Equity markets rallied sharply in November after responding favorably to declines in inflation, Treasury yields, commodity prices, and the U.S. Dollar. For the month, the BBH US Large Cap Equity Composite (“US Large Cap Equity” or “the Strategy”) gained 7.87%, outperforming the 5.59% gain of the benchmark S&P 500 Index. At the sector level, the Information Technology and Consumer Discretionary sectors exhibited relative strength while the Financials and Communication Services sectors underperformed. The top contributor for the month was semiconductor capital equipment and solutions provider KLA Corp. (KLAC, 24.67%) while the primary detractor was regional banking franchise Signature Bank (SBNY, -12.00%). At the Strategy level, allocation (+30 basis points1) and selection (+192 basis points) were both positive. We added to existing positions in specialty chemical manufacturer Celanese (CE) and semiconductor manufacturer Texas Instruments (TXN). The portfolio concluded the month with 29 holdings, 5.2% cash, and a price to our estimate of intrinsic value2 of 79%.
KLA Corporation’s share price appreciated meaningfully during the month as investors took a more favorable view of chip stocks due to earnings reports in late October that were better than expected. Semiconductor stocks performed well in general as measured by the SOX Index;3 KLA and its Wafer Fabrication Equipment industry peers performed particularly well within the group. KLA reported a “beat-and-raise” quarter where management suggested the company has not yet experienced early indications of a cyclical downturn that usually causes customers to delay acceptance of equipment or cancel orders. Despite a consensus view of an impending cycle, KLA continued its strong performance from earlier in the year. In addition to earnings-related performance, shares continued their positive reaction to October’s news that the U.S. would prohibit the export of chips and high-end chipmaking equipment to certain customers in China. The release of specific criteria from the U.S. Commerce Department helped quantify KLA’s exposure to the export controls and served as a clearing event for shares by narrowing the uncertainty around impending regulations. Beyond cyclical and geopolitical concerns, we continue to believe KLA will maintain a leading position in this essential industry.
Signature Bank’s stock price has been under intense pressure throughout the year and November was no exception. This pressure reflects a misunderstanding of the company’s exposure to the crypto ecosystem and disregards the fundamental strengths of the business. Of the bank’s $103 billion in deposits at the end of the third quarter, roughly $23 billion emanated from participants in the cryptocurrency and blockchain space; Those deposits came from exchanges, institutional and retail traders, and balances backing stablecoins.4 All of the deposits are dollar denominated so the company has no exposure to cryptocurrency price volatility. In addition, Signature has no credit risk associated with crypto and does not act as a custodian for crypto-related assets, nor as a fiduciary for crypto investors. Nevertheless, the turmoil engulfing the crypto ecosystem this year has raised concerns about the cost and durability of Signature’s crypto-related deposits. Given the uncertain trajectory of the crypto markets, Signature has elected to reduce its exposure to the space by running off $8 billion to $10 billion of crypto-related deposits. The company is able to fund the runoff with $7 billion of excess cash on hand and borrowings from the Federal Home Loan Banks. It is worth noting liquidity is not an issue as Signature has over $33 billion of untapped borrowing capacity – enough to fund the runoff of all its crypto deposits. Despite all the volatility in its crypto deposits, the company’s underlying results have been sound. Signature’s credit quality remains excellent, the balance sheet is well capitalized and liquid, revenues are up over 40%, and earnings per share are up over 50%. It is likely that running off a substantial portion of its crypto deposits will cause the company’s earnings to decline modestly in 2023. Even taking that decline into consideration, the company’s shares are trading for under seven times next year’s expected earnings – a valuation we think is exceptionally compelling.
While we are pleased to see equities and the Strategy benefit from a strong recovery in November, we recognize it has been, and will likely continue to be for some time, a challenging investment environment characterized by persistent inflation, higher interest rates, elevated geopolitical tensions, and slowing economies around the globe. Our focus will always remain on businesses characterized by durable cash flow and earnings growth, healthy balance sheets, and attractive valuations. We believe the Strategy represents compelling value and is well-positioned to generate attractive returns through the business cycle.
