Large cap stocks traded higher in the first quarter of 2015 despite several sharp directional changes along the way. While actual volatility remains somewhat modest, the market’s frequent reversals seem to reflect erratic sentiment changes related to macroeconomic developments and readings on global monetary policy, as well as the impact of high-frequency trading and passive investment flows. Underlying fundamental performance among companies remains challenged by tepid economic growth, fading productivity gains, and sharp currency movements. Nevertheless, the market’s small gain in the quarter following almost six years of steadily higher equity prices suggests that mainstream investor sentiment remained positive.

The S&P 500 Index[1] had a positive return of 1.0% for the first quarter, while the BBH Core Select Composite (“Core Select” or “The Strategy”) declined by -0.9%. Over the last five years, Core Select has compounded at an annualized rate of 14.1% per annum versus 14.5% for the S&P 500 Index. Measured from the prior market peak reached in October of 2007, the Strategy has compounded at 8.9% per annum, which compares to 6.4% for the S&P 500.

Despite the modest decline in Core Select during the quarter, we remain very pleased with our longer-term absolute returns on a compounded basis. In the nine years that our Core Select team has been together, we have helped our investors with long-term growth of capital during periods of stress and we have participated meaningfully during rising markets. Given the concentration of our portfolio and the company-specific challenges that arise from time to time, these performance patterns may not always hold in each individual month or quarter, but our “batting average” has been very solid, and our long-term results since 2005 have been attractive on both an absolute and a relative basis. We believe that we can best position ourselves to replicate this success over time by maintaining our focused approach and our emphasis on owning resilient, high-quality businesses that trade at discounts to our appraisals of intrinsic value[2].

Our strongest contributor in the first quarter was Novartis, which had a total return of 9% and is our largest investment in the healthcare industry. Novartis has distinguished itself among pharmaceutical companies through its consistently strong business execution, productive R&D pipeline, and sharp focus on market segments that offer secular growth. Following a business realignment set to be completed this year, Novartis will operate three core franchises in which its competitive positioning, intellectual property, and global scale are particularly strong: eye care, generics, and high-value pharmaceuticals. While sustainable revenue growth is top-of-mind for the company’s management’s team, there is also a very clear emphasis on driving further improvements in operational productivity and resource allocation. Novartis’ recent financial results have been solid despite negative impacts from generic competition, adverse currency movements, and challenging macroeconomic conditions in developed markets. Emerging market sales (up 11% in 2014) and revenues from recently launched products (up 14%) remain key drivers of the business and have a higher level of growth contribution for Novartis than is true for other large pharmaceutical companies. Later this year, we anticipate that Novartis will benefit from the launches of two key products: first, a biosimilar drug for leukemia treatment that recently received FDA approval in the U.S., and second, a heart failure drug that could have a very large addressable market. The biosimilar approval was particularly noteworthy since it was the first granted by the FDA. Novartis’ Sandoz unit is among the very few generics companies worldwide that have the R&D scale, production capabilities, and commercial distribution to produce successful biosimilar drugs. We anticipate rapid growth in the market for biosimilars over the next few years as public and private payors push for more cost-effective sources of specialized large-molecule drugs.

Our second-best contributor in the fourth quarter was Zoetis, which advanced by approximately 8% in the quarter and is up by more than 50% since our initial purchase in early 2014. Zoetis is now a top-10 position in Core Select. The company’s strong share price performance reflects several factors, including i) its exposure to attractive end markets with visible growth drivers, ii) solid financial execution despite rising headwinds from currency movements, iii) strengthening credibility with the investment community, iv) a well-articulated long-range capital deployment plan, and v) some speculative interest related to the involvement of activist investors in the shareholder base. We continue to believe that the fundamentals of Zoetis and the overall animal health industry remain strong. The company continues to drive demand and strengthen its diverse portfolio of products through product lifecycle development, strong customer relationships, and access to new markets and technologies. Zoetis remains focused on improving the performance and delivery of its current product lines, expanding product indications across species, pursuing approvals in new geographies and developing innovative medicines, treatments and solutions for emerging diseases, and unmet customer needs. While the stock’s discount to our intrinsic value estimate has narrowed in recent quarters, we continue to view it as one of our long-term “compounders” by virtue of its strong fundamental profile, growth opportunities, and attractive returns on capital.

