LETTER TO SHAREHOLDERS
SEPTEMBER 30, 2009 – SEMI-ANNUAL REPORT
October 4, 2009
Dear Fellow Shareholder:
The third calendar quarter was a very good one for our Funds. Each of our stock funds gained over 16% for the quarter. This brings year-to-date returns to +23.6% for the Value Fund, +29.7% for Partners Value, +34.2% for Hickory and +39.0% for Partners III Opportunity. During this period, the S&P 500 gained +19.3%.
Corporate bond prices have also been strong this year. This reflects both reduced credit concerns and a newfound appreciation for the more stable investment characteristics of bonds. Our bond funds have shown excellent returns throughout the turbulence of the past two years.
The Balanced Fund invests in both bonds and stocks and it has also produced very good results this year. It gained +11.4% in the third quarter and is up +25.8% for the first nine months, handily outpacing its "blended" benchmark’s return of +13.5%.
Results for all of our Funds (except the Government Money Market Fund) are shown in the performance table which can be obtained by clicking here. The table shows results over various intervals since inception. This table also contains results for various market indices for comparison purposes. There are separate sections of the September 30, 2009 report that discuss each Fund in more detail and we encourage shareholders to explore them.
Market Commentary—Cautious Optimism
The enormity of the credit crisis and governmental responses to it are unprecedented. The withdrawal of cheap and easy credit has changed the way individuals and companies conduct their lives and businesses. Much of the government capital that has been injected into banks, Freddie Mac and Fannie Mae, and the asset-backed securities markets will eventually need to be replaced with private capital. Budget deficits, new regulations and tax policies will impact all aspects of economic life.
The recession that has been triggered by this crisis is not an ordinary recession. There are signs that the economy may be bumping along a bottom and that the worst of the decline may be over, but we expect the recovery to be slow and uneven. Investors, always trying to anticipate the next change in direction of the economy, jumped back into the stock and bond markets six months ago. The enthusiastic rallies have pushed stock prices up over 50% from the March lows, and the improvement in corporate bond prices has been equally dramatic. It is not unusual to see a strong initial rally off panic lows—like a bungee cord snapping back up after a long plunge—but further progress on the upside will probably be more difficult.
We believe there will be lots of surprises—both positive and negative—as the world recovers from what some are calling the Great Recession. What makes us optimistic from an investment point of view is that we are settling into a version of "normal" business activity in which companies can make plans and investors can make estimates of business value. Last fall, as Lehman failed, AIG teetered, commercial paper markets shut down and capital markets in general nearly ceased to function, there was no way to know where economic or institutional "solid ground" was. Now, the "system" seems to be secure, even if many individuals and companies continue to face severe stress.
Going forward, even though the "easy money" of the initial rally has been made, we see companies whose stocks are under-valued and which have a reasonably clear path to business value growth. With patience and discipline, we believe we should be able to earn reasonable returns even if the recovery is stretched over a period of years.
Portfolio Review
As we observed last quarter, many of the strongest stocks in the recent rally were the ones that had fallen the hardest during the bear market. Prominent among these were companies facing cyclical earnings declines and those subject to credit concerns (however unwarranted) in the post-Lehman liquidity crisis. Many of these stocks rebounded strongly when investors’ fears subsided. Cabela’s and Mohawk tripled from their lows and Liberty Capital rose nearly tenfold from its low point.
On the other hand, the stronger companies which had held up relatively well, such as Wal-Mart, Microsoft, UPS, Procter and Gamble, etc., showed the smallest rebounds. The Value Fund has a higher concentration of these large-capitalization companies and fewer of the smaller companies that starred over the past six months, so although it out-performed the S&P 500, it trailed its sibling funds. Performance attribution details are available in the fund-specific sections of the report.
Healthcare stocks made up only 9-12% of our stock funds going into the third quarter but they have been in the news lately (to put it mildly), and we thought shareholders might appreciate an update. Business fundamentals for these stocks—earnings, cash flow, balance sheets, etc.—have been completely over-shadowed by the debate over healthcare reform legislation. We do not claim special insight into the likely outcome of the debate, but we have been able to buy the stocks when they seemed to discount the worst possible outcome (for the companies—not necessarily for society) and to sell them when fears subsided. They have made a positive contribution to our results this year, but during the quarter we reduced our exposure to the group.
Finally, a word on cash levels in the Funds. The amount of cash we hold in a stock fund reflects our perception of how cheap our stocks are. In March, when stocks were very cheap, we bought more shares of several of our favorites and cash levels fell to roughly 5% of total assets. As stocks rose and became less cheap, we trimmed many of our holdings. As a result, cash levels at the end of the quarter ranged from 19% to 23%. Cash levels rise and fall as we buy and sell in response to changes in valuation levels, not because we "target" a certain cash level.
