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22 Annual Report International Fund International Fund Management Discussion Longleaf Partners International Fund declined 6.59% in the fourth quarter and 14.76% for the full year, underperforming the
22 Annual Report International Fund International Fund Management Discussion Longleaf Partners International Fund declined 6.59% in the fourth quarter and 14.76% for the full year, underperforming the MSCI EAFE Index s decline of 3.57% and 4.90% for the two periods. The Fund s relative performance divergence occurred primarily in the second half of the year. At the end of the first quarter, the International Fund was ahead of the Index for trailing one and five year periods, but relative returns reversed with the steep decline over the last six months. We are disappointed in the recent performance and its impact on our longer term numbers, but we remain highly confident in the quality of our businesses and management partners. Over the 16+ years since its start, Longleaf International has doubled the cumulative performance of the MSCI EAFE Index. We believe the portfolio is positioned to outperform from its current discounted level over the next several years. Cumulative Returns at December 31, 2014 Since Inception 15 Year Ten Year Five Year One Year 4Q International Fund (Inception 10/26/98) % % 36.02% 19.98% % -6.59% MSCI EAFE Index Average Annual Returns at December 31, 2014 Since Inception 15 Year Ten Year Five Year One Year International Fund (Inception 10/26/98) 7.74% 6.20% 3.12% 3.71% % MSCI EAFE Index Returns reflect reinvested capital gains and dividends but not the deduction of taxes an investor would pay on distributions 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 The December 31,2014 and 2013 total expense ratios for the International Fund are 1.25% and 1.27%, respectively. The expense ratios are subject to fee waiver to the extent normal annual operating expenses exceed 1.75% of average annual net assets. Positive performance at a number of holdings was overshadowed by declines across the majority of our companies due primarily to the combination of a strong U.S. dollar and tighter regulation and economic controls in China. More than half of the Fund s negative return for the year was attributable to currency translation into the U.S. dollar (USD). USD strength against the euro, which was the base currency for a dozen of our holdings over the year, meant that positive local returns at many of our European holdings translated into negative USD returns. These currency conversions did not reflect the underlying operating performance of our businesses and did not impact our long-term appraisals nearly as much as they impacted prices. The USD/euro disparity may continue given current fears of a Greek exit from the Eurozone as well as slower economic growth in Europe. Most of our European holdings are global market leaders with strong balance sheets, and much of their underlying revenue exposure is International Fund Longleaf Partners Funds 23 outside of Europe. Most short-term currency dislocations will self correct over time, and our outlook for our companies fundamentals remains strong. The stock return figures cited below are shown in USD; most local returns were higher. Hong Kong based conglomerate Cheung Kong was the largest contributor for the year, gaining 15%. Overthecourseof2014,resultsatmostofthe company s operating divisions were strong. Additionally, management made several valueenhancing asset sales across multiple business lines at low cap rates and used proceeds to opportunistically reinvest in discounted infrastructure deals outside of Asia with doubledigit IRRs (internal rates of return). Management also returned proceeds to shareholders in the form of dividends. Most recently, in a joint venture with Mitsubishi Corp, Cheung Kong bought an airplane leasing portfolio. With its strong balance sheet, Cheung Kong can take advantage of Hong Kong land banking opportunities if prices correct. Canadian property and casualty insurance company Fairfax Financial added 15% for the year before we sold it in the fourth quarter. We first purchased Fairfax in January 2000, and it returned approximately 11% annualized over our holding period. CEO Prem Watsa steered the company through challenges in the early 2000s and improved insurance operations over time. He also regularly grew book value, with particularly strong investment returns in the Global Financial Crisis of 2008/2009 when he made substantial gains on credit default swaps. French luxury goods business Christian Dior (CDI), which we bought early in the year, was the largest performance contributor for the quarter, adding 17%, and ending the year up 13%. Christian Dior is the holding company for LVMH Moët Hennessy-Louis Vuitton (LVMH) and Dior Couture, the world s most prominent collection of luxury brands. Given its holding company structure, CDI has historically traded at a discount to LVMH ranging from 7% to 40%. Gaining LVMH economic exposure through CDI aligns our interests with owner-operator Bernard Arnault. After nearly tripling shareholder capital on LVMH s 24% stake in Hermès, Arnault distributed the Hermès stake to LVMH shareholders, and CDI s board decided to distribute its pro-rata share of the Hermès stake. We sold the Hermès shares above our appraisal. The