European and Asian equities rose meaningfully in the first quarter of 2015, while U.S. equities edged up slightly and Latin American equities fell. For U.S. investors, the strong U.S. dollar was a significant headwind during the quarter. Not only did the strong dollar (up 5% in the quarter and up 15% over the past year versus the Euro) reduce the local-currency gains of foreign stocks, but it has also lowered the expected 2015 earnings of U.S. multinationals. A key factor behind recent currency movements and the largely bullish investor sentiment towards global equities is continued loose monetary policy, most recently in Europe where the European Central Bank (ECB) has embarked on a massive quantitative easing program. While we remain skeptical about the long-term economic benefits of quantitative easing, the ECB’s bond-buying program has certainly boosted the near-term prices of equities and other financial assets.
The MSCI World Index1 rose 2.31% in the first quarter, while BBH Global Core Select Composite (“Global Core Select” or “the Strategy”) appreciated 0.07%. Since the Strategy’s inception, Global Core Select has appreciated at a compound annual rate of 7.74% versus 12.36% for the MSCI World Index. Global Core Select is a concentrated portfolio of 34 businesses and we have selected these businesses based on their own merits using our differentiated business criteria, our intrinsic value2 estimates, and an absolute value framework. We have not sought to mirror the index’s sector or geographic weights. Accordingly, there are likely to be meaningful differences, both year-to-year and over the long term, in Global Core Select’s investment performance relative to the MSCI World Index. We view these differences relative to the index as likely to be positive over the long term since we see significant risks today in global financial markets and think our portfolio companies in aggregate are far more resilient and better capitalized than the average company.
Among our biggest positive contributors in the first quarter were our three large healthcare holdings: Novartis, Sanofi, and Zoetis. Novartis is a top five holding and was up 9% in the quarter making it our top overall contributor. The Company now operates three core franchises in which its competitive positioning, intellectual property and global scale are particularly strong: eye care, generics and high-value pharmaceuticals. While sustainable revenue growth is top-of-mind for the Company’s management’s team, there is also a very clear emphasis on driving further improvements in operational productivity and resource allocation. Later this year, we anticipate Novartis to benefit from the launches of two key products: first, a biosimilar drug for leukemia treatment that recently received FDA approval in the U.S., and second, a heart failure drug that could have a very large addressable market. The biosimilar approval was particularly noteworthy since it was the first granted by the FDA. Novartis’s Sandoz unit is among the very few generics companies worldwide that have the R&D scale, production capabilities and commercial distribution to produce successful biosimilar drugs. We anticipate rapid growth in the market for biosimilars over the next few years as public and private payors push for more cost-effective sources of specialized, large-molecule drugs.
Sanofi, which is also a top five position for Global Core Select, was up 8% in the quarter. In February the Company appointed Olivier Brandicourt, an experienced executive who had previously worked in senior positions at Bayer and Pfizer, as its new CEO. Brandicourt’s appointment was greeted positively by investors since there had been considerable uncertainty created by his predecessor’s sudden departure in October. Sanofi also announced in February the FDA’s approval of Toujeo, a once daily, long-acting insulin product and a key next-generation addition to the Company’s highly profitable diabetes franchise. Sanofi has indicated that it expects to launch as many as 18 new products between 2014 and 2020 with potential incremental revenues of over €30 billion. We believe that many investors are still not giving Sanofi full credit for its superb pipeline. Like Novartis, Sanofi is also well positioned in some of healthcare’s most attractive sub-sectors, including diabetes, vaccines, consumer health, animal health and rare diseases. Sanofi and Novartis both have strong distribution capabilities in emerging markets, where pricing trends are more benign and standards of care are rising rapidly.
Zoetis, which also returned 8% in the quarter and is up more than 50% since our initial purchase in early 2014, has been benefiting from several factors, including (i) its exposure to attractive end markets with visible growth drivers, (ii) solid financial execution despite rising headwinds from currency movements, (iii) strengthening credibility with the investment community, (iv) a well-articulated long-range capital deployment plan, and (v) some speculative interest related to the involvement of activist investors in the shareholder base. We believe that Zoetis’s competitive position and the fundamentals of the overall animal health industry remain strong. While Zoetis’s discount to our intrinsic value estimate has narrowed meaningfully in recent quarters, we continue to view it as one of our long-term ‘compounders’ by virtue of its strong fundamental profile, growth opportunities and attractive returns on capital. We also recognize that the share prices of Novartis, Sanofi, and Zoetis have all benefitted from fund flows into the healthcare sector, which has been one of the best performing sectors and has recently experienced significant merger and acquisition activity.
In addition to the healthcare holdings, several of our consumer and information companies were significant positive contributors in the first quarter including Campari, Google, Nestle, Pearson, Reckitt Benckiser, Sally Beauty and Unilever. All of these companies are highly cash-generative businesses with strong competitive positions and capable management teams. With fixed income rates near zero, it is not surprising that some investors have been allocating capital to “bond-like” equities with these characteristics. Our focus, though, continues to be on these companies’ operating fundamentals, growth rates, cash flows and returns on capital. These are the factors that drive our intrinsic value estimates and investment decisions. Importantly, we are not trying to position ourselves in front of central bank fund flows and we have not lowered the equity discount rates we use to value our companies. In the cases of Campari and Pearson, we were also helped by modest investor expectations. Campari and Pearson both had challenging years in 2014 with Campari working through a major realignment of its production and distribution assets in the U.S. and certain European markets (this is what enabled us to buy shares starting late last year) and Pearson facing headwinds in its U.K. testing and U.S. K-12 businesses amidst regulatory changes and a multi-year transition towards digital products and services. During the first quarter, however, both companies reported solid finishes to 2014 and provided positive outlooks for 2015.
