Global equity markets rose modestly in the second quarter despite heightened tensions in Europe over the Greek debt crisis, a sharp drop in the Chinese equity market, and growing concerns about a debt default in Puerto Rico. Japanese equities were the quarter’s best performing developed market, while European equity indices fell and U.S. equity indices inched higher. Overall, the MSCI World Index rose 0.31% during the quarter bringing the index’s year-to-date return to 2.63%. BBH Global Core Select Composite (“Global Core Select” or “the Strategy”) appreciated 1.33% in the second quarter and is up 1.40% year to date. Global Core Select is a concentrated portfolio of 34 companies that we have constructed without trying to mirror the sector or country weights of any index.
The strongest contributors to performance in the second quarter were Lundin Petroleum, Celanese, and J.C. Decaux. Lundin Petroleum returned 25% in U.S. Dollars in the quarter and was also one of the strongest contributors year to date. We remain very encouraged by the company’s progress on its two key development projects, the Edvard Grieg and Johan Sverdrup fields on the Norwegian continental shelf. Management continues to expect that the Edvard Grieg field will produce first oil in the fourth quarter of 2015, thereby tripling the company’s run-rate production. With the stepped-up production and a strong balance sheet, Lundin should be well positioned to fund the development of the massive Johan Svedrup field which is estimated to begin production in 2019. During the second quarter, Lundin also announced a key management change that reflects in part the company’s transformation from an exploration-led company to more of a development and production company. The company’s CEO, Ashley Heppenstall, is stepping down and will be succeeded by current COO Alex Schneiter. We have high respect for the Lundin management team, which in our view is broad and deep, and are encouraged that Mr. Heppenstall will remain on the company’s board. We continue to view the business as very attractively valued and we added to the position during the quarter. Lundin remains our largest energy investment in the Fund.
J.C. Decaux appreciated by 26% in U.S. Dollars in the quarter and has been one of our strongest performers, both on a year-to-date basis and since the Fund’s inception. As the global leader in the outdoor advertising industry, the company is well positioned to capitalize on very favorable long-term industry dynamics including increased urbanization around the world and the gradual recovery of the European advertising market with low risk of digital disintermediation. J.C. Decaux’s competitive advantages are strengthened by its global scale, strong relationships with global and local advertisers, and a very strong balance sheet which positions it well in terms of contract wins and industry consolidation. The shares have performed well in response to operating results reported in the quarter that exceeded expectations despite ongoing challenges in the Russian market and only a modest advertising recovery in Europe. Additionally, the company announced a €500 million share repurchase program that will be executed via a tender offer in the third quarter. From a valuation perspective, however, the discount to our intrinsic value estimate has narrowed considerably and we trimmed our position during the quarter.
Shares of Celanese rose 29% in the quarter in response to a well-received earnings report that demonstrated Celanese’s ability to increase its earnings power even in the face of pricing challenges, adverse currency movements, and inventory de-stocking in a key product area. The combination of Celanese’s strong commercial execution, its industry-leading cost of production and its ongoing tightening of corporate infrastructure costs substantially offset top-line pressures related to the indirect pass-through effects of lower raw material prices. Notably, the company’s cash flow conversion and its returns on capital showed continued improvement. Although the stock’s recent advance has narrowed its discount to our intrinsic value estimate, we continue to view the risk-reward tradeoff favorably at current levels.
Microsoft, Fuchs Petrolub, and Campari were strong contributors to performance as well. Microsoft reported better-than-expected earnings for its fiscal second quarter as strong contributions from the company’s cloud-related businesses offset continued headwinds related to PC market softness, adverse currency movements, and certain areas of regional weakness. We remain encouraged by the ongoing transformation of the business as Microsoft shifts from a product mindset towards a focus on cloud services and platforms.
Fuchs continues to execute on its strategy to lead the market in providing specialty lubricants that are largely tailored to customers’ applications and processes, supported by relatively high levels of research and development (R&D) and direct sales capabilities. The business model is designed to engender high levels of customer loyalty and pricing power and in turn supports very high returns on invested capital and relatively stable economics despite end-market and macroeconomic volatility. Operating results reported during the quarter demonstrated the resilience of the business model as moderate improvements in key industrialized markets mitigated slower growth in developing markets. The company’s operating results also benefitted from the tailwind of the weakening Euro which, given the significant year-over-year decline, bolstered reported results of its non-European operations.
Campari was a strong performer during the quarter and the Fund’s strongest contributor year to date. The company is performing well relative to what we believe were very low investor expectations going into the year and is poised to improve both sales performance and profitability over time as management begins to leverage a substantial investment and integration cycle. The company operates in the attractive global spirits industry and has invested in broadening the portfolio and more importantly in controlling distribution in key markets that can then be leveraged for product expansion at attractive rates of return.
