Large cap equities pressed higher in the first quarter of 2017 as the S&P 500 Index entered a ninth year of gains. Broadly speaking, investors appeared to rotate toward ‘risk-on’ sectors and securities in light of improving corporate earnings forecasts, expectations of pro-growth U.S. tax and regulatory reform, and hopes that the Federal Reserve will be able to normalize interest rates and its bloated balance sheet without impacting economic growth or equity valuations. BBH Core Select Composite (“Core Select” or “the Strategy”) returned 5.0% during the first quarter, the biggest quarterly gain in three years, and has now compounded at annualized rate of 11.3% over the last five years. These are strong absolute gains and we would normally be very pleased with double-digit returns over five years. The S&P 500 Index, however, was up 6.1% during the first quarter and has returned an annualized 13.3% over the past five years. While we have always said that Core Select would likely trail broad market indices in an extended bull market, we are not surprisingly fielding a number of questions now about relative performance and when Core Select might once again outperform.
Our investment team is working diligently to select the companies that best fit our Core Select business and valuation criteria. We continue to believe that owning competitively advantaged businesses trading at discounts to intrinsic value1 is a prudent and powerful way to invest. While holding cash and not owning for valuation reasons certain companies whose shares have performed particularly well have hurt our relative performance in recent years, we believe it would be a major mistake to jettison our valuation framework at this point in the investment cycle. We are staying focused on businesses we understand well and can value using conservative assumptions so that we can achieve our dual goals of protecting and growing the capital invested in Core Select. Measured from the last market peak reached in October of 2007, Core Select has compounded at 9.3% per annum, which compares to 7.0% for the S&P 500 Index. We are aiming to generate attractive absolute returns and outperform the S&P 500 Index over the next cycle as well.
Our top contributor in the first quarter was Oracle, which gained 16% and was our second-largest position at quarter end. In our view, Oracle remains a global leader in infrastructure software as well as an increasingly important vendor in the ecosystem of cloud-based software, applications software, hardware and technology services. Oracle shares traded higher throughout the quarter and reacted positively to the company’s 3Q17 earnings report in March. Oracle’s total dollar volume growth of cloud-based subscription revenues was strong in the quarter, offsetting declines in on-premise license revenues as the overall business model continues to shift toward the ‘as-a-service’ construct. Importantly, the third fiscal quarter marked a return to growth for Oracle's total database franchise (cloud plus on-premise). The application software areas of the business also performed well, with Human Capital Management continuing to stand out in particular given its 100%+ growth rate in the last three quarters. The company has improved its sales execution, with strong pipeline conversion, win rates and successful product bundling helping drive upside to bookings. Operating expenses were also well managed in the quarter, declining as a percentage of revenue on an acquisition-adjusted basis. Looking ahead, we believe that Oracle can expand margins from current levels as the company leverages fixed costs related to data center infrastructure and centralized overhead and benefits from lower sales and marketing costs on incremental revenue dollars. We believe the shares remain attractively valued.
Our second- and third-largest positive contributors in the quarter were our two cable companies, Comcast and Liberty Global. Despite their different geographic exposures (Comcast operates networks in the U.S. and Liberty Global in Europe), both companies are benefitting from best-in-class broadband service, strong video offerings and improved user interfaces. Both companies also recently announced new mobile initiatives, with Comcast soon to roll out a new wireless offering leveraging Verizon Wireless’s network and Liberty Global merging its Netherlands subsidiary, Ziggo, with Vodafone’s Netherlands mobile business and having recently acquired the mobile operator BASE in Belgium. We also remain optimistic about Liberty Global’s new-build activity in which despite some delays, the company added 1.3 million new homes passed in 2016 and aims for a similar result in 2017. On the content and entertainment front, Comcast’s NBC Universal division continued to execute well as it benefits from increasing retransmission fees, a strong theatrical slate and upgrades and new attractions at its theme parks. We view the management teams of both companies as excellent operators and capital allocators.
Other strong performers in the first quarter included Unilever, Diageo, Alphabet and PayPal. Unilever’s shares rose sharply in February following the disclosure of a bid by Kraft Heinz to acquire it, followed soon after by a slight decline when the companies agreed to end discussions. We do not predicate our investment decisions on potential acquisitions, and the intrinsic estimate we have been using for Unilever assumes the company remains independent. That being said, we believe that Kraft Heinz’s bid highlights the appeal of Unilever’s differentiated, world-class product franchises and the hard-to-replicate breadth of its manufacturing and distribution network. Unilever generates more than 55% of its revenues from high-growth emerging markets such as India and Indonesia, where it is the leading player in the personal care category. Moreover, Unilever operates within attractive categories that are in many cases less threatened by certain secular pressures and consumer trends that are affecting other players in the industry.
