Large cap U.S. equities rose in the second quarter of 2016 despite a volatile end to the period after the United Kingdom (U.K.) voted to leave the European Union. The S&P 500 Index returned 2.5% during the second quarter, while BBH Core Select Composite (“Core Select” or “the Strategy”) was up by 1.0%. Year to date, the S&P 500 is up by 3.8%, and Core Select is up by 3.5%. Over the last five years, Core Select has compounded at an annualized rate of 10.8% per annum versus 12.1% for the S&P 500 Index. Measured from the prior market peak reached in October of 2007, the Strategy has compounded at 8.8% per annum, which compares to 6.0% for the S&P 500.
Investors’ initial reactions to June’s ‘Brexit’ referendum were swift and severe, not only due to wrong-footed market expectations prior to the event, but also due to the heightened possibility of other European Union (EU) countries taking similar actions. The subsequent strengthening of the U.S. Dollar once again raised the specter of revenue and earnings headwinds for U.S. multinationals and a greater risk of external debt pressures for emerging market countries. Other short-term ripple effects of the announcement included sharp selloffs in the shares of British and European banks, global cyclicals and consumer discretionary companies, while traditional safe havens fared better. In the closing days of the quarter, however, equity markets snapped back, led by financials, energy and industrials.
Our approach for Core Select emphasizes bottom-up fundamental analysis and always maintaining a margin of safety* in the valuations of the companies we own. We typically do not attempt to make high-level market predictions or trade in and out of our positions accordingly. We do, though, take into account key macroeconomic developments that could pose a risk to the operations and earnings of our companies. To that end, we note that the Brexit situation and the fall in the trading value of the British Pound will affect our U.K.-domiciled companies Diageo and Unilever (which we own via American Depository Receipts (ADR)) as well as several of our large multinational companies that are active in the U.K. However, because Diageo and Unilever generate a majority of their profits abroad and most of the multinationals earn less than 10% of their earnings in the U.K., we believe the direct impact of Brexit and Pound weakness on our portfolio will be relatively modest. For a few companies, we have made downward adjustments to our U.S. Dollar intrinsic value estimates, but these changes have all been relatively small.
As we have noted in prior updates, and consistent with the recent Brexit experience, the market remains highly sensitive to macro-level factors and anticipated policy responses of the world’s central banks. This dynamic was evident in the market’s volatility in late June. For us the issue is not the specific macro developments that come and go, rather the larger implications for the structure of today’s financial markets, which in our view have become increasingly distorted by ultra-low and negative interest rates.
Our baseline view continues to be that the current valuation environment remains challenging for value-oriented investors, as excess liquidity and interest rate suppression have caused future returns to be consumed in the present, thus raising the likelihood that forward returns could be modest, particularly if companies continue to report weak organic earnings growth. We also believe that today’s extended period of anemic interest rates is pushing many investors toward yield-oriented investments in areas such as telecommunications, utilities and REITs. These sectors have been among the market’s best performers in 2016 as forecasts for higher interest rates have been continually pushed farther out into the future. For Core Select, we have not made investments in these areas, given an overall lack of fit with our business criteria and very rich valuations. While this posture has hurt our year-to-date performance relative to the S&P 500, we remain firm in our conviction that business quality and valuation are critical for compounding capital over a full market cycle.
Another observation regarding the market performance thus far in 2016 is that many of the sectors and companies that fared the worst in share price terms during the selloff that started the year proved to be the best performers in the sharp rebound that started in mid-February. Examining the list of the 100 worst performers from the start of the year through the market low on February 11th, 2016, and also the 100 best performers from that point through the end of June, we found that only one of the companies was a Core Select holding (EOG Resources), and very few were even on our watch list of companies that fit our investment criteria. In other words, much of the volatility in the market, both on the downside and the upside, was happening in areas outside of our scope of interest. We believe this highlights the continued ‘risk on, risk off’ behavior of the market, with short-term swings being largely driven by sentiment and positioning, often in more cyclical or factor-driven parts of the market.
* With respect to equity investments, 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.
Turning to the details of our second quarter performance, our strongest contributor was Novartis, which rose by 14%. The Company’s ADRs rose throughout the quarter and then surged following the initial Brexit shock as investors pursued stable, dividend paying companies and the steadiness of Swiss Franc denominated assets (benefiting the exchange value of our US Dollar-denominated ADRs). In April, Novartis reported solid quarterly results driven by growth from new product launches in the Pharmaceuticals and Sandoz (generics) segments as well as further cost improvements enabled by the centralization of overhead functions and a tighter focus on procurement efficiency. Importantly, Novartis achieved high single-digit volume growth in both Pharmaceuticals and Sandoz, implying good sales execution, attractive product positioning and improving standards of care in growth markets. The Company’s Alcon business continues to work through ongoing challenges related to market growth, competition and business execution, but we are pleased with the decisive actions that Novartis has taken to address the situation. Under new leadership and with an operating structure that now divides the ophthalmic drug business from equipment and consumables, Alcon is reinvesting in growth and customer relationships while also tightening costs.
