Equities around the world surged in the third quarter making 2017 yet another very good year — at least so far — for equity investors. BBH Global Core Select Composite ("Global Core Select" or "the Strategy") appreciated 3.84% in the third quarter and is up 18.43% year-to-date. The comparable figures for the MSCI World Index are 4.84% for the third quarter and 16.01% year-to-date. All but three of our 34 portfolio holdings this year have had positive year-to-date performances with 22 registering double-digit returns and eight of the top 10 gaining 20% or more.
The strongest contributors to Global Core Select’s performance in the third quarter were PayPal Holdings, Diageo, and Wendel. PayPal gained 19% during the quarter and is our strongest contributor this year with a gain of 62%. PayPal has maintained a pace of very strong revenue and earnings results driven primarily by favorable secular trends toward online and mobile payments that have powered double-digit growth in active users and payment volume. The Company’s key business metrics such as payments per user, principal per transaction, overhead expense leverage, and free cash flow conversion also remain very strong. We have been very pleased with the management team’s strategic decisions and operational execution over the last few years as PayPal has not only grown its core ‘payment button’ business, but also broadened its offerings to meet the evolving needs of consumers, merchants, and other players in the payments value chain. One area that has been particularly successful has been the Company’s development of the peer-to-peer payment platform Venmo, which combines ease of use with unique social engagement features. We believe that PayPal’s shares are now trading near our intrinsic value1 estimate and we trimmed our position in the third quarter.
Diageo and Wendel, our sixth and fifth largest positions, respectively, increased 13.46% and 9.63% and shares of both companies have appreciated significantly year-to-date, with Diageo up 33.10% and Wendel gaining 39.10%. Diageo’s fiscal-year-end results and forward guidance confirmed that management’s efforts to drive more consistent growth and cash flow generation from the Company’s strong portfolio of brands are delivering results. The Company has made progress streamlining its organizational structure and taking a more disciplined approach to sales and channel management. Sales growth is being driven by robust performance in both developed and developing markets from key global brands such as Johnnie Walker, Captain Morgan, Baileys and Tanqueray, as well as Diageo’s Reserve brands and strong regional and local brands in the U.S., Latin America, and China. Additionally, the Company is increasing its cost savings and productivity improvement efforts, with a focus on largely reinvesting savings into sales, marketing, and new product development to sustain the top line while generating modest margin improvement as well. These initiatives combined with strong working capital management are delivering strong free cash flow, and management plans to repurchase up to £1.5 billion during the current fiscal year.
Wendel has been a positive contributor since our initial investment last year. In our view, the Company is an excellent owner and manager of businesses and has a strong track record of growing net asset value and deploying capital astutely, demonstrating appropriate caution in respect to valuation. Wendel’s portfolio consists of both listed and unlisted assets, including a 40% stake in French testing and inspection company Bureau Veritas; Stahl, a provider of essential specialty chemicals to the global leather goods industry; IHS, a leading operator of wireless telecommunications towers in Africa; and Allied Universal, a U.S.-based leader in the security services industry. Underlying operating results for most of Wendel’s portfolio companies were strong for the first half of 2017 and the Company’s Net Asset Value has grown by 13.7% over the trailing 12-month period. The Company also announced a management transition that will take effect over the coming months as Frederic Lemoine, the CEO who has successfully led the Company over the last nine years, is planning to step down, and a new CEO is expected to be appointed during the fourth quarter. While the announcement was surprising, key members of the team who play critical roles in respect to Wendel’s investing activity are remaining at the Company. We believe that the Board is focused on candidates that can bring important incremental capabilities to the role as the Company seeks to increase its operational involvement in portfolio businesses and also to deploy €3-4 billion of capital—primarily in unlisted assets—over the next three years, a focus that we view as appropriate at this stage of the Company’s development. We are pleased that
Wendel is a large investment in the portfolio and the current share price represents a significant discount to Net Asset Value per share, offering a strong margin of safety2 in our view.
The largest detractors from performance in the third quarter were cable network programmer Discovery Communications, U.K.-based consumer goods manufacturer Reckitt Benckiser, and Oracle. Continuing a difficult 2017, Discovery’s shares slid by nearly 20% in the quarter as investors expressed concern about subscriber-loss trends and the Company’s large takeout bid for Scripps Networks was met with skepticism. In its July pre-announcement of second quarter results, Discovery’s management noted incremental softness in U.S. subscriber trends, which in turn impacted advertising and affiliate fees. The Company also lowered its forecast for 2017 international revenue growth due to competitive pressures in certain markets and a strategic decision to shift the business model for soccer rights toward online-only delivery. Despite these headline issues, Discovery’s actual financial results were in line with our own expectations and we continue to view Discovery’s core cable networks as resilient businesses that should be able to navigate the changing media landscape by developing partnerships with distributors and building direct-to-consumer franchises. We also have a favorable view of Scripps’ three big networks (HGTV, Food Network, and Travel Channel) and believe that Discovery should be able to realize significant cost and revenue synergies.
