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PORTFOLIO MANAGER LETTER –
VALUE, HICKORY, PARTNERS VALUE, PARTNERS III OPPORTUNITY
December 31, 2007 – QUARTERLY REPORT
January 16, 2008
Dear Fellow Shareholders:
We are glad that 2007 is history. The U.S. stock market showed a modest aggregate gain (S&P 500 +5.5%), but the market had a distinctly split personality. The housing, mortgage finance and consumer sector stocks were very weak, while others, seen as beneficiaries of booming Asian economies, were very strong. We were positioned squarely on the wrong side of the 2007 market and as a result, both our relative and absolute performance were poor (gory details are shown in the table below).
It was a particularly disappointing year because we had been very aware of the growing speculative excesses that finally reached critical mass in 2007. We had consciously focused our portfolios on companies that we believed would not only survive a likely credit/liquidity crisis but be able to take advantage of one.
The majority of our companies performed very well last year, but there were two main flaws in our execution: (1) Countrywide Financial was more vulnerable to a funding crisis than we realized. We owned too much of it for too long before reversing our field and selling it during the 4th quarter; and (2) We were too willing to "look across the valley" of likely softness in consumer, housing-related and financial services stocks. We have thrived over the years by being willing to be early and "out of step" in buying good companies at temporarily depressed prices. Given the magnitude of the speculative credit bubble, we just did not need to have been so eager to take our contrarian stand.
The financial markets are still experiencing extreme distress. Year-end earnings reports of banks and other financial companies will undoubtedly feature further asset value write-downs and will highlight the need of many to raise additional capital. The economy appears to be slowing and both investors and market commentators are very pessimistic. Thus, the stock market has begun 2008 on a decidedly downbeat note.
The flipside of this gloomy picture is that the recovery process for the financial system has begun. Marginal lenders have exited the business. Viable companies whose capital has been impaired by actual and "mark to market" losses have begun to find new sources of replacement capital. Some of this capital is coming from foreign governments who are eager to recycle some of their excess trade surplus dollars into U.S. earning assets.
The Federal Reserve and the Treasury have made liquidity available to banks and brokers and Congress is working on fiscal stimulus measures. Major banks’ "off-balance sheet" investments, which had threatened to cause additional liquidity issues, are now being brought back "on-balance sheet." (Banks did not technically "own" these assets—hence the term "off-balance sheet"—but they received most of the "economics" of ownership. By using this accounting technicality, banks could hold more assets than would otherwise have been allowed by regulators. This activity backfired when asset values collapsed and lenders who had financed these assets asked for their money back.) This "involuntary balance sheet expansion" further burdened bank capital, but was less disruptive than the feared distressed sale of tens of billions of loans and securities.
Excess housing inventory generated by foreclosures and voluntary sales will eventually be cleared. Builders have sold thousands of lots to speculators and we may see "bulk" sales of houses (albeit at distressed prices). There will be plenty of personal and corporate "pain and suffering" over the next year or two as assets are transferred from over-leveraged borrowers to those with the capital to take advantage of the situation. We are certainly not making light of the human costs involved in this transfer of housing assets, but within a few years, there will be a "normal" new housing market and a functioning mortgage market.
We have not been immune to this financial crisis, but we think our companies are ones that can withstand a slow economy. We would not be so presumptuous as to suggest that a market bottom is imminent, but stocks do have a way of anticipating recovery and beginning to go up long before the news turns positive. We believe the prospects for our companies over the next few years are excellent and that from today’s price levels, our portfolios should be able to generate very good investment returns. We will discuss individual companies later in the letter, but first, the numbers.
The table below shows investment results over various intervals for our equity Funds (after deducting fees and expenses) and for the S&P 500 (larger companies), the Russell 2000 (smaller companies) and the Nasdaq Composite (a proxy for technology companies).
