Large-cap U.S. equities rose in third quarter 2016 as investors reacted favorably to the likelihood of continued easy monetary conditions and a generally slow but stabilizing economic backdrop in the developed world. The S&P 500 returned 3.9% last quarter, while the BBH Core Select Representative Account1 (Core Select) was up 3.4%. Year to date, the S&P 500 is up by 7.8% and Core Select by 7.0%. Over the past year, Core Select has compounded at an annualized rate of 11.8% per annum vs. 15.4% for the S&P 500. Over the past five years, Core Select has compounded at an annualized rate of 14.0% per annum vs. 16.4% for the S&P 500. Measured from the prior market peak in October 2007, the strategy has compounded at 8.9% per annum, which compares with 6.3% for the S&P 500.
Our largest positive contributor last quarter was Qualcomm, which gained 29%. The shares rose sharply in July after the company released better-than-expected second-quarter earnings highlighted by two important developments: substantial progress with intellectual property royalty collections in China, as Qualcomm reached agreements with previously non-paying manufacturers, and better-than-expected smartphone chipset shipments. On a broader strategic level, Qualcomm’s growing body of work related to 5G wireless development, including proof-of-concept demonstrations, standards submissions and ecosystem partnerships, demonstrate the company’s solid position in the industry’s next major cycle. In addition, in the quarter’s closing days, press reports suggested that Qualcomm may be considering a bid to acquire NXP Semiconductors, a Dutch provider of digital and mixed-signal integrated circuits used in several consumer and industrial applications. The prospect of a deal lifted Qualcomm’s share price. At this early stage, we have no specific comments on the merits of a potential deal, but in general, we tend to be somewhat wary of large, transformative acquisitions given the execution risk involved.
Alphabet advanced by 14% during the quarter and was the second largest contributor to Core Select’s overall performance. Having fallen by 7% in the prior quarter, Alphabet’s shares recovered sharply from June-ending levels, achieving new all-time highs due primarily to strong earnings results. We continue to believe the company can achieve double-digit compounded revenue and cash flow growth over the next several years driven by the continuing secular shift of advertiser dollars online globally and incremental growth in mobile device usage. In our view, these secular trends will support strong baseline growth for Alphabet’s core search and display advertising revenues (within Google and YouTube) and will be augmented further by growth in media content sales, apps, cloud services and Alphabet’s diverse “other bets” category.
EOG Resources shares rose toward the end of the quarter in near lockstep with crude oil prices as hopes built that OPEC members could reach an agreement that would limit production and therefore improve the global supply and demand balance. Consistent with the approach we have used for investing in the energy industry, we are far less concerned with short-term movements in commodities prices than we are with our companies’ ability to sustainably grow production in an efficient way by targeting low-cost developments and maintaining a disciplined approach to capital deployment. To that end, we remain pleased with EOG’s execution during the current prolonged period of depressed oil prices. In particular, we highlight the company’s recent strong growth in developing “premium” drilling inventory, defined as prospective wells that have sufficient productivity and capital efficiency to earn a direct rate of return exceeding 30% assuming $40 crude oil prices.
PayPal shares were volatile in the quarter but nonetheless gained 12%. In conjunction with its release of strong financial results for second quarter 2016, PayPal announced a major operating agreement with Visa that set new commercial terms between the companies. While the agreement has distinct “give and take” attributes to it and will put pressure on PayPal’s transaction margins, we believe the net effect over the long run may in fact be positive, as Visa has agreed to open certain of its payment channels and technologies to PayPal. We see the potential for double-digit gains in PayPal’s transaction volume and revenues for the next several years, and given the highly scalable nature of the business, we believe that the company will be able to spend aggressively on innovation and customer experience.