The largest detractors in the first quarter were Perrigo and Qualcomm. Perrigo’s shares fell by 20% in the quarter, continuing a protracted slide in market value that appears to us to be more of a crisis of investor confidence rather than an indication of a broken business. The key issues that have weighed on the company’s earnings results and investor sentiment over the last year have been i) heightened pricing pressure for Perrigo’s prescription generic drug business due to political and media scrutiny as well as consolidation among consortium buying groups and increased competition; ii) weaker-than-expected performance and a significant asset write-down within Perrigo’s European consumer healthcare products division (which had been acquired in 2015); iii) uncertainty following substantial management and Board turnover in the last year; and iv) a delay in filing the company’s 2016 10-K. With the benefit of hindsight, our entry into Perrigo last year was too early and our initial intrinsic value estimate was too high. Nevertheless, we continue to believe that Perrigo has a very attractive competitive position in its core consumer health business and that it has solid, but underperforming, assets in its generics and branded products segments.
The company should continue to benefit from several major secular trends in healthcare, including prescription-to-OTC shifts, demand growth related to demographics, and a persistent need for cost-effective solutions. As part of management’s ongoing strategic review, Perrigo recently sold its royalty interest in Tysabri for $2.2 billion with the potential for additional future consideration contingent upon the achievement of revenue milestones. The inflow of cash gives the company greater flexibility to reduce debt, repurchase shares, or make targeted acquisitions in core areas. The filing delay for the 10-K relates largely to past revenue recognition for the Tysabri license stream and we do not expect any impact on cash flows. With very low embedded growth expectations and significant negative sentiment toward the entire specialty pharmaceuticals sector, Perrigo continues to trade at a substantial discount to our current estimate of intrinsic value.
Qualcomm’s shares, which last year were one of Core Select’s best performers, fell sharply in the quarter following the disclosure of legal challenges from both the U.S. Federal Trade Commission and Apple Inc. While the respective complaints differ in their specifics, they are linked by the common assertion that Qualcomm’s business model and market position are believed to be monopolistic and coercive. As a leader in the development and commercialization of wireless technologies, and with a cumulative research and development outlay measuring in the tens of billions of dollars over the last ten years, the company has created a large portfolio of intellectual property consisting of thousands of patents that are essential not only for the useful operation of mobile devices and networks worldwide, but also for the efficient use of scarce radio frequency spectrum and finite physical resources in handsets. As such, device manufacturers and standards organizations have recognized the value of Qualcomm’s innovations and have therefore been willing to operate under an industry model in which Qualcomm and other holders of valuable patent pools receive royalties that are based on the wholesale prices of devices. Moreover, manufacturers have freely chosen to reach ‘portfolio license’ agreements with Qualcomm in order to get the full benefit of the comprehensive patent portfolio, rather than just the baseline elements. The FTC and Apple complaints attempt to find fault with these arrangements, but in our view, the arguments they have set forth include some inconsistencies and factual liberties that seem unlikely to carry the weight of law. Qualcomm has faced similar legal challenges in the past, both from commercial counterparts and global regulators. While there have been occasional setbacks and meaningful fines, recognition of the company’s intellectual property and the validity of its licensing model have endured.
Portfolio Changes and Valuation
During the first quarter, we added to our existing holdings of Praxair, Nielsen, and PayPal at attractive discounts relative to our intrinsic value estimates. Praxair shares have traded in a narrow range this year as the company continues work toward completing a $40 billion merger-of-equals with Germany’s Linde AG. While consummation of a deal is not yet assured, we are enthusiastic about the merits of the combination and we believe that regulatory impediments, labor relations issues or disagreements on terms can all be addressed, but the process may take some time. We view Praxair and Linde’s businesses as being highly complementary, and we believe that the application of Praxair’s best-in-class operational discipline and high standards for capital productivity to the combined company can produce substantial incremental value.
We continued to build our position in Nielsen in January and early February as the stock traded lower in the absence of any specific news. We first purchased Nielsen for Core Select at the end of December 2016 and have now built up a mid-sized position (around 2.5% at quarter end). We were pleased with the company’s earnings results announced in February, which came in ahead of expectations despite continued challenges in certain parts of both operating divisions, Watch and Buy. In particular, the more discretionary elements of the Buy business faced headwinds as major customers in the consumer packaged goods industry have tightened their marketing budgets, prompting Nielsen to re-evaluate certain parts of the business. However, the recurring, syndicated data parts of the Buy business continued to perform well. Even as macroeconomic challenges linger and technological and behavioral changes affect media companies, advertisers and consumer goods companies, we remain confident in the strength and resilience of Nielsen’s business model over the long term. The company’s investments in new services, advanced analytics and emerging markets continue to gain traction, strengthening Nielsen’s competitive position as a global leader in audience measurement and retail sales data.
