During the first quarter of 2019, large cap U.S. stocks rebounded sharply from the deep sell-off that had occurred late in 2018. The resolution of a U.S. federal government shutdown and hints of progress on trade negotiations with China aided investor sentiment, but by most accounts, it was the abrupt dovish turn in forward guidance and commentary by the Federal Reserve (Fed) that sparked the swift stock market rally. All sectors within the S&P 500 Index had positive returns for the period, and for the first time in more than two years, the equal-weighted S&P 500 outperformed the capitalization-weighted benchmark. Notably, small-cap stocks and the pro-cyclical sectors of the market had particularly large upward moves, further illustrating the breadth and risk appetite that characterized the gains.
The S&P 500 Index returned 13.65% in the first quarter. By comparison, BBH Core Select Composite (“Core Select” or “the Strategy”) rose by 11.68%. Over the last five years, Core Select has compounded at an annualized rate of 7.79% per annum versus 10.91% for the S&P 500 Index. On a full-cycle basis, as measured from the pre-crisis market peak reached in October of 2007, the Strategy has compounded at 8.1% per annum, which compares to 7.6% for the S&P 500. As measured from the interim market peak reached in September 2018 (prior to the major fourth quarter 2018 correction), Core Select has declined by 1.4%, while the S&P 500 remains down by 2.3%.
The broad strength in equity prices during the quarter was evident in the portfolio contribution of our holdings, with nearly two-thirds of our stocks advancing by double-digit percentages and only six declining. Our largest positive contributor was FleetCor Technologies Inc., which returned almost 33% and was one of our five largest positions at quarter-end. As with many of our holdings, the market’s sharp rebound from the prior quarter’s sell-off was a factor in FleetCor’s gains, but the company’s very strong earnings report in early February was equally influential. FleetCor reported 11% organic revenue growth, significant margin expansion, strong bookings, and a robust outlook for revenue and earnings in 2019. Customer retention rates notched all-time highs, while continued progress in key growth areas such as corporate payments and electronic tolling was expressed in the strong top and bottom-line figures. We were also pleased with management’s commentary regarding the need to keep investing in innovation and sales. A hallmark of the company’s value creation over many years has been its forward-thinking efforts not only to drive incremental business with existing customers, but also to pursue inroads in ancillary ‘white space’ areas of commercial payments technology. This long-term perspective combined with our positive view of digitization-driven growth in the addressable payments market are key factors supporting our bullish investment thesis. Further, we also commend management for its opportunistic and value-driven approach to share repurchases, which totaled $570 million in the fourth quarter as the stock price declined by as much as 23% without any corresponding slippage in the company’s resilient and growing business.
Other positive contributors in the first quarter included Oracle Corp., Comcast Corp., Alphabet Inc., and Copart Inc. In our fourth quarter 2018 letter, we had written that the shares of Oracle and Alphabet had fallen sharply for reasons that we viewed as being mainly market-related and not indicative of any degradation of underlying fundamentals. To some degree, the strong performance of both companies’ shares in the first quarter was a reversal of that phenomenon, although their respective quarterly earnings updates were also positive factors. Similarly, Comcast rose alongside the broader market but also benefited from a better-than-expected earnings report in late January, highlighted by solid core operating margins, favorable indications regarding 2019 capital intensity, and cable subscriber losses that were favorable relative to expectations.
The largest performance detractors in the first quarter were Qurate Retail Inc., Qualcomm Inc., and Kroger Co. Against a continued backdrop of cautious investor views toward companies whose business models have links to the traditional pay-TV ecosystem, Qurate shares came under further pressure after it reported weaker-than-expected profitability and management outlined the need for incremental investment in marketing, technology, and infrastructure, which will likely weigh on future margins. While Qurate has been able to grow its customer base despite pressures from e-commerce, pay-TV subscription declines, and traditional brick-and-mortar retailers, it has come at an increasing cost as the company has expanded marketing capabilities through additional headcount and performance marketing technology to better target potential customers. Qurate has also encountered higher fulfillment costs due to the cost of drop-shipping products from online-only sales (at higher rates relative to its TV-based shopping networks). To better manage its shipping costs, Qurate has begun construction of a new fulfillment center that is expected to open later in 2019 and should ultimately help reduce delivery times and freight costs. While these incremental investments are likely to pressure profitably in the near term, we believe they are appropriate initiatives focused on strengthening the business in what is a very competitive retail environment. Nevertheless, we remain cognizant of the larger structural challenges that the business may be facing longer-term, and despite what appears to be a currently pessimistic public market valuation, we elected to reduce our position size during the quarter and redeploy the proceeds into higher-conviction holdings.
