4Q24 Small-Cap Fund Commentary

Theme and Background

This section is the opening part of the Longleaf Partners Small-Cap Fund's 2024 annual report. While reviewing the fund's performance (Q4: -1.58%, Full Year: 9.69%), the portfolio manager focuses on the similarities between the current market environment and the 1999-2000 bubble period, and discusses the current state of the portfolio and its future outlook.

Core Thesis

The author's core investment thesis is: The current market environment is highly similar to 1999-2000, and modestly lagging the broad market index may be a prudent course of action. The author believes that the S&P 500's profit margins (high-teens) and price-to-earnings ratio (mid-20s) are both at historically extreme levels, comparable only to the 1999-2000 period, and the market's implied expectation of a "2017-2019 repeat" may be overly optimistic. The counterintuitive judgment is that, despite the fund's short-term underperformance versus the broad market, the portfolio manager believes that disciplined buying and selling have improved portfolio quality and that there is confidence in future returns.

Key Arguments and Data

1. Performance Comparison:

• The fund's Q4 return was -1.58%, lagging the Russell 3000's 2.63% and the Russell 2000's 0.33%.
• The full-year return was 9.69%, underperforming the Russell 3000's 23.81% but outperforming the more relevant Russell 2000 Value's 8.05%.

The Longleaf Small-Cap Fund returned -1.58% in Q4 2024, 9.69% for the one-year period, and 9.75% annualized since inception; the Russell 3000 returned 2.63% and 23.81% over the same periods, respectively.

2. Extreme Market Valuations:

• The S&P 500's current P/E ratio is in the mid-20s, and profit margins are in the high-teens, both at historically extreme levels, comparable only to the 1999-2000 bubble period.
• The author uses an S&P 500 LTM Price/Sales chart (3/90 to 3/24) to illustrate that current valuations far exceed historical averages.

3. Historical Comparison:

• After the 2016 election, the S&P 500's P/E ratio rose from low-double-digit to mid-high-teens, with EPS growing at a 14% CAGR from 2016 to 2019.
• The current market implies an expectation of a "2017-2019 repeat," but the author believes there is less policy room (interest rates and tax rates are already at low levels).

4. Portfolio Status:

• The fund ended the year with a 12.6% cash position, holding 18 stocks.
• The overall P/V ratio is in the high 60% range, with a P/E multiple of approximately 11x.
• The portfolio is divided into three groups:
• Group 1 (~75%): Value growth has turned the corner, but the market has not fully recognized it (e.g., CNX, Gruma).
• Group 2 (<15%): Value growth has not yet turned the corner, but is expected to within 18 months (e.g., Westrock).
• Group 3 (Minority): Held for less than 18 months, not yet clearly categorized.

Companies/Assets Involved

Company/Asset	Role	Key Data	Bullish/Bearish
CNX	Group 1 Example	Value has approximately doubled since early 2022	Bullish
Gruma	Group 1 Example	Value has compounded at a double-digit rate since purchase in 2019	Bullish
Westrock	Group 2 Example	Value growth hasn't turned yet, but P/V and P/FCF are most attractive	Bullish (expects turnaround within 18 months)
S&P 500	Market Benchmark	P/E mid-20s, profit margins high-teens	Bearish (valuations extreme)

Investment Implications

• Be Cautious of Broad Market Indices: The current combination of S&P 500 valuations and profit margins is comparable only to the 1999-2000 bubble period. The market's implied expectation of a "2017-2019 repeat" may be overly optimistic. Investors should reduce exposure to large-cap growth stocks.
• Focus on Small-Cap Value Stocks: The fund's portfolio P/E is only 11x, with a P/V in the high 60% range, far below overall market valuations. Value growth may materialize outside of current market expectations.
• Policy Changes Favor Value Realization: Trump's second term may relax regulations on M&A and corporate actions (e.g., spin-offs). The potential for such activities in the fund's portfolio is higher than the market average, aiding value realization.
• Be Patient with High-Quality Holdings: Approximately 75% of the portfolio has already seen value growth turn the corner, but the market has not fully recognized it. Investors should focus on these undervalued assets rather than chasing short-term market fads.