Other strong performers in the quarter included Nestle, Unilever, and Waste Management. While Nestle’s Swiss listed shares were essentially flat in the quarter, the ADR shares that we own in Core Select returned 4% due to the appreciation of the Swiss Franc in U.S. dollar terms. Our ADR shares of Unilever NV returned 8%. Both Nestle and Unilever are facing macroeconomic challenges, destocking effects, emerging market slowdowns, and pricing softness. Nevertheless, with their strong brands, wide distribution, continual product innovation, and effective marketing programs, both companies appear positioned to maintain low- to mid-single-digit organic sales growth through additional market share gains. In addition, both companies have kept a tight focus on their operating cost structures as they target stable to slightly expanding margins in spite of continued growth headwinds.

Waste Management has been a steady gainer over the last several quarters as good pricing discipline and cost controls have helped to drive double-digit earnings growth even while core waste volume growth remains negative. The company is also working to restructure many of its commercial agreements in the recycling business in order to offset the impact of volatile prices of recycled commodities and certain other operational challenges inherent to that segment. Following last year’s $1.9 billion divestiture of the Wheelabrator waste-to-energy business, Waste Management’s leadership is focused on core market consolidation opportunities in the collection business. On a total-return basis, Waste Management has been an important contributor to Core Select’s compound returns over the last nine years.

Our weakest performers in the first quarter were Microsoft, Southwestern Energy, and Berkshire Hathaway. After posting a 28% total return in 2014, Microsoft’s shares declined by 12% in the first quarter of 2015 driven primarily by a weaker revenue growth outlook, macroeconomic pressures in certain geographies, and continued concerns regarding the future monetization structure of the mainstay Windows business. The key factors impacting the company’s revenue growth outlook for the remainder of calendar 2015 are currency translation pressures (mainly the weaker euro), proactive pricing declines for Windows licenses in the low-end PC, tablet and academic markets, and difficult growth comparisons relative to a very strong 2014, which had benefited from accelerated corporate Windows licensing activity as the support period ended for the aging Windows XP platform. Intel Corp., a key player in the PC industry ecosystem, further amplified these challenges when it announced in March that its revenue growth will be hurt by worsening conditions in the corporate PC market, particularly in Europe. Other parts of Microsoft’s business continued to perform well, highlighted by strong market uptake of cloud services, such as Azure and Office 365, and accelerating unit growth in tablet and phone hardware.

Despite the negative market reaction to Microsoft’s near-term headwinds, we believe the company is making good progress on its major strategic initiatives. Microsoft is undertaking a major transition toward a services-led strategy in an increasingly open and multi-platform computing landscape. Our view for the last few years has been that this transition will be accompanied by some meaningful changes in the monetization patterns of the traditional offerings, notably including Windows, and we believe this is causing some investor anxiety to add to the other growth headwinds at present. On balance, we remain pleased with the strategic clarity and operational execution of the management team as it pursues multiple threads of innovation while maintaining a customer-centric focus and a keen sense of economic value creation. We have also been encouraged by management’s willingness to challenge its own incumbency in a sense by embracing creative destruction within its own walls. Historical evidence shows that large technology companies who resist this behavior tend to struggle in the long run as innovation marches on without them.