Our second best contributor in the quarter was Comcast, whose shares gained 7%. Notably, Comcast has also been the top contributor for Core Select over the last three- and five-year periods. The Company continued to achieve steady performance in its core cable and broadband business, in which moderating churn rates, higher rates of customer up-selling and bundling, and share gains in the small and midsize business market have driven mid-single digit revenue growth. While some of this top-line benefit is being offset by higher programming costs as well as investments in customer service and advanced infrastructure, the cable business overall remains solidly cash generative. In the NBC Universal segment, performance remained solid across the broadcast, cable networks, film and theme parks businesses. Comcast also announced in May its plan to acquire DreamWorks Animation for $3.8 billion. DreamWorks produces full-length animated feature films as well as television shows for various distribution partners, and it owns a majority stake in an online media company that targets younger demographics. Strategically, we believe that DreamWorks fits well alongside Comcast’s Illumination animation studio, but the purchase price appeared high to us.
Other strong performers in the second quarter included EOG Resources, Zoetis, Nestle and Waste Management. The shares of EOG Resources advanced by 8% in the quarter and 27% from the market lows of February, propelled by a recovery in crude oil prices. While operating conditions for domestic exploration and production remain challenging, EOG has distinguished itself by its strong execution on costs and its proactive moves toward novel applications of enhanced oil recovery (EOR) in its prolific shale acreage, as well as its continued focus on limiting drilling activity to its sizable base of premium land inventory. With its characteristically high well productivity and per-barrel cost advantages, EOG has been able to carefully deploy capital at healthy returns despite the dramatic declines in the commodity cost environment over the last year. The Company’s balance sheet remains solid and the shares continue to trade at a discount to our estimate of intrinsic value.
Zoetis and Nestle, which were both among our top ten holdings at the end of June, produced mid-to-high single digit returns for the quarter, driven primarily by good business execution and investors’ increasing focus on high quality, low volatility companies that have better-than-average prospects for steady revenue growth and operating leverage.
Just prior to the close of the quarter, Nestle’s Board of Directors announced its succession plan for the roles of Chairman and CEO. Nestle plans to nominate Paul Bulcke, the Company’s current CEO, for election to Chairman at the April 2017 general meeting. As Mr. Bulcke will be resigning from his position as CEO at the end of 2016, the Board has appointed an external candidate, Ulf Mark Schneider, to succeed him. Since 2003, Mr. Schneider has served as CEO of Fresenius Group, a diversified healthcare company that has a leading global position in dialysis care. The Company believes that Mr. Schneider’s experience and track record as a CEO will complement Nestle’s experienced and deep leadership group, and that there will be a good level of cultural and strategic fit given Fresenius’s focus on quality, innovation and R&D as well as its emerging markets presence. While Nestle firmly stated its intention to remain a food and beverage focused company, we believe Nestlé’s appointment of a longstanding healthcare CEO signals the Board’s intention to not only continue the company’s “Nutrition, Health, and Wellness” strategy, but also to further integrate its existing health and pharmaceuticals-adjacent businesses into the Company’s core. Nestle’s shares traded higher following the announcement, but some portion of the rebound was likely tied to the post-Brexit market recovery.
Having advanced by 13% in the second quarter, Waste Management is now our best performing stock thus far in 2016. The Company has continued to make progress on its various operational and commercial initiatives, particularly with respect to pricing discipline, capital productivity, and the reduction of cyclical exposure in the recycling business. In its first quarter earnings update, Waste Management reported positive volume growth for the first time in several years, marking a key inflection point that greatly facilitates the Company’s ability to leverage its cost base and generate higher rates of growth in economic profits. The large gains in Waste Management’s share price this year have reduced the stock’s discount to our estimate of intrinsic value per share.
Our largest detractors in the second quarter were Perrigo, Discovery Communications, Alphabet and Bed Bath & Beyond. Perrigo is a new position for Core Select as of April, and we steadily accumulated shares as they fell during the quarter. Our investment thesis on Perrigo is explained later in this letter.
