Equity markets overcame two sharp selloffs in the fourth quarter to end 2014 at all-time record highs. After more than five years of robust gains in U.S. equities, investor sentiment remained broadly positive into year-end as economic trends picked up slightly and monetary policy statements indicated a supportive stance among global central banks. The S&P 500 Index rose by 4.9% during the quarter, finishing the year with a total return of 13.7%. By comparison, the BBH Core Select Composite (“Core Select” or “The Strategy”) returned 3.8% in the fourth quarter (as adjusted for distributions), and was up by 9.5% for all of 2014. Over the last five years, Core Select has compounded at an annualized rate of 15.7% per annum versus 15.5% for the S&P 500 Index. Measured from the prior market peak reached in October of 2007, the Strategy has compounded at 10.5% per annum, which compares to 6.5% for the S&P 500.
We are pleased with the compounded annual returns that Core Select has generated over the last several years. Granted, equity market conditions have been quite favorable since early 2009 – initially as a sharp recovery emerged out of the global recession of 2008, then later as loose monetary policies worked in concert with stabilizing economic conditions to feed a steady upward climb in investor sentiment and valuation levels. Over this span of time, and in line with our long-term expectations, Core Select has participated in most but not all of the equity market’s upside, as indicated by the performance numbers shown above.
Consistent with our view that overall equity valuation levels have risen faster than underlying macroeconomic fundamentals, we believe that (i) margins of safety have diminished at a security-by-security level, (ii) future equity returns are being pulled forward and partially consumed in the present, and (iii) non-fundamental factors such as yield chasing, momentum following, and asset rotation are influencing equity prices. However, we do not view this set of circumstances as a source of frustration or a reason to reassess our approach; rather, we see it as potentially the final phase of a multi-year market cycle heavily influenced by central bank policies. In our view, now is a time for patience in deploying capital; the lessons of history suggest to us that compromising on business quality or valuation levels can lead to poor outcomes when market conditions change. Moreover, we do not have an inclination to simply mirror equity market index performance – to do so would have us stray from our core principles in several ways, such as having a lower concentration of holdings, maintaining large weights in the recent best performers, remaining fully invested even when valuation conditions appear stretched, and owning securities that do not meet our investment criteria.
Our firm espouses a performance-driven equity investment culture, and as such, our ultimate responsibility is to deliver attractive absolute investment performance over full market cycles. To meet this objective, our consistent focus remains long-term ownership of top-caliber businesses at discounts to our appraisal of their intrinsic value2. We carefully underwrite each investment with a process that draws on extensive fundamental due diligence, robust financial analysis, and a keen focus on value. Our investment team has successfully employed this approach for more than nine years, and we are confident that it remains the right way to achieve our shared long-term goals.
Turning to the portfolio performance in the fourth quarter, our largest positive contributor was Target, which returned more than 22% as investors weighed improving trends in comparable store sales growth and gross margins, growing momentum in digital and mobile channel sales, and a broad-based reset of strategic and operational priorities led by the new CEO, Brian Cornell. Overall, though, we would characterize the company’s recent operating results as solid but not spectacular, with store traffic subdued, gross margins suppressed by competitive pricing conditions, and operating costs running high due to internal investments and fulfillment costs. Target also continues to struggle with its Canadian operations due to initial execution missteps. While it may be too early to call the Canadian entry a complete failure, management has hinted that the best course of action may be to scale back or even exit the operation. On a more positive note, we are encouraged by the new CEO’s re-underwriting of the company’s core principals of quality, value, innovation and differentiation. New efforts in merchandising, service, and “omni-channel” capabilities exemplify some of the progress being made this year. Our intrinsic value estimate for Target’s shares takes into account these positive elements but also reflects our longer-term conservatism on the discount retail industry and the continued challenges in Canada. We took advantage of the recent upswing in sentiment related to lower gasoline prices to reduce our position size in the fourth quarter as the stock traded above 90% of our appraisal.
