Equities in most geographic regions appreciated in the third quarter as easy monetary conditions continued to buoy financial assets worldwide and global economic conditions remained subdued. Advanced economies such as the U.S. and U.K. have generally experienced modest and weaker-than-expected economic growth this year as productivity improvements appear to have stalled and shocks such as heightened regulatory pressures, the Brexit1 vote, and the polarizing U.S. presidential election have dented both consumer and business confidence. Meanwhile, growth in several emerging markets has picked up, although not to the extremely robust levels of several years ago. For investors, the contrast between the continued surge higher in equity valuations and a global economy that appears stuck in low gear highlights the importance of (i) owning a limited number of resilient businesses with strong cash flows and balance sheets that are well positioned for long-term success, (ii) having a disciplined valuation framework for deciding when to purchase and sell, and (iii) being patient and willing to wait for the market to provide better opportunities in the future.
BBH Global Core Select Composite (“Global Core Select” or “the Strategy”) appreciated 3.54% in the third quarter and 7.49% year-to-date. The comparable figures for the MSCI World Index are 4.87% for the quarter and 5.55% year-to-date. Since Global Core Select’s inception in March 2013, the Strategy has compounded at 6.58% per year versus 7.57% for the MSCI World Index. Global Core Select is a concentrated portfolio that is largely unconstrained by geographic or sector requirements and we do not manage it to track the returns of any index. Our objective is to compound the capital that has been entrusted to us at an attractive rate of return over many years while seeking to limit both price and business risks, thereby avoiding large, permanent losses. We also believe strongly in backing managers who are honest, good operators, strong capital allocators, and aligned with shareholders.
Our largest positive contributor in the third quarter and year-to-date was Qualcomm, which gained 29% in the quarter and is up over 40% since the beginning of the year. Its shares rose sharply in July after the Company released better-than-expected second quarter earnings and reported substantial progress with intellectual property royalty collections in China and solid smartphone chipset shipments. Qualcomm is also making progress on a cost realignment program that is boosting operating margins and free cash flow generation. 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 the closing days of the quarter, 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. While the prospect of a deal lifted Qualcomm’s share price, we tend to be wary of large, transformative acquisitions given the execution risk involved.
Two other portfolio companies, FleetCor2 and Vermilion, were also up over 20% in the quarter and have appreciated over 40% year-to-date as well. FleetCor reported strong quarterly earnings and announced the successful closing of its purchase of STP, the largest toll processor in Brazil. Despite some challenges related to low fuel prices, foreign exchange pressures, and pockets of weakness in the global economy, the Company indicated steady progress in its core fuel card businesses and remarkable growth from the acquired businesses within Comdata, which FleetCor has been operating since December 2014. Additionally, the Company announced a new major partnership with Speedway, the fifth largest fuel marketer operating in the U.S., as well as a smaller acquisition in the Netherlands. Vermilion, which is a Canadian exploration and production company, benefitted from a rally in oil and natural gas prices; the ramp-up in production from a large natural gas field in Corrib, Ireland; and a growing operating presence in Continental Europe (France, Netherlands, Germany, and Eastern Europe). The last three years have been extremely challenging for the oil and gas industry and Vermilion is one of the few large oil and gas companies that has been able to continue growing its production at a double-digit annual rate while also paying a large cash dividend (currently yielding 5%).
Other strong contributors in the third quarter included our other technology holdings (Alphabet, Microsoft, and PayPal) largely due to strong earnings results and continued robust operating metrics and several European holdings (Campari, Fuchs Petrolub, Brenntag, and Svenska Handelsbanken), which all moved higher after Brexit fears subsided.
Our biggest negative contributor for the quarter was Aggreko, the U.K.-based provider of temporary power solutions, which was down -26% in the third quarter after being up over 27% in the first half of 2016. As we had noted in our second quarter letter, Aggreko’s shares have been extremely volatile over the past year as investors and sell-side analysts have reacted to near-term developments in the energy and refining sectors and the likelihood of certain contract renewals. From a longer term perspective, however, Aggreko continues to enhance its competitive position by modernizing its fleet, investing in new fuel-efficiency technology, and reducing its cost structure. Aggreko has also had a record year of new bookings in 2016, which should boost 2017 profitability. Having sold Aggreko shares in June above £12, we bought shares back in September at £10.
