Large-cap U.S. equities led global markets higher in 2014, while most international equity indices posted modest gains. The sharp appreciation of the U.S. dollar in the second half of the year, however, means that most European and Asian equity indices ended 2014 down meaningfully when measured in U.S. dollars. In addition to the surging U.S. dollar, the other major macroeconomic development in 2014 was a more than 40% fall in oil prices in the second half of the year prompted by increasing oil production in the U.S., lower global demand due to economic weakness in Europe and emerging markets, and OPEC’s decision not to cut oil production. Lower energy prices should be a major positive for global economic growth in 2015, although for certain oil-producing countries such as Russia and Venezuela, as well as for many energy production and service companies, the sustained low prices could prove very destabilizing. Lastly, 2014 was another year of record-low interest rates in most countries due to aggressive monetary policy by central banks which led to strong price appreciation of high-dividend-paying sectors such as utilities and healthcare as investors searched frantically for yield.
The BBH Global Core Select Composite (“Global Core Select” or “the Strategy”) rose 0.39% in the fourth quarter bringing its full year gain to a modest 1.65%. The comparable figures for the MSCI World Index are 1.01% for the fourth quarter and 4.94% for the full year. Since its inception in April 2013, Global Core Select is up 9.94% while the MSCI World Index has risen 12.76%. Global Core Select ended 2014 with positions in 36 businesses and a weighted average price to intrinsic value of 85%, slightly lower than the 86% level at the start of the year. Our cash position at year end was 5.0%.
The trends mentioned in the first paragraph above were evident in our portfolio. The Strategy’s leading positive contributors in 2014 were mainly U.S. companies (Wells Fargo, Microsoft, Zoetis, Target, Oracle, and Sally Beauty). Swiss healthcare giant Novartis, was also a big positive contributor. Largely offsetting these gains were losses from (i) a number of our foreign businesses (Tesco, Sanofi, Pearson, Diageo, and J.C. Decaux), (ii) Google and Solera, which both generate more than 50% of their sales abroad, and (iii) our energy investments (Lundin Petroleum, ARC Resources, Vermilion Energy, Occidental Petroleum, and Schlumberger).
Several dramatic shifts in investor sentiment toward certain sectors were a noteworthy aspect of 2014. For example, all of our retail companies were down sharply in the first half of 2014 amidst fears about online competition and weak consumer sentiment but then rallied strongly in the second half of the year (with the exception of Tesco) due to modestly better same-store sales and the prospect of lower energy prices boosting consumer spending. We were able to take advantage of the excessive pessimism in the first half by adding to our positions in Bed, Bath & Beyond and Sally Beauty at meaningful discounts to our intrinsic value estimates and both names were big contributors in the second half of the year. Late in the fourth quarter we modestly trimmed our positions in Target and Wal-Mart after their shares had moved closer to our intrinsic value estimates.
The other sector that saw a dramatic reversal in 2014 was energy. After being among the best performing sectors in the first half of 2014, the share prices of most energy companies plummeted with falling oil prices late in the year. While we had not expected such a large decline in energy prices at this time, we have always recognized that energy prices are inherently volatile with small changes in supply and demand leading to big swings in near-term prices. Accordingly, we have focused on exploration and production companies with strong balance sheets, a proven ability to operate at the low end of the cost curve, and long-lived reserves in politically stable regions to support sustained production growth. These favorable attributes should enable our exploration and production companies to weather the current low commodity price environment and emerge stronger as energy prices rebound over time toward the marginal cost of production, which we believe is materially above current levels for both oil and natural gas. We purchased shares of Lundin Petroleum and added to Vermilion Energy in the third quarter and then added further to both companies at even lower prices late in the fourth quarter. Both companies will likely benefit over time from the near-term weakness in energy prices. For example, Lundin is in the process of developing two massive off-shore discoveries and the sharp pullback in energy industry activity levels means that the likelihood of Lundin’s projects progressing on time and under budget has greatly increased. Similarly, Vermilion has a degree of financial flexibility supported by its strong balance sheet and a meaningful percentage of its profits earned from European natural gas, for which prices remain attractive. Based on our current intrinsic value estimates, Lundin and Vermilion are Global Core Select’s two most attractively valued investments.
2014 was also interesting in that a number of our companies whose share prices fell this year were companies whose share prices had appreciated significantly in 2013. For example, Solera, which provides claims software and workflow solutions for the automotive insurance industry, fell 28% in 2014 after appreciating over 30% in 2013. In Solera’s case, the company continued to report respectable organic revenue growth in 2014, but the company faced significant currency headwinds and a cyclical slowdown in automotive claims in several of its key European markets. Other companies that did very well for us in 2013 but not in 2014 included: (i) internet search giant Google; (ii) global spirits leader Diageo; and (iii) French outdoor advertising firm J.C. Decaux. These are all companies that we view as clear leaders in attractive industries.
We purchased shares of five new companies for Global Core Select in 2014 while exiting three investments. The five companies that we added were: (i) Zoetis, a leading global provider of vaccines and medicines for livestock and companion animals that had been spun out of Pfizer in 2013; (ii) Unilever, the British-Dutch consumer products giant with a very strong presence in emerging markets, (iii) Oracle, the leading database and enterprise software company; (iv) Lundin Petroleum, a Sweden-based oil exploration and production company; and (v) Davide Campari-Milano, an Italian spirits company. In our prior letters, we have described our investment theses for the first four companies. Campari is a family-controlled public company that produces premium spirits including Campari, Aperol, SKYY, Wild Turkey, Appleton Estate, and Cinzano. Its largest markets are Italy, the United States, Germany, and Jamaica. We view the global premium spirits category as an attractive industry with a history of stable sales growth, high profit margins, and attractive returns on invested capital. Campari’s strategy is to invest in its six core brands and to strengthen its presence in existing markets by building distribution platforms and acquiring select local brands.
