Large cap equities traded to all-time highs during the second quarter of 2015 but subsequently retreated as sentiment was pressured by uncertainties around U.S. monetary policy changes and potential fallout from a worsening fiscal crisis in Greece. Despite some incrementally positive indications within developed-market employment data and industrial activity levels, the overall global economic picture remains mixed, even as lower energy prices and accommodative financial conditions persist.
The S&P 500 Index returned 0.3% during the second quarter, while BBH Core Select Composite (“Core Select” or “The Strategy”) declined by -0.6%. Year-to-date, the S&P 500 is up by 1.2%, and Core Select is down by -1.8%. Over the last five years, Core Select has compounded at an annualized rate of 15.0% per annum versus 17.3% for the S&P 500 Index. Measured from the prior market peak reached in October of 2007, the Strategy has compounded at 8.5% per annum, which compares to 6.2% for the S&P 500.
While the flattish performance of large cap equities, thus far, in 2015 is consistent with the cautious investment stance that we have held for some time, trying to navigate the short-term movements of the market is neither our objective nor is it a factor in our investment process. Instead, we apply a consistent, bottom-up approach focused on identifying resilient, high-quality companies and continually assessing the opportunities and challenges that these businesses face in their markets. Our extensive valuation work – not sentiment, money flows, or trend following – informs all of our portfolio decisions. We buy and sell based on the presence or lack of an adequate margin of safety in each security.
Core Select follows an investment approach for which the best measures of success will evolve over full market cycles given our buy-and-own mindset and our focus on absolute compounding of returns rather than profiting through short-term trading. We underwrite each business with a very long-term perspective, and we are willing to own our companies through varying economic and market environments. Nevertheless, we understand and appreciate investors’ need to carefully evaluate the shorter-term investment performance of their managers, and in that vein we hope to provide some perspective on the recent relative underperformance of Core Select. Reflecting on the last two years, we have several observations. First, given our concentrated and differentiated approach to portfolio construction, we fully expect periodic performance differentials versus broader equity benchmarks. These differentials can play out in either direction – during market corrections, we aspire to outperform the S&P 500, while in bull markets we expect to participate in most but not all of the upside. Second, in the more recent period of the unusually long equity run-up that dates to March 2009, we believe market leadership has begun to narrow around a set of “must-own” stocks and investment themes such as momentum, “growth at any price,” acquisitive companies, and takeover speculation. The danger in trying to chase performance along those lines is that crowded trades create accumulations of price risk and ever-greater potential of a meaningful correction. Last, we take to heart the advice of Benjamin Graham, who said that “the market is there to serve you, not inform you.” In other words, our recent relative performance weakness should not be viewed as a sign that our investment approach has lost its potency or that we need to try to run with the crowd. Instead, we view Graham’s words as a call to maintain our core principles of business quality discipline and investing with a margin of safety.
Turning to the details of our second quarter performance, our strongest contributor was Celanese, which had a total return of 29%. In April, the company’s shares rose sharply in response to a well-received earnings report that demonstrated Celanese’s ability to increase its earnings power even in the face of pricing challenges, adverse currency movements and inventory de-stocking in a key product area. The combination of Celanese’s strong commercial execution, its industry-leading cost of production and its ongoing tightening of corporate infrastructure costs substantially offset top line pressures related to the indirect pass-through effects of lower raw material prices. Notably, the company’s cash flow conversion and its returns on capital showed continued improvement. At a strategic level, we believe management has made the right moves in the last few years in key areas such as contract structuring, regional simplification, raw material supply internalization, and investments in value-added applications. Slightly underappreciated, in our view, is the potential long-term value creation capability conferred by Celanese’s two-track business model that effectively marries a structurally advantaged, cash-generative commodity business with a higher-growth advanced materials business. While some investors may make the argument that the activities should be separated, we believe the two sides complement each other quite well. Although the stock’s recent advance has narrowed its discount to our intrinsic value estimate, we continue to view the risk-reward tradeoff favorably at current levels.
Our second best contributor in the quarter was Comcast, which advanced by 6.9% and was the largest position in Core Select as of June 30. Notably, Comcast has also been our largest positive contributor over the last five years by a substantial margin. In April, we were disappointed to learn that Comcast was abandoning its proposed acquisition of Time Warner Cable due to regulatory pressures from the FCC and the U.S. Department of Justice. While our base-case valuation models had not assumed any benefits from the deal, we did see the combination as being potentially value accretive and a structural improvement for the industry. We believe the government’s position on this matter exemplifies a larger pattern of micromanagement and regulatory over-reach that has affected multiple industries. We do not disparage regulators’ legitimate desires to protect consumers and foster competition and innovation, but our view is that these efforts are too often misinformed, retaliatory, or politicized in some manner, and the costs and strictures they impose on businesses can ultimately harm capital formation and create unintended consequences.