Our largest detractors last quarter were Liberty Interactive, Oracle and Wells Fargo. Liberty Interactive shares declined sharply after the company reported second-quarter earnings. While the actual results were in line with market expectations, the company disclosed that U.S. sales in its QVC division had slowed significantly starting in June and that the weakness had continued into the third quarter, likely resulting in declining revenues and cash flow for the period. QVC’s management believes that the slowdown was primarily the result of aggressive discounting by other retailers as they cleared inventory, normal seasonal weakness and suboptimal execution in terms of having fresh products available to replace slowing categories, such as handbags and kitchen tools. During our conversations with management in the past few weeks, we explored these and other issues and concluded that it is unlikely that there has been a negative inflection in the business model. At its current levels, we believe the stock offers an attractive risk-reward tradeoff given what we see as a substantial discount to our estimate of intrinsic value per share.2
Oracle shares fell following the release of quarterly earnings in mid-September. While the company showed stronger-than-expected revenue growth in its software and cloud businesses, weakness in the hardware segment, along with slightly higher operating expenses and taxes, cut into earnings. During the past two years of Oracle’s transition toward a subscription-based cloud model, short-term headwinds have dented investor sentiment to some degree, but we take a much longer-term view of the company’s progress and believe that its strategy is on track. The company’s shares continue to trade at a meaningful discount to our intrinsic value appraisal.
Wells Fargo shares dropped sharply in September after the announcement of a $185 million settlement reached with three separate government agencies resolving claims related to alleged fraudulent account openings between 2011 and 2016. The settlement kindled intense public scrutiny of Wells Fargo, including Congressional hearings, a Department of Labor investigation, investigations by the Department of Justice and a number of derivative lawsuits. As detailed in the settlement, Wells Fargo’s employees may have opened as many as 2 million unauthorized customer accounts, including 1.5 million deposit accounts and more than 500,000 credit card accounts. Management became aware and started remediation of the related problems in 2011 and as part of that process fired 5,300 employees between 2011 and 2015 who were found to have acted improperly. In response to the settlement and its fallout, the company’s board moved to claw back $41 million in compensation from Chairman and CEO John Stumpf and $19 million from Carrie Tolstedt, the former head of retail banking. (Note: In early October, Stumpf stepped down from his position at the company.) While the aggregate fines are very modest in relation to Wells Fargo’s earnings power and capital, revelations of customer abuse may result in increased customer churn and slower new account acquisition. There is no question Wells Fargo’s reputation has suffered, which may create additional earnings headwinds. Despite the foregoing and the attendant risks, Wells Fargo remains highly profitable, well-capitalized and liquid. At quarter-end, the company was trading at a similar price-to-book multiple as it did during the financial crisis and at a substantial discount to our intrinsic value estimate.
At the end of the quarter, we had positions in 29 companies, with 49% of our assets held in the 10 largest holdings. As of September 30, Core Select was trading at 84% of our underlying intrinsic value estimates on a weighted average basis.
Seven years into a bull market and now reaching the nine-year mark since the last market peak, our perspective on the financial markets continues to be that higher levels of price risk are being embedded in securities prices as valuations have risen through the cycle even while economic conditions have made only modest progress and corporate earnings have been lackluster. The experience of the past few years has shown that low interest rates and quantitative easing can spur growth in credit far more easily than they can create sustainable growth in aggregate demand. We believe risks have built in the system, as the income growth necessary to support the higher levels of financial leverage may at some point prove inadequate, creating a far greater chance of a debt deflation cycle and meaningful corrections in asset values. Whether or not monetary and fiscal spending are maintained or expanded, we believe that pricing distortions in the market are becoming increasingly clear, and for this reason we believe it is critically important for us to remain disciplined on valuation and be willing to think and behave differently from other investors. Our long-term point of view and our objective of achieving attractive compounding over full market cycles give us the confidence to maintain our approach even in the face of unfavorable short-term relative performance. We believe that our fundamentals-based, ownership-oriented investment philosophy is well suited to current conditions. We focus our efforts on identifying well-positioned, resilient businesses trading at substantial discounts to our appraisals of their intrinsic values, and we will trim or sell positions as those discounts diminish. Our top priority remains capital preservation, and while that may cause us to forego some upside toward the end of a market cycle, we believe the benefits of this discipline will remain evident over time.
For additional information on how the Core Select portfolio companies performed during third 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.
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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.