After a difficult end to 2014, shares of Southwestern Energy declined by an additional 15% in the first quarter of 2015 as natural gas commodity prices remained weak and investors signaled disappointment with the substantial equity dilution required to finance last year’s large purchase of acreage in the Marcellus and Utica shales. While the newly acquired assets offer the potential of sustainably strong incremental production growth at very low finding and development costs, we do have some concerns that the sheer size of the deal and the financing risks assumed were incongruent with Southwestern’s typically measured approach. In a positive development, near the end of March Southwestern entered into agreements to divest parts of its gathering and transport infrastructure in Pennsylvania and certain conventional oil and gas assets in the East Texas and Arkoma regions. These divestitures, which are expected to raise $718 million in total, were the final pieces of the financing program supporting last year’s acquisitions. Longer term, we continue to have a positive outlook on the structural demand drivers for natural gas given its growing share of power generation and industrial usage and the potential for significant developments in the liquefied natural gas (LNG) export market. While supply conditions for natural gas remain saturated, we believe that the firming of long-term recurring demand will help support the commodity price over time.

Depressed oil and gas prices also continued to weigh on the operating results of our other exploration and production companies, EOG Resources and Occidental Petroleum. However, we were very pleased by both companies’ recent updates regarding near-term capital plans and their focused drilling activity proposed for 2015. EOG and Occidental are both managed with strong principals around economic returns and conservative usage of debt. These key traits, along with low production costs, become critically important during periods of weak commodity prices, as companies like EOG and Occidental are able to sustain themselves while many other less-disciplined operators struggle and often times fail outright.

Berkshire Hathaway’s shares declined by 4% during the quarter despite a solid earnings report and an upbeat assessment of the company’s operational and strategic direction contained in Warren Buffett’s annual chairman’s letter released in February. We did not observe an obvious catalyst for the share price weakness in the quarter, but it is possible that investor sentiment has simply faded somewhat due to the multi-year advance in the company’s share price and, to a lesser extent, some pockets of emerging headwinds in key businesses such as railroad and commercial insurance. We also believe there is a lingering market perception that Berkshire should only trade at a relatively small premium to book value, given that many of its assets are deployed passively and are therefore “marked to market.” While this may have been reasonably accurate in the past, Berkshire today is a very different organization, composed of a diverse group of competitively advantaged businesses whose assets are carried on the balance sheet at historical costs that have no explicit linkage to the current earnings power of those assets. As such, we believe that Berkshire as presently constituted can indeed trade at a meaningful premium to its book value, and our perspective is that today’s valuation of approximately 1.5x on this basis (i.e., market capitalization to book value) is still attractive given the quality and visibility of the underlying businesses and the company’s undeniably strong financial position.

Near the close of the quarter, Berkshire announced that it will collaborate with 3G Capital to purchase a controlling stake in Kraft Foods and combine it with HJ Heinz Co, which has been jointly owned by Berkshire and 3G since 2013. Berkshire will inject $5 billion in additional common equity to finance the transaction. Kraft will remain a public company, and its existing shareholders will receive a 49% post-deal stake and a cash distribution of $16.50 per share. Notably, the equity value of $16 billion attributed to HJ Heinz in the proposed transaction is nearly four times Berkshire’s original equity investment of $4.25 billion made in 2013. On a standalone basis, we had not viewed Kraft as being particularly well positioned in the consumer sector given its substantial exposures to private label competition, commodity price fluctuations, and product categories that are in many cases misaligned with burgeoning consumer trends relating to health and wellness, culinary uniqueness and “clean label” ingredient lists. Nevertheless, Kraft possesses a large stable of venerable brands in important everyday food categories, and in the hands of 3G and Berkshire, we believe that Kraft will trim its cost structure and eventually be able to leverage the global distribution capabilities of HJ Heinz as the companies are integrated.

While their detraction from Core Select’s first quarter performance was less significant than that of the three companies noted above, we did have several other holdings whose share prices were hurt by the lowering of market expectations for near-term revenue growth due largely to the unforeseen strength of the U.S. dollar. This list includes Baxter, Oracle, Praxair, Celanese, and Denstply International. We have typically carried a slightly larger aggregate exposure to non-dollar based earnings in Core Select as compared to the S&P 500 Index. As such, while it is impossible to measure with precision, it is likely that the sharp increase in the dollar against other major global currencies has had a modestly larger impact on Core Select’s performance than the market more broadly. We do not employ macro analysis or currency forecasting in our management of Core Select, but we do indeed carefully examine translational and transactional foreign exchange impacts in our financial models, and we contemplate various scenarios to help us risk-adjust our valuation estimates. This has been a key focus of our investment team during the recent period of rapid dollar appreciation.