Our second-best contributor for the fourth quarter was Berkshire Hathaway (“Berkshire”), whose shares rose by more than 9%. The company reported record quarterly results in November, with double-digit growth in operating profits, strong free cash flow conversion, strengthening in the balance sheet, and a 14% year-over-year increase in book value per share. Each of Berkshire’s insurance businesses showed solid growth in premiums, while improved underwriting profits in reinsurance and primary commercial lines helped to offset a small uptick in the loss rate at GEICO. Leveraging Berkshire’s strong reputation, underwriting capabilities, and best-in-class balance sheet, the company’s recently launched Specialty Insurance offering has swiftly gained a growing book of business, contributing to a robust 31% gain in premium volume for the Primary lines. In its non-insurance operations, Berkshire achieved $5.0 billion in pre-tax operating earnings for the quarter, up 19% from the prior year. Growth was balanced across the railroad, utilities, manufacturing and other product and service segments. Given the growing importance of crude oil volumes across Berkshire’s rail network, we are alert to the possibility that a potential slowdown in onshore drilling activity in the U.S. may limit the near-term growth prospects for that business.
In November, Berkshire Hathaway announced the acquisition of Procter and Gamble’s Duracell business in exchange for $4.7 billion in P&G shares currently held by Berkshire. P&G also agreed to make a $1.8 billion cash contribution to Duracell as part of the transaction. While the battery business does not possess particularly attractive growth characteristics or sharp competitive differentiation, we do believe it is a market in which brand equity matters and cash flows are relatively durable and long-lived. As such, Berkshire’s move appears particularly savvy – it was able to exchange long-held P&G shares (with a large embedded tax liability) for a cash generative consumer brand platform that has a leading position in its industry.
Two other strong contributors in the fourth quarter were Oracle and Zoetis. Oracle’s shares rose by 18% driven by consistent operating results, accelerating revenue growth in software- and platform-as-a-service offerings, and improving investor sentiment. While the company maintains a large and robust base of business in its traditional on-premise infrastructure software, it has also invested aggressively in recent years to re-architect these products for consumption by enterprises as cloud-based, subscription services. Investor skepticism notwithstanding, quarterly results have revealed increasing interest and adoption by Oracle’s enormous enterprise customer base, albeit at a measured pace. This transition in the distribution mode of the company’s applications has coincided with significant releases of new functionality in its database software which is designed to be complementary with its other mission-specific applications. When sold as a suite, the result is a deepening of Oracle’s penetration into enterprise IT organizations and strengthening competitive advantages of switching costs and scale. Oracle began the fourth quarter trading at a meaningful discount to our estimate of intrinsic value, but the price reaction following strong quarterly results in mid-December closed the discount by nearly half.
Zoetis advanced by almost 17% during the quarter spurred by several positive catalysts, including a healthy third quarter earnings report, a well-received inaugural investor day, and an escalation of speculation regarding a potential sale of the business or aggressive restructuring following reports of potential shareholder activism. While these developments have fed very positive investor sentiment in the short term, our focus continues to be the company’s ability to create sustained shareholder value by virtue of its strong portfolio of long lifecycle products sold into attractive and growing end markets by a productive and diffuse sales force. We also see the potential for further earnings power resulting from gross margin enhancements tied to efficiency gains and modest pricing power, and a longer-term possibility of tax rate optimization. We do agree that Zoetis could be attractive to one or more potential acquirers in the healthcare industry, but our investment thesis is underwritten solely on the standalone value of the business. The sharp rise in the company’s share price in 2014 has significantly reduced the discount to our estimate of intrinsic value per share, but we still see reasonable upside potential.
For the full year 2014, our top contributors included Berkshire Hathaway, Zoetis, Wells Fargo, Microsoft, and Novartis. Each of the five produced solid double digit-returns. Despite the diversity of their business models and end markets, our favorable investment experience with these companies over time provides a fine working example of how our demanding investment criteria combined with top caliber, forward-thinking management teams had lead to sustained value creation even in mature and competitive industries.
The largest performance detractors in the quarter were three of our energy sector holdings – Southwestern Energy, Schlumberger, and Occidental Petroleum. Our fourth energy holding, EOG Resources, was also down in the quarter. OPEC’s decision in November not to reduce production levels and the resulting dramatic fall in oil prices conflicted with our baseline assumptions regarding near-term industry developments. Nevertheless, we have always recognized that energy prices are inherently volatile, with small changes in supply and demand leading to large swings in near term prices. Accordingly, we have focused on exploration and production companies with strong balance sheets, a proven ability to operate at the low end of the industry cost curve, and long-lived reserves in politically stable regions to support sustained production growth. These favorable attributes should enable our three E&P companies to weather the current low commodity price environment and hopefully emerge stronger when energy prices rebound over time toward the marginal cost of production, which we believe is materially above current levels for both oil and natural gas.