Detractors from performance in the quarter included retailers Bed Bath & Beyond and Wal-Mart which declined -10% and -13% respectively during the quarter. Shares of retailers partially retraced the strong gains seen in late 2014 which were fueled by expectations that the sharp fall oil prices would provide a boost to consumer spending. That expected “dividend” has yet to be reflected in consumer spending which has remained fairly constrained, particularly in the U.S. mass market. Retailers are also facing significant changes in consumer spending preferences and shopping behavior. The migration to digital modes of purchasing, along with the use of mobile technology and social media, is occurring rapidly. Retailers, as well as consumer companies more broadly, are re-engineering their businesses to defend or enhance their positions in the face of rising competition and fragmentation. Bed Bath & Beyond and Wal-Mart both reported results that reflect these dynamics: sales growth has been modest and largely driven by digitally originated transactions, and both companies are investing heavily in migrating their businesses to serve customers with a model that includes both physical retail and e-commerce. Both companies maintain strong competitive positions that are relevant to their core customer bases (low cost/low price position in the case of Wal-Mart and differentiated product/service position in the case of Bed Bath & Beyond) and excellent physical store locations that can be leveraged to address consumers’ demand for convenience. Bed Bath and Wal-Mart generate very strong cash flows and, given their strong balance sheets and financial flexibility, can invest in technology and fulfillment capabilities while maintaining very high returns on invested capital and returning cash to shareholders.
Qualcomm and Oracle were detractors from performance as well. Qualcomm declined by -9% in the quarter and is down -15% year to date. Investors have been disappointed by the recent performance of the company’s chip business in which low-end price pressure, adverse shifts in OEM market share at the premium handset tier, and the loss of a key component placement at Samsung have impaired the near-term revenue run rate and margin performance of this business. Conversely, Qualcomm’s technology licensing segment has enjoyed the benefits of strong unit volumes and higher average selling prices of mobile devices, fueling sizable gains in aggregate industry sales upon which the company’s IP royalties are levied. Moreover, the settlement of a lengthy regulatory inquiry in China has improved the outlook for the business as previously unreported sales of royalty-bearing devices will now be recognized. We continue to believe that Qualcomm has unmatched engineering capabilities that create enormous value for the global ecosystem of device manufacturers, wireless carriers, and end users. Our valuation work suggests that even with a conservative forecast applied to the technology licensing business, little or no value is being attributed to the chip business at today’s share price. While the company still faces competitive and execution related challenges in the chip business that will require careful management of the cost structure and commercial strategy, we believe that the stock’s current valuation offers a very attractive long-term opportunity and we added to the position late in the quarter.
We also added to our position in Oracle as the shares traded lower following the company’s release of fiscal fourth quarter results. Oracle’s report showed similarities to those of other software companies that have transitioned parts of their business models from license and maintenance revenue to subscription-based billing. This transition typically results in slower recognition of near-term revenues alongside front-loaded sales and marketing expenses and capital expenditures. The net effect is lower reported revenue, margins, and cash flow for several quarters until revenue recognition increases in future periods. For Oracle, this shift was exacerbated by a particularly strong selling performance in Europe which negatively impacted U.S. Dollar-based results and the company’s blended tax rate. Looking past the transitory impacts of the business model shift, we believe Oracle’s cloud-based product suite is gaining traction with IT procurers, leading to improved sales execution and a growing list of reference customers. The related increases in organic capital expenditure are an attractive reinvestment into Oracle’s business as they represent a layering of visible, profitable streams of future billings. Organic reinvestment opportunities of this caliber have been reasonably rare for cash-rich legacy technology companies in recent years.
Lastly, Solera Holdings declined -13% during the quarter as low transaction volumes in its core automotive claims business led to weaker-than-expected quarterly earnings. Solera also earns most of its profits in Europe, and the strengthening U.S. dollar has presented a meaningful headwind to reported earnings. Over the last two years, Solera has aggressively acquired businesses and point solutions with the objective of expanding beyond claims processing and positioning the company to offer comprehensive solutions that extend into vehicle maintenance and repair and driver behavior analytics. It is still too early for us to determine how successful these acquisitions have been. During the quarter we reduced our investment in Solera, although as the shares fell further during the quarter we stopped selling. We believe many investors are waiting to see if Solera’s organic growth reaccelerates in the second half of 2015.
The portfolio ended the quarter trading on a weighted average basis at 84% of our intrinsic value estimates and with 39% of the strategy concentrated in the top 10 holdings. Our cash position increased from 11.4% to 14.7% during the quarter as we trimmed a number of positions when prices approached our estimates of intrinsic value. We did not purchase any new companies during the quarter as valuations remain rich for most high quality, cash-generative businesses. We believe that being selective and maintaining our valuation discipline are particularly important today for achieving attractive returns and protecting against large losses. Our investment team has also developed a strong pipeline of investment candidates across the globe and we believe that if we are patient, macroeconomic dislocations or company-specific challenges may give us opportunities to make compelling purchases. We also remain very focused on aligning ourselves with executives who have proven track records of allocating capital intelligently to create shareholder value.
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: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.