Longleaf Partners Global Fund Q3 2023 Commentary

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Longleaf Partners Global Fund declined -3.45% in the third quarter, in line with the FTSE Developed Index, which fell -3.43%. Equity markets were in risk-off mode during the third quarter, driven by high inflation and higher-for-longer interest rates in Western markets, coupled with a weak Chinese economy. With persistent geopolitical headwinds, sentiment broadly remained negative, and volatility was high. Most of our companies saw solid operational progress, translating into positive stock performance at some of our larger positions in a quarter when only Energy and Communication Services were positive absolute sectors for the FTSE Developed Index.

The Global Fund has no exposure to the small handful of mega-cap stocks that have dominated global markets and are trading at historic valuation multiples. Many headlines refer to the “Magnificent Seven,” but we prefer to look at the top 11 most actively traded stocks globally, all of which are in the US. These 11 stocks (comprised of the Magnificent Seven + Advanced Micro Devices, Adobe, Broadcom and Netflix) have a combined market cap of over $11 trillion and a weighted average price to earnings ratio (P/E) of 29x, while the rest of the FTSE Developed trades at approximately 14x. These already huge companies are facing increased competition against one another coming off all-time-high aggregate profits on the back of increased interest rates. By contrast, the Global Fund owns high-quality businesses, led by management teams that are executing across the board, and the portfolio trades at 12.5x P/E on not yet optimized earnings, even after returning 26% over the last 12 months. We are confident in the portfolio’s positioning for future relative outperformance in multiple market environments.

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We encourage you to watch our video with Portfolio Managers Ross Glotzbach and Staley Cates for a more detailed review of the quarter.

Contribution To Return As Of September 30, 2023

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• CNX Resources – Natural gas company CNX Resources was the top performer in the quarter. The company benefited from rising energy prices, as well as strong operational execution. CNX remains highly discounted, as the market does not give the company credit for its longer-term undrilled assets or its “new technology investments,” which include methods to reduce carbon on a net basis. Management expects this to be a material business for CNX over the longer term, but for now it is a high-quality hidden asset. CNX has taken advantage of the price disconnect through meaningful share repurchase.
• Mattel – Global toy and media company Mattel contributed in the quarter on the back of the success of the Barbie movie. Beyond the near-term positive financial impact, the Barbie movie is emblematic of Ynon Kreiz’s plan to monetize the strong intellectual property that the company owns. When we interviewed Kreiz on the Price-to-Value Podcast in June 2020, he said, “Barbie is so much more than a toy. Barbie at this point is a cultural phenomenon, and the consumers have a very strong emotional connection with our brands.” We expect Mattel to continue to monetize more of its strong brands in ways beyond selling toys.
• IAC – Digital holding company IAC was the largest detractor in the quarter after reporting weak earnings, particularly at underlying holding Angi, which represents a relatively small (single-digit %) proportion of the value but has an outsized impact on IAC’s stock price. Casino and online gaming company MGM Resorts (which we also own directly and was a detractor in the quarter) comprises the largest portion of the IAC value. MGM faced multiple headwinds this quarter with a cyberattack that impacted all its properties and pending labor strikes in Las Vegas. Even with these events factored into our appraisal, MGM remains highly discounted today, and management is taking advantage of the price weakness to add value through meaningful share repurchase. Dotdash Meredith should begin showing its true earnings power as synergies of the merger begin to materialize. IAC is focused on growing the value of its hidden assets, like Care.com and Turo, which might go public later this year. IAC is well positioned with a net cash balance sheet to go on offense in any kind of market environment and offers a meaningful margin of safety and upside opportunity from today’s depressed level.
• Delivery Hero – German-listed food delivery business Delivery Hero, a new position initiated in 2Q23, was also a top detractor. We have followed the business closely through our investment in Prosus, which is a 30% owner of Delivery Hero. Delivery Hero is headquartered and listed in Germany, but the majority of its business is in Asia, the Middle East and North Africa, where it has number one market share in countries like Korea, Saudi Arabia and UAE. Delivery Hero was a large beneficiary of Covid lockdowns, when people were stuck at home and used the service to deliver food and groceries, leading to unsustainable demand growth that has plateaued this year, leading to a sharp decline in the share price. This extreme swing gave us the opportunity to invest in this high-quality business with a management team that is clearly focused on balancing growth and profitability, with compensation aligned to these goals. We expect to see management exit markets where they do not have a leading position, which would reduce cash burn substantially and focus the business on core markets. We believe that Prosus’ presence will ensure capital allocation and operational discipline, and we added to the position in the quarter as the stock price pulled back.
• Warner Bros Discovery – Media conglomerate Warner Bros Discovery (WBD) declined in the quarter with a combination of the writers’ and actors’ strikes headlines, and a fight between Charter and Disney that led to more concerns about the linear and streaming profit structure. Although both situations actually improved as the quarter went on, both created uncertainty that weighed heavily on the WBD stock price in the near term. The underlying business is executing better, with solid free cash flow generation reported in the quarter that should continue for the foreseeable future. The competitive landscape is getting brighter with multiple streamers taking price increases. WBD is in the hands of a strong management team and board that are focused on creating long-term value for shareholders.

Portfolio Activity

After a busy first half of the year, we initiated two new positions in the quarter. We bought Fortune Brands, a large conglomerate that has strategically slimmed down to a high-quality owner of plumbing and other housing-related businesses, which we own in the Partners Fund. We also initiated a position in Swiss luxury goods business Richemont, a long-term holding in our Non-US portfolio, which reached a trough valuation multiple in the quarter in the face of macro concerns that impacted the luxury goods indiscriminately. Richemont’s market leading brands Cartier and Van Cleef & Arpels are well positioned to benefit from long-term structural growth themes that we believe are still very much intact. We exited long-term holdings General Electric (GE) and CK Hutchison. GE was a multi-year portfolio holding for us that started out rocky but ultimately was a good illustration of owning a “quality” business that was temporarily viewed as “value” (aka, perceived as low quality) before ultimately being weighed properly by the market. CEO Larry Culp was a great partner, creating significant value for shareholders and closing the price-to-value gap. Under his leadership, GE materially improved its operations and is well under way on plans to simplify the business by separating it into three world-class companies. The market has finally caught up with reality versus perception and is pricing GE accordingly.

Unfortunately, this means we no longer see a margin of safety for the business but will continue to watch GE and Culp closely and hope to have the opportunity to partner with him again. We exited CK Hutchison as a result of a lack of value growth and disappointing capital allocation, coupled with increasingly challenging macro-economic headwinds. We also sold smaller positions in Hasbro, Kansai Paint and Fiserv, all of which ran away from us with positive price performance before we could fill out full positions.

Outlook

Despite disappointing short-term absolute returns in the quarter, we are pleased with the progress made across the businesses we own amid a challenging market with investors increasingly turning to an ever-narrower group of mega-cap companies or, on the other side of the barbell, retreating to cash that now earns something. As the valuation gap between what has worked and the rest of the market stretched even wider, we have grown more confident in our outlook for the portfolio from here. We own competitively entrenched businesses with strong balance sheets and management teams that are on offense. Our portfolio holdings in aggregate have grown their values this year. The portfolio ended the quarter with a price-to-value ratio in the low-60s%, offering meaningful upside potential. As more bottom-up opportunities have qualified this year, we have improved the quality of the portfolio over the last several quarters and have a strong and growing pipeline of new investments. We are confident our businesses will continue to deliver and are grateful for your continued partnership.

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