Stocks recovered from a sharp January sell-off to close out the first quarter of 2014 in positive territory. The market’s continued resilience even after a five-year run of tremendous gains suggests that broad investor sentiment remains quite bullish despite a backdrop of lukewarm macroeconomic performance and considerable uncertainties pertaining to emerging market growth, central bank policy, and geopolitical events. The S&P 500 Index1 returned 1.8% for the quarter to reach a new all-time quarterly high. By comparison, the BBH Core Composite (“Core Select” ) returned 2.1%. Over the last five years, Core Select has compounded at an annualized rate of 21.8% per annum versus 21.2% for the S&P 500 Index.

Our largest positive contributor in the first quarter was EOG Resources, which rose by 17% and is our largest investment in the energy industry. The company’s recent operating results continued a multi-year trend of attractive production growth, low operating costs, robust reserve replacement, and an appropriately balanced capital strategy. Leveraging its proprietary technical knowledge and high quality acreage in the Eagle Ford and Bakken formations, EOG has continued to grow its production of crude oil and other liquids at industry leading rates among companies of its size. Importantly, the company has also shown outstanding growth in its stock of proved reserves, highlighted by a 45% increase in the net potential recoverable reserves in the Eagle Ford to an impressive 3.2 billion barrels of oil equivalent. Even at its currently high rate of growth, EOG has demonstrated laudable financial prudence evidenced by its ability to spend within its cash flow in 2013 while maintaining a reasonable 23% rate of net debt to total capitalization.

Also within the oil and gas sector, Southwestern Energy was among our top performers for the quarter. The company’s core natural gas production business continued to perform well, while the commodity price in the U.S. rose to multi-year highs driven by cold winter temperatures in highly populated regions of the country. Southwestern disclosed a modest setback in its small exploratory crude oil venture in Louisiana, but we do not believe this represents a material impairment of the company’s base valuation. We had not included any prospective benefits of this venture in our intrinsic value2 calculations.

Other strong performers this quarter included Wells Fargo, Novartis, Microsoft, and U.S. Bancorp. Wells Fargo and U.S. Bancorp benefited from solid earnings reports and positive outcomes in the latest round of Federal Reserve capital reviews. While the pace of core loan growth remains slow for both banks and mortgage issuance has fallen sharply, the companies’ net income performance has benefited from low credit costs, operating efficiency, and growth in fee-based sources of revenue. Both banks have repeatedly raised their dividends and have expanded their share repurchase programs.

Shares of Novartis traded higher in the quarter driven by good quarterly results that benefited from stronger than expected volumes in emerging markets and the continued positive growth impact from products less than five years old. In our view, investor sentiment toward Novartis has improved in recent quarters thanks to management’s good execution and the potential benefits of its comprehensive ongoing business review.

Microsoft advanced by more than 10% as investors responded positively to the naming of Satya Nadella as the company’s new CEO. We had viewed Nadella as being one of the most compelling internal candidates for the position, as we believe he possesses the right mix of outward- and inward-facing skills to be effective in the role. Nadella has been instrumental in the advancement of Microsoft’s enterprise cloud strategy, including the Azure platform. As such, we believe he sits at the forefront of the company’s evolution toward a more open, service-based model, and that he will continue to champion this critical transformation as CEO. Microsoft has a unique strategic position that juxtaposes a massive installed base and existing product suite against a growing set of new opportunities in cloud, mobile, analytics, pervasive computing, and other areas.

Baxter’s shares moved sharply higher at the end of March following a surprise announcement of a plan to split the company into two separate businesses, Biosciences and Medical Devices. We had long considered this strategic change a possibility given the lack of overlap between the businesses and the likelihood that the Biosciences segment in particular may achieve a more robust valuation as a standalone entity (its two closest peers trade at meaningfully higher multiples than Baxter), but our impression was that Baxter’s management and Board preferred to operate as a unified business. We are not aware of any external pressures that may have precipitated the move – instead, we believe that management was ultimately motivated by the potential revaluation opportunity and the desire to have each business set its own focused strategic agenda and goals.

