Following a robust 2013, global equities got off to a mixed start in 2014. North American and Western European equities overcame still tepid macroeconomic growth and growing geopolitical tensions to post modest gains in the first quarter, while Asian, Eastern European, and many other emerging market equities fell. Overall, the MSCI World Index1 rose 1.26% in the first quarter. The BBH Global Core Select Composite (“Global Core Select” or “the strategy”) rose 1.09% in the quarter with gains in our energy, banking, and technology holdings offsetting losses from our retailers and education company Pearson. At quarter end, the Global Core Select equities were trading at 84% of our weighted average price-to-intrinsic value calculation.
Our largest positive contributor in the first quarter was Oslo-listed seismic company, TGS Nopec, which rose by over 23% and is our largest investment in the energy sector. TGS had been our worst performer in 2013 and we added to it several times last year as its share price fell, so it was satisfying to see its share price rebound strongly in the first quarter following a solid year-end earnings report. Most importantly, we continue to view TGS as well positioned for long-term value creation. Over the past decade, total exploration and production spending has grown by over 400%, yet global oil production is up by just 15%. Most industry participants see the robust growth in Exploration and Production (E&P) spending – and spending for seismic data in particular – as continuing due to the constant need to replace reserves and the critical role advanced seismic technologies play in the exploration process for hydrocarbons. TGS’s multi-client and capital-light model also helps the company consistently generate attractive returns on capital despite inherent industry cyclicality.
Two other energy companies that performed well for us in the quarter were oil field services giant Schlumberger and Canadian independent E&P company Vermilion Energy. Schlumberger is benefitting from the same long-term trends as TGS and it has solidified its position as the global technology, innovation, and reliability leader in the energy services sector. The result has been accelerating revenue growth and continued margin improvement at a time when several competitors have experienced slowing growth and margin erosion. Vermilion has an excellent position in Western Canada and is one of the few mid-sized U.S. or Canadian E&P companies that has demonstrated an ability to perform well outside of North America. The company has built a strong portfolio of assets in Australia and Europe (France, the Netherlands, Ireland, and Germany), where high net price realizations and a keen focus on operating and capital costs have resulted in attractive netbacks and returns.
Our two banks, Wells Fargo and Svenska Handelsbanken, were also strong contributors in the first quarter. While the two banks operate in separate geographic areas (Wells Fargo primarily in the U.S. and Handelsbanken in Scandinavia, the U.K., and the Netherlands), they have similar operating philosophies centered on high levels of customer service and loyalty, stable funding and strong balance sheet metrics, and traditional banking products and services. Both companies announced higher than expected dividend increases (and in Wells Fargo’s case, share buyback increases as well) in the quarter following a positive outcome for Wells Fargo in the U.S. bank stress test and a favorable clarification of certain Swedish mortgage risk ratios.
Other positive contributors in the quarter included Microsoft, Novartis, and Baxter. Microsoft advanced by more than 10% as investors responded positively to the naming of Satya Nadella as the company’s new CEO. We had viewed Nadella as being one of the most compelling internal candidates for the position, as we believe he possesses the right mix of outward and inward facing skills to be effective in the role. Nadella has been instrumental in the advancement of Microsoft’s enterprise cloud strategy, including the Azure platform. As such, we believe he sits at the forefront of the company’s evolution toward a more open, service-based model, and that he will continue to champion this critical transformation as CEO. Microsoft (MSFT) has a unique strategic position that juxtaposes a massive installed base and existing product suite against a growing set of new opportunities in cloud, mobile, analytics, pervasive computing, and other areas.
The shares of Novartis traded higher in the quarter driven by good quarterly results that benefited from stronger than expected volumes in emerging markets and the continued positive growth impact from products less than five years old. In our view, investor sentiment toward Novartis has improved in recent quarters thanks to management’s good execution and the potential benefits of its comprehensive ongoing business review. Meanwhile, Baxter’s shares moved sharply higher at the end of March following a surprise announcement of a plan to split the company into two separate businesses, Biosciences and Medical Devices. We had considered separation of the company a possibility given the lack of overlap between the businesses and the likelihood that the Biosciences segment in particular might achieve a more robust valuation as a standalone entity (its two closest peers trade at meaningfully higher multiples than Baxter). However, our impression was that Baxter’s management and Board preferred to operate as a unified business. We are not aware of any external pressures that may have precipitated the move – instead, we believe that management was ultimately motivated by the potential revaluation opportunity and the desire to have each business set its own focused strategic agenda and goals.
Our weakest performers in the quarter included our retailers (Bed Bath & Beyond, Sally Beauty, and Tesco) and education company Pearson. Investor sentiment towards traditional brick-and-mortar retailers in developed markets has been extremely weak due to concerns about continued competition from Amazon and other online retailers, increased competition from discount retail formats, and continued weak consumer spending. In Bed Bath & Beyond’s case, its shares tumbled after the company disclosed weaker than expected comparable store sales, additional pressure on gross margins due to promotional activity, and a cautious outlook for 2014. In Sally Beauty’s case, the company reported positive same store sales, but margins for its retail stores were weaker than expected due to a negative product mix shift and higher SG&A expenses. The company also reported a data breach affecting potentially up to 25,000 customers. While the retail environment in the U.S. has indeed been challenging, we have a high level of confidence in the management teams at both companies and believe that they are positioning their respective businesses to thrive in an evolving retail landscape. We would also note that both companies are very cash generative and have a history of buying back stock at depressed levels.