transaction realized a 13% yield on our average cost for CDI. Arnault s opportunistic purchase of Hermès in the Global Financial Crisis and subsequent decision to distribute the fully-valued shares illustrate his financial discipline and intense focus on shareholder value creation. Global fertilizer and chemical producer OCI also had a strong fourth quarter, adding 13% after positive news on various fronts. Egyptian natural gas shortages that had negatively impacted OCI s plant utilization rates stabilized; the company wonanegyptiantaxcaserelatedtothe2007sale of its cement unit; and the EPA issued its final construction permit for the greenfield Beaumont, Texas plant that will be the largest methanol facility in the U.S. and is scheduled to begin production in CEO Nassef Sawiris decision in the third quarter to spin out the legacy construction business should help the market properly value OCI as a pure-play nitrogen company. Sawiris opportunistically bought shares personally throughout the year to take advantage of the price discount. Those names that most hurt performance in the year were among the large detractors in the fourth quarter. Increased regulatory and economic controls in China directly or indirectly impacted stock prices. Chinese VIP gamblers reduced their visits to Macau, and lower Chinese demand for natural resources pressured many commodity prices as well as stocks and currencies in countries that produce resources. Some of our businesses and many of our stocks felt the impact, but the longer term fundamentals of our holdings are intact. This broad economic pressure is reminiscent of late 2011 when any stocks directly or indirectly associated with Europe were under pressure. Price declines lasted through the first half of 2012, but those discounted names set the stage for our strong outperformance in We believe our current Asian holdings are similarly well-positioned for a strong recovery. The longer term fundamentals of our holdings are intact. 24 Annual Report International Fund International Fund Management Discussion Increased government scrutiny and regulation in China hurt all Macau gaming companies indiscriminately and made our stakes in Melco and Galaxy via K.Wah primary performance detractors for the year with Melco down 39% and K.Wah, bolstered by its Hong Kong real estate, down 19%. At Melco, less than 15% of EBITDA (earnings before interest, taxes, depreciation, and amortization) is tied to lower margin VIP visitors who have been most severely impacted by China s anti-corruption scrutiny and increased regulation. Melco grew its mass gaming business at a higher rate than the overall market. The company bought back 15.8 million shares, approximately 1%, over the last four months, and CEO Lawrence Ho bought an approximate $HK600 million personally in K. Wah owns 3.9% of Galaxy Entertainment, which caters more to Macau s VIP business. Galaxy significantly outperformed the broader VIP market, and has an advantage with its planned opening in mid-2015 of the next major casino expansion on the Cotai Peninsula. Excluding the discounted market value of its stake in Galaxy, K. Wah s remaining property business trades at less than 1 3 of book value. Management opportunistically bought urban Hong Kong land at a discount to subsequent auctions in the same area. The planned launch of large scale projects in Tseung Kwan O should increase 2015 sales. Even in the storm of worry that labeled 2014 a disastrous year for Macau gaming, overall revenues fell less than 3%, the number of visitors rose, and mass revenues grew doubledigits. The Chinese government has demonstrated its long-term support of Macau with massive infrastructure projects, and efforts to crack down on corruption and attract more legitimate visitors ultimately will benefit our holdings. We are excited to own these businesses as increased accessibility and additional room supply should enable revenues to rise at healthy levels. Lower demand from China, increased supply from major industry players, and adverse movements in resource-rich currencies and stock markets depressed iron ore prices by 49% for the year, reaching their lowest level since June Our position in Brazilian iron ore company Manabi declined 45% in the fourth quarter and 60% in the year. Manabi s lower price reflects the current commodity environment and delays in implementing the company s operating plan. Iron ore pressure also hurt Australian based mining services company Mineral Resources (MIN RE), whichweboughtinthefirstquarter,withreturns down 32% in the year after a 15% fourth quarter decline. Because MIN RE owns some mines, it traded with the iron ore industry. Its core business of iron ore crushing and services, however, depends on volume of work rather than commodity price. Because MIN RE provides crushing services at less than half the cost that miners can achieve themselves, the company benefits as large Australian miners turn to lowercost outsourcing when ore prices fall. Businesses unrelated to its mines produce $250 million in EBITDA, meaning the company trades at just over 4x EV/ EBITDA (enterprise value/earnings before interest, taxes, depreciation, and amortization). Management is using its financial flexibility to invest in crushing and processing capacity at this opportunistic time. We bought BR Properties, Brazil s largest manager of commercial