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Total Returns* |
Average Annual Total Returns* |
||||||||
|
4th-Qtr. |
1-Year |
3-Year |
5-Year |
10-Year |
15-Year |
20-Year |
Since Inception (6/1/83) |
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|
Value |
-6.7% |
-10.3% |
2.0% |
9.6% |
9.4% |
12.8% |
13.2% |
N/A |
|
|
Partners Value** |
-6.6 |
-8.5 |
3.0 |
9.5 |
9.5 |
13.2 |
13.4 |
14.0 |
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Hickory |
-7.3 |
-13.1 |
2.1 |
14.1 |
7.0 |
N/A |
N/A |
N/A |
|
|
Partners III** |
-7.2 |
-12.9 |
1.4 |
12.7 |
10.2 |
14.5 |
14.2 |
14.1 |
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S&P 500 # |
-3.3 |
5.5 |
8.6 |
12.8 |
5.9 |
10.5 |
11.8 |
12.2 |
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Russell 2000 # |
-4.6 |
-1.6 |
6.8 |
16.3 |
7.1 |
N/A |
N/A |
N/A |
|
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Nasdaq Composite # |
-1.6 |
10.7 |
7.6 |
15.5 |
5.9 |
9.5 |
11.0 |
9.1 |
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These performance numbers reflect the deduction of each Fund’s annual operating expenses. The current annual operating expenses for the Value Fund, Partners Value Fund, Hickory Fund and Partners III Opportunity Fund, as stated in the most recent Prospectus are 1.14%, 1.15%, 1.22% and 1.57%, respectively, of each Fund’s net assets. This information represents past performance and past performance does not guarantee future results. The investment return and the principal value of an investment in any of the Funds will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. Current performance may be higher or lower than the performance data quoted above. Click here for performance data current to the most recent month-end.
* All performance numbers assume reinvestment of dividends (except for the 15- and 20-year Nasdaq numbers for which reinvestment of dividend information was not available).
** As of December 31, 1993, the Partners Value Fund ("Partners Value") succeeded to substantially all of the assets of Weitz Partners II Limited Partnership and as of December 30, 2005, the Partners III Opportunity Fund ("Partners III") succeeded to substantially all of the assets of Weitz Partners III Limited Partnership (together with Weitz Partners II Limited Partnership, the "Partnerships"). The investment objectives, policies and restrictions of Partners Value and Partners III are materially equivalent to those of the respective Partnerships and the Partnerships were managed at all times with full investment authority by Wallace R. Weitz & Company. The performance information includes performance for the period before Partners Value and Partners III became investment companies registered with the Securities and Exchange Commission. During these periods, neither Partnership was registered under the Investment Company Act of 1940 and therefore were not subject to certain investment restrictions imposed by the 1940 Act. If either Partnership had been registered under the 1940 Act during these periods, the Partnership’s performance might have been adversely affected.
# Index performance is hypothetical and is for illustrative purposes only.
Market Commentary
It is no wonder that investors are confused and frightened. Huge, well-known financial institutions have faced embarrassing losses (or worse) and the viability of whole industries (e.g. mortgage insurance and bond insurance) has been questioned. Everyone—lenders, borrowers, investors, speculators, regulators and rating agencies—played a part in creating the financial crisis. Every corner of the financial world is affected, yet the dimensions of the future losses are not yet measurable. Lenders and borrowers are hesitant to do business with each other, and the financial markets are not functioning normally.
In this environment, the stocks of companies with real problems have been punished severely. Unfortunately, the stocks of many other companies that have been impacted in minor or temporary ways have also been subject to heavy selling pressure. The potential rewards for successfully navigating this kind of market are great. However, to earn these rewards, investors must have the courage of their convictions so they can stick with their investments during extended periods of uncertainty. This can be painful.
Some people do not have the temperament for investing in markets like this, and they would probably be better off owning Treasury Bills or a government securities money market fund (we offer one). There is no shame in staying on the sidelines if that allows one to sleep well. Peace of mind is important.
For those with the courage and patience to buy good assets when nobody else wants them or can afford to buy them, we think this is a very good time for investing. Terrific assets and companies with strong franchises are available at very attractive prices. We believe that it takes very little imagination to envision the possibility of 50% appreciation in most of our stocks over the next 2-3 years.
Portfolio Review
We look at companies one at a time and are generally not guided by "top-down" macroeconomic considerations or investment "themes." Ideally, we would find 30-40 companies whose stocks are very cheap and whose businesses respond to economic conditions in unrelated ways. In reality, certain groups of stocks with real or perceived similarities tend to move up and down together as investors generalize about their outlooks. Our favorite investment ideas tend to cluster in these unpopular groups.
It is important to understand, though, that each company has its own business model and its own strategy for dealing with the credit crisis and consumer spending slowdown/recession. We thought it might be helpful to shareholders to review several of our key holdings and explain why we believe the 2-3 year outlook for each is very good.
Berkshire Hathaway is the epitome of the company one would like to own in a period of distressed financial markets. Its excess liquidity and ability to generate billions in free cash flow every year make it uniquely well-suited to buy individual assets and whole businesses and to expand existing businesses. The stock has appreciated nicely in the past year, but we believe it is still reasonably priced.
