% or higher that is in the scheme of things is You let the fear of missing out run yield, and that yield can improve not the important issue. It’s finding a little too wild, and then you jump from free cash flow growth. it. There was a pandemic in the U.S. in at the very wrong time. We want in the 1960s, and there have been to avoid both of those extremes. Bob: Lastly, this is an incredibly SARS, MERS and other diseases We think we’ll have the ability to challenging and uncertain time— we have overcome, even though it do that. perhaps the greatest in the ca- doesn’t feel like it. reers of all investors alive today. Bob: Fund flows have favored What makes you optimistic? There is an aspect of this that feels passive products, especially ETFs, like no one will travel again. If we over the last five or so years. What Ross: Glotzbach: It is a hard time. all remember, it felt like that after guidance do you offer to advisors We need to acknowledge the pain 9/11. People did get back to travel- who are facing the decision as to that this has caused on so many ing. During the GFC, there was sys- whether to allocate to active or levels on the human side. But we temic risk to the financial system, passive products? have a resilient world with health- banking distress, stories of trapped care workers and scientists work- cash and panicked CFOs. Those We acknowledge there’s a Staley: ing to get us solutions to this cri- problems have been fixed, and the place for passive as well as active. sis. Rough months are ahead, but financial system is in a better place. We’re not trying to be a one-trick there’ve been lots of challenges Those are foundational reasons to pony, but because of the valuation before that have been overcome. be long-term optimistic. measures we were talking about, We don’t have to bet on broader we believe that this is just way market things happening one way

5 Disclaimer Average annual total returns for the Longleaf Small-Cap Fund and its benchmark for the one, five, ten year and since 10/26/98 incep- tion periods ended March 31, 2020 are as follows: Small-Cap Fund: -30.62%, -3.56%, 6.00% and 9.01%; Russell 2000: -23.99%, -0.25%, 6.90% and 8.17%. Returns reflect reinvested capital gains and but not the deduction of taxes an would pay on distri- butions or share redemptions. Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting southeasternasset.com. The total ratio for the Longleaf Partners Small-Cap Fund is 0.93%. Before investing in any Longleaf Partners fund, you should carefully consider the Fund’s investment objectives, risks, charges, and expens- es. For a current Prospectus and Summary Prospectus, which contain this and other important information, visit southeasternasset.com/ account-resources. Please read the Prospectus and Summary Prospectus carefully before investing. RISKS The Longleaf Small-Cap Fund is subject to risk, meaning stocks in the Fund may fluctuate in response to developments at individual companies or due to general market and economic conditions. Also, because the Fund generally invests in 15 to 25 companies, share value could fluctuate more than if a greater number of securities were held. Smaller company stocks may be more volatile with less financial resources than those of larger companies. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. The statements and opinions expressed are those of the speaker and are as of the date of this article. As of March 31, 2020, ViaSat represented 3.9% and Hyatt represented 1.8% of the Longleaf Partners Small-Cap Fund. P/V (“price to value”) is a calculation that compares the prices of the stocks in a portfolio to Southeastern’s appraisal of their intrinsic values. The ratio represents a single data point about a Fund and should not be construed as something more. P/V does not guarantee future results, and we caution investors not to give this calculation undue weight. “Margin of Safety” is a reference to the difference between a stock’s market price and Southeastern’s calculated appraisal value. It is not a guarantee of investment performance or returns. Free Cash Flow (FCF) is a measure of a company’s ability to generate the cash flow necessary to maintain operations. Generally, it is calcu- lated as operating cash flow minus capital expenditures. Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment. The price-to-free cash flow ratio is a valuation method used to compare a company’s current share price to its per-share free cash flow. An exchange traded fund (ETF) is an investment fund traded on stock exchanges. The Global Financial Crisis (GFC) is a reference to the financial crisis of 2007-2008. Price / Earnings (P/E) is the ratio of a company’s share price compared to its earnings per share. Yield is the income return on an investment, which is the interest or dividends received, expressed annually as a percentage based on the investment’s cost, its current market value, or its face value. The S&P 500 Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P is designed to be a leading indicating of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3,000 Index, which represents approxi- mately 10% of the total of the Russell 3000 Index. Longleaf Partners Funds distributed by ALPS Distributors, Inc.

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