As a standalone company, we continue to believe Comcast remains very well positioned in cable distribution, high-speed broadband, content, and entertainment. Comcast’s advanced network and innovative user platforms are well suited to changing patterns of content consumption and growth in bandwidth demands. In the content and entertainment areas, NBCUniversal continues to show improvements in audience metrics, which should translate over time into monetization rates that are more in line with peers. The film division has benefited from a recent string of successful premieres, while the theme parks segment continues to report strong gate revenues driven by new attractions.
Other strong performers in the quarter included Microsoft, Wells Fargo, and Zoetis. Microsoft reported better than expected earnings for its fiscal second quarter as strong contributions from the company’s cloud-related businesses offset continued headwinds related to PC market softness, adverse currency movements and certain areas of regional weakness. We remain encouraged by the ongoing transformation of the business as Microsoft shifts from a product mindset toward a focus on cloud services and platforms. Recent changes in the company’s management structure and the winding down of activities in certain non-core areas affirm its commitment to this important evolution.
Wells Fargo’s shares gained 4% driven by a solid earnings report and modestly improved external drivers such as interest rates, employment levels and wage growth. Despite an industry environment that remains challenged by narrow lending spreads, regulatory pressures and generally low levels of growth-oriented credit usage by commercial and industrial customers, we believe that the company continues to execute quite well. In a rising interest rate cycle, we believe Wells Fargo’s asset sensitive balance sheet and the redeployment of its currently high mix of short-duration, low-yielding investments could drive an appreciable increase in earnings power, although the stock’s strong performance suggests that other investors are gaining comfort with this assumption as well.
Zoetis finished the quarter with a 4% gain despite having retraced a sharp run-up in June after reports of an acquisition by Valeant Pharmaceuticals failed to materialize. Zoetis nevertheless remains our top contributor thus far in 2015, largely driven by strong earnings performance and the announcement of a $300 million restructuring program that will include additional overhead reductions as well as the pruning of certain product offerings that are either declining in sales volume or have lower profitability. Regarding the merger speculation, as we have stated in the past, we can see the strategic and financial appeal that Zoetis may offer to a potential acquirer, but our investment thesis is underwritten solely on the standalone value of the business. The sharp rise in the company’s share price over the past year significantly reduced the discount to our estimate of intrinsic value per share, but we still see reasonable upside potential from the quarter-ending level.
Our weakest performers in the second quarter were Berkshire Hathaway, Bed Bath & Beyond, and Qualcomm. After falling by 4% in the first quarter, shares of Berkshire Hathaway declined by an additional 6% in the second quarter of 2015 without any particular downside catalyst. The company’s May earnings report showed strong and broadly diversified profit growth across most of the businesses, with a particularly strong contribution from the railroad segment. Mixed share price performances among some of Berkshire’s large public holdings have restrained growth in book value per share, but we do not view this as an indication of permanent impairment. During the quarter, the company made incremental capital commitments in several smaller transactions, including the exercise of warrants related to the HJ Heinz acquisition undertaken in 2013. One key takeaway from Berkshire’s May shareholder meeting was CEO Warren Buffett’s assertion that the company will not be considered a Systematically Important Financial Institution (SIFI) by U.S. regulators. A SIFI designation, if applied, would subject Berkshire to additional oversight, capital requirements, stress tests, and substantial compliance costs. Our view is that Berkshire’s large holdings of cash and securities and its very strong capital position are clearly a bulwark against financial stress.
Bed Bath & Beyond shares faded from the levels hit earlier in 2015 as weak retail sales levels and stirring wage inflation pressured sentiment toward the sector. The company reported solid first quarter earnings that reflected the interplay of several continuing trends – flattish in-store sales growth, strong gains in online sales, lower gross margins due to competitive pricing, and higher operating expenses driven by digital initiatives. The company’s balance sheet and cash flow generation remain strong, enabling a large repurchase program that has now reduced the number of shares outstanding by 16% over the last year at prices that we believe are attractive. In May, the buyout firm Leonard Green & Partners disclosed that it had built a previously undisclosed stake in Bed Bath & Beyond, fueling speculation that the company could at some point be a candidate for a go-private transaction. We do not believe this is the current intention of management or the Board of Directors, and our investment thesis is solely based on the standalone value of the business.
Qualcomm’s share price declined by 9% in the quarter and is down 15% year to date. Investors have been disappointed by the recent performance of the company’s chip business, in which low-end price pressure, adverse shifts in OEM market share at the premium handset tier and the loss of a key component placement at Samsung have impaired the near-term revenue run rate and margin performance of this business. Conversely, Qualcomm’s technology licensing segment has enjoyed the benefits of strong unit volumes and average selling prices of mobile devices, fueling sizable gains in aggregate industry sales upon which the company’s IP royalties are levied. Moreover, the settlement of a lengthy regulatory inquiry in China has improved the outlook for the business as previously unreported sales of royalty-bearing devices will now be recognized. We continue to believe that Qualcomm has unmatched engineering capabilities that create enormous value for the global ecosystem of device manufacturers, wireless carriers, and end users. Continued global demand growth for advanced handsets and the concurrent need for spectrum efficiency, circuit densification and low power consumption play well to Qualcomm’s technology leadership position. In addition, burgeoning growth in the “Internet of Things” concept will expand the addressable market over time as more devices for personal and industrial usage will require wireless connectivity. Our valuation work suggests that even with a conservative forecast applied to the technology licensing business, little or no value is being attributed to the chip business at today’s share price. While the company still faces competitive and execution-related challenges in the chip business that will require careful management of its cost structure and commercial strategy, we believe that the stock’s current valuation offers a very attractive long-term opportunity vis-à-vis the risks assumed. Near the end of the second quarter, we added to our existing holdings at prices in the low $60s.