Qualcomm shares declined as investor uncertainties accumulated during the testimony period of a non-jury courtroom trial in California in which the U.S. Federal Trade Commission (FTC) seeks to remediate alleged anticompetitive business practices by Qualcomm in the global market for mobile chips and related technology licensing. While the FTC’s complaint made specific allegations of trade restraint, coercion, and monopolistic behaviors, and the courtroom proceedings primarily pertained to these same issues, the parade of competitors, customers, partners, and expert witnesses that were called to testify seemed to give the three-week trial the appearance of being a de facto referendum on Qualcomm’s ability to conduct its status-quo business model and collect royalties from handset manufacturers whether or not they are also buyers of Qualcomm’s modem chips. Without predicting any outcomes or the likely contours of a pre-emptive settlement (if there were to be one), our own assessment of the trial and precedent cases led us to a view that Qualcomm may be at heightened risk of receiving an adverse ruling, if for no other reason than the fact that the realities of the modern-day mobile handset industry and supply chain do not fit neatly into the mold of comparable case law that the FTC seemed to be applying to the situation. While an adverse ruling would likely lead to an appeals process, one potential near-term result of such an outcome would be that handset manufacturers could become emboldened to cease royalty payments to Qualcomm using the protective cover of the FTC decision. Given the importance of these royalty payments to Qualcomm’s profitability, the range of long-term outcomes for the company’s steady-state earnings power widened materially, in our view, and thus we decided to exit our position at a loss. Two other factors that influenced our decision were 1) the continued deceleration of smartphone unit growth worldwide, and 2) the general escalation of tensions between the U.S. and China, which in our view has derivative influence on the lingering intellectual property dispute between Qualcomm and Huawei.
Kroger shares retreated in the final month of the quarter due to the weaker-than-expected operating results and rising investor concerns that the company’s fiscal year 2020 planning goal of $3.5 billion in operating profit will require near-flawless execution in a food retail market that remains very challenging both in terms of pricing and the need to invest in digital transformation. For its part, management continues to believe that it can deliver on its goal given not only the initiatives it has taken to fortify its core business, but also the prospects of incremental upside from alternative businesses within Kroger that are higher margin and more capital efficient than standalone grocery. Notable among these ancillary profit drivers are Kroger’s in-store financial services (e.g. basic banking, gift cards, expedited bill payment) and its first- and third-party offerings that leverage shopper data insights for the purposes of marketing, promotions, pricing analysis, and product studies. We will continue to closely track the company’s progress on these efforts. Prior to the March share price decline, we had twice trimmed our Kroger position (once in January and again in February) to manage our position size vis-à-vis other investment opportunities and the risk-reward tradeoff we perceived in the valuation at that time.
Portfolio Changes and Valuation
During the quarter, we initiated new positions in Costco Wholesale Corp. and Colgate-Palmolive Co. Both companies strongly embody our Core Select investment criteria and are well positioned in their industries, yet their respective share prices had begun to discount overly negative investor sentiment entering 2019, in our view.
Our investment in Costco marks the second time we have owned its shares in Core Select. The company is a leading warehouse club retailer that offers a limited assortment of essential products that are sold in bulk at discounted prices, mainly through its fleet of nearly 800 clubs, but also via e-commerce. Ancillary offerings include pharmacy, fuel stations, optical care centers, auto centers, and travel services. Costco is one of the world’s largest retailers by sales volume, and it serves more than 94 million members globally.
While the U.S. retail industry is undergoing structural shifts, we believe Costco can effectively leverage its size, scale, and unique shopping experience to not only compete but also sustain a leadership position. We believe the company’s key advantage derives from a ‘flywheel’ effect in which low prices, quality products and skilled merchandising drive strong customer loyalty and store traffic, which in turn enable the company to further drive its pricing, sourcing, and merchandising leadership via scale and data insights. Key to Costco’s business model is the presence of an annual membership fee paid by shoppers, ranging from $60 to $120 in two tiers for individual and business customers. By design, the company earns the vast majority of its operating profit through the membership fee, which enables it to sell products at very low markups relative to competitors. Given the key role that the membership fee plays in Costco’s pricing strategy and thus its entire model, member retention is a critical metric for the health of the business. Retention has consistently trended higher over the last 20 years and is currently in the high 80% range on a company-wide basis, while the U.S. and Canada regions have renewal rates in the low 90% range. These rates have persisted even as management has periodically raised the membership price, generally by 10% every five years. Growth of the aggregate membership fee income via price increases and strong retention combined with a steady trend of customers moving to higher-tier membership levels have been the most significant drivers of the company’s long-running profit growth.
