Large cap equities experienced a substantial pullback during the third quarter amid a global de-risking of portfolios. While rising concerns of spillover effects from economic slowdowns in the developing world were arguably the primary catalyst for worsening sentiment, we also believe that investors have been weighing other factors such as generally high equity valuations, lukewarm macroeconomic conditions, rising debt levels, geopolitical challenges and questions about the efficacy of extended monetary accommodation by central banks.
The S&P 500 Index declined by -6.4% during the quarter, while BBH Core Select Composite (“Core Select” or “the Strategy”) declined by -4.7%. Year to date, the S&P 500 is down by -5.3% and Core Select is down by -6.0%. Over the last five years, Core Select has compounded at an annualized rate of 12.6% per annum versus 13.3% for the S&P 500 Index. Measured from the prior market peak reached in October of 2007, Core Select has compounded at 8.6% per annum, which compares to 5.2% for the S&P 500.
The equity market pullback in the quarter neither surprised nor disappointed us, given our observations over the last few quarters regarding stretched valuations, narrowing market leadership and evidence of increasingly indiscriminate buying on the part of ETFs and index strategies as well as short-term focused investors who had been chasing the markets higher. As we have noted in our prior investor updates, our cautious posture and adherence to high standards for business quality and valuation had resulted in our building up a higher level of un-deployed cash in Core Select than has been typical in the past. Cash is not an intrinsically attractive asset, but it can be a valuable buffer in bullish market environments with rapidly accumulating price risks. As such, our cash position contributed to our downside protection as markets came under pressure in the third quarter.
The market decline in August and continued volatility in September gave us several opportunities to deploy capital at attractive discounts to our estimates of intrinsic value. Nevertheless, it would still be difficult for us to make the case that all signals are clear for the equity markets generally – the global economy remains in a somewhat tenuous state, corporate earnings growth has moderated, financial leverage has continued to build and the U.S. Federal Reserve appears unsure of how to engineer a needed policy normalization without creating additional risks of market tumult and foreign exchange imbalances. We believe these factors present potential risks for our businesses and equity valuations overall, and as such, we have been relatively measured in the pace of our incremental investments. Moreover, we have favored adding to companies in which our level of confidence and visibility is highest, rather than simply putting cash into the stocks with the largest discounts to our intrinsic value estimates. This approach is consistent with how we have invested over time in both rising and declining markets.
Examining our third quarter performance, the strongest contributor was Chubb, which had a total return of 29%. Chubb’s shares rose following the Company’s announcement that it had agreed to be acquired by Ace Ltd., a large, globally diversified property and casualty insurer headquartered in Switzerland. The proposed acquisition price of $125 per share, which includes both a stock and cash component, was in line with our estimate of Chubb’s intrinsic value. Since we initiated our position in 2007, Chubb’s focused and long-term oriented management team has meaningfully grown shareholder value through strong operational execution and intelligent capital allocation. We believe that Chubb presented an attractive acquisition target given its strong market position, good brand reputation and well-capitalized balance sheet. As it is not our intention to roll our Chubb position into shares of Ace, we began to reduce our position in Chubb in July.