Shares of eBay traded modestly higher in the quarter despite substantial interim volatility. Concurrent with the release of 4Q13 earnings, the company disclosed that the activist investor Carl Icahn had built a position in the stock and is also nominating two candidates to the Board of Directors. Mr. Icahn’s central assertion is that the company should split PayPal into a standalone business, purportedly to achieve a “pure play” valuation for PayPal either in the public market or via a divestiture. eBay recommends that investors vote against Icahn’s breakup proposal and in favor of re-election of current eBay directors as they believe that shareholders and customers are best served by keeping PayPal and eBay together due to tight operational and strategic links, mutually beneficial synergies, and the basic principle that eBay collectively is an end-to-end e-commerce platform for which payment technology is a necessary and vital part. We agree with management’s rationale and stance, and we believe that the businesses should in fact remain together. However, we also note that maintaining an entrepreneurial and open culture at PayPal should be among the company’s highest continuing priorities given the competitiveness and pace of change in the payments industry.

Our weakest performers in the first quarter were Bed Bath & Beyond, Chubb, Progressive, and Comcast. Bed Bath & Beyond’s shares fell after the company disclosed weaker than expected comparable store sales, additional pressure on gross margins due to promotional activity, and a cautious outlook for 2014. These issues largely stem from weak trends in consumer spending in the U.S., but also reflect the impact of sizable operating and capital expenses related to several structural investments in the business. These investments, which relate to e-commerce capabilities, fulfillment, consolidation of certain activities, and digitization of the promotional strategy, will continue to weigh on margins and cash flow for the medium-term future, but we believe that management is taking the correct actions and better positioning the company to thrive in an evolving retail landscape.

Chubb and Progressive traded down alongside the broader property and casualty insurance industry amid investor concerns over rate competition and mark-to-market losses in fixed income portfolios. We also believe that many investors have a sense that both companies are relatively fully valued at current levels. In our view, the discounts to intrinsic value have indeed narrowed for both Chubb and Progressive, but more important, we believe they remain among the best positioned companies in their respective industries with distinct competitive advantages, strong balance sheets, and high quality management teams.

Comcast’s shares declined following the company’s February announcement of its intention to acquire its smaller peer Time Warner Cable in an all-stock deal initially valued at $67 billion including the assumption of debt. We believe the proposed deal makes strategic sense in several ways, most notably the substantial scale benefits of combining two of the largest players in the market whose networks have little overlap. The potential scale benefits pertain not only to operating and capital cost synergies, but also programming cost leverage, network density, cross selling opportunities for next-generation services, and a more attractive platform for national advertisers and agencies. Successful completion of the transaction will require regulatory approvals and meaningful divestitures, but we are optimistic that these hurdles can be cleared. The lack of bilateral breakup fees attached to the deal seems to indicate that the respective management teams of Comcast and Time Warner are similarly confident in a favorable outcome. The implied valuation for Time Warner appears reasonable in our view even without any inclusion of prospective revenue synergies. We believe the negative reaction in Comcast’s shares was a reflexive response that is not uncommon in large merger situations given regulatory uncertainties and the potential for management distraction. Given our favorable assessment of the deal, the potential for incremental value creation in the years post-closing and Comcast’s experience with smoothly executing large acquisitions, we feel that the market’s response may have been misguided.

We were pleased to add two new companies to Core Select during the first quarter: Zoetis Inc. and Unilever NV. These businesses fit well with our demanding investment criteria and offer compelling long-term value creation potential driven by secular growth, strong market positioning, and broad global distribution.

Zoetis, which was spun out of Pfizer in 2013, is a global leader in the animal health business. The company provides branded drugs, vaccines, diagnostics, and related services to a wide variety of customers who raise and care for animals. Zoetis’ products are used both in the production animal market (roughly 64% of sales) and for companion animals (36% of sales). In our view, the company holds a strong and durable position in the industry owing to its 1) diverse base of safe and effective products, 2) geographic breadth, 3) direct sales force with market-specific knowledge, and 4) productive internal R&D organization. We believe that animal health is an attractive segment of the global healthcare market that benefits from favorable secular growth trends such as increased per capita protein consumption and increased ownership and medicalization of pets. Moreover, the animal health market benefits from a relatively benign regulatory environment, minimal influence of government reimbursement, limited competition from generics, and sustainable pricing power. With its capable and experienced management team, we believe that Zoetis can sustain and grow its earnings power over time.