American International Group (AIG) is an enormous insurance company with a global franchise. It owns and insures some mortgages and corporate bonds, but its insurance business is quite diversified and its balance sheet is sound. It sells for less than 10 times current earnings, and we expect significant earnings growth and P/E multiple expansion over the next several years.
American Express represents a royalty on consumer and business spending, which is slowing, and it extends credit (albeit to a "prime" clientele). While the market focuses on rising credit losses which are real, we emphasize the company’s ample growth opportunities in the U.S. and abroad, and the significant cash flow it generates even after investing in its future. Its 4th quarter earnings report was mildly disappointing, but the stock seems, to us, to have over-reacted. At about 13 times expected 2008 earnings, we consider the stock under-valued.
Redwood Trust’s management foresaw and prepared for the current credit crisis and has a substantial portion of its capital in liquid reserves. It plans to use these reserves to buy assets that will enhance returns (and dividends) for years to come. In spite of Redwood’s strong financial position and excellent prospects, the stock is down over 50% from its high. We believe Redwood has $4-5 per share earning power and 90% of earnings will be paid out in dividends. A return to previous price levels over the next few years seems very plausible (and would mean a doubling of the current price).
Fannie Mae and Freddie Mac own and guarantee mortgages, so their earnings will be impacted by rising credit losses over the next few years. Fannie and Freddie are "Government Sponsored Entities" (GSE’s) meaning that they were created by Congress to make mortgages more readily available to U.S. homeowners. While their debt is not guaranteed by the U.S. government, they enjoy unique access to global capital markets. With the secondary market for mortgages virtually shut down, they are in a position to earn higher than usual returns on new business. Over the next 2-3 years, as losses on older mortgages run off and the higher returns on new business flow into earnings, we believe investors will recognize their higher earning power and the stocks will appreciate.
The stocks of retailers were generally weak in 2007. Fears that consumer spending would slow were on target, but we believe investors over-reacted. Wal-Mart rose slightly, but the shares of Lowes, Bed Bath & Beyond, Cabela’s and Liberty Interactive (primarily QVC) suffered declines ranging from 12-38%. These companies are strong competitors in their own niches. They generate free cash flow which can be used to expand their businesses and/or buy back stock. We would expect each to come out of the current weak period in very strong positions.
Media and telecom companies like Liberty Capital (primarily DirectTV), Comcast, Liberty Global, Washington Post and Telephone and Data Systems all had very good years from a business point of view. They grew earnings, cash flows and business values, yet the performance of their stocks was mixed. Each sells at a significant discount to our estimate of their business values and we expect them to make good contributions to portfolio returns when recession fears subside.
UnitedHealth Group and WellPoint were strong contributors to 2007 results but are still very reasonably priced at 13-14 times expected 2008 earnings. Omnicare experienced competitive challenges over the past year but we believe that cost savings following a recent acquisition will produce economic earnings well above market expectations over the next two years.
There are few industry groups which are more out of favor than building materials, but we believe demographics suggest a positive long-term outlook. USG, Mohawk, Vulcan, Martin Marietta and Eagle have unusually strong raw material assets, distribution systems and balance sheets which give these companies very strong recovery potential. Their earnings are cyclical, but they earn strong returns on equity and we believe that we can earn attractive average annual returns by buying them when their businesses are weak and investors are fearful.
Each of the Funds also holds some cash reserves. We do not target a particular cash level but holding some excess cash allows the Funds to add to positions and to pursue new investment ideas as opportunities arise.
Outlook
Looming credit losses will probably wreak havoc with many companies for another year (or two). Headlines will be scary. The shrinkage of available credit may depress consumer spending and we may well experience a recession. If the domestic economy slows significantly, the rest of the world will probably be affected, too. If this is the case, the booming Asian economies may slow and some of the hot areas of the 2007 market—energy, metals, other commodities, etc.—may not be the safe refuge that they have been recently.
However, much of the bad news seems to be priced into the stock prices of the most obvious victims of the current mortgage crisis/U.S. economic slowdown. Panic selling can take stocks to unimaginably low levels (I remember 1974 all too well), but prices do not stay at ridiculously low levels for long. We believe that if we buy shares of businesses at deep discounts to their underlying intrinsic values, the eventual rewards will be great. For investors with courage and patience, we think this is a great time to be a contrarian stock investor.
Thanks again for your patience in a decidedly trying period for our Funds.
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 |
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. The Prospectus 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. 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.
Copyright 1999-2008 Weitz Securities, Inc. Member FINRA
1125 South 103rd Street, Suite 600, Omaha, Nebraska 68124-6008