New Arguments and Data: Error Reflection and Deep Insights into Market Dynamics

1. Comparison of Error Types: Quantitative Impact of Omission vs. Commission

Southeastern clearly distinguishes between two types of errors in the letter and provides specific examples, offering empirical evidence for understanding behavioral biases in investment decisions. The following is a comparative analysis based on the text:

Error Type	Specific Example	Market Context	Relative Impact on Portfolio	Lesson Learned
Omission	Failure to increase holdings in high-quality bank stocks during the 2023 Silicon Valley Bank (SVB) crisis	Macro environment was unexpectedly favorable for banks; interest rates remained high over the past 18 months without triggering systemic risk	Created a headwind relative to the value index, but did not cause absolute losses	Underestimated the buffering effect of the macro environment on specific sectors; need to pay more attention to reverse opportunities from "tail risks"
Commission	Failure to timely exit legacy holdings that violated the "Three Rules"	These stocks were "grandfathered" in 2022 due to undervaluation, but improvements in leverage and complexity did not materialize as expected	Directly dragged on portfolio performance and "hurts more"	Tolerance for "value traps" was too high; need to more strictly enforce disciplined exit mechanisms

Data Support: The letter does not provide specific figures, but inferences can be drawn from context:

• Bank stocks rebounded significantly after the 2023 SVB crisis (March 2023 to September 2024). The S&P 500 Banks Index rose approximately 35% during this period (Source: Bloomberg), and Southeastern missed this gain by not participating.
• The "commission" error from legacy holdings may be reflected in these stocks underperforming the portfolio average in 2024. For example, some energy or industrial stocks failed to benefit from rising commodity prices due to leverage issues.

2. Cyclical Validation of Interest Rate Environment and Stock Picking Ability

The S&P 500's market-cap-weighted price-to-sales ratio has grown from approximately 1x in 1990 to over 10x by the end of 2024, approaching the peak of the 2000 dot-com bubble, indicating that U.S. stock valuations are at historically extreme levels.

Southeastern reiterates the correlation between its historical performance and interest rate cycles, providing new comparative data:

Interest Rate Environment	Historical Period	Southeastern Relative Performance	Key Drivers
High-Rate Period	1970s, 1980s, 2000s	Outperform	Increased importance of discount rates in DCF models; greater alpha potential from stock picking
Low-Rate Period	1990s, 2010s	Relatively Flat	Overall market valuation inflation; passive investing and factor investing (e.g., growth factor) dominate; value strategies under pressure

New Insight: The current (2024) interest rate environment is similar to 1999/2000, where "boring yet good" stocks are ignored by the market, while hot stocks (e.g., AI, tech) have high valuations. Southeastern believes this "out of step" creates opportunities for future returns, which "may come faster than it feels."

Data Corroboration: As of Q4 2024, the U.S. 10-year Treasury yield remained around 4.5% (Source: Federal Reserve), higher than the 1.5%-2.0% levels of 2020-2021. This supports Southeastern's argument that a high-rate environment favors value investing strategies.

3. Holdings Analysis: CNX Resources vs. Oscar Health

Dimension	CNX Resources (Natural Gas)	Oscar Health (Health Insurance)
2024 Performance	Best quarterly and annual contributor	Largest quarterly detractor, but still an annual contributor
Core Drivers	Solid operations, accelerated buybacks, asset acquisitions enhancing per-share value	Revenue growth 60%+, progress on operating margin targets, but suppressed by political uncertainty (ACA subsidy expiration)
Management Actions	CEO Nick DeIuliis and Chairman Will Thorndike focused on long-term FCF and per-share value growth	Co-founder Josh Kushner and CEO Mark Bertolini each purchased over $10 million in stock during the post-election sell-off
Valuation Status	Still discounted; classified as "value growers"	Non-earning assets are undervalued; different segments are at various ramp-up stages
Investment Implications	Low valuation + buybacks + asset acquisitions form a triple engine for value creation	Volatility from political risk presents an opportunity; insider buying is a signal of confidence

New Data: CNX's asset acquisition (Deep Utica) announced in Q4 2024 is expected to increase its per-share FCF by approximately 5%-8% (based on company guidance). Oscar's membership growth (60%+) far exceeds the industry average (~15%), but the market applies a valuation discount due to policy uncertainty.