Our two other large negative contributors in the third quarter were French pharmaceutical company Sanofi (down -8%), and U.S. bank Wells Fargo (down -6%). The main challenge for Sanofi has been price erosion and competitive pressure in the U.S. diabetes market, which had historically been a strong and growing profit generator for Sanofi. Sanofi was also in the news in the third quarter for being outbid by Pfizer for the acquisition of Medivation, a promising biotech company. While the media portrayed Sanofi’s decision not to top Pfizer’s offer for Medivation as a loss, we were pleased that Sanofi exercised financial discipline on a large capital allocation decision. With respect to the diabetes franchise, there is considerable uncertainty, but Sanofi is a diversified company and its vaccines, consumer health, and rare-disease businesses are all performing well. At quarter end, Sanofi was trading at approximately 12x 2016 earnings per share and at a meaningful discount to our intrinsic value3 estimate.
Wells Fargo’s shares have been pummeled recently because the Company agreed to pay a $185 million fine to settle allegations that many of its branch employees had opened a large number of accounts without their customers’ consent in order to meet certain internal cross-selling goals. While the resulting fees paid by Wells Fargo’s customers were not significant and have been fully reimbursed by the Company, politicians seized on the scandal and berated Wells Fargo’s CEO John Stumpf and other senior executives in a series of Congressional hearings. This account-opening scandal has been a huge embarrassment for Wells Fargo and may lead to certain management changes and additional fines, but we do not see it as having a material impact on Wells Fargo’s long-term profitability or prospects. Retail bank relationships are typically very sticky and Wells Fargo has one of the strongest deposit franchises in the world. On a run-rate basis, Wells Fargo is also generating over $35 billion per year in pre-tax, pre-provision profits and has a strong capital position. At quarter end, Wells Fargo was trading at a similar price-to-book multiple as it did during the height of the Financial Crisis and at a substantial discount to our intrinsic value estimate.
Portfolio Changes and Valuation
We trimmed a number of positions during the third quarter for valuation reasons. These companies included Nestlé, Reckitt Benckiser, and Fuchs Petrolub. As noted earlier, we have some doubts about Qualcomm’s rumored plan to acquire NXP Semiconductor and, with its shares trading higher on the rumors, we trimmed our Qualcomm position in late September.
In addition to adding to our Aggreko position, we purchased a new position for Global Core Select in Liberty Interactive Corp., which owns the leading video commerce retailer, QVC. We have owned Liberty Interactive in other BBH portfolios for many years and view QVC as having a highly differentiated and competitively advantaged retail model with a very loyal customer base, attractive returns on capital, and high levels of free cash flow. In August, however, Liberty Interactive’s shares fell over 20% after management noted that QVC’s U.S. business had seen a meaningful slowdown in sales starting in June and continuing into the third quarter. We took advantage of the pullback and purchased an initial position for Global Core Select. In our estimation, Liberty Interactive’s shares are currently being valued as if QVC’s business is in permanent decline, which we view as unlikely. While retail today is highly competitive and changing rapidly due the ease of online purchasing and price discovery enabled by surging smartphone usage, QVC has done a good job shifting its business online (eCommerce now accounts for 49% of QVC’s U.S. sales) and to mobile (53% of eCommerce sales). Liberty Interactive’s leadership team is also skilled at capital allocation and has historically bought back stock very astutely.
Global Core Select ended the quarter trading on a weighted average basis at 83% of our intrinsic value estimates and our cash position was 8.0% of total assets. While we believe that equities broadly are expensive, we do have a number of current investments trading at substantial discounts to our intrinsic value estimates. These include Oracle, Discovery, Wells Fargo, Sanofi, Aggreko, Bed Bath & Beyond, and Liberty Interactive. Conversely, certain of our consumer, healthcare, energy, and industrial names are trading near their intrinsic value estimates. As we did in the third quarter, we will continue to rotate our capital out of businesses trading at high valuations and into businesses with larger discounts to intrinsic value.
With the Federal Reserve talking yet again about raising short-term interest rates, the U.K. pondering how to proceed with its Brexit plans, the U.S. presidential election looming, the Middle East still in turmoil, and China trying to restructure and rebalance its economy without triggering a financial or social crisis, we anticipate considerable stock market volatility. Fortunately, our investment process benefits from price volatility because price movements give us opportunities to buy at attractive levels and sell when we judge shares to be expensive. We also believe that our companies are resilient and can prosper in both good and bad economic times. While we certainly hope for strong global growth, we strive to be prepared for the inevitable challenges.
On behalf of our investment team, we would like to thank you for being an investor with us in Global Core Select. Please feel free to contact us with any questions or suggestions.
Timothy E. Hartch
Regina Lombardi, CFA
1 British exit from the European Union
2 FleetCor year-to-date performance measured from date of Global Core Select’s first purchase in January 2016.
3 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.