In late June, we also added to our position in Oracle as the shares traded lower following the company’s release of fiscal fourth quarter results. Oracle’s report showed similarities to those of other software companies that have transitioned part of their business models from license and maintenance revenue to subscription-based billing. This transition typically results in slower recognition of near-term revenues alongside front-loaded sales and marketing expenses and capital expenditures. The net effect is lower reported revenue, margins, and cash flow for several quarters until revenue recognition increases in future periods. For Oracle, this shift was exacerbated by a particularly strong selling performance in Europe which negatively impacted U.S. dollar based results and the company’s blended tax rate. Looking past the transitory impacts of the business model shift, we believe Oracle’s cloud-based product suite is gaining traction with IT procurers, leading to improved sales execution and a growing list of reference customers. The related increases in organic capital expenditure are an attractive reinvestment into Oracle’s business as they represent a layering of visible, profitable streams of future billings. Organic reinvestment opportunities of this caliber have been reasonably rare for cash-rich legacy technology companies in recent years.
In April, we reduced our position in Waste Management as the shares traded closer to our estimate of intrinsic value per share. Since that time, the company’s shares have come under meaningful pressure owing to a mix of waste volume weakness, declining prices for recycled materials, lower fuel surcharges, and weakness in the Canadian dollar. While these are not new headwinds, we believe that the management team has formulated the appropriate strategic responses, including firm pricing discipline, further cost reductions, reduced capital deployment and the careful consideration of consolidation opportunities in the collection and disposal market. Moreover, the company has the ability to direct a portion of its ample free cash flows toward share repurchases.
At the end of the second quarter, we owned 29 companies with 47% of our assets held in the 10 largest holdings. Core Select ended the quarter trading at 83% of our underlying intrinsic value estimates on a weighted average basis, compared to 82% at the end of the first quarter and 87% at the end of 2014. We raised our intrinsic value estimates for several companies as we updated our forecasts, but lowered them for certain others that have experienced earnings pressure from foreign currency translation or, in the case of the energy industry, lower commodity price realizations due to the sharp decline in crude oil and natural gas over the last 12 months. Notwithstanding the equity market pullback at the end of the quarter that allowed us to add to our Qualcomm and Oracle positions as noted above, the overall valuation environment has remained challenging, which has limited our opportunities to deploy capital at sufficiently large margins of safety. Consequently, our cash position remained high at 11% as of the end of the quarter.
We continue to believe that financial markets are in a somewhat fragile state following a multi-year rally that has not been matched by equally robust underlying macroeconomic conditions or company fundamentals. Moreover, escalating geopolitical risks, sustained fiscal imbalances and increasingly reckless monetary policy remain present, creating additional risks for investors. In equilibrium, equity valuations should reflect the consensus views of knowledgeable investors who have weighed the future cash flow prospects of companies against the risk-adjusted opportunity cost of committing capital. Yet looking back at the last few years, our belief is that equity prices have been heavily influenced by interest rate suppression, excess liquidity, and global capital flows. An obvious problem with this set of circumstances is that a directional change in any of the conditions that caused the run-up could create cascading risk reduction efforts and deleveraging by investors, leading to market instability. This scenario is not a forecast on our part, but it nonetheless bears some influence on our broadly cautious stance.
If we are correct in our view that the equity market could be in the late phase of a long-running bullish cycle, then it is not entirely surprising that our “quality and value” style of investing has been somewhat out of fashion as investors have continued to reach for capital gains, thereby bidding up certain parts of the market that were already robustly valued. As a side note, stunning valuations in other areas such as “pre-IPO” technology companies and global luxury real estate suggest to us that the momentum impulse has overshadowed prudence and capital preservation among many investors. Despite this setting, we have no desire or intention to change the approach our team has employed for Core Select over the last 10 years. Our investment horizon is three to five years, and we are grateful to have steady-handed clients that share our perspective. We are confident that our selective criteria, detailed bottom-up fundamental work and strict valuation parameters will enable us to deliver absolute returns over full market cycles.
Our Core Select investment team appreciates your continued interest and support. We look forward to providing further updates in the second half of 2015.
Timothy E. Hartch
Michael R. Keller
1S&P 500 Index: An unmanaged, market capitalization weighted index of 500 stocks providing a broad indicator of stock price movements.
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.
3 Intrinsic Value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.