The biggest detractor for Global Core Select in the first quarter was the strong U.S. dollar, which reduced the Strategy’s total return by over 300 basis points3. Other significant negative contributors included our energy exploration and production companies (Arc Resources, Vermilion Energy, Occidental Petroleum, and Lundin Petroleum) and two of our large technology holdings (Microsoft and Qualcomm). Depressed oil and gas prices have continued to weigh on the operating results and share prices of our exploration and production companies, but all four companies have strong balance sheets and are well positioned to withstand an extended period of low energy prices. We have been particularly pleased with the progress Lundin Petroleum, which is the Strategy’s largest holding in the energy sector, continues to make on two large discoveries on the Norwegian continental shelf. In February, for example, Lundin and its partners announced that they had submitted a plan for development of the Johan Svedrup field which will be one of the largest ever developed in the North Sea and has excellent reservoir characteristics. We also see Vermilion as particularly well positioned given its significant production in Europe where both crude and natural gas prices are materially higher than in most parts of North America. Importantly, the managers of our energy businesses are strong capital allocators and all four companies are positioned at the low end of the cost curve. While our investments in the energy sector are not predicated on a near term rebound in energy prices and price volatility is inherent in the sector, our investment team does expect oil and natural gas prices to bottom in mid-2015 and then move higher over time as supply and demand move back into balance.
After posting a 28% total return in 2014, Microsoft’s shares declined by 12% in the first quarter of 2015 driven primarily by a weaker revenue growth outlook due to currency translation pressures, proactive pricing declines for low-end Windows licenses, and difficult growth comparisons relative to 2014 which benefited from accelerated corporate Windows licensing activity as the support period ended for the aging Windows XP platform. On the positive side, Microsoft is seeing strong uptake of cloud services, such as Azure and Office 365, and accelerating unit growth in tablet and phone hardware. Microsoft is also becoming more of a services-led business in an increasingly open and multi-platform computing landscape. Our view has been that this transition will be accompanied by some meaningful changes in the monetization patterns of the Company’s traditional offerings, including Windows, and we believe this is causing some investor anxiety. However, we remain pleased with the strategic clarity and operational execution of the management team as they pursue multiple threads of innovation while maintaining a customer-centric focus and a keen sense of economic value creation. We are also encouraged by the Company’s willingness to challenge its own incumbency by embracing creative destruction within its own walls. Historical evidence shows that large technology companies that resist this behavior tend to struggle in the long run as innovation marches on without them.
Qualcomm reported strong quarterly earnings in late January, but its shares fell sharply as the Company reduced its fiscal 2015 outlook due to challenges in its chip business. These challenges related to customer mix shifts, low-end price pressure in China, and a large customer’s decision to insource a key component. By quarter end, however, Qualcomm’s shares had partially recovered due to the favorable resolution of a long-running anti-monopoly investigation in China. The resolution gives Qualcomm a much clearer path forward in the large and attractive domestic market in China for mobile devices and technologies. While 2015 is proving to be sideways year for Qualcomm from an earnings perspective, we continue to believe that Qualcomm’s industry-leading intellectual property portfolio, engineering capabilities, and pipeline of innovations can drive sustained growth in cash flow and intrinsic value per share over the long term.
Microsoft, Qualcomm, and our other large technology holding, Oracle, all appear to be out of favor with investors. The three companies are trading at low-teens after-tax free cash flow multiples, implying that most investors are expecting little or no future growth. As we noted above, low investor expectations are often good for future shareholder returns. Modest valuations also make share repurchases more powerful in boosting shareholder value. In the first quarter, Qualcomm launched a new $15 billion share repurchase plan (including $10 billion planned over the next twelve months), while Microsoft announced its intention to complete a massive $40 billion share repurchase program by year-end 2016. Oracle has also been a steady repurchaser of its shares. For us and other long-term shareholders, the recent pullback in these companies’ share prices is thus a long-term positive.
Our cash position increased from 5% to 12% during the first quarter as we exited two investments (Target and California Resources Corp) and trimmed several other investments that had appreciated towards our intrinsic value estimates (Bed Bath & Beyond, Brenntag, Intact, Pearson, Sally Beauty, Svenska Handelsbanken, and Wal-Mart). Despite a failed attempt to enter Canada, a large data breach, and a change in management, Target proved to be a successful investment for Global Core Select returning over % in the last nine months. Our initial investment in Target had been predicated on Target’s high levels of customer engagement and the resulting strong free cash flows of Target’s traditional U.S. stores, and these are the factors that have recently boosted Target’s share price. At over $80 per share, however, we viewed Target as fully valued. California Resources Corp (CRC) was a spinoff from Occidental Petroleum. We sold our shares in late February after CRC’s share price had recovered from a post-spin swoon. We did not purchase any new names, but we did add to our existing positions in Campari and Oracle.
At quarter end, our portfolio was trading on a weighted average basis at 85% of our intrinsic value per share estimates. Based on our calculations, our energy and technology companies remain our most attractively valued investments. It is a challenging time to find new companies that meet our investment criteria trading at bargain prices, but we remain highly confident in our approach and expect the passage of time will bring us many compelling investment opportunities.
On behalf of our investment team, we thank you for your continued investment in Global Core Select. We will update you on our companies’ progress during the year.
Timothy E. Hartch
1 MSCI World Index is an unmanaged, free float-adjusted, market capitalization weighted index of approximately 1,600 stocks that is designed to provide an indication of the equity market performance of developed markets. One cannot invest directly in an index.
2 Intrinsic Value: What one estimates to be the value of a company’s common stock based on analysis of both tangible and intangible factors.
3 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.