We added modestly to our existing PayPal holdings in early February after the shares slipped following the company’s earnings update at the end of January. PayPal continues to produce very strong fundamental performance results as it expands its share of consumer payments online and via mobile devices. Despite some potential pressure from adverse currency movements in 2017, we are expecting a continued trajectory of strong growth in revenues and free cash flows for the company as the business scales and global commerce activity continues to shift away from legacy payment methods.
During the quarter, we reduced our holdings of Progressive and Zoetis as their share prices approached our estimates of intrinsic value. As industry leaders with attractive business models, talented management and resilient demand characteristics, both companies have compounded capital very well for us and have been among our top five positive contributors in the last three years.
In February, we trimmed our position in Bed, Bath & Beyond at a loss given our view that the risk-adjusted range of long-term outcomes even for well-run and differentiated retailers has become less favorable in light of continuing channel shifts and changes in shopper behavior. On the positive side, Bed Bath & Beyond is trading at low valuation multiples and the company has been effective in expanding its online and multichannel presence. Importantly, though, it is hard to know what the ultimate profit margins of the business will be.
At the end of the quarter, we had positions in 28 companies with 52% of our assets in the 10 largest holdings. Core Select finished the quarter trading at 86% of our underlying intrinsic value estimates on a weighted-average basis, which was unchanged from the level at the beginning of the year as our trading actions increased the position weights of companies trading at larger discounts to intrinsic value, thus offsetting the effect of the overall portfolio rising in value. We ended the quarter with a cash position of 9.1%, down from 9.6% at the end of 2016 due to portfolio appreciation and our net purchases.
The Investment Environment
Despite the strong performance of the equity market over the last few quarters, we remain concerned about some of the underpinnings the current run-up as well as its durability given today’s high valuation levels and considerable uncertainties regarding the political environment, the direction of monetary policy and the actual strength of the economy. In our view, low levels of Index volatility and continued fund flows toward broad-mandate passive strategies suggest a complacent environment in which equity exposure has been somewhat commoditized, with a greater proportion of investors simply seeking to own the market as opposed to owning businesses. The danger posed by this commoditization trend is that securities prices could begin to simply express money flows and crowd behavior rather than appropriate risk-adjusted fair valuation. Moreover, a very narrow group of large-cap growth stocks has had a disproportionate positive impact on the performance of the S&P 500. The simple math of Index construction implies that choosing not to own these few companies has made it much more difficult to capture all of the market’s upside.
For Core Select, if our short-term performance goals were benchmark sensitive, we would be not only inclined, but actually forced to identify the most popular growth stocks and macro thematic drivers and position our portfolio weights relative to the Index accordingly. But we believe this way of thinking presents a false choice for two reasons. First, our primary objective is not to hew closely to the Index performance within various parts of an investment cycle, but instead to generate attractive absolute returns over entire market cycles by consistently owning a select group of high quality businesses at valuations that we believe offer an identifiable margin of safety2 . Second, while growth and macro context are important considerations in our qualitative business assessments and valuation work, they are certainly not the only things. The logical flaw in chasing ‘story stocks’ is that investors inevitably begin paying a very dear premium for the comfort of the crowd, and in many cases, they are also paying up for what is perceived to be an embedded call option in companies that already have high valuations. This embedded option becomes a de facto form of leverage, and greatly increases the risk of downside if the companies’ performance slips or if market confidence erodes due to macro factors or liquidity conditions. For this reason, we view the impulse to keep up with the market by owning leadership stocks as being wholly inconsistent with the pure application of a margin of safety framework.
Our Core Select investment philosophy and valuation discipline have some contrarian aspects, particularly in the sense that we endeavor to tune out the market noise and focus on the patient allocation of capital to businesses we have studied extensively and purchased at attractive prices. Not all market environments will be hospitable to that approach, and we believe we are currently living through such times. As noted in the first section of this update, our adherence to these principals has cost us in terms of relative performance over the last few years and begs the question of whether our investment approach has simply lost its relevance. Framing the question differently, one might ask what type of market ‘setup’ would have to emerge to make value-driven, bottom-up active investing improve its performance profile relative to the broader market? In our view, the answer is very simple – it may already be happening. As described above, we believe the view of equities as an ‘exposure’ rather than a collection of business ownership interests is a perspective that gains favor as bull market cycles age, and investors become focused on keeping up. This phenomenon tends to draw the marginal investor into the market, creating supply and demand dynamics that can only be balanced via higher stock prices, at least in the short term. We profess no ability to divine the timing of when today’s bullish market forces might run to excess or be interrupted by other means, but we are quite certain that at some point it will. When it does, we are confident that our stable commitment to owning a portfolio of resilient, well-capitalized companies with strong returns on capital and talented management teams will serve us and our clients well.
We appreciate your continued interest in Core Select, and we always welcome your questions and feedback.
Timothy E. Hartch
Michael R. Keller, CFA
1BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
2 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.