Unilever is one of the world’s largest consumer products companies, operating in the food, home, and personal care markets. The company’s products serve basic consumer needs such as nutrition, fortification, and hygiene for lower income consumers, while at the same time offering more premium and value-added products that offer convenience and performance features for higher income consumers. With roughly 57% of its sales coming from emerging markets, we believe that Unilever has an especially attractive footprint among global consumer staples companies. The company has deep distribution and high brand awareness in key markets such as India, Brazil, South Africa, and Indonesia. Despite current concerns about the pace of growth in these and other emerging markets, the long-term prospects remain attractive in our view given that these regions represent 80% of the world’s population with strong birth rates, rising incomes, emerging middle classes, and more women entering the workforce – all of which are factors that should boost demand for Unilever’s products both at the low end and the high end. Through organic and inorganic means, the company has been shifting its business mix towards health and personal care categories, where margins, capital intensity, and cash flow characteristics are generally more attractive than is true of the food business. We have a high regard for Unilever’s management team and the way it has instituted a more long-term oriented approach that balances top line growth, productivity, cash flow, and targeted reinvestment.

Following our initial purchase of Zoetis in January, we added to the position at several points during the balance of the quarter at lower prices. We also added modestly to our existing positions in Bed, Bath & Beyond and Diageo to take advantage of weaker trading in these stocks in the first half of the quarter.

We continued to trim our holdings of DENTSPLY and Liberty Interactive as the stocks traded closer to our estimates of intrinsic value. With a significant number of our companies now trading at 90% or more of our underlying intrinsic value estimates, we expect to continue reducing certain position sizes as the year goes on, assuming that markets remain stable or potentially advance further. At the end of the first quarter, we owned 31 companies with 45% of our assets held in the 10 largest holdings.

Core Select ended the quarter trading at 86% of our underlying intrinsic value estimates on a weighted average basis, compared to 89% at the end of 2013. The differential between the three percentage point increase in the aggregate portfolio discount and the portfolio’s 1.8% positive return was driven by our buying and selling activity along with several increases in our estimates of intrinsic value for the individual companies. With the price-to-intrinsic value relationship remaining at historically high levels for both our current holdings and many of our “wish list” stocks, we continue to be constrained in our ability to make new investments and add to existing positions at appropriate discounts. Consequently, our cash position remained somewhat high at 10% as of the end of the quarter.

The equity market is correctly viewed as being a forward-looking mechanism, but with stocks now having nearly tripled from their crisis lows in 2009, it is worth looking back at how this remarkable advance has transpired. The 2008-2009 recession was marked by severe balance sheet stress for many companies and governments and a deep erosion of business and consumer confidence globally. A logical expectation at the time would have been that a rebound in economic growth would emerge gradually but would potentially require several years of capital replenishment driven by corporate cost vigilance, consumer caution, and tight capital budgets. Our sense is that this is essentially what has occurred in the “real” economy, but at the same time, financial markets have followed a very different path due to the profound influence of monetary policy actions over the last five years. The world’s central banks have pursued interest rate policies that skew the market’s normal discounting mechanism and force asset class tradeoffs among investors. The net result, in our view, is that financial asset appreciation has far outpaced the creeping pace of real growth in the economy, while the buildup of excess reserves in the system has created risks of inflationary pressure were the economy to accelerate. We believe that several unintended consequences have resulted from these policies, including the financial repression of savers, more levered trading activity, and the return of looser lending terms and structures.

The purpose of this reflection is not necessarily to call out imminent risks for the equity market, but instead to reiterate our view that financial asset prices have reached a point where further upside is likely to be much more linked to economic and earnings trends as opposed to the liquidity-fueled levitation of sentiment and multiples. In this context, we remain firm in our conviction that our straightforward and fundamentals-based investment approach is well-suited to current conditions. We will continue to buy and own well-positioned, resilient leaders at discounts to our appraisals of their intrinsic value, and we will trim or sell positions as discounts diminish. Our top priority will remain capital preservation, and rather than aiming to chase relative performance, we will focus on generating attractive absolute returns on a compound basis over full market cycles.

As we noted last quarter, we would not be disappointed by a period of flat or even negative returns in the market. We believe that our Core Select companies would perform well in such conditions, and that they could potentially benefit from opportunistic acquisitions and share repurchases. In addition, less challenging valuation levels would offer us potential opportunities to deploy capital at better prospective returns.

The Core Select investment team is grateful for your continued support and interest, and we look forward to providing further updates as 2014 progresses.

 

Sincerely,
Timothy E. Hartch
Michael R. Keller

For informational purposes only.

 

1S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index is not available for direct investment.

2Intrinsic Value: What one estimates to be the true value of a company’s common stock based on analysis of both tangible and intangible factors.