office buildings, in the first quarter. Brazilian stocks and currency declined following the recent re-election of President Dilma Rousseff, who has doubled the pace of interest rate increases in an effort to slow inflation. Our stake in BR Properties fell 27% in the fourth quarter and 29% over our holding period. As lending rates increased to 11.75% and the Brazilian real fell to a nine-year low in December, the entire Brazilian real estate sector declined. BR Properties successfully navigated the political environment under Dilma over the past four years, and the long-term businessvalueofitspropertiesismuchmorestable than either these rate changes or currency moves. The company continued to lease its new buildings, sold non-core assets, and bought back shares at a steep discount. Broad pressure on the Norwegian economy and stock market following the price slide in oil hurt our return in consumer goods company Orkla, as did the kroner s decline to its lowest level since Orkla lost 25% in the fourth quarter, offsetting earlier gains and ending the year down 9%. Management moved to focus on the branded International Fund Longleaf Partners Funds 25 consumer goods business following the IPO (initial public offering) of its aluminum business, Granges. This listing strengthened Orkla s balance sheet by deconsolidating the company s debt. investment management partners, we have been adding to our personal holdings in the International Fund, which currently trades at a mid-60s% price-to-value ratio (P/V). Throughout the year we bought nine new positionsasdislocationsaroundtheworldandat individual companies gave us more attractive opportunities than usual. In addition to the first quarter purchases of CDI, MIN RE, and BR Properties discussed above, we added Vopak. In the second quarter, we bought Iida and Colt, and in the third quarter, adidas and Vivendi. In the last three months, we bought Australian-based testing, inspection, and certification company ALS Limited. The same previously described mining pressures impacted ALS, which is associated with Australian mining even though the company has minimal exposure to iron ore. We exited an unusually high number of businesses because some approached our appraisals and others presented the opportunity to sell more fully valued and/or lesser quality names to position the portfolio in businesses with a larger margin of safety and higher expected value growth. In the most recent quarter, we sold Fairfax and the Hermès distribution from CDI as described above. We exited Vopak, a first quarter purchase, Iida, a second quarter purchase, and NewsCorp after our investment cases changed. We thank our fellow shareholders for your continued partnership in a year when short-term performance did not reflect our long-term value proposition. As the Fund s largest owners, we are not pleased with our recent performance. The return, however, does not adequately reflect the underlying progress our companies made during theyear.weareconfidentinthecollectionof high quality, industry-leading companies in the portfolio as well as in our management partners who are taking action to build shareholder value. As we would expect from shareholder-oriented managements with meaningfully discounted shares, we saw buybacks at most companies and personal share purchases by many of our partners. As you would expect from your 4 Before investing in any Longleaf Partners fund, you should carefully consider the Fund s investment objectives, risks, charges, and expenses. For a current Prospectus and Summary Prospectus, which contain this and other important information, visit Please read the Prospectus and Summary Prospectus carefully before investing. RISKS The Longleaf Partners International Fund is subject to stock market 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 invest in 15 to 25 companies, share value could fluctuate more than if a greater number of securities were held. Mid-cap stocks held by the Funds may be more volatile than those of larger companies. Investing in non-u.s. securities may entail risk due to non-us economic and political developments, exposure to non-us currencies, and different accounting and financial standards. These risks may be higher when investing in emerging markets. MSCI EAFE Index (Europe, Australasia, Far East) is a broad based, unmanaged equity market index designed to measure the equity market performance of 22 developed markets, excluding the US & Canada. An index cannot be invested in directly. 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. Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows from an investment equal zero. EV/EBITDA is a ratio comparing a company s enterprise value and its earnings before interest, taxes, depreciation and amortization. As of December 31, 2014, the holdings discussed represented the following percentages of the Longleaf Partners International Fund: Cheung Kong, 7.7%; Christian Dior, 5.2%; OCI, 6.1%; Melco, 7.4%; K Wah, 5.8%; Manabi, 2.1%; Mineral Resources, 4.1%;BR Properties, 4.6%; Orkla, 3.7%; Colt, 4.7%, adidas, 4.9%; and Vivendi, 4.9%. Holdings are subject to change and holding discussions are not recommendations to buy or sell any security. Current and future holdings are subject to risk. Funds distributed by ALPS Distributors, Inc. LLP Expires 4/15/15
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