Global Core Select also now includes small positions in two businesses that were spun-off in the fourth quarter from existing portfolio companies: (i) California Resources, which is the largest combined oil and natural gas producer in the state of California and previously was part of Occidental Petroleum and (ii) Indivior, a specialty pharmaceutical business focused on addiction treatment that was spun out of Reckitt Benckiser. Both companies have capable management teams and their shares are trading at deeply discounted valuations as many shareholders have dumped shares post spinoff.
During 2014, we exited from three companies: (i) Straumann, a Swiss dental implant manufacturer, (ii) Tesco, the large international retailer, and (iii) PepsiCo, the global beverage, snacks, and food company. Tesco was an unsuccessful investment and the Strategy’s biggest negative contributor in 2014. In retrospect, we underestimated the competitive challenges facing Tesco in its home U.K. market. We sold our Straumann shares early in 2014 after they had appreciated over 40% in 2013 and were close to our intrinsic value estimate. We exited our successful investment in PepsiCo in the fourth quarter for valuation reasons, as well. We also have some concerns about the challenging long-term outlook for carbonated beverages and the non-snack segments of PepsiCo’s food business.
In this letter, we have purposefully devoted our attention to Global Core Select’s recent purchases and sales, as well as to identifying the key drivers of our investment performance in 2014. It is important to note, however, that Global Core Select very much remains a relatively low-turnover, buy-and-own strategy. Our aim is to capture the benefits of equity investing, namely long-term capital appreciation, while trying to minimize the potential for large permanent capital losses. Most of our large holdings a year ago remain top positions today and it is the operating and financial performance of these businesses that will largely determine the Strategy’s long-term investment performance. We aim to be very selective in identifying which businesses we own and which management teams we partner with. We look for businesses that we believe are inherently resilient due to the following characteristics: (i) sales of essential products and services, (ii) strong customer loyalty, (iii) leadership in an attractive industry, (iv) durable competitive advantages, (v) strong balance sheets, and (vi) high returns on invested capital. In evaluating managers, we look for integrity, alignment of interests with shareholders, and strong track records of good execution and intelligent capital allocation.
At year-end 2014, our top three company holdings were: (i) Wells Fargo, (ii) Nestlé, and (iii) Novartis. All three were top five positions at that start of 2014 and they are good examples of businesses that had made steady operating progress year after year. Wells Fargo has been one of the real winners in the U.S. financial sector since the financial crisis. It has a very strong balance sheet that is largely funded by low-cost, core deposits. At a time when many of its big-bank peers have been distracted by regulatory issues and constrained by new capital rules, Wells Fargo has been growing its deposits and loan portfolio at healthy rates and generating very attractive returns on tangible equity (over 15%), enabling it to continue distributing the bulk of its earnings to shareholders.
Nestlé is the world’s largest food company with superb brands and global distribution. Nestlé participates in a number of very attractive product categories, including pet food, infant nutrition, coffee, and skin-care that are still exhibiting respectable growth in mature, developed countries. It also has a leading presence in many emerging markets and generates 44% of its revenues from these regions. This large emerging market presence has actually been a drag on the company’s recent results due to currency weakness and recessions in Brazil, China, and other markets. Looking out over the next decade, however, these markets should be big drivers of higher growth and profits. Because of its scale and established presence in these markets, Nestlé is one of the few Western companies that should be able to generate operating leverage with revenue growth in the emerging world. Over the past decade, Nestlé has been able to consistently generate mid-single-digit organic revenue growth and annual underlying profit margin improvements.
Novartis is one of the world’s largest and most profitable healthcare companies. The company has three major divisions that possess global scale and are well positioned for long-term growth: (i) a pharmaceutical division which markets over 50 key products, including many leading products in oncology, hypertension, respiratory, dermatology, and other therapeutic areas; (ii) Alcon, which is the leading global eye care company providing surgical products, ophthalmic pharmaceuticals, and contact lenses; and (iii) Sandoz, which is a leading generics manufacturer with special expertise in biosimilars. Novartis has an excellent track record of bringing innovative new products to market and had a number of R&D successes in 2014 including very strong Phase 3 data for a potential new blockbuster heart failure drug.
While the share prices of Wells Fargo, Nestlé, and Novartis have all appreciated meaningfully over the past five years, the gains have been supported by rising earnings and after-tax free cash flows, and these industry juggernauts are the kinds of businesses that we believe demonstrate a high level of resilience and the ability to compound returns over long periods of time.
As we enter 2015, equity valuations remain high, particularly in the U.S. The main topics of conversation among many investors are the price of oil and actions that central bankers around the world may take in the new year. While our team members are certainly conversant on these issues, we think our team’s edge is in identifying high quality businesses, underwriting for high severity risks, and determining conservative yet reasonable estimates of intrinsic value. Our investment decisions are based on company-specific analyses, not macroeconomic predictions. We aim to be patient in waiting for a few attractive investment opportunities, and when we find them, we will be decisive in making sizable investments for Global Core Select.
We appreciate your confidence in our investment team and your continued investment in Global Core Select. We also welcome any questions or suggestions from our shareholders.
Timothy E. Hartch
 MSCI World Index is a stock market index of approximately 1,600 world stocks. It is maintained by MSCI Inc. and is often used as a common benchmark for ‘world’ or ‘global’ stock funds. The index is an unmanaged, market-weighted index and the returns of the index include net reinvested dividends but, unlike the Fund’s returns, do not reflect the payment of sales commissions or other expenses incurred in the purchase or sale of the securities included in the index.
 Intrinsic Value: What one estimates to be the true value of a company’s common stock based on analysis of both tangible and intangible factors.