Market volatility continued during the third quarter influenced by the cross-currents of geo-political dynamics and trade tensions which have had real impacts in terms of both dampening of demand and investment in some sectors and creating significant shifts in risk appetites and resultant sector rotations. The MSCI World index registered a modest gain of 0.53% for the quarter, with a “risk-on” gain in September recovering the declines seen in August. BBH Global Core Select Class N (“Global Core Select” or “the Fund”) appreciated by 1.36%, bringing the year-to-date gain to 21.20% while the MSCI World index gained 17.61% year-to-date. The U.S. Dollar has strengthened against most major currencies and was a headwind to returns in the quarter of more than 150 basis points.1
We see increasing risks to growth and earnings with elements of the global economy under pressure in part due to trade tensions, and the ongoing saga of Brexit remains a source of uncertainty. In this context, we are very pleased with the operating performance of our portfolio companies, and we continue to focus intensely on businesses that have structurally strong and competitively advantaged market positions and that we believe can demonstrate resilience during periods of economic uncertainty; at the same time, we remain mindful of valuation.
Among our best performing investments in the third quarter were Alphabet, Zoetis, and Deutsche Boerse. Alphabet gained 12.8% in the quarter, more than recovering its second quarter decline and bringing the year-to-date return to 17.7%. Alphabet’s shares reacted positively to its July earnings report in which revenue growth returned to rates comparable to last year, validating management commentary that the slowdown in growth in the first quarter was a function of the timing of product changes and that the structural tailwinds to the company’s growth remain firmly in place. Management offered additional disclosures on several fronts, including the Google Cloud business which is receiving continued investment as one of the fastest growing products within Alphabet, and it expects to triple the size of the Cloud sales force over the next few years to support and sustain this growth. The company also increased the share repurchase authorization of its Class C shares to $25 billion, an action we support given the significant cash balance and the current share price’s discount to our estimate of intrinsic value.2 Overall, we believe the company’s operating performance demonstrates the broad strength of Alphabet’s portfolio and that the investments in cloud, hardware, machine learning, voice, and augmented/virtual reality will benefit Google’s core as well as its broader ecosystem.
Zoetis’s share price appreciated by 10% in the quarter bringing its year-to-date gain to 46%. Shares responded positively to strong operating results reported during the third quarter which demonstrated the company’s excellent execution, including the continued strong growth of the company’s dermatology portfolio and management’s ability to navigate pockets of challenging end markets in the livestock segment. An expedited timeline of key product launches that should support a robust new-product life cycle positions Zoetis well to enhance its operating performance. Over the long term, we believe new products should continue to allow the company to maintain its leadership position and continue to outpace the rate of growth in the broader animal health industry, an industry that we view as very attractive. Animal health is largely shielded from any of the issues in human healthcare, such as pricing pressure and reimbursement challenges, and benefits from healthy growth rates that are supported by pricing power.
Deutsche Boerse gained 10.4% in the third quarter, building on the strength that we had seen in the second quarter and bringing the year-to-date return to 33%. Shares responded positively to second quarter results in which the company reported solid mid-single-digit revenue growth and 10% profit growth, all on a secular basis and bolstered by company initiatives to improve its cost structure. Operating performance underscored management’s ability to achieve the objectives of its structural growth strategy, which we expect to be supported by ongoing bolt-on acquisitions.
Fairfax Financial Holdings, Henry Schein, and Lloyds Banking Group were the most significant detractors from performance during the third quarter. Fairfax shares declined by -10% in the quarter with no company-specific catalyst for the weakness; we believe the decline was more a function of market rotation dynamics, though the low rate environment does pose a headwind to the company’s investment income. Fairfax reported solid second quarter operating results during the quarter with good contributions from its insurance operations and positive trends in the combined ratio across major insurance businesses. The pricing environment continues to be favorable with strong premium growth across the majority of Fairfax’s lines. The outlook for property and casualty insurance pricing remains constructive and we expect Fairfax to be a beneficiary of a hardening market. Shares are trading below book value and we believe Fairfax has the potential to deliver strong mid-teens returns on equity and continue to grow book value per share at attractive rates. As such, we viewed the recent share price weakness as an opportunity to add to our position.
Henry Schein declined by 9% as indications of a growth slowdown in the dental industry began to emerge in July and was further confirmed in Henry Schein’s own quarterly report in August. Market deceleration was most pronounced in equipment sales in North America and was partially the result of the timing of promotional activity. Sales of dental consumables in North America were steadier by comparison, but they did show a modest slowdown as well. We are not especially concerned by these short-term trends – we see the broad dental industry as being a steady long-term grower with favorable demand characteristics and relatively low risk from reimbursement pressures. In contrast to the growth dip in North America, Henry Schein’s International business performance was steady, and the company’s Medical distribution segment continued to grow at a very solid rate.
Lloyds’ U.S. Dollar return was -5% in the quarter, with the local return decline amplified by weakness in the British Pound relative to the Dollar; the year-to-date return in Dollar terms was 6.6%. Shares were pressured as interest rate expectations have come down globally, which in turn has negatively impacted bank valuations, and as the prospect of a “hard Brexit” occurring at the end of October continued to rise. Management’s guidance is predicated on one rate increase per year through year-end 2020, and this scenario appears to be increasingly unlikely; based on our discussions with the company, we would expect Lloyds to try to compensate through efficiency measures. The ongoing Brexit saga and the prospect of a hard Brexit has pressured sentiment and, coupled with trade uncertainties, has buffeted business activity. Sentiment has weighed on the British pound as well, detracting from our performance in U.S. Dollars. Importantly, key tenets of our investment thesis in Lloyds are its strong downside protection and compelling value over the long term, even in a hard Brexit scenario. While revenues may be weaker than otherwise in that scenario, we would also expect reduced loan losses and funding costs alongside lower interest rates. Lloyds has a meaningful cost advantage over its peers, driven by its efficiency and leadership as both a digital and physical bank. Lloyds remains extremely well capitalized, and we believe it has the opportunity to take market share from less efficient, less well-capitalized peers.