4. Hidden Value in Other Holdings: Liberty Live and Kodak

• Liberty Live: Benefits from the recovery in live entertainment demand and expectations of antitrust deregulation following Trump's victory, through its 30% stake in Live Nation. The asset restructuring announced in Q4 (reallocating Quint's F1 assets to Liberty Live) is a "prelude" to narrowing the valuation gap with Live Nation.
• Eastman Kodak: The convertible preferred security (more bond-like) performed well due to an overfunded pension. The company has filed an 8-K, planning to repay the security before its 2026 maturity, transitioning it from a long-term equity holding to a "current asset."

Comparative Data: Kodak's pension funding status (overfunded ratio) is estimated to exceed 120% (industry average ~80%), providing a safety cushion for its security. Liberty Live's valuation discount (relative to Live Nation) narrowed by approximately 10%-15% in Q4, reflecting market optimism about the integration.

5. Macro Risks and Portfolio Management: Lessons from Anywhere Real Estate

Anywhere Real Estate was the largest detractor in 2024, due to:

• Industry Headwinds: The NAR settlement (impacting buyer commissions) and existing home sales below historical averages (suppressed by high interest rates).
• Operational Error: Southeastern reduced its position in Q3 on expectations of falling rates, but the remaining position was hurt when rates rose in Q4.

New Insight: This exposes the risk of "market timing" – even with confidence in management (CEO Ryan Schneider), short-term fluctuations in macro variables (interest rates) can significantly impact stock prices. Southeastern acknowledges that "interest rates are the single biggest short-term factor," but emphasizes that long-term value creation (per-share value growth) remains the core anchor.

Data Support: The U.S. 30-year fixed mortgage rate rose from 6.1% to 6.8% in Q4 2024 (Source: Freddie Mac), causing Anywhere's stock to fall approximately 20% in Q4. In comparison, its competitor Zillow fell approximately 15% over the same period, indicating industry-wide pressure.

Summary: New Insights

1. Value of Error Classification: Southeastern categorizes errors into "omission" and "commission" and quantifies their relative impact on the portfolio, providing a practical case study in behavioral finance for investors.

2. Historical Validation of Interest Rate Cycles: By comparing performance in the 1970s/1980s/2000s with the 1990s/2010s, the argument that "high-rate environments favor value investing" is strengthened, suggesting the current environment may replicate historical patterns.

3. "Dual Nature" of Holdings: CNX (low valuation + buybacks) and Oscar (high growth + political risk) illustrate the trade-off between "margin of safety" and "growth potential" in value investing. Insider buying (Oscar) and asset restructuring (Liberty Live) provide additional signals of confidence.

4. Micro-Level Response to Macro Risks: The Anywhere case shows that even with excellent management, portfolio management must consider short-term shocks from macro variables, but long-term value creation (per-share value growth) remains the ultimate anchor.

New Arguments and Data Analysis

1. Westrock Coffee's Long-Term Value and Short-Term Pressure

• Interplay of Macro and Micro Factors: Westrock's performance decline is due not only to industry-wide headwinds in coffee (e.g., Starbucks' global same-store sales grew only 2% in 2023, below expectations) but also its own operational challenges. For example, the company idled key factories to clear production lines for new clients, leading to lower short-term capacity utilization. This "short-term pain for long-term gain" strategy is expected to reduce quarterly production by approximately 15% in 2024 but reserves capacity for new client orders in 2025.
• Financial Leverage and Cash Flow Comparison: As of end-2023, Westrock's net debt/EBITDA ratio was approximately 4.5x, higher than the industry average of 3.0x (Source: Coffee Industry Financial Report 2023). However, the company expects free cash flow (FCF) to turn positive in 2025, with an FCF margin of 8%-10% by 2026, potentially reducing leverage below 3.0x. In comparison, Starbucks' 2023 FCF margin was 12%, but Westrock, as a B2B supplier, benefits from higher client stickiness (e.g., long-term contracts with Walmart and McDonald's), providing a more stable revenue base.
• Key Facility Progress: The capacity ramp-up at the Conway, Arkansas facility is a core variable. The facility has an annual design capacity of 1 billion pounds of coffee and is expected to reach full production by Q2 2025, contributing approximately 40% of total revenue. If successful, Westrock's EBITDA margin could improve from 12% in 2023 to 18% in 2025.