Positioning Our Portfolios for a Subdued Recovery
When adversity strikes, companies do not just sit and "take it." They innovate and adapt, offer new products and "value" pricing, they modify advertising messages and add new promotions. On the financial front, they cut costs, delay expansions, make opportunistic acquisitions, and extend debt maturities. In many cases, the strong get stronger and the weak get weaker.
Some companies, though, are particularly adaptable. They own portfolios of businesses and/or securities and are able to take advantage of changing market conditions to maximize returns over time. In addition to having flexible structures, they also have managements we trust to make good capital allocation decisions. (There are very few managers we would trust with this much latitude.) In short, they are better able than most to "reinvent" themselves. These companies may be better suited for a time of wrenching economic dislocation than more traditional companies. Three of our long-time holdings fit this description.
Redwood Trust is a real estate investment trust that invests in mortgages and mortgage-backed securities. We were initial investors when they were started in 1994 and have been their largest investor most of the intervening 15 years. We know management well and trust them. Over that period, they have shifted focus opportunistically and have successfully negotiated some treacherous mortgage markets. The stock has been volatile and we have been reasonably successful in taking advantage of the price swings. They have also paid over $35 per share in dividends. Redwood is currently focusing new investment on high quality mortgage-backed securities purchased at distress prices to provide very attractive yields. We believe they are well-positioned to take advantage of the current mortgage market chaos.
Berkshire Hathaway and Warren Buffett are well-known to our shareholders. Our Funds and their predecessor accounts have owned Berkshire continuously since 1976. We have varied our position size over time as the stock fluctuated between extremely cheap and fairly valued, but over those 33 years, it has been a compounding machine. Warren had accumulated cash and other reserves over the past several years and was in a wonderful position to take advantage of the financial crisis that struck last year. His investments in Goldman Sachs and GE made major headlines, but he also made equity and debt investments in several other companies that needed financing for acquisitions or to shore up their own balance sheets. He also bought both public securities and whole companies. Although the stock is about 35% off its high, there is no doubt that Berkshire’s long-term earning power is considerably higher today than it was a year or two ago.
Our association with Liberty Media and John Malone goes back about 20 years. Liberty was formed from various programming assets owned by Telecommunications, Inc. (TCI), John Malone’s cable company. Its corporate history is very complicated as Malone spun Liberty out of TCI, merged it back in, sold TCI to AT&T, and spun Liberty out again. A few years ago, Liberty Media (which was one of our largest holdings at the time) began a series of maneuvers that created five separate publicly traded entities—Liberty Entertainment, Liberty Capital, Liberty Interactive, Liberty Global and Discovery Communications—each of which, in turn, represents a portfolio of businesses. We currently own all five entities in our stock funds.
Malone has done a good job of managing these portfolios. He and CEO Greg Maffei have made acquisitions and asset swaps that have added substantial value to the overall enterprise. The latest apparent coup was a $400 million investment in Sirius XM Satellite during the depths of the credit crisis last year. Liberty Capital received 18% bonds and preferred shares convertible into 40% of the equity of the company. The bonds have already been redeemed, so Liberty’s investment has been returned with interest, but it has kept the convertible preferred. This equity investment in Sirius is highly speculative, but it cost Liberty virtually nothing and is currently valued at over $1 billion (over $10 per Liberty Capital share).
Each of these companies is well-positioned to deal with the recession and come out of it stronger. These seven stocks make up 26-40% of our stock fund portfolios and have been strong contributors to our results this year. If the recovery does take a long time, and if there is a "new normal" as some pundits suggest, these companies seem likely to be able to adapt as well as any and keep our investment growing.
Outlook
These are interesting times. Intelligent observers disagree strongly over the outlook for the U.S. and world economies, world stock and bond markets, and most other areas of finance. We expect a sluggish economic recovery with many setbacks but an environment in which good companies can do business.
Much has changed in economic, political and investment arenas, but we believe that human nature has not changed. People acting out of fear and greed cause assets to be mis-priced from time to time. Our business is to take advantage of this mis-pricing. Investing is more art than science, but investors with experience, common sense and patience ought to be able to earn reasonable (or, hopefully, unreasonable) returns in this environment.
Thanks again for your patience and confidence.
Sincerely,
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| Wallace R. Weitz | Bradley P. Hinton |
| Co-manager Value and Partners Value | Co-manager Value and Partners Value |
| Portfolio Manager Hickory and Partners III | Portfolio Manager Balanced |
| wally@weitzfunds.com | brad@weitzfunds.com |
Investors should consider carefully the investment objectives, risks, and charges and expenses of the Funds before investing. The Funds’ Prospectus contains this and other information about the Funds and should be read carefully before investing. Portfolio composition is subject to change at any time and references to specific securities, industries, and sectors referenced in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. See the Schedule of Investments in Securities included in the Funds’ quarterly report for the percent of assets of each Fund invested in particular industries or sectors.
Weitz Securities, Inc. is the distributor of the Weitz Funds.