Discovery Communications declined by 12% in the quarter amidst negative investor sentiment toward the traditional pay television industry and fallout from the Brexit situation, given the Company’s significant business activity in the UK and Europe. We continue to view Discovery’s strong international presence as a long-term growth driver. In the first half of 2016, however, International weighed on Discovery’s overall results, primarily due to i) adverse foreign currency translation, ii) higher programming costs related to recent investments in sports rights, and iii) a contract renegotiation that led to a temporary blackout (which has now been favorably resolved). With the exception of the currency pressure, which is outside of management’s control, we believe these factors will have less of an impact on the Company’s results in the balance of 2016. On the broader matter of negative investor sentiment toward pay television, the central concern continues to be that consumers will increasingly ‘cut the cord’ or migrate to lower-cost channel packages that do not include certain networks. We do not dispute that this phenomenon is occurring, but recent results reported by both cable distributors and content providers do not support assertions of sharp changes in the trend. Our forecasts for Discovery’s affiliate fees and advertising revenues have always assumed a permanent but modest decline in cable subscribers. Even if we apply more severe assumptions into our scenario models, we still conclude that the stock’s current valuation reflects unwarranted pessimism. Accordingly, we are pleased that Discovery has kept up its aggressive pace of share repurchases.
Shares of Alphabet, the parent company of Google, declined by 7% in the quarter, with much of the downside move occurring after the Company reported first quarter earnings that fell short of investor expectations. Core business results in the quarter were strong, highlighted by 23% currency-neutral revenue growth, improved margins and free cash flow of more than $5 billion, a new quarterly high mark for the Company. Offsetting the good performance were substantial currency pressures affecting both revenue and earnings, as well as certain non-operating, non-cash charges taken against other income. We maintain a very favorable assessment of Google’s fundamental performance and growth drivers, and we believe the shares are attractively valued at current levels.
Bed Bath & Beyond shares declined by 13% during the quarter as the Company and other retailers continue to struggle with weak in-store sales, anemic inflation, tight margins and aggressive competition from e-commerce players. The sector is clearly out of favor with investors and we have received numerous questions from investors asking why we have held on to our Bed Bath & Beyond shares. We recognize that competitive pressures have intensified for the Company, but we see Bed Bath & Beyond as remaining the industry leader in the attractive household and home furnishings retail category. We believe that Bed Bath & Beyond is intelligently transforming its online and multi-channel capabilities. Importantly, the Company also remains highly profitable and cash generative with strong returns on capital. At quarter-end, Bed Bath & Beyond was trading at approximately 9x our current-year earnings per share estimate and a large discount to our intrinsic value estimate.
Shares of Microsoft were down by 7% in the quarter due to weaker than expected results reported for the March 2016 quarter and investors’ lukewarm response to the Company’s June 13 announcement of an agreement to acquire LinkedIn for $26 billion. Much like its peer group of US-based multinational software companies, Microsoft has faced significant headwinds in recent quarters from foreign currency translation, pockets of regional weakness in developing markets and general macroeconomic caution on the part of enterprise customers. At the same time, the continued shift toward subscription-based cloud services, while very healthy in the long run, has dampened traditional up-front ‘transactional’ licensing activity. Despite these pressures, we are pleased with the trajectory of the business overall as Microsoft continued to execute its strategic plan centered around cloud-based solutions and high-value, differentiated tools and experiences for enterprises, business users, consumers and developers. The newly-announced combination with LinkedIn appears to be well aligned with this vision, but the deal has a very high price tag, and Microsoft has a decidedly rocky track record of success with large acquisitions. That being said, we view LinkedIn as a unique asset with an attractive business model in a growing industry in which classic network effects fortify a strong competitive advantage. With 433 million members in 220 markets worldwide, LinkedIn is not only a de facto standard location for employees’ online resumes and professional identity, but it has also become a valued tool for salespeople, marketers, recruiters and headhunters. While the businesses will be run separately, we believe that the two companies complement each other very well given their large overlap of users in the corporate world. This overlap has the potential to enhance Microsoft’s suite of business productivity software and services, accelerate its Dynamics customer relationship management business and eventually perhaps form the basis for developing a differentiated human capital management platform.
Our two large domestic banks, Wells Fargo and US Bancorp, have experienced share price declines year to date in 2016 largely due to the impact of the Federal Reserve’s repeated decisions to defer normalization of benchmark interest rates. As many loans are priced based on short-term reference rates, the Fed’s deferral has created incrementally weaker earnings growth trends for banks relative to expectations at the beginning of the year. In addition, the stubbornly narrow Treasury yield curve has further dampened banks’ earnings power from interest-bearing assets. In contrast, two very positive developments for our banks during the second quarter were i) strong showings in the most recent rounds of stress tests and capital reviews conducted by the Fed, in which both Wells Fargo and US Bancorp showed adequate levels of capital cushioning even in hypothetical scenarios of dire economic and credit developments; and ii) a sharp rebound in energy prices, which helped to ease fears of potential earnings erosion from credit losses in this sector.