During the first quarter, we added opportunistically to our investments in Southwestern Energy, Qualcomm, and Oracle, as each experienced pressure in its share price. Qualcomm fell sharply at the end of January after reducing its fiscal 2015 outlook due to headwinds in its chip business. These challenges related to customer mix shifts, low-end price pressure in China and a large customer’s decision to insource a key component. The size of our purchase turned out to be less than we had hoped as the stock then ran above our desired price level upon the announcement of a slightly better than expected resolution of the long-running anti-monopoly investigation in China. We added to our Oracle position as the stock dipped in the week before the company reported strong fiscal third quarter earnings.

We continued to trim and then ultimately exited our remaining position in Target during the first quarter as the shares approached our estimate of intrinsic value. Despite its disappointing experience entering and then exiting the Canada market, Target was a successful investment for Core Select over our three-year ownership period. The company’s recent management changes, restructuring initiatives, and refocusing around its core strengths appear to be a well-received remedy for its earlier missteps; however, we continue to see challenges for the business in the future and believe that our valuation appropriately captured Target’s long-term earnings power on a risk-adjusted basis.

During the quarter, we also exited our small position in California Resources Corp., which we had received last year as a spin-out from Occidental Petroleum. For a variety of reasons, we do not view CRC as being as tight a fit with our approach in the energy sector as our other holdings. Finally, we made another small trim in our Wal-Mart position as the share price moved closer to our estimate of intrinsic value per share.

With a significant number of our companies continuing to trade near 90% of our intrinsic value estimates, we may continue reducing certain position sizes as the year progresses, assuming that markets remain stable or potentially advance further. At the end of the first quarter, we owned 29 companies with 44% of our assets held in the 10 largest holdings. Core Select ended the quarter trading at 82% of our underlying intrinsic value estimates on a weighted average basis, compared to 87% at the end of 2014. Despite this apparent reduction in the portfolio’s valuation level, there continue to be very few companies among our current holdings and our “wish list” that have a sufficiently large margin of safety for us to be able to put meaningful amounts of capital to work. As such, our cash position remained somewhat high at 12% as of the end of the quarter.

With equity markets now in their sixth consecutive year of gains despite continued challenges and uncertainties in the global economy, we continue to believe that a cautious investment stance remains warranted. In their efforts to spur credit creation and positive wealth effects, the world’s major central banks have employed an unprecedented level of intervention for an extended period of time by suppressing interest rates and making large asset purchases. These liquidity actions have had a large influence on money flows and valuation levels by crowding out investment in traditional lower-risk assets and encouraging more speculative activity. If this sustained intervention proves to be successful, as measured by stronger gains in economic growth, organic capital investment, and real wages, then it is certainly possible that equity valuations are defensible at their currently elevated levels. However, as in other historical periods of heightened risk acceptance and excess liquidity, there is also the distinct potential for systemic misallocation of capital and eventual credit stress, which could pose critical risks for equity investors. The other potentially large risk is that central banks may struggle in their eventual attempts to normalize policies, creating instability and even panic as investors race to adjust positioning.

Despite these uncertainties, we remain confident in our approach – we will continue to buy and own high quality businesses at discounts to our appraisals of their fundamental value, and we will trim or sell positions as discounts diminish. Our key objectives remain capital preservation and sustainable generation of attractive absolute returns on a compound basis over full market cycles. We will not trade safety for short-term relative performance.

The Core Select team appreciates your continued support, and we always welcome your questions and feedback.

Sincerely,

Timothy E. Hartch

Michael R. Keller

[1] S&P 500 Index: An unmanaged, market capitalization weighted index of 500 stocks providing a broad indicator of stock price movements.

[2] 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.