Southwestern’s shares were the hardest hit, falling 22% in the quarter due to weaker natural gas prices and investor skepticism about a $5 billion asset purchase the company made in the quarter. In the transaction, Southwestern purchased more than 400,000 net acres of producing gas and liquids assets from Chesapeake Energy in the Marcellus and Utica shale areas covering parts of West Virginia and Pennsylvania. The deal also includes portions of Chesapeake’s gathering and transport infrastructure in the region, a transfer of some operational personnel, and a related purchase of working interests from Statoil. While some commentators have suggested that Southwestern overpaid, and indeed the purchase price appears quite full on the basis of simple transaction multiples, we believe that the acreage had been greatly under-producing relative to its potential. This is not only due to the currently modest drilling program being employed, but also as a function of the “stacked pay” nature of the assets (i.e. multiple overlapping layers of hydrocarbon-containing shales at different depths). We are confident that Southwestern will be able to develop the new acreage into a successful and highly cash-generative play with low capital and operating costs per unit produced. Where Southwestern’s management may have misjudged, though, is that the large size of the transaction requires a substantial issuance of equity or equity-linked securities to maintain the company’s investment-grade credit rating. We believe Southwestern’s shares are trading at a large discount to intrinsic value, so issuing shares at today’s depressed levels is costly. Nonetheless, we still have a high regard for Southwestern’s management team and they have historically done an excellent job generating attractive returns on capital investments.
Schlumberger is a key provider of services and expertise to the global exploration and production sector, and as such, the precipitous decline in oil prices has largely negative implications for the company’s intermediate-term business trajectory. Particularly at the marginal tiers of higher-cost production, there will be curtailments of capital plans, and this in turn may reduce the outlook for spending on resource characterization, project planning, operational support, and specialized equipment – all of which are key revenue sources for Schlumberger. However, the long-term industry dynamics of modest but positive demand growth, mid-single-digit annual global depletion rates, and the high costs and high decline rates of newer sources of supply indicate to us that Schlumberger’s role in the industry as a technology-driven partner for a wide range of producers will remain vital and highly valued.
Occidental’s shares were also heavily pressured by the slide in crude oil prices. We believe that the company’s low production costs, attractive asset base in its core Permian Basin region, and its clean balance sheet are key advantages in this type of environment as they not only provide a financial cushion against weakening price realizations, but also create opportunities for accretive deployment of incremental capital via asset acquisitions and share repurchases. Outside of its domestic operations, we expect the company to enjoy a step-up in free cash flow in 2015 as its Al Hosn joint venture in Abu Dhabi enters production after a long period of capital investments. During the fourth quarter, Occidental distributed its California operations to shareholders as a separately traded company called California Resources Corporation. In the long run, we do not view CRC as being as tight a fit with our approach in the energy sector as our other holdings. That said, post-spin selling pressure combined with the cratering oil price have driven CRC’s share price to a level that is meaningfully lower than what we believe its fair value could be, and as such, we have elected to hold our shares at this time.
For the full year 2014, Southwestern and Occidental were among our largest detractors along with Diageo and Google. Diageo has achieved modest underlying growth in profits despite continued headwinds from emerging market slowdowns, de-stocking, and price competition in certain categories such as mainstream vodka and African beer. We continue to see Diageo as being the leader in an attractive and growing global market with demonstrable competitive advantages in brands, distribution, marketing, and innovation. As we have noted in the past, we see the company as one of our long-term “compounders” that can produce attractive returns on capital and sustained growth in profits over many years.
Google’s business has continued to perform quite well, with strong double-digit growth in revenue and free cash flow driven by its leading share of the growing search and display ad markets along with the success of its owned platforms, including YouTube, Google Play, Android, and Google Apps. The stock has been pressured, however, by investor concerns regarding (i) the potential growth implications of in-app search volume cutting into Google’s mainstay “organic” search business, (ii) adverse price mix related to lower monetization rates for mobile search, and (iii) escalating regulatory pressures pertaining to taxation, user privacy, content usage, and the tying of search results to other Google services. On the first point, we agree that in-app search activity will grow over time, likely in some proportion to app usage (as opposed to browser-based usage). However, we believe there is still a vast amount of growth left to be exploited in traditional search and display, both desktop and mobile, as online media growth continues to shift advertisers’ spending away from print, radio and television formats. On the regulatory front, Google’s experience is similar to that of other companies whose dominant market shares and robust profits have drawn scrutiny from judicial and ministerial bodies worldwide, particularly in Europe. These are not trivial issues, and they are certainly worthy of our continued investigation; however, our observation over time has been that these situations tend to be resolved with manageable concessions rather than dramatic, punitive measures, as regulators are wary of pushing too hard and ultimately harming consumers or their own domestic industries. To that end, we believe Google will be able to navigate these challenges.