Our second best contributor in the quarter was Google, whose Class C shares rose by 16%. Google is among our top five holdings and has been a meaningful positive contributor to Core Select’s performance over the last three years. The shares advanced sharply in July after the Company reported strong quarterly results led by growth in mobile search, YouTube and programmatic campaigns. Despite pressures from adverse currency translation and the continued mix shift toward distribution platforms that have a lower ‘cost per click,’ Google’s core revenues (excluding pass through payments to online publishers) grew at a robust 13%. Equally important was the deceleration of growth in the Company’s operating costs in the quarter, which along with lower-than-expected capital spending helped to drive strong free cash flow conversion. Google’s recently-appointed CFO Ruth Porat affirmed the Company’s intention to sharpen its focus on cost and capital optimization in the interest of driving improved long-term shareholder value. We view this as an appropriate pivot for Google at this stage in its lifecycle, and we do not believe it undermines Google’s ability to innovate and grow. The Company’s commitment to this strategic evolution was also apparent in its August announcement of a new operating structure that will create a public holding company called Alphabet. Within this new structure, Google’s core internet businesses will be reported as one segment, and its nascent endeavors in areas such as life sciences, broadband connectivity and home automation will be reported separately. As part of this transition, Sundar Pichai, currently the Senior VP of Products at Google, will take over as the CEO of the core Google business. Following the reorganization, Alphabet will become the publicly listed entity and the current Class A (ticker GOOGL) and Class C (GOOG) common shares will represent the same number of corresponding shares in the resulting Alphabet equity capital with the same shareholder rights. We view this reorganization and the increased transparency it will provide as a positive, given that it will enable investors to evaluate the growth and profitability of the core online advertising operations apart from the non-core, early stage investment businesses. Google continues to trade at a meaningful discount to our estimate of intrinsic value per share.
Other solid performers in the quarter included Progressive Corp., Nestlé and Baxter International. Shares of Progressive gained 10% as investor sentiment toward the auto insurance sector began to improve with reports of rate increases beginning to take hold industrywide. In the last few years, the rate environment in property and casualty insurance has been generally weak due to low inflation in claims costs and the pass-through impact of lower reinsurance pricing. Spurred by a recent uptick in accident frequency and severity, the auto insurance market has achieved some firming of rates, which has improved the earnings outlook for well positioned companies like Progressive and GEICO (part of Berkshire Hathaway).
Nestlé shares returned 4% in the third quarter, as the Company’s strong product portfolio and good execution have continued to offset unsteady economic conditions, particularly in developing markets. Nestlé is distinguished by its participation in generally higher-growth categories and geographic markets, which has enabled the Company to balance weaker performances with outperformers. Nestlé’s focus on nutrition, health and wellness has positioned it well to capitalize on important consumer trends and changing demographics. Additionally, the Company’s forward-looking stance on innovation – along with its strong gross margins that fund this innovation – has enabled it to engage with consumers with appealing products at both the high and low ends of the value spectrum. The strength of Nestlé’s brands and its innovation capabilities drive pricing power which, combined with internal efficiency programs, should enable the Company to improve margins even if it experiences input cost inflation. We believe that Nestlé’s consistent formula of mid-single digit organic growth with improving margins and strong cash conversion should continue to drive long-term value creation for shareholders. While reported results in the near-term may be impacted by emerging market pressures and foreign exchange impacts, the fundamentals of the Company remain strong.
At the beginning of July, Baxter International completed the spin-off of its biosciences business into a new, publicly-traded entity called Baxalta, which we will discuss later. Baxter is now comprised of the medical products and renal care businesses of the former combined entity. Shortly after the spin-off, Baxter’s shares rose sharply at the end of July and into early August, initially driven by the Company’s disclosure that its Board of Directors had started a search for a new CEO to replace Bob Parkinson, then later by the announcement of a large stock position accumulated by an activist investor who was seeking seats on the Board. Spurred by these catalysts, the stock quickly traded toward our intrinsic value estimate, leading us to exit our position for Core Select.
Our weakest performers in the third quarter were Southwestern Energy, Zoetis and EOG Resources. Southwestern shares fell 44% in the quarter and are down by 54% thus far in 2015. While all four of our energy industry holdings have been hit hard by continued weakness in the underlying commodity prices, Southwestern has been particularly pressured as investors have been skeptical about the Company’s ability to generate sufficient cash flows to fund growth in its newly acquired low-cost acreage in the southwest Marcellus and Utica shales while at the same time running a smaller drilling program in the Fayetteville shale, which has generally higher total costs. In addition, Southwestern and its peers operating in the Marcellus have continued to experience wide differentials between their price realizations and broadly traded benchmark natural gas prices due to constraints on pipeline capacity in the region. We agree with the Company’s assessment that these differentials are likely to narrow over time, but in the short term, they will likely continue to pressure production revenues. Southwestern’s operating skills and low costs of drilling and completion combined with incremental reductions in external well service costs are key factors that we believe will allow the Company to ride out the current sustained period of headwinds. Southwestern’s balance sheet swelled with last year’s acquisition of the additional Marcellus and Utica acreage, but we believe the term structure of the supporting debt is appropriate and the Company’s reliance on variable capital sources such as credit facilities is relatively small.