Costco’s store operations have also showed strength and resilience over time, with core same-store sales growing at mid-single-digit rates since 2007 through periods of varying economic conditions. In our view, this demonstrates the value and necessity that members see in Costco’s offering. Leveraging its scale and merchandising capabilities, Costco has also cultivated its own private label brand called Kirkland Signature which offers high-quality products directly alongside national brands at attractive price points (and profit margins). Kirkland Signature products account for roughly 30% of merchandise sales. While growth and retention of the membership base remain the company’s critical goals, management also continues to pursue opportunities to open additional clubs both in the U.S. and internationally. This ongoing initiative targets greenfield markets as well as infill opportunities, ultimately helping to attract new members and improve service to existing members. With an expected run rate of 20-25 openings per year, we believe that Costco can further grow its revenue base and thereby drive the favorable flywheel effect noted above. From a financial perspective, Costco has been a consistent generator of strong and growing levels of free cash flow, and its return on invested capital (currently in the mid-teens range) exceeds the cost of capital, creating favorable compounding effects for shareholder value as the company grows. Costco is conservatively financed, with cash balances currently exceeding funded debt and operating earnings providing ample interest coverage.
We purchased shares of Costco in early January at prices we viewed as a compelling valuation opportunity that had resulted from i) the general market selloff at the end of 2018; ii) lingering concerns regarding a gross margin dip that had occurred in 2018 due to fuel margin pressures and member reward redemption activity; and iii) general skepticism about the sustainability of the wholesale club model given changing demographic trends and e-commerce ubiquity. On the latter point, we believe such concerns are overstated given the differentiated nature of the shopping experience (bulk quantities, ‘treasure hunt’ merchandising, large mix of fresh and perishable items) and value proposition (reliably low prices) offered in the club model versus e-commerce channels.
In late January, we initiated a position in Colgate-Palmolive. Colgate is a leading Home and Personal Care (HPC) product manufacturer with a focus on oral care, soaps, cleaning agents, and specialized pet food. Colgate has a global footprint, with approximately 50% of its sales coming from developed markets and the balance from emerging markets. The company has a leadership position in oral care in most of its geographies, with high relative market shares, broad presence in both small and large retailer channels, and a product portfolio that addresses multiple price points. The company’s innovation strategy leverages science-based research and development to drive incremental product improvements as well as category-disrupting launches that are offered across the price ladder, thereby reinforcing barriers to entry against other global players and local competitors.
Our investment in Colgate is based on our view that the oral care category is an attractive, high-margin, high-return business with substantial opportunity for growth given low penetration in much of the company’s footprint. We believe that Colgate’s market-leading positions in nearly every market in which it participates combined with the attractiveness of its footprint in regions with strong secular tailwinds will enable it to capture meaningful growth in the category over an extended period. Furthermore, we believe the science-based nature of its major product segments gives Colgate the ability to consistently ‘premiumize’ within its categories and therefore capture meaningful incremental revenue as even mature markets continue to develop and those consumers seek superior value propositions and functionality beyond basic paste and brush offerings.
In addition, we believe Colgate is appropriately supplemented in scale with its Personal Care and Home Care businesses, occupying defensible niches in specific markets where the additional scale at retail can benefit the portfolio on a combined basis. Finally, we have a positive view of the specialty, veterinarian-driven pet food niche that Colgate occupies with its Hill’s brand. Exhibiting many characteristics similar to the medical detailing aspect of Oral Care, Hill’s dedicates meaningful research and development (R&D) and marketing resources to building relationships with practitioners and providing clinical data supporting product efficacy. As with Oral Care and Colgate’s other HPC categories, the R&D and clinical data are global in nature, and we believe Hill’s is positioned well to capture growth in its narrow niche of specialty and prescription pet foods as the companion animal category develops market-by-market.
Colgate exhibits the key attributes that we look for when evaluating companies throughout the consumer staples sector, including i) strong brand franchises that have scalability across multiple markets, both developed and developing; ii) competitively advantaged distribution infrastructure that can be leveraged as additional products are introduced to a market; and iii) attractive categories in which brand investments translate into premium market positions and pricing power. We believe these characteristics position Colgate to generate stable and sustainable revenue growth and long-term compounding of operating income, earnings, and cash flow at rates above the growth in sales. Colgate’s flagship franchise generates strong free cash flow supported by the growth of key end markets and product segments (including premium, natural, and organic products), lower future capital investments and development cost requirements following its current investment cycle (expected to ramp up during 2019), and significant future operating leverage driven by the global nature of category R&D and clinical data. We believe the company’s balance sheet remains sufficiently flexible to continue to invest in the business and make opportunistic purchases in evolving HPC categories and segments (e.g. other Oral Care brands and Personal Care) while returning free cash flow to shareholders and repurchasing shares when appropriate.
