Our Interview with Mason Hawkins of Southeastern Asset Management April 1, 2008

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1 Our Interview with Mason Hawkins of Southeastern Asset Management April 1, 2008 Mason Hawkins has been Chairman and Chief Executive Officer Southeastern Asset Management since 1975, and he and his partners manage the Longleaf Partners Funds. Mr. Hawkins is a legendary deep value investor, and his funds were singled out for praise from David Swensen in his book Unconventional Success: A Fundamental Approach to Personal Investment. Among the many accolades Southeastern has achieved, they were named 2007 Domestic Fund Managers of the Year by Morningstar. The Partners fund recently re-opened to investors and Mr. Hawkins agreed to answer our questions. Across your funds, you rely on the metric of P/V, which is the ratio of current price to intrinsic value. Can you explain how you determine intrinsic value? Over the last six months, have more opportunities arisen because of changes in the numerator (P) or the denominator (V)? We use three methods to arrive at an appraisal. The first and most predominant is determining the value of the free cash flow of the operating business. For understandable, predictable, competitively entrenched companies, we project the next seven years of free cash flow (net income plus non-cash charges minus required maintenance capex and working capital costs,) put a low or no growth terminal multiple on the business past 7 years, and discount back at a conservative discount rate (9-11% today.) The second method calculates net asset value by adjusting book values of assets and liabilities to current liquidation values. (For example, real estate is rarely worth the original cost carried on the books, particularly if it s been held for a long period.) Third, we check our longhand math against a data base of comparable transactions over the last 30 years, taking into account the interest rate environment at the time of the transactions. We mark our appraisal to the lower of the two values when comparable sales and our longhand math differ.

2 Over the last six months, most of the improvement in P/V has come from the P, or prices coming down. Values are not nearly as volatile as prices, which obviously gives us opportunity at times when fear is driving prices. Most of our appraisals have grown or remained steady throughout the last six months. At a number of our companies we expect values to grow substantially because management is using the financial strength of the business to aggressively buy in shares at steeply discounted levels. Buying in shares at half of value grows the value per share of the company materially. You compare each fund to a benchmark, as well as to an objective measure of inflation plus 10%. What is the history and rationale behind the choice of this benchmark (inflation + 10%)? You can t fund scholarships or retirement or college with relative returns. For our capital which is 100% invested in the Longleaf Funds, absolute, real returns matter. A real return of 10% far exceeds the market s long term average, and recognizes the premium that investors in businesses would require over bonds in order to take on the risks of business ownership. Relative to your benchmarks, the Partners Fund has not performed as well over the last 5 years as it did during its first 15 years. What do you attribute this to? Has the discipline of value investing become more competitive over the last five years? The primary frustration over the last five years, until recently, has been the lack of volatility in the markets. Without volatility we get few opportunities to steal businesses and lay the foundation for future compounding. Obviously that has shifted dramatically since late In addition, much of what has done well has been the natural resource and emerging market areas, driven largely by China. We typically don t own many natural resource companies because they are commodities without competitive advantage and are often depleting assets. We believe that the relative returns from here for the next five years will be compelling, and the opportunity set is what caused us to temporarily re-open the Partners Fund. What tools do you employ for identifying potential candidates for investment, specifically the companies on your on deck list for the Partners Fund?

3 Each analyst is tasked with finding the best opportunities that meet our qualitative and quantitative criteria. He can source the ideas from a myriad of places including general business publications or trade journals, the new low list daily, insider buying and share repurchase reports, data screens that indicate things that might be cheap, management teams that we respect, and a wish list of great businesses with capable managers that we would like to own at the right price. I d like to ask about one of the holdings in the Partner s Fund, ebay. With a P/E of over 100, how does this fit into your value investing framework? ebay has an impressive franchise where the company s competitive advantage is in being the first mover and therefore largest marketplace. Its size and dominance are self perpetuating buyers want to go where the most sellers are, and sellers want to list on marketplaces with the most buyers. Given its size as well as the current slowdown in consumer spending, ebay s growth rate has slowed from previous nosebleed rates to closer to 10%. Paypal, the secure internet payment service, is continuing to post stronger growth even as Google and others have tried to compete. On the people, management owns a significant stake in the business. In addition to addressing various operating improvements, the company has been aggressively buying in its shares at discounted prices. The reported EPS in 2007 were only $0.25 after the one-time write down of Skype that equated to over $1.00 per share. At approximately $29/share, ebay is selling at 17.5x the Wall Street First Call 2008 EPS consensus $1.66 estimate. At year-end 2007, there was $3.40 of net cash per share on ebay s balance sheet and we calculate that there is about $0.10/share of additional free cash flow from amortization and negative working capital requirements. Thus, the real price to cash earnings multiple is $25.60/1.76, or 14.5x for a uniquely competitive business. As value investors, how do trends in the overall economy enter into your decision process? How is the likelihood of recession, inflation, or higher oil prices affecting the way you structure your portfolio? We structure the portfolio on a bottom up basis with each individual building block needing to meet our investment criteria. Macro observations do not enter our decisions about what to buy or sell. However, a slowing economy or higher oil prices will impact some of the businesses we own, and our appraisals account for this. For example, in a recessionary time, for those businesses that are particularly sensitive to

4 economic cycles we might assume lower or no growth over the next year. Given that our appraisals generally look out seven years, economic cycles have less impact than if we were trying to guess the next 6 months. Are any of your positions in the Partner s Fund specifically targeting opportunities that have arisen out of the sub-prime crisis? UBS has an incredibly valuable overseas wealth management business as well as a strong retail bank in Switzerland, an asset management business, and a wealth management business in the US. The exposure that the firm had to the mortgage market has caused the entire business to be put on sale at multiples that investment banks trade for versus what dominant wealth managers are worth. What risks concern you most regarding the Partner s Fund? Not raising enough capital to take advantage of the plethora of extremely discounted opportunities in the market today. Unlike most funds, we have had positive net flows since November when the volatility began. We are fortunate to have great investment partners in the Longleaf Funds who have not only kept their money invested, but have added to their accounts, thereby benefitting all shareholders. Turning to the mutual fund industry, your firm has been singled out by David Swensen and others as exemplary in your investment principles and governance. One of the more contentious issues today concerns 12(b)1 fees (which I understand you do not pay). The SEC is calling for a shift to have these fees paid by the brokerage industry, instead of by funds themselves. Do you believe this would be healthy for the mutual fund industry and a benefit to investors? We have never believed in paying for distribution because we view the Funds as our personal vehicles for compounding capital and want other shareholders only if they subscribe to our investment approach, not because someone was paid to sell the Funds to them. Since we don t have 12b1 fees, we are not affected by whatever the SEC decides. We do think that it s important for shareholders to understand what fees they are paying and to whom. In addition, if a fund is closed, it seems hard to justify continuing to collect distribution fees such as 12b1s. However, brokers can serve as a useful source of investment advice, and should be paid for the services they render. Their clients should be provided a full account of how and by whom the broker is compensated.

5 A larger issue facing the actively managed mutual fund industry, cited by John Bogle (among others), is the governance conflict that incents fund managers to grow their asset base (to generate fee income for the fund company), rather than focusing on performance that would benefit fund investors. Do you see this as an impediment to growth in the industry and, if so, do you see any remedy? The industry will grow if managers are providing investors with a valuable service. We believe that the best way to eliminate conflicts is to require managers to put 100% of their net worth into the funds that they manage. As owner operators heavily vested in their own funds, their stock picking will be laser focused and their choices about growing their asset base and setting fees will be more aligned with shareholders. For a free subscription to the Advisor Perspectives newsletter, visit: