BBH Global Core Select Composite ("Global Core Select" or "the Strategy") declined -1.27% in the fourth quarter, bringing down our full year return to 6.13%. The comparable figures for the MSCI World Index were 1.86% for the quarter and 7.51% for the full year. Since Global Core Select’s inception the Strategy has compounded at 5.77% per year versus 7.57% for the MSCI World Index. Despite Global Core Select being down in the quarter and trailing the index on a relative basis for the year, we felt good about the fourth quarter as we were able to purchase four new, superb businesses at attractive discounts to our intrinsic value estimates. We also exited our remaining energy investments due to their share prices moving higher and their businesses being a weaker fit with our investment criteria. We were also pleased with the resilient operating and financial results of most of our portfolio companies in 2016. Over the long term, it is the cash that our companies generate and the returns that our businesses earn on reinvested capital that should determine our investment results.
With respect to relative performance, Global Core Select is a concentrated portfolio constructed security-by-security via a bottom-up process and is largely unconstrained by geographic or sector allocation. As such, we expect investment performance to deviate meaningfully from index performance in many time periods. Our focus is on selecting businesses that we know well, are good fits with our investment criteria, and have capable management teams that we respect. If we cannot find investment candidates with these characteristics trading at a discount to intrinsic value, we will hold cash.
During 2016 there were a number of macro factors that impacted the financial results and share prices of our portfolio companies. One of the most significant was the strong U.S. Dollar, which hit a 14-year high against most major currencies in 2016 and has risen over 32% and 39% versus the Euro and British Pound respectively since 2014. While the strong Dollar lowered Global Core Select’s 2016 investment returns, we continue to believe that there are some high quality investment opportunities outside the United States. Indeed, the four businesses we bought in the fourth quarter are all domiciled outside the U.S.
While many investors rotated out of European and Asian stocks and into U.S. equities in the fourth quarter following Trump’s surprise victory (presumably on the view that corporate tax cuts and a reduced regulatory burden would promote higher U.S. economic growth), we look for value rather than fund flows and at the moment, we are finding more new investment opportunities abroad.
With respect to equity valuations, prices generally appear high to us, as they have now for several years. The fact that interest rates are still near record lows globally is a key factor. However since we do not own the index, aggregate price levels are less important to us than the price-to-intrinsic value ratios of the 33 businesses we own. At year-end, the Global Core Select portfolio was trading at approximately 82% of intrinsic value, which compares to 80% at the end of 2015. We aim to bring down the price-to-intrinsic value ratio of our portfolio over time by i) selling shares trading at or near intrinsic value, ii) buying new positions at meaningful discounts to intrinsic value, and iii) the organic growth of the intrinsic values of our portfolio companies. It is also important to recognize that for every company our estimate of intrinsic value represents a range of potential outcomes rather than a precise figure. We always endeavor to be careful in establishing our base-case financial and intrinsic value estimates that we use to guide our purchase and sale decisions; arguably we have been too conservative in recent years as in a number of instances we have either sold shares in companies whose values continued to appreciate or chose not to buy businesses that have subsequently exceeded our expectations. Being careful about valuation, however, should reward our investors over multiple full market cycles.
Our largest positive contributor in the fourth quarter was Wells Fargo, which is our second largest position and whose shares rose over 25% in the quarter, with all of the appreciation occurring after the U.S. election. This performance was a sharp reversal from the weakness that we had seen through most of the year, as Wells Fargo’s share price had been pressured by prospects of a protracted low-interest-rate environment and compounded by an account-opening scandal that drew national attention and ultimately led to the resignation of the Company’s long-time CEO, John Stumpf. While senior management at Wells Fargo clearly made a mistake in not addressing these issues sooner, we continue to view the team positively and do not expect the scandal to have a large impact on Wells Fargo’s long-term earnings power. In our view, Wells Fargo remains a high quality banking franchise and has one of the strongest deposit footprints in the world.
Celanese, Microsoft, and Sanofi all reported strong operating results during the quarter and were meaningful positive contributors to fourth quarter investment performance. Celanese, a leading global provider of acetic acid and specialty chemicals, rose 18% in the quarter and has executed extremely well despite significant weakness in several industrial end markets. With a seasoned management team, sizeable technological advantages, and continued focus on cost and capital discipline, we believe Celanese can continue to create shareholder value with or without a positive step-change in global industrial activity. Microsoft continues to successfully transition its business model towards cloud-based solutions and recurring revenue streams. Management noted on its most recent earnings call that 88% of total revenue is now driven by “annuity” contracts, a huge change from several years ago when upfront software license fees and other one-time, transactional sales were over 50% of revenue. Sanofi’s shares bounced back in the fourth quarter as strong results in multiple sclerosis, rare diseases and vaccines offset continuing challenges in its diabetes franchise. Lastly, shares of Rotork, a U.K.-based industrial company which we added to the portfolio during the quarter, appreciated sharply following a third quarter sales update that indicated stabilizing trends in key end markets.
The strongest contributor to full-year performance was QUALCOMM, which returned more than 35% this year driven by progress in collecting licensing royalties in China and a positive market reaction to the announced acquisition of NXP Semiconductors. As the share price has appreciated, the discount to our intrinsic value has narrowed, and we modestly trimmed our position in the fourth quarter. Additional strong contributors to performance for the year included two of our energy investments, Vermilion Energy and Lundin Petroleum, as well as Microsoft, Oracle, and Celanese.
Our biggest negative contributor for the quarter was Nielsen Holdings which declined more than 21% in the quarter. Nielsen’s share price fell dramatically following its third quarter earnings report in which management reduced its near-term outlook based on weak trends in the “Buy” segment. Nielsen’s Buy business, which comprises one third of the Company’s EBITDA, collects point-of-sale data from retailers and sells it to consumer packaged goods (CPG) companies and retailers as a valuable and essential market share measurement and sales analysis tool. The Company also provides project-based analytical work which is relatively more discretionary and is currently under the most pressure. Despite these near-term challenges, the Buy business has a very strong competitive position as the only global provider of a critical service; management is working hard to bundle its vast data with additional analytics to drive more recurring revenue and to reach smaller CPG companies. The balance of Nielsen’s business, the “Watch” side, is performing well and drives the majority of the Company’s profit. Nielsen’s Watch offerings are essential to the measurement of video consumption; its national and local TV ratings remain the essential currency by which media companies and advertisers transact. As video consumption has fragmented beyond linear television, the Company has evolved its products into a total audience measurement platform where we feel it has a strong advantage in providing measurement of content and advertising across online, mobile, and on-demand distribution. Nielsen’s business is highly cash generative and earns healthy returns on invested capital, and we viewed the share price decline as an opportunity to increase our position at attractive prices.
Several of our consumer staples investments were also negative contributors in the quarter, including Davide Campari-Milano, Diageo, Nestlé and Unilever, due to the sell-off in certain more “defensive” sectors that are broadly viewed as bond-proxies, compounded by negative currency impacts. While valuations of many consumer staples remain elevated and growth has been constrained by weak emerging markets and commodity-led deflationary pressures, we believe that our consumer investments have excellent, geographically diverse franchises, strong brand equities and related pricing power, and strong management teams, and we expect they can generate industry-leading revenue and cash flow growth over the long term. These companies all have substantial and highly profitable businesses in the U.S., so while the Dollar’s strength has had a negative short-term impact on our returns as U.S.-based investors, our businesses’ reported financial results in their currencies stand to benefit.
Perrigo was the biggest negative contributor to full-year performance, primarily due to the sharp sell-off in the shares earlier in the year which we have discussed in prior letters. The new CEO of the Company, elevated to the role in early 2016, is overseeing a strategic review of the Company’s assets, including a possible divestiture of the non-core Tysabri royalty stream, and has taken concrete steps to improve operating performance in Perrigo’s European consumer health business. The Company’s store-brand OTC business continues to deliver solid results and has a strong pipeline of new products. The prescription drug business continues to face pricing challenges, however operating results reported during the quarter indicate stabilization and this business is a potential candidate for divestment as well. We are encouraged by the steps that management is taking to realign the business and capitalize on its strengths while reinforcing the balance sheet. Other detractors for the full year included Novartis, Bed Bath & Beyond, JCDecaux and Nielsen.
Portfolio Changes and Valuation
During the fourth quarter, we completed a comprehensive review of our energy investments against our Core Select investment criteria. As a result, we exited our positions in Lundin Petroleum, Schlumberger, Occidental Petroleum, and Vermilion, due to i) changes to the structure and long-term outlook for the global oil and gas industry, ii) valuation scenarios that resulted in a relatively wide range of potential outcomes, iii) share prices that approached our estimates of intrinsic value, and iv) compelling valuation opportunities in a number of new and existing portfolio companies that are stronger fits with our investment criteria. As previously mentioned, we invested in four new businesses at attractive discounts to our estimates of intrinsic value: Wendel, Liberty Global, Rotork and Heineken Holding.
Wendel is a publicly traded French holding company and professional investment firm that has investments in non-listed subsidiaries as well as large stakes in two listed companies, including a leading Testing, Inspection, and Certification company, Bureau Veritas (BV). We view BV as very strong fit with our investment criteria and have studied the Company and the industry extensively, and it represents the largest single component of Wendel’s gross asset value. Wendel’s other investments reflect its strict investment criteria which are centered on quality, capital preservation, and long-term growth, and which are strongly aligned with our own Global Core Select investment criteria. Wendel takes an active role not only in investing in its portfolio companies but also in their development, as Wendel’s mission is to build and grow its portfolio companies over the long term. Its key investments and operating companies include: Saint-Gobain, a producer of specialized building materials; 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 leading provider of security services in the U.S. Wendel’s share price at time of our initial investment represented a significant discount to Net Asset Value (NAV) per share, which in our view offered a strong margin of safety.
Liberty Global is a pan-European video, broadband, and communications provider with its largest operations in the U.K., The Netherlands, Germany, Switzerland, and Belgium. Liberty Global operates a significantly more advanced network than competitors in most of its key markets, and this network superiority provides greater broadband speeds and a better video experience to customers versus competitors. The Company is in the midst of a large capital spending cycle as it expands its network in key markets with the goal of reaching an additional 6 million households by 2018 and up to 10 million by 2020. This investment cycle is negatively impacting cash flow growth, a factor that has pressured the share price and offered us an opportunity to buy shares at what we believe to be an attractive valuation. As the “new build” strategy nears completion and capital expenditures normalize, subscriber growth should increase with minimal incremental investment and drive free cash flow growth.
U.K.-based Rotork is the global leader in the design and assembly of actuators, products that control the flow of liquids and gases. The Company’s products are essential to many end-market applications and it has a highly developed sales process such that its products are often designed in at the early stages of projects. While Rotork serves cyclical end-markets—with oil and gas being the most significant—it operates with an asset-light model and outsources manufacturing, allowing it to earn attractive returns on invested capital over economic cycles. While returns have been pressured by the severe downturn over the past couple of years in many of the end-markets it serves, Rotork’s returns remain well above its cost of capital and cash flow generation remains strong. We initiated a position during the quarter at a price that in our estimation represented an attractive discount to intrinsic value.
Heineken Holding is the majority owner of Heineken, the world’s second-largest brewer of beer and owner of the Heineken brand, as well as leading local brands including Tiger in Asia; Star in Nigeria; Dos Equis, Sol, and Tecate in Mexico; and Strongbow cider. Heineken possesses key attributes that we look for in our consumer products investments: strong brands, a balanced footprint between cash-generative developed markets and high-growth emerging markets, a well-developed distribution infrastructure, and constructive industry structure in key geographic markets and profit pools. Through organic growth and a series of acquisitions, Heineken has established leading positions in attractive emerging markets including Vietnam, Africa, Mexico, and India. It has also diversified its portfolio beyond the flagship Heineken brand, offering the Company the opportunity to meet consumer demand across a ladder of price points. The Company’s strong free cash flow is driven by the attractive economics of the beer industry, though currently a heightened level of capital spending is weighing on cash flow and returns on capital. We anticipate capital spending normalizing and returns improving over time as investments are leveraged.
In addition to the four new purchases, we added to a number of existing positions during the fourth quarter, including Aggreko, JCDecaux, Nielsen, Novartis, Oracle, and Perrigo. With the new purchases and additions to existing positions, Global Core Select’s cash position dropped to 6.3% of total assets at year end.
We are pleased to announce that Tim Harris joined our investment team in January 2017 and will focus on international financial services companies for Global Core Select. Tim joins us from Nomura, where he was an Executive Director in Nomura’s investment banking division and covered European financial institutions for over 10 years. Tim started his professional career at BBH, and we are excited that he has rejoined our firm. While many financial institutions will not meet our strict criteria, those that do may offer the potential for significant long-term value creation given continued negative sentiment for the sector internationally.
Our investment team is very committed to fundamental analysis and owning competitively advantaged businesses offering essential products and services to a loyal base of customers. We look for businesses with strong balance sheets, high levels of free cash flow, and high returns on capital with limited risks outside of management’s control. Companies with these characteristics tend to be resilient regardless of the external environment and we remain focused on owning these businesses when we determine there is an appropriate margin of safety in the purchase price.
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.
Timothy E. Hartch
Regina Lombardi, CFA