As noted above, during the second quarter we initiated a new position in Perrigo PLC, an Ireland-based provider of over-the-counter consumer healthcare products and specialty prescription pharmaceuticals. Perrigo is the leading manufacturer and distributor of ‘store brand’ consumer health products such as allergy medications, analgesics and infant formula sold at leading retailers. Through the acquisition of Omega Pharmaceuticals in 2015, Perrigo entered the market for branded consumer healthcare products in the European market. In its prescription pharmaceuticals business, Perrigo develops, manufacturers and markets a portfolio of generic and specialty drugs in the US and UK markets. As part of its 2013 business combination with Elan Corp., Perrigo acquired royalty rights to Tysabri, a multi-billion Dollar multiple sclerosis drug. These royalty rights generate substantial free cash flow for Perrigo, but for modeling purposes we value them separately from the core operating business and include the related asset value in our intrinsic value estimate.
We have followed Perrigo closely over many years based on its fit with our investment criteria and our view that the Company is well positioned in attractive parts of the healthcare market. Specifically, we believe that Perrigo’s focus on high quality, affordable healthcare products is well aligned with key trends in the industry. We also believe that the Company’s revenue growth will benefit from three durable trends: greater penetration of store-brand products (at better price points for consumers and better margins for retailers), a sizeable pipeline of likely prescription-to-OTC conversions and favorable demographic trends worldwide. Over the past year, however, Perrigo’s shares have fallen precipitously due to several factors including disappointing results from the recently acquired Omega, significant pricing pressure for certain prescription generics, lowered earnings guidance, and the departure of Perrigo’s highly regarded CEO Joseph Papa, who left to become the new CEO of embattled healthcare company, Valeant Pharmaceuticals. Given our views regarding the attractiveness of Perrigo’s core business and its long-term growth and cash flow prospects, as well as our confidence in Perrigo’s new CEO John Hendrickson, who had previously served as Perrigo’s President, we were pleased to purchase a meaningful position in Perrigo.
During the brief market dislocation following the Brexit surprise at the end of June, we identified several opportunities to add to certain of our existing holdings, including Perrigo, PayPal and Oracle. We had two other standing orders that approached but did not reach our purchase price objectives. PayPal and Oracle remain high conviction investments in which we have opportunistically built up our holdings over the last few quarters.
In April and May, we continued trimming our position in Baxalta pending the completion of its sale to Shire Ltd. A progressive narrowing of the deal’s arbitrage spread and a rising share price for Shire facilitated our trims at attractive prices. We then exited our remaining position in Baxalta in late May just prior to the shareholder approval vote. Remarkably, Baxalta was a public company for less than a year, as the initial Shire bid came shortly after the spinoff from Baxter International in mid-2015. In our short time as shareholders, Baxalta had a strong positive contribution to Core Select’s results.
At the end of the quarter, we had positions in 30 companies with 49% of our assets held in the ten largest holdings. As of June 30, Core Select was trading at 82% of our underlying intrinsic value estimates on a weighted average basis, compared to 80% at the end of 2015. We ended the second quarter with a cash position of 9%, which was below the 12% level at which we exited 2015, with the difference being attributable to the net effect of our new positions in Perrigo and Fleetcor along with multiple additions to existing holdings, offset by a handful of position trims and our exits from Chubb, Southwestern Energy and Baxalta. We remain alert to the possibility of continued sharp volatility in the equity market in response to macroeconomic catalysts or company and sector-specific issues. As we noted above, the current mood of the market shows little patience with disappointments or surprises, so our approach will be to stand ready to deploy capital in our high-conviction holdings at prices that meet our 75% threshold of market price to intrinsic value.
We are excited to report that Andrew Hodgkins, CFA has joined the Core Select investment team as of July. Andrew has been a BBH employee for several years, most recently working in our mid-market private equity business. Andrew will work closely with our Consumer and Media team, joining Regina Lombardi, Marla Sims and Tripp Blum.
In today’s volatile and expensive equity market environment, we remain committed to the patient application of our Core Select investment criteria and valuation approach. We are grateful for your continued interest and support and look forward to providing further updates in the second half of 2016.
Timothy E. Hartch
Michael R. Keller, CFA