Often the best place to look for investment ideas is in the places where recent performance has been the worst. In the late nineties investors should have been looking at boring old value investing opportunities instead of high flying technology companies. After a decade of underperformance perhaps now investors should be looking at the tech giants like Microsoft, Intel and Cisco.
When I go looking for investment ideas I take a similar approach to scanning the portfolios of well known fund managers. It only makes sense that I'm not going to find as many undervalued opportunities in the portfolio of the fund manager who just had a fabulous couple of years. Instead I should be looking at the portfolio of a long time outperformer who has had a recent run of bad performance.
As I've written for Seeking Alpha here and here I think the portfolio of Bruce Berkowitz of the Fairholme Funds may be the single best place to find great ideas for the next five to ten years.
Another place an investor may want to look for investment ideas is in the portfolio of Longleaf Partners which has an enviable long term track record but has underperformed over the past few years.
Since inception in 1987 the Longleaf Partners Fund is up 1,102% vs 658% for the S&P 500. However, over the past five years the Longleaf Partners Fund is down 13.48% vs down 1.24% for the S&P 500.
The long term outperformance is more telling of the quality of Longleaf as investors. Even more important is their investing process which they detail quite well in their letters to investors. Every investor is going to outperform for short term stretches, but if the process they use is solid over the long term they do well.
Like Berkowitz at Fairholme, Longleaf runs a very concentrated portfolio which means each idea gets analyzed carefully. If an investment makes it through the Longleaf process and becomes one of their concentrated holdings I figure it is worth my consideration as an investment as well.
The current five largest positions in the Longleaf Partners Fund offer some interesting opportunities:
1) Dell (DELL) - 8.9% of the Longleaf Partners Fund
Longleaf believes that the stock market is overly focused on Dell's slowing PC business. While it is true that the PC business is "dying" Longleaf believes it only represents about 25% of Dell's value. What makes Dell attractive is its enormous free cash flow yield which is 16%. However, even that understates the value proposition because if investors adjust for the net cash position on Dell's balance sheet the free cash flow yield is actually over 20%.
I've had my eye on Dell because of this enormous free cash flow yield as well.
2) Chesapeake Energy (CHK) - 7.7% of the Longleaf Partners Fund
Longleaf has long had a large position and it certainly is a part of the five year underperformance of the fund. It must be frustrating to no end to see Chesapeake add millions of acres of highly valuable property year after year only to have the stock market ignore it.
Longleaf believes that Chesapeake sells for less than half of its Net Asset Value partially because the stock market doesn't believe that CEO McClendon will stop spending more on acreage than the company produces in cash flow. For Chesapeake's stock to really get moving Longleaf believes that natural gas prices will need to improve which Longleaf also believes is inevitable as everyone drilling for gas today is losing money.
3) Loews (L) - 6.6% of the Longleaf Partners Fund
Loews is a frustration to many value investors as it has become a bit of a "value trap". On a sum of the parts analysis the stock price of Loews clearly does not equal the underlying value. The question then becomes whether that underlying value will ever be unlocked.
Loews is positioned with $4 billion in cash that is available to CEO Jim Tisch to deploy in order to create value for shareholders. Additionally Loews key assets are pieces of casualty insurer CNA, offshore driller Diamond Offshore and natural gas pipeline and storage company Boardwalk. Longleaf believes that if you add up the intrinsic value of these key assets that value is at least twice the current Loews share price.
Since the Tisch family owns 25% of the company and has grown the business for decades Longleaf will likely be quite happy to sit and wait for Mr. Market to figure this one out.
4) Aon (AON) - 6.1% of the Longleaf Partners Fund
Longleaf likes Aon due to the fact that it is the top global insurance broker in an oligopoly. This puts a solid moat around a business that has a free cash flow yield over 10%. Longleaf believes that Aon is currently undervalued because earnings are cyclically depressed and because low interest rates on premium float reduce profitability.
While the stock is cheap management is repurchasing shares which will reward shareholders when the cycle and interest rates turn up.
5) DIRECTV (DTV) - 5.7% of the Longleaf Partners Fund
DIRECTV is yet another high free cash flow yield story which obviously is what drives the Longleaf investment process. The company is another one with a very powerful moat as it has the dominant position in Latin America where most countries have no alternative due to the lack of cable and fiber in place and the lack of infrastructure in place.
Another big fan of DIRECTV is new Berkshire Hathaway portfolio manager Ted Weschler who has added the company to Berkshire's portfolio and had 26% of his prior fund invested in DIRECTV.
Disclosure: I am long CHK.