Along with the new purchases noted above, we also added to our existing holdings of Copart Inc., Brown-Forman Corp., Dollar General Corp., Henry Schein Inc., and Alphabet Inc. during the first quarter. From this list, the first three companies were new investments for Core Select in 2018, and we have continued to opportunistically build the positions. Regarding Henry Schein, we added to our holdings to maintain our desired portfolio exposure following a corporate spin-off (which is discussed further below). Alphabet remains among our highest-conviction investments given our positive views regarding its durable growth drivers, embedded technology advantages, financial strength, and potential long-term benefits from internal incubation of new products and services.
As noted above, we exited our entire position in Qualcomm near the end of January. In February, we received shares of Covetrus Inc., a newly formed company created in a two-part transaction in which Henry Schein spun off its animal health distribution business and then merged it into Direct Vet Marketing Inc. (which operates as Vets First Choice), a provider of prescription management services for veterinary practices. While we maintain a generally positive view of the animal health market overall given the durability of its growth drivers and favorable structural factors related to reimbursement, we did not view Covetrus as being a strong fit with certain elements of our criteria. Moreover, as with many vertical mergers, the blending of corporate cultures presents uncertainties that warrant careful consideration. We elected to sell our shares of Covetrus in February.
In addition to the previously mentioned trims in Qurate and Kroger during the first quarter, we also reduced our holdings of Liberty Global PLC and Discovery Inc. Both companies’ share prices rose substantially during the quarter, giving us opportunities to lighten our positions in reflection of our continued concerns regarding the long-term range of business outcomes for the traditional media sector. With Discovery, we continue to believe that its leadership in branded non-fiction programming content is valuable and desired by consumers and advertisers, but when we objectively consider factors such as i) the ongoing fragmentation of media viewership, ii) the realignment of distributors’ channel bundles, iii) the persistent headwind of cable-TV subscription losses, and iv) the unit economics of directly distributed online content relative to traditional carriage, the resultant variability of the full-lifecycle value of the company raises the question of whether the investment meets the threshold level of certainty that we aspire to have in our portfolio holdings. In the case of Liberty Global, the company maintains competitively advantaged broadband and cable businesses in several large European markets (most notably the UK), but over the last year it has entered into several large divestiture agreements, which upon closure will raise significant amounts of capital. While we believe management has a good track record of capital allocation, we cannot be sure of the ultimate deployment of the proceeds, and as such, it is harder to say with enough certainty whether the company in its future state will meet our investment criteria. Following these trims, Liberty Global and Discovery were among our smallest positions at quarter end.
At the end of the quarter, we had positions in 30 companies with 55% of our assets held in the 10 largest holdings. As of March 31, Core Select was trading at 85% of our underlying intrinsic value estimates on a weighted-average basis, which was eleven percentage points higher than the prior quarter due to the market rally. We ended the quarter with a cash position of 3.4%, which was little changed from the prior quarter level as our purchases and sales largely offset each other.
The upward scramble of equity markets to double-digit gains in the first quarter calls to mind the old bit of wisdom suggesting that bull markets thrive on skepticism, as incremental buyers are slowly compelled to shed their caution and join the trend. Given the very long duration of the current expansion in both the U.S. economy and corporate earnings, the escalation of trade tensions, tightness in the domestic labor market, stagnation in several major developed economies (ex-U.S.), the rising profile of anti-business themes entering the mainstream political discourse, and the already robust valuation levels of large-cap equities, it is easy enough to spot sources of skepticism in today’s market. Arguably less clear, however, have been the driving forces that have allowed the market to consistently resolve these puzzling inconsistencies and maintain its upward push, even in the face of non-corroborating economic data.
In the first quarter, the Fed’s public commentary and guidance regarding its adoption of a ‘wait-and-see’ approach to monetary policy normalization was broadly viewed as being the major bullish impetus for the market. But in the interest of balance, an alternative view might be that the Fed’s telegraphed forbearance was actually the result of its own forward view of potential obstacles for the economy. We also note that bond markets seemed to interpret the Fed’s message in a very different way (i.e. a strong bid in safe assets and a sizable decline in benchmark rates). Our investment process is not predicated on us attempting to resolve these discrepancies and then make directional calls. But that does not imply that we ignore the market context under which we are operating, especially as it pertains to accumulation of price risks if and when sentiment gets pushed too far in one direction. In that vein, we believe the key takeaway for the prudent investor in light of today’s cross-currents should be that adherence to fundamentally-driven stock selection principals and valuation discretion are as important as ever. With our consistent bottom-up focus on companies’ business quality, industry structure, growth opportunities, financial soundness, and management capabilities, we are confident in both our process and our portfolio, as well as our long-term prospects for attractive compounding of capital.
The Core Select team appreciates your continued interest and support.
Michael R. Keller, CFA
The strategy is ‘non-diversified’ and may assume large positions in a small number of issuers which can increase the potential for greater price fluctuation.
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IM-06309-2019-04-17 Exp. Date 07/31/2019