We added one new investment to the Fund during the third quarter, Booking Holdings. Booking owns a collection of leading global online travel agency (OTA) brands including Booking.com, Priceline.com, Agoda.com, and Rentalcars.com, as well as travel metasearch website KAYAK and OpenTable, the reservation platform for restaurants. Across its platforms, Booking Holdings has more than 30 million listings in nearly every country. The company benefits from two secular tailwinds: share shift from traditional to online channels for booking travel and increasing consumer spending on travel and experiences. OTAs benefit from network effects as consumers choose the platform and suppliers list on the platform with the most demand. The scale of Booking’s platform increases the company’s value as a channel to match supply and demand. Booking also focuses on overnight accommodations, a segment of the market in which local scale is particularly relevant. The company is the dominant player in Europe, where the accommodations market is very fragmented and independent hotel market share is 60%-70%, giving Booking better pricing power with customers and supporting higher aggregate commission rates and profitability relative to smaller competitors. The network effects and barriers to entry that Booking enjoys result in a strong financial profile that we believe to be sustainable, reflected in strong returns on invested capital and high free cash flow conversion.
We exited three positions during the quarter, Wells Fargo, PayPal Holdings, and JCDecaux.
In July, we sold our position in Wells Fargo, which had been a solid long-term contributor to Core Select’s results but was a more troubled story in recent times following a sequence of operational and oversight blunders that attracted regulatory censure and substantial remediation costs. This reputational pall was a factor in our decision to sell, but as of mid-year, we had also been carefully considering other developments, including i) resumed downward pressure on interest rates and a potential reversal in the Federal Reserve policy stance; ii) the elongated period of time without a permanent CEO in place; and iii) our growing perception that the company’s incremental recurring expenses for compliance programs, legal advice, risk management, and process remediation were becoming more structural than transitional in nature, creating an efficiency burden that competitors may not face to the same degree.
Starting in 2017, we had periodically trimmed our position in PayPal as the share price appreciated, driven by the company’s strong fundamental performance, intelligent capital deployment, and strong investor sponsorship. In hindsight, our early trims now appear to have been overly conservative, as PayPal proved able to sustain a high rate of earnings growth. Maintaining an appropriate risk-adjusted margin of safety3 in each of our investments remains a key part of our valuation discipline, and as such, while we aspire to participate as fully as possible in share-price upside for our holdings, we will sometimes favor the side of caution and reduce our positions on the way up. We continued trimming PayPal this year and ultimately sold the balance in mid-August. While the company’s absolute earnings growth has remained very strong, we also (at the time of our sale) held the view that there could be certain areas of potential growth deceleration as 2019 progressed, creating risk for the share price given its robust valuation and long run of gains.
We exited our position in JCDecaux as we believe that the high and rising fixed-cost intensity of the business may continue to hinder the its ability to improve its (return on invested capital) ROIC and free cash flow generation relative to our initial investment thesis. We are concerned that the company’s bargaining position with its landlords has weakened and that, combined with the increasing sophistication of its customers, could continue to cap JCDecaux’s returns. While the outdoor advertising industry has been resilient relative to trends in other media such as print and TV and we have seen growth in digital displays within outdoor advertising, this has come from cannibalization of existing analog displays. Increased industry capacity enabled by digital may lead to greater margin pressures in the event of a demand-driven downturn. Taken together, we decided to exit our small remaining position and redeploy the capital into investments that we deem a stronger fit with our criteria.
With respect to additional portfolio changes, we added to our positions in Alcon, Bureau Veritas, Heineken Holding, Fairfax, Henry Schein, Mastercard, and Fuchs Petrolub, and we trimmed our position in FleetCor Technologies.
We ended the quarter with 31 portfolio companies and 47.5% of the portfolio in the top 10 positions, a cash position of 3.5%, and our weighted-average price-to-intrinsic-value was 87%.
On behalf of our entire 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.
Regina Lombardi, CFA
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.
The strategy is 'non-diversified' and may assume large positions in a small number of issuers which can increase the potential for greater price fluctuation. Investors should be able to withstand short-term fluctuations in the equity markets in return for potentially higher returns over the long term. The value of portfolios changes every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.
Data presented is that of a single representative account ("Representative Account") that invests in the strategy. It is the account whose investment guidelines allow the greatest flexibility to express active management positions. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the proposed investment strategy.
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Gross of fee performance results for this composite do not reflect the deduction of investment advisory fees. Actual returns will be reduced by such fees. "Net" of fees performance results reflect the deduction of the maximum investment advisory fees. Performance calculated in U.S. dollars.
The Composite includes all fully discretionary, fee-paying global equity accounts over $10 million that invest in a portfolio of approximately 30-40 companies primarily in developed markets, with a focus on companies with market capitalizations over $3 billion. Under normal conditions, at least 40% of investments will be in companies headquartered outside the United States. The strategy is benchmarked to the MSCI World Index (net of foreign withholding tax).
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IM-07060-2019-10-16 Exp. Date 01/31/2020
1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
2 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
3 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.