During the fourth quarter, we added opportunistically to our investments in EOG Resources, Southwestern Energy, and Schlumberger. Consistent with our comments above, our purchases were not motivated by an explicit prediction of a near-term increase in energy prices. Rather, we have added to our energy holdings when the companies’ share prices reflected large discounts to our intrinsic value estimates and spot prices were meaningfully below our estimates of long-term marginal production costs. We also continued to build our holdings of Oracle and Unilever in the quarter at prices below 75% of our intrinsic value estimates. Along with Zoetis, Oracle, and Unilever were new positions for Core Select in 2014. We remain enthusiastic about the long-term prospects for all three of these well-positioned, industry leading companies.
We trimmed and then ultimately sold our remaining position in PepsiCo during the fourth quarter as the shares approached our estimate of intrinsic value. We also had some concerns about the challenging market for carbonated beverages and the non-snack segments of PepsiCo’s food business. As noted above, we reduced our position in Target as its share price traded above 90% of our intrinsic value estimate. In similar fashion, we trimmed our holdings of Wal-Mart and Waste Management for valuation reasons. While the share prices of these three companies have performed reasonably well of late, each has faced certain challenges in their core business activities. Lastly, in November we sold the Liberty Ventures tracking stock that had been distributed to us via our position in Liberty Interactive. The standalone e-Commerce businesses attributed to the tracking stock did not meet our investment criteria.
At the end of 2014, we held positions in 31 companies with 46% of our assets held in the 10 largest holdings. Our five largest positions at year end were Berkshire Hathaway, Comcast, US Bancorp, Wells Fargo, and Google. Core Select ended the year trading at 86% of our underlying intrinsic value estimates on a weighted average basis compared to 85% at the end of the third quarter and 89% at the beginning of the year. With the price-to-intrinsic value relationship remaining at high levels for both our current holdings and many of our “wish list” stocks, we have had relatively few opportunities to make new investments or add to existing positions at appropriate discounts. Consequently, our cash position remained elevated at 10.1% as of the end of the year.
We conclude by reiterating our view that conservative, long-term oriented investors should act with patience and prudence in today’s environment. We see many indications of late-cycle behaviors in the market. For example, throughout the year we saw investors overreact, in our opinion, to relatively minor developments and adopt surprisingly short-term investment horizons. As one illustration, our retail industry stocks were among our worst performing investments in the first half of 2014 due to modestly disappointing same-store sales growth, but in the second half of the year their share prices soared as energy prices fell and same-store sales improved modestly. Similarly, Google and Diageo were among our best performing investments in 2013, but their shares declined in 2014 as investors transferred their attention to other companies with more immediate catalysts. We believe that global central banks have far overstepped their core mandates by creating de facto policies of higher asset prices and speculative activity, even while underlying job creation, industrial production, productivity growth, and capital spending remain subdued. We are unsure as to how this divergence may eventually be resolved, but there is certainly a possibility of a downside scenario in which market prices decline materially or at least stop rising for an extended period of time. As such, we maintain that capital preservation should be foremost among investors’ considerations when evaluating the market’s prospects from this point forward.
We remain committed to the consistent application of our investment criteria and value-driven approach. Our investment team conducts hundreds of management meetings, site visits, and other consultations each year to assess the quality, durability, and opportunities of many different companies and industries. We build independent models of companies’ financial trajectories, and we use absolute, not relative methods to estimate their intrinsic values. Ultimately, we believe that if we can identify and prudently invest in businesses that have the ability to create sustained shareholder value, our long-term investment results and interim capital protection will affirm the advantages of this approach.
As always, the Core Select team appreciates your continued interest and support, and we look forward to providing updates on our progress throughout 2015.
Timothy E. Hartch
Michael R. Keller
 S&P 500 Index: An unmanaged, market capitalization weighted index of 500 stocks providing a broad indicator of stock price movements.
 Intrinsic Value: What one estimates to be the true value of a company’s common stock based on analysis of both tangible and intangible factors.