Large-cap equities traded higher in fourth quarter 2016, with the S&P 500 returning 3.8% as investors reacted favorably to political developments in the U.S. and broadly stabilizing economic conditions. The index achieved a positive total return for the eighth consecutive year, rising 11.9% in 2016. Notably, the S&P 500 level now sits 236% above its bottom tick reached in March 2009, or 16.7% compounded annually. The BBH Core Select Representative Account1 (Core Select) returned 2.1% in the fourth quarter (as adjusted for distributions) and was up 7.9% for all of 2016. Over the past five years, Core Select has compounded at an annualized rate of 11.3% per annum vs. 14.6% for the S&P 500. Measured from the last market peak reached in October 2007, the strategy has compounded at 7.6% per annum, compared with 6.4% for the S&P 500.
Our strongest contributors in the fourth quarter were U.S. Bancorp and Wells Fargo. Shares of both banks rose sharply in November following the U.S. elections, as investors speculated that Republican control of the executive and legislative branches of government could lead to developments that lessen the severity of regulatory requirements on the financial services sector. In addition, improving economic forecasts and rising expectations of higher base interest rates have fueled positive sentiment toward the banks in general. In December, we modestly trimmed our position in U.S. Bancorp as the stock traded closer to our per-share estimate of intrinsic value.2
Early in the quarter, Wells Fargo CEO John Stumpf announced his immediate resignation in the wake of an account opening scandal that put the company under intense regulatory scrutiny and caused substantial negative press. Timothy Sloan, a 29-year veteran of the company who had served as its president and COO, was named as Stumpf’s replacement. Wells Fargo continues to work to rectify the downstream impacts of having opened accounts that were unwanted or misunderstood by customers, but this process will take additional time. Despite these challenges, the company’s shares had a trough-to-peak advance of nearly 30% within the quarter, highlighting not only how inefficient the market can be in the short term, but also the degree to which basket trades, rapid exchange-traded fund flows and other directional buying can dramatically affect valuations. While the company is facing meaningful challenges, it remains very profitable, well capitalized and liquid, and we believe the shares still offer reasonable upside relative to our appraisal of fair value.
Two other strong performers last quarter were Berkshire Hathaway and Celanese. Berkshire’s Class A shares rose more than 14%, driven by strong quarterly results reported in November, sizable share price advances for certain of its public equity investments, including Wells Fargo and American Express, and bullish views regarding the potential for lower corporate taxes and higher government infrastructure spending under the Trump administration.
Celanese shares rose 18% in the quarter, gaining steadily after a solid earnings report in mid-October. The company is a leading provider of acetic acid and other base chemicals as well as a large manufacturer of plastic polymers, acetate tow used in filters and other specialty chemicals. We believe it is operating very well in what continues to be a challenging backdrop of lower-than-normal global industrial production.
For full-year 2016, Core Select’s largest positive contributors were Berkshire Hathaway, Comcast, U.S. Bancorp and Qualcomm. Notably, the first three names on this list were also our best performers over the past five years. We are pleased with the 2016 gains among this group and the consistently strong business execution that each has shown; however; the share prices of all four companies have now edged closer to our intrinsic value estimates.
Our largest detractors in the fourth quarter were Perrigo, Nestle, FleetCor Technologies and Novartis. Pharmaceutical stocks had a challenging year in 2016, with the S&P Pharmaceuticals Select Index declining almost 24% – and 12% in the fourth quarter alone. The key issues affecting the sector have been drug price pressures, regulatory scrutiny and growing concerns that a rollback of parts of the Affordable Care Act could lead to broadly lower healthcare utilization. Novartis continued to face headwinds from generic drug competition, adverse currency movements and a lengthy period of underperformance within the Alcon business unit. On the positive side, the company has executed well on its cost management initiatives, while sales from newer products generated solid double-digit growth within the core Innovative Medicines division. We took advantage of the share price weakness and added to our holdings in late November.
The weakness in Perrigo shares last quarter was not catalyst driven, but rather reflected a continuation of price pressures in the generic drug business and disappointing trends in the European branded healthcare products segment. Importantly, the performance and outlook for the core private-label Consumer Healthcare business remains very solid.
FleetCor shares declined 19% in the fourth quarter. In late December, FleetCor’s major competitor, WEX, announced it had successfully bid for Chevron’s private-label credit card processing business, which will transition away from FleetCor in 2018. This contract accounts for less than 3% of current-year revenues, had not grown for a number of years and presumably was less profitable than the company average. Nevertheless, the loss of the contract exacerbated already negative investor sentiment following a somewhat lackluster quarterly earnings report in early November. We made a small additional purchase of FleetCor shares during the quarter.
Nestle’s U.S.-listed American depositary receipts (ADRs) slid 9% last quarter. Like many of its peers in the global food and beverages business, Nestle’s top-line results have been pressured by macroeconomic weakness, price deflation, currency headwinds and changing consumer habits. We also believe the recent move in the ADRs had some degree of linkage to the increase in U.S. Treasury rates, which tend to influence equity dividend yields, particularly for companies in areas such as consumer staples. Notwithstanding the current set of challenges, we believe the company’s long-term strategic focus and willingness to invest in innovation and operational improvements over time remain key strengths. Nestle’s growing focus on health and wellness should position it well to capitalize on consumer trends and changing demographics.