Also within the energy sector, EOG Resources was down by 17% in the third quarter as crude oil prices retreated from a mid-year bounce. Despite the continued price-related headwinds in the oil and gas markets, we have been quite pleased with the operating performance at EOG as the Company has carefully managed its capital deployment and delivered material cost reductions to offset sharp revenue pressures. Notably, EOG’s management team has asserted that production in its core domestic shale plays (Eagle Ford, Bakken and Delaware Basin) can earn after-tax rates of return in excess of 30% at $50 crude oil prices. Returns at those levels are enabled by the Company’s attractive assets, low operating costs and incremental technology advances in well targeting and spacing. These characteristics, along with a well-managed balance sheet, inform our view that EOG can deliver long-term value creation despite its often-volatile industry setting. We do not make near-term predictions on the trading price of crude oil, but in the current context we acknowledge that prices may remain depressed for some time given the aggressive stance of OPEC and continued broad pressures on commodity price sentiment in the context of slowing global GDP growth. The oil and gas price assumptions we use in our base case valuation models in the energy sector assume only a gradual movement back toward marginal costs of production several years in the future. While there is certainly no guarantee that commodity prices will hew to those marginal cost levels over time, our extensive work on the supply and demand economics of the industry and the growing budgetary pressures within major oil exporting countries help to de-risk a constructive stance, in our view. EOG remains our largest position in the energy industry.
Zoetis shares declined by 14% during the quarter, with much of the downside occurring in late September alongside the healthcare industry broadly as sentiment was impacted by a political backlash against prescription drug price escalation in the U.S. Fundamentally, Zoetis continues to perform well and operates in areas that are shielded from government-driven price pressures. The Company appears to be executing well on its major operational restructuring that was announced in May to streamline operations and emphasize key product lines and key regions. Zoetis estimates that operating margins could expand from 25% in 2014 to an estimated 34% in 2017, reflecting a shift to higher margin products and regions as well as expense reduction initiatives. We also expect that working capital levels could ease over the next few quarters, potentially driving stronger growth in free cash flow. These financial improvements are a key part of our investment thesis on Zoetis, but we also remain very positive on the Company’s consistent top-line growth, particularly in the U.S. market and in the companion animal market, despite currency headwinds. We believe the underlying fundamentals of the Company and its leadership position in the attractive animal health market remain strong.
The third quarter was an active period for us in terms of portfolio changes. In August, we initiated a new position in Discovery Communications, a world leader in non-fiction and science-based TV programming. Discovery reaches nearly 3 billion cumulative viewers across 220 countries with a broad assortment of unique, high-quality video content through well-known branded networks such as Discovery Channel, TLC, Animal Planet and Science. In our view, Discovery’s key strengths include i) its strong positioning in desirable content categories, ii) its appeal to engaged affinity groups that are valuable to advertisers, and iii) its expansive international business, where pay TV penetration is growing.
The share prices of Discovery and its peer companies in the media content business have come under substantial pressure over the last year mainly due to mounting concerns that changes in viewership habits and shifts to ‘over-the-top’ digital distribution of content will upend the current industry structure in the critical U.S. market, in which cable distributors pay affiliate fees to content providers on a per-subscriber, per-month basis, then construct bundled channel offerings for which consumers pay a bundled rate. The common argument against this long-standing industry structure is that newer platforms such as Netflix, Amazon and Hulu will compel consumers to abandon bundled cable subscriptions in ever-larger numbers, which will put increased pressure on affiliate fee revenues for the networks. We agree that digital distribution will become more prevalent over time, and that at the margin, there could be unbundling or downsizing of channel packages. However, we believe that Discovery has defensive and offensive attributes that will allow it to thrive in the changing landscape. Specifically:
- Discovery’s programming and its content library appeal to a large audience with attractive demographics. As the Company engages with alternate distribution platforms over time (or potentially creates its own), the growth in related royalties will be an important offset to any erosion of the traditional affiliate fee model. Even as distribution models change, high-quality content remains the scarce asset in the media ecosystem, and we strongly believe that customers will continue to pay for it.
- Even with modest subscriber declines for the industry within the U.S., we expect Discovery’s affiliate fee revenue to achieve steady positive growth driven by pricing power. Our view is that cable distributors will not risk alienating subscribers by removing Discovery’s content, especially given its relatively low cost compared to other networks and the audience share it delivers.
- The Company’s continued growth in International markets should act as a meaningful offset to subscriber declines in the U.S.
Declines in advertising revenue have been another recent headwind for the cable networks. These pressures have largely resulted from ratings declines that have occurred as consumers spend more time on alternative video platforms such as Netflix and YouTube. We expect these headwinds to persist in the intermediate term, but as noted above, we believe that Discovery’s pricing power and the likelihood of greater engagement and monetization of digital platforms over time will act as key offsets to declines in traditional linear TV advertising revenues.
Our baseline financial assumptions for Discovery incorporate continued mid-single digit growth in revenues, reasonable margin leverage as content is spread across the geographic footprint at little extra cost, a mix shift toward international profits that are taxed at lower rates, and continued modest capital requirements. The resulting free cash flow growth opportunity is attractive in our view, and the Company’s shareholder-friendly capital return policy should drive additional value over the long term. After our initial Discovery purchase in August, we added to the position several times at prices that represented a substantial discount to our estimate of intrinsic value per share.
In early July we received shares of PayPal Holdings after it was spun off from eBay as an independent company. We are enthusiastic about the long-term prospects for PayPal as it pursues continued growth in the attractive global market for online and mobile payments. We believe that the Company's vast two-sided network of users and merchants and its scalable, secure global infrastructure represent a strong competitive position and multiple avenues for growth. PayPal has 169 million active users who collectively transacted more than $250 billion in payment volume in the year ended June 30, 2015. With an open and flexible platform approach, PayPal adds value for the parties on both sides of a transaction. PayPal’s online and app-based interfaces enable consumers to be in control of the purchase flow while limiting the amount of personal information they share. Merchants benefit from competitive pricing, value-added site tools and guaranteed payment. Alongside its core online payments business, we believe that PayPal has several compelling parallel opportunities in areas such as next-generation point-of-sale solutions, multichannel payment integration, cross-border remittances, small business credit, transactional consumer credit, social payment technologies and merchant loyalty solutions. Given these opportunities and the solidity of the core business, we believe that PayPal’s shares are attractive at current levels. In August, we approximately doubled our position size at prices in the low $30s.
Also in early July, Baxter International split off its biosciences business into a new public company called Baxalta. With $6 billion in sales, Baxalta is a global leader in the development, manufacturing and commercialization of therapies that address unmet medical needs in various disease areas including hemophilia and immunology. The Company is also investing in complementary areas including oncology, gene therapy and biosimilars. Baxalta’s core strategy is to improve diagnosis, treatment and standards of care across a wide range of bleeding disorders and other rare chronic and acute medical conditions by developing and leveraging a differentiated product portfolio, ensuring the sustainability and safety of supply to meet growing demand for therapies, and accelerating innovation in new treatment areas by leveraging internal expertise as well as acquisitions and collaborations.
We believe that Baxalta has a very strong leadership team and a solid portfolio of new and differentiated products. The Company has invested in its market-facing activities to sharpen its commercial execution in sales and the product launch process. Importantly, the Company has also reinvigorated its R&D organization by moving away from a focus on product lifecycle management and instead pursing cutting edge innovation with an expanded team of world-class scientists at a newly created facility in Cambridge, Massachusetts. Over the last two years Baxalta has received seven key approvals and advanced five programs into regulatory review. We believe that the Company can grow its revenues at attractive high single-digit rates for several years while also achieving margin and cash flow improvements as separation costs and capital spending are reduced. We added to our position shortly after the spinoff based on our view that the public market valuation did not appropriately reflect the quality of the business and the free cash flow strength that we foresee over the next few years.
We were surprised to learn in early August that the Irish pharmaceuticals company Shire PLC had approached Baxalta with an all-stock merger proposal at a substantial premium. Baxalta’s management team and board declined the initial offer given their view that the strategic rationale was somewhat lacking and the valuation was too low. For our part, we see some merit to a potential combination on the basis of cost consolidation and tax savings, and we believe it is possible that the two companies will continue a dialogue over the next few months. Since the initial announcement, the proposed value of the deal has slipped as Shire’s share price has fallen.
With the large market decline in mid-August and subsequent volatility throughout the remainder of the quarter, we were able to make several small additions to other positions in Core Select at attractive discounts to our intrinsic value estimates. We added to our position in Oracle at three different points as the shares’ valuation continued to imply low growth expectations and muted investor sentiment in spite of what we believe to be solid underlying business performance. We also added to Qualcomm, as we believe the currently low valuation reflects an overreaction to certain cyclical and competitive challenges.
We added modestly to our existing holdings in Diageo and Wal-Mart, two consumer-oriented companies in which investor sentiment and expectations have trended negatively over the last few quarters. Both are facing headwinds in their markets, but we are pleased with the strategic course the management teams are pursuing. Finally, we added to our positions in US Bancorp and Wells Fargo after the share prices dropped sharply driven by concerns that equity market volatility would compel the Federal Reserve to further delay raising short-term interest rates.
At the end of the third quarter, we had positions in 31 companies with 47% of our assets held in the ten largest holdings. Core Select ended the quarter trading at 76% of our underlying intrinsic value estimates on a weighted average basis, compared to 83% at the end of the second quarter and 86% at the end of 2014. As detailed above, we took advantage of the market’s weakness and bought or added to our holdings in several companies, ultimately investing nearly seven percentage points of portfolio value on a gross basis. Offsetting these additions were our reductions in Chubb and Baxter International. While the valuation environment overall is clearly more favorable than it was even a few months ago, we still see certain high-level risks that could affect our companies’ earnings or market sentiment generally. In addition, absolute valuation levels still remain fairly high for many companies in Core Select and our investment ‘wish list.’ As such, we will remain patient in our deployment of capital and will continue to favor high conviction businesses where we have better visibility regarding the range of potential outcomes. We ended the third quarter with a cash position of 8%.
Our investment team is pleased to announce the milestone of our 10-year anniversary managing Core Select. We are proud of the long-term track record that we have achieved through the consistent application of our highly selective, value-oriented ‘buy and own’ approach. As we have said in the past, we strongly believe that the ultimate driver of differentiated performance over the long run is a differentiated approach that is delivered in a consistent way by a dedicated and talented team. Our fellow Core Select investors can be assured that our adherence to this philosophy remains every bit as tight as it did when we set out in 2005. Our commitment for the future is straightforward: we will consistently apply our demanding qualitative investment criteria, we will exhaustively research our companies and our industries, we will invest with a margin of safety, and we will maintain a long-term, ownership-based approach. We will not bind ourselves to short-term thinking or benchmark sensitivity, but instead will aspire to deliver attractive compounding over full market cycles by participating in rising markets and protecting capital during challenging periods.
We greatly appreciate the interest and support you have shown us over the last ten years. We feel very fortunate to have an outstanding group of clients and partners that have entrusted us with their capital. Here’s looking ahead to another great decade!
Timothy E. Hartch
Michael R. Keller, CFA