Tesco generates over 65% of its revenues and profits from its core U.K. grocery business, which has struggled due to weak consumer spending and increased competition from hard discounters. The company is in the midst of executing a strategy of refocusing capital expenditures away from building new stores and overseas expansion towards refurbishing its existing U.K. store base. Management is also investing in increased customer service levels, continuing to expand Tesco’s industry leading online grocery offering, and making selective investments in pricing. While Tesco’s operating margins are likely to remain under pressure in the near term, we believe that its margins will ultimately stabilize at still attractive levels. It is important to remember that Tesco remains the largest retailer in the U.K. and possesses significant scale advantages. Tesco’s Asian operations (South Korea and Thailand in particular) also remain very attractive assets long term.
Pearson remains the leading global provider of educational content and solutions, but its share price fell 20% in the first quarter following disappointing earnings guidance for 2014. The company expects continued restructuring costs and infrastructure investments in 2014, as well as continued operating pressures due to U.S. and U.K. school curriculum changes and weak higher education enrollments at for-profit colleges. While the education market is taking longer to rebound than expected, Pearson has made considerable progress in reshaping its business (e.g., moving much of its sales from upfront print book purchases to digital subscription payments) and it is now the clear leader in digital solutions and integrated services. The company also has a rapidly growing presence in emerging markets. Management has indicated that 2015 should be the inflection point when revenues begin to ramp and costs decline, leading to renewed earnings and cash flow growth. Our current intention is to maintain our investment in Pearson through this expected transformation, as we believe it is well positioned to benefit from a rebound in the education market and transition to digital.
Our cash position at quarter end was 7%, down from 10% at year end. During the quarter we exited our remaining investment in Swiss dental implant business Straumann, whose share price had risen above our intrinsic value estimate despite certain operating challenges, and we also modestly reduced our holdings in Microsoft and Qualcomm, both of which have appreciated considerably over the past year.
During the quarter we added to our investment in French pharmaceutical giant Sanofi, making it one of our top 5 holdings at quarter end. What we like about Sanofi are (i) its strong presence in emerging markets (over a third of sales), (ii) its leading position in the treatment of diabetes, which is truly a global epidemic, (iii) its Genzyme/rare disease franchise, which is quite differentiated and gives the company the skills to partner with biotech companies, and (iv) its high levels of free cash flow. Sanofi’s share price has been essentially flat over the past year and investors appear surprisingly skeptical about the company’s ability to bring new drugs to market and grow its top line. In our view, Sanofi is one of the most attractively valued companies in the Global Core Select portfolio.
We were pleased to purchase shares in two new companies trading at 75% or less of our intrinsic value estimates during the first quarter: Zoetis Inc. and Unilever NV. Both businesses fit well with our demanding investment criteria and offer compelling long-term value creation potential driven by secular growth, strong market positioning, and broad global distribution.
Zoetis, which was spun out of Pfizer in 2013, is a global leader in the animal health business. The company provides branded drugs, vaccines, diagnostics, and related services to a wide variety of customers who raise and care for animals. Zoetis’s products are used in both the production animal market (roughly 64% of sales) and for companion animals (36% of sales). In our view, the company holds a strong and durable position in the industry owing to its (i) diverse base of safe and effective products, (ii) geographic breadth, (iii) direct sales force with market-specific knowledge, and (iv) productive internal R&D organization. We believe that animal health is an attractive segment of the global healthcare market that benefits from favorable secular growth trends such as increased per capita protein consumption and increased ownership and medicalization of pets. Moreover, the animal health market benefits from a relatively benign regulatory environment, minimal influence of government reimbursement, limited competition from generics and sustainable pricing power. With its capable and experienced management team, we believe that Zoetis can sustain and grow its earnings power over time.
Unilever is one of the world’s largest consumer products companies, operating in both the food and personal care markets. The company’s products serve basic consumer needs such as nutrition, fortification, and hygiene for lower income consumers, while at the same time offering more premium and value added products that offer convenience and performance features for higher income consumers. With almost 60% of its sales coming from emerging markets, we believe that Unilever has an especially attractive footprint among global consumer staples companies. The company has deep distribution and high brand awareness in key markets such as India, Brazil, South Africa, and Indonesia. Despite current concerns about the pace of growth in these and other emerging markets, the long-term prospects remain attractive in our view given that these regions represent 80% of the world’s population with strong birth rates, rising incomes, emerging middle classes and more women entering the workforce – all of which are factors that should boost demand for Unilever’s products both at the low end and the high end. Through organic and inorganic means, the company has been shifting its business mix towards health and personal care categories, where margins, capital intensity, and cash flow characteristics are generally more attractive than is true of the food business. We have a high regard for Unilever’s management team and the way they have instituted a more long-term oriented approach that balances top line growth, productivity, cash flow, and targeted reinvestment.
In this quarterly letter, we have purposefully discussed at some length the individual companies that we own and are buying and selling. This focus on our portfolio companies reflects our view that it is the operating and financial performance of these companies that should be the primary driver of the strategy’s long term future returns. While equity valuation multiples may rise and fall with market sentiment, our expectation is that the collective earnings and cash flows of our businesses will grow steadily over time, thereby helping us protect capital in down markets and ultimately generate attractive, absolute returns for our shareholders.
On behalf of our entire investment team, we would like to thank you for your continued investment in Global Core Select. We look forward to updating you on our companies’ progress next quarter.
Timothy E. Hartch
For informational purposes only.
1 The MSCI World is a stock market index of approximately 1,600 world stocks. It is maintained by MSCI Inc. and is often used as a common benchmark for ‘world’ or ‘global’ stock funds. The index is an unmanaged, market-weighted index and the returns of the index include net reinvested dividends but, unlike the Composite’s returns, do not reflect the payment of sales commissions or other expenses incurred in the purchase or sale of the securities included in the index. One cannot invest directly in an index.