Wallace Weitz's Value Fund Q2 Commentary

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Oct 07, 2014

The Value Fund returned +2.3% during the second calendar quarter, versus gains of 5.2% for the S&P 500 and 5.1% for the Russell 1000. Through the first six months of calendar 2014, the Fund increased 5.4% compared to gains of 7.1% and 7.3% for the S&P 500 and Russell 1000, respectively. Residual cash declined from 29.8% of net assets at the end of the first quarter to 26.5% of net assets at June 30 as we took advantage of buying opportunities in several of our existing holdings.

Apache Corp (+22%), DIRECTV (+11%) and Pioneer Natural Resources (+23%) were the largest contributors to Fund performance during the quarter. Roughly a year ago, Apache (APA, Financial) began a significant reshaping of its business with the goal of streamlining its disparate portfolio of oil and gas assets and unlocking latent value in its stock. CEO Steve Farris and his team have made significant progress, generating a total of $9.5 billion in pre-tax proceeds from largely non-core asset sales to-date. In recent months, management has expressed confidence in its ability to further reduce the company’s exposure to its two large liquefied natural gas (LNG) projects. Investors are gradually beginning to take notice of the new and improved Apache, and we believe a more consistent and attractive self-funding growth profile is likely to help further narrow the stock’s discount to intrinsic value.

Following weeks of speculation surrounding a possible sale, AT&T (T, Financial) announced an agreement to acquire DIRECTV (DTV, Financial) on May 18th. The $95 per share offer, while heavier on T stock than we would prefer, is close to double what we paid for our stake during the fourth quarter of 2012. From today’s vantage point, the potential obstacles to regulatory approval appear manageable, leading us to hold onto the majority of our shares at prices in the low-to-mid-$80s. Should the gap between DTV’s stock price and deal price narrow materially, we are likely to close our position and move on. Pioneer Natural Resources, a new addition to the Fund last quarter, benefitted from strong first quarter operating results, an upward revision to its already enviable reserve position in the Permian Basin, and the announcement of an agreement with the U.S. Commerce Department allowing the company to begin exporting condensate this fall.

Express Scripts (-8%), Valeant Pharmaceuticals (-4%) and eBay (-9%) were the largest detractors from Fund performance during the quarter. At the end of April, Express Scripts (ESRX, Financial) lowered its forecast for prescription growth during 2014 due largely to delays in implementing several new client contracts. Rumblings of customer service issues during the final stages of the Medco Health integration and management’s relatively guarded comments about the 2015 selling season also contributed to the recent weakness in ESRX shares. These near-term challenges, while disappointing, have not changed our stance on the larger opportunity, and significant ongoing share repurchases at lower prices provide a welcome silver lining. We added to our position during the quarter.

In mid-April, Valeant (VRX, Financial) announced its intent to acquire aesthetic dermatology giant Allergan (AGN, Financial) in a $47 billion cash-and-stock deal. Despite subsequent increases in the cash portion of its offer, Allergan’s board of directors has thus far refused to enter negotiations. In its attempt to remain independent, Allergan has worked -- with early success -- to undermine confidence in the durability of Valeant’s business model. While Allergan is undoubtedly an attractive strategic fit for VRX, our investment does not depend upon the success of the deal. And more broadly, we remain confident in Valeant’s ability to generate mid-single digit organic growth with its current cost structure. Finally, eBay shares weakened during the quarter due to the announcement of a data breach earlier in the year, the departure of PayPal head David Marcus to Facebook, and the possibility of a slowdown in traffic to ebay.com following changes to Google’s search algorithms. We added to the Fund’s position with the stock below $50 and remain confident in the company’s competitive positioning and long-term growth prospects.

Catamaran Corporation (CTRX, Financial), the third largest independent pharmacy benefit manager (PBM, Financial) in the U.S., was the lone new addition to the Fund during the quarter. Catamaran boasts several avenues through which it can create significant shareholder value over the coming years, including growth in its relationship with health insurer Cigna, opportunities to continue acquiring additional small- and middle-market PBMs, and tailwinds from the Affordable Care Act and rise in specialty pharmacy. We outline our investment thesis in greater detail in this quarter’s Analyst Corner. The Fund closed its position in retailer Target Corp. at $62 in late April with a reasonable gain, directing the proceeds to portfolio holdings with higher conviction and wider discounts to business value. Target’s more recent struggles have been well-documented. Bricks-and-mortar retailing is an increasingly difficult business, and our broader structural concerns combined with Target’s self-inflicted wounds led to an unattractive shift in our investment thesis.

The Value Fund invests primarily in our best larger company ideas. As of June 30, the Fund’s weighted average market cap was approximately $88 billion and its top twenty holdings represented just over 60% of net assets.

Click here to see our Full Performance Summary, including current to the most recent month end. The performance numbers above reflect the deduction of the Fund's annual operating expenses which as stated in its most recent Prospectus are 1.20% of the Fund's net assets. The returns assume redemption at the end of each period and reinvestment of dividends. Total returns show include fee waivers and expense reimbursements, if any; total returns would have been lower had there been no waiver of fees and/or reimbursements of expenses by the Adviser. This information represents past performance and past performance does not guarantee future results. The investment return and the principal value of an investment in the Fund 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.