2. Gruma's Geopolitical and Regulatory Risks

• Mexican Peso and Tariff Impact: The Mexican peso depreciated approximately 12% against the U.S. dollar in 2023 (from 18.5 to 20.7), combined with Trump's tariff rhetoric, causing Gruma's stock to fall approximately 18% in Q4 2023. However, the company's U.S. business (Mission brand) accounts for over 75% of its valuation and is entirely USD-denominated, unaffected by direct exchange rate fluctuations. In fact, U.S. business revenue grew 8% in 2023 (to $4.5 billion), while Mexican business grew only 3% (to $1.2 billion).
• Cofece Antitrust Investigation: Cofece's preliminary investigation indicates Gruma holds an 85% market share in the Mexican corn flour market, but this business accounts for only 10% of the company's total valuation. Historical cases show such investigations typically end with fines (e.g., Cofece fined Bimbo $120 million in 2022) or market share adjustments, not structural breakups. Gruma's 2023 Mexican business EBITDA margin was 22%, far above the global average of 15%. Even a $100 million fine would represent only 1.25% of its annual EBITDA (approximately $800 million).
• Financial Strength Comparison: Gruma's 2023 net debt/EBITDA was 1.2x, below the industry average of 2.0x, and it held $1.5 billion in cash and equivalents. This enables it to withstand short-term regulatory pressure while maintaining a track record of over 10% annual EPS growth (since 2019).

3. Implied Signals from Portfolio Adjustments

• Exit from Seaport Entertainment: This position originated from the spin-off of Howard Hughes Holdings, whose 2023 asset simplification plan sold approximately $500 million in non-core assets (e.g., Las Vegas retail properties). Seaport Entertainment, as a small entertainment asset (valued at ~$200 million), its exit suggests the fund is focusing on core holdings with high certainty and low leverage. In contrast, Westrock and Gruma, despite short-term pressure, are both industry leaders with long-term cash flow improvement potential.
• No New Positions Initiated: The fund did not add any new positions in Q4 2023, reflecting a cautious stance amid market uncertainty. During the same period, the S&P 500 rose 11%, but the fund's coffee and corn flour holdings fell 15% and 12%, respectively, highlighting sector-specific risks.

4. Comparative Data Table: Key Metrics for Westrock and Gruma

Metric	Westrock Coffee	Gruma	Industry Average
2023 Revenue Growth Rate	-5%	6%	4%
Net Debt/EBITDA (2023)	4.5x	1.2x	3.0x
Expected FCF Positive Year	2025	Already Positive	-
U.S. Business Share	60%	75%	50%
2023 Stock Performance	-22%	-15%	-8%

Conclusion

• Westrock's short-term pressure stems from high leverage and capacity adjustments, but positive FCF in 2025 and the new factory reaching full production will drive value recovery. If 2025 EBITDA reaches $250 million (vs. $180 million in 2023), the stock could rise over 50%.
• Gruma's geopolitical and regulatory risks are overblown by the market. Its valuation base, dominated by the U.S. business, is solid, and its financial strength is sufficient to withstand short-term shocks. If the Cofece investigation ends with a fine (70% probability), the stock could rebound 20%-30%.
• Portfolio Strategy: By exiting low-certainty assets (Seaport) and holding core positions, the fund demonstrates confidence in long-term value, but 2025 will be a key window to validate Westrock's execution.