Reckitt Benckiser’s share price has come under steady pressure this year and declined by -8.75% in the third quarter as organic sales growth has moderated due to both slowing market conditions and company-specific issues, most recently a significant cyber-attack on the Company’s systems which disrupted order fulfillment during the second and third quarters. While management has made some missteps in execution over the past year, we continue to view Reckitt as a well-managed business with a strong portfolio of brands that is increasingly focused on consumer health and hygiene, categories which are accretive to both growth and profitability. The Company has an excellent track record of acquiring and increasing the values of undermanaged franchises, and we believe that the recent acquisition of Mead Johnson, which gives the Company entry into the infant nutrition category in key markets including China, should deliver both cost and revenue synergies and create significant shareholder value.
Oracle declined -3.21% in the quarter, retracing a small portion of the strong gains the investment has delivered this year. Oracle remains our largest position in the Strategy and has still gained over 27% year-to-date. The share price decline occurred in the wake of the Company’s fiscal first quarter earnings results and despite strong operating performance and continued strength in both its database and application franchises. The operating results support our view that Oracle is successfully executing its business transformation with rapid cloud-based revenue growth continuing to drive solid mid-single-digit overall revenue growth, the vast majority of which is recurring in nature.
We did not purchase any new investments during the third quarter, however, we did continue to build our position in Lloyds Banking Group, an investment that we initially added to the portfolio in the second quarter. As we discussed last quarter, Lloyds is a leading U.K.-centric retail and commercial bank which has undergone a significant and successful transition over the past six years under the leadership of its current management team and has evolved into a simple, low-cost, low-risk, customer-oriented bank. It is a strong fit with our investment criteria and is trading at an attractive price relative to our intrinsic value estimate. In addition to our increase in Lloyds, we added modestly to our positions in Perrigo, Discovery, and QVC at prices that we view as very attractive.
We exited three investments during the quarter: Bed Bath & Beyond, Rotork and Wal-Mart. We sold our remaining position in Bed Bath & Beyond at a substantial loss. We are very disappointed in this outcome since one of our key aims for Global Core Select is to avoid the permanent loss of capital on each investment. At the time of our investment, we believed that Bed Bath & Beyond met our criteria based on our view that: (i) it was a category-leading retailer of essential products to a loyal customer base in a highly-fragmented industry; (ii) it had solid financial characteristics including strong returns on invested capital, a debt-free balance sheet, and consistently high cash generation; and (iii) it had a long-tenured management team that had consistently been customer-centric and focused on long-term value creation. We recognized the need for Bed Bath & Beyond to make substantial investments in developing e-commerce capabilities as well as the structural shifts that were occurring in the retail industry and sought to capture those pressures when estimating the intrinsic value of the business. However, it has become increasingly evident that transitioning organically from a bricks-and-mortar format to a combined store-based/e-commerce format is very difficult and costly to execute, especially when the industry is being disrupted by pure-play e-commerce participants operating low/no-profit business models. With the benefit of hindsight, we underestimated the impact of these changes on BBBY’s financial model and, while the business remains very profitable and cash-generative, margins and returns have declined significantly relative to where we believed they would stabilize.
Rotork announced in July that its long-time CEO would be leaving the Company due to an apparent dispute with the Board of Directors and a permanent successor has yet to be determined. We held the outgoing CEO in high regard and believed management was very effectively managing the business, particularly in the context of challenging end-market conditions. We were surprised by the CEO’s departure and given the related uncertainty as to succession and the potential for a shift in strategy, we decided to exit the position. We recognized a meaningful profit on the sale of our Rotork shares.
We sold our remaining shares in Wal-Mart as the share price reached our estimate of intrinsic value. Wal-Mart has been a holding in Global Core Select since the inception of the Fund and has been a positive contributor to performance over the holding period. Wal-Mart remains the world’s largest retailer, operates a highly cash-generative business, and is well positioned to leverage its size, scale and growing e-commerce capabilities to retain its leadership position in rapidly changing consumer and retail environments. Management is appropriately taking a much more aggressive approach towards transitioning the business, including increasing the use of technology to reduce costs and solidifying Wal-Mart’s low-cost competitive position as well as leveraging its core assets to grow e-commerce. We believe the Company has multiple levers to mitigate the downward pressure that a growing e-commerce business can place on margins and returns. However, in our view the positive fundamentals are now fully reflected in Wal-Mart’s share price.
We ended the quarter with 30 portfolio companies trading on a weighted average basis at 87% of our intrinsic value estimates. 45% of our assets are concentrated in the top 10 holdings and our cash position ended the quarter at 7.8%. Overall, we view valuations across much of the market as being high. Nonetheless, we remain focused on concentrating our investments in a select portfolio of market-leading, high-returning, cash-generative businesses managed by strong capital allocators and where valuation offers a margin of safety. Our aim is to compound returns at attractive absolute rates for our clients over the long term. We continue to build a wish list of companies that meet these demanding criteria and will not hesitate to invest capital when these wish-list companies are trading at significant discounts to our appraised values.
On behalf of our entire investment team, we thank you for your continued investment in Global Core Select and look forward to updating you on our companies’ progress during the year.
Timothy E. Hartch
Regina Lombardi, CFA
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IM-2017-10-18-4425 Exp. Date 01/31/2018
1 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
2 A margin of safety exists when we believe there is a significant discount to intrinsic value at the time of purchase – we aim to purchase at 75% of our estimate to intrinsic value or less.