The fourth quarter was an active period for portfolio changes in Core Select. Most notably, we concluded a multi-quarter process of analysis and revetting of the energy sector and ultimately decided to exit our three remaining investments in that area: EOG Resources, Occidental Petroleum and Schlumberger. Our decision to move away from the sector was not driven by bearish views about the near-term prospects for the three businesses, but rather the result of our reassessment of the industry’s degree of fit with the Core Select investment criteria.
During the quarter, we initiated new positions in Liberty Global and Nielsen Holdings. Liberty Global is a leading broadband communications provider of video, high-speed data, voice and mobile services in 12 European markets, including the U.K., Germany and Netherlands. Having previously owned shares of the company between 2006 and 2011, we know Liberty Global and the European cable industry well and have a high degree of confidence in the management team and board of directors. Over the past 18 months, Liberty Global’s shares have dropped more than 40% due to rising fears of slower revenue and cash flow growth, competitive intensity in certain markets, adverse currency translation and concerns regarding the company’s new build strategy. From our perspective, however, Liberty Global continues to possess the best infrastructure for delivering broadband access, which in today’s world is an essential service.
In late December, we initiated a position in Nielsen Holdings, a global leader in media and retail measurement and analysis services. Nielsen provides mission-critical data and insights that are highly valued by media companies, advertisers, consumer packaged goods companies and other customers. In both of its business segments, Watch (47% of revenues) and Buy (53% of revenues), Nielsen is a large global player, with significant competitive advantages resulting not only from the breadth and quality of its data and analytics, but also from the embedded nature of these services within customers’ day-to-day workflows and longer-term strategic planning activities. In the Watch segment, Nielsen’s entrenched market position is further reinforced by the fact that its ratings are the de facto “currency” by which media buyers and sellers transact. Roughly 70% of the company’s revenues are recurring, with contract terms averaging five years. Nielsen’s share price fell sharply in the fourth quarter after it reported weaker-than-expected growth in certain project-based and discretionary offerings within the Buy segment. Much of this shortfall occurred within parts of the business that management considers non-core, and in light of the weaker trends, the company has stated its intention to discontinue or divest some of these areas. This will create some additional revenue pressure, but the impact on margins should be favorable. We view Nielsen as a profitable, scalable business with strong free cash flow generation, a well-constructed balance sheet and better-than-average forward visibility. Our baseline intrinsic valuation model suggests meaningful potential upside in the shares.
At year end, we had positions in 28 companies, with 52% of our assets in the 10 largest holdings. Core Select ended 2016 trading at 86% of our underlying intrinsic value estimates on a weighted average basis, compared with 84% at the end of the third quarter and 80% at the end of 2015. We finished the year with a cash position of 11%, down from 12% at the end of the third quarter, as our new purchases and selected additions outweighed the full exit from our energy sector stocks and trims in other holdings.
With the seeming likelihood of volatile trading patterns and broad sentiment shifts continuing, we are alert to the possibility that early 2017 may present some opportunities if investors begin to adjust their risk exposures, potentially widening valuation discounts at the stock-specific level within Core Select. As always, we will be patient in our deployment of capital and will continue to favor high-conviction businesses into which we have better visibility regarding the range of potential outcomes.
We appreciate your investment and look forward to providing you with further updates on the progress of our companies in 2017.
For additional information on how the Core Select portfolio companies performed during fourth quarter 2016, contact your BBH relationship manager.
The S&P 500 index is an unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index is not available for direct investment.
Core Select may assume large positions in a small number of issuers, which can increase the potential for greater price fluctuation. The holdings identified do not represent all of the securities purchased, sold or recommended for clients. Performance data quoted represents past performance, which is no guarantee of future results; investor principal is not guaranteed, and there is a possibility of loss on all investments. Further information on the calculation methodology and a list showing every holding’s contribution to the overall account’s performance during the quarter is available upon request.
BBH prepares proprietary financial models for each Core Select company in order to determine an estimate of intrinsic value. Discounted cash flow analysis is the primary quantitative model used in our research process. We supplement our discounted cash flow work with other quantitative analyses, such as economic profit models, internal rate of return models and free cash flow multiples.
A number of the comments in this document are based on current expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of BBH’s best judgment at the time this document was compiled, and any obligation to update or alter forward-looking statements as a result of new information, future events or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class or markets generally, nor are they intended to predict the future performance of any BBH account, portfolio or fund.
There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities mentioned within the article. A complete list of portfolio recommendations for the past year is available upon request.
The information provided in this article should not be considered a recommendation to purchase or sell any particular security.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
© Brown Brothers Harriman & Co. 2017. All rights reserved. 2017.
1 The representative account is the largest account managed with the same investment objective and employing substantially the same investment philosophy as the Core Select strategy. Performance figures for the representative account are reported net of a 1% investment advisory fee. Performance of different types of investment vehicles employing this strategy may differ as a result of the different fees, expenses, charges, number of securities and restrictions applicable to the vehicles.
2 Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.