Large cap equities rose sharply in the fourth quarter as the S&P 500 gained 7.0% and recovered from a significant pullback experienced in the prior quarter. Despite the strong finish, stocks ended the year with only modest gains overall, with the S&P 500 delivering a total return of only 1.4%. By comparison, BBH Core Select Composite (“Core Select” or “the Strategy”) returned 4.5% in the fourth quarter, and was down by -1.7% for all of 2015. Over the last five years, Core Select has compounded at an annualized rate of 11.9% per annum versus 12.6% for the S&P 500 Index. Measured from the prior market peak reached in October of 2007, the Strategy has compounded at 8.9% per annum, which compares to 5.9% for the S&P 500.
A key reason for the market’s minimal gains and volatile movements in 2015 was that equities entered the year trading at already-high valuation levels. Accordingly, the market would have needed an acceleration in underlying economic growth and corporate earnings to justify additional gains. Instead, lackluster growth in developed regions and weaker conditions in emerging markets did little to boost investor sentiment in 2015, while escalating geopolitical issues, higher debt levels and a growing view that the benefit of monetary activism by global central banks was reaching its limit also suppressed risk appetites among market participants. We believe these conditions may persist for some time, in which case a sideways market or a potential correction would seem to be reasonably likely outcomes. Given this has been our stance for several quarters, we acknowledge our caution has hurt our relative performance in recent years as our election to trim our holdings as they approached our intrinsic value estimates has resulted in a higher cash position.
Nevertheless, we are firm in our view that superior full-cycle compounding of returns requires a willingness to behave differently than other investors. We continue to insist on a margin of safety for each investment and to select individual companies based on their business fundamentals and fit with our investment criteria. That these principles seem to have been broadly superseded by momentum-chasing behavior and a growing preference for passive strategies in the presently aging and narrowing bull market informs our view that the Core Select approach is well suited to present times.
During the fourth quarter and over the full year, we continued to see larger-than-normal differences in the share price performance and valuations of companies and sectors that were in favor versus those that have experienced secular challenges or other headwinds. As we will discuss further in this letter, certain of our investments within the energy, retail and technology sectors were sharply pressured in 2015 by a variety of fundamental challenges. At the same time, we also experienced sizable gains in a number of our Core Select companies. We believe there is an element of a ‘winners and losers’ mindset at play in the market today, which in our view fits a broader pattern of investors’ collective reach for return, the impact of short-term, computerized trading, and growth in passive investment flows. Further evidence of this pattern can be seen in the remarkable narrowness of the market’s performance in 2015, a point highlighted by the fact that the S&P 500 Index level would have actually declined by more than 3% for the year were it not for the collective contribution of only nine stocks.
Turning to the details of our fourth quarter performance, our strongest contributor was Microsoft, which rose by 29%. The shares were up sharply in October after the Company reported good quarterly results highlighted by solid growth in revenue and bookings, firming gross margins, tighter operating expenses and strong free cash flow conversion. With near-to-intermediate-term operating trends in the business suggesting that these key financial drivers are likely to persist, we believe that the visibility of the Company's earnings trajectory has meaningfully improved. With its aggressive push toward cloud-based services and platforms over the last several years, Microsoft represents a good example of a company that has embraced, rather than fought, a critical disruptive trend in its industry. The Company has leveraged its longstanding relationships with enterprise customers, software developers and individual users to iteratively build cloud services that dovetail with its traditional offerings. Microsoft’s Azure platform now commands a strong position in the market for public cloud services at tremendous scale, second only to Amazon Web Services. We believe that the addressable market opportunity for public cloud platforms will continue to grow rapidly and that Microsoft’s differentiated and enterprise-friendly approach will enable it to build a multi-billion dollar business in only a few years’ time. Office 365 is another cloud-based service that has achieved critical mass and demonstrated the Company’s ability to successfully update and monetize an older product category in an annuity-based model with minimal friction and high levels of customer satisfaction. The successful release and growing activations of Windows 10 with its ‘pay once’ model and cross-device capabilities is another example of Microsoft’s embrace of creative destruction in its own business. These and other positive developments have improved investor sentiment toward the Company’s shares in recent quarters, as evidenced by a now meaningfully higher trading multiple relative to free cash flow per share and a much narrower discount to our estimate of intrinsic value. Accordingly, we trimmed our position during the fourth quarter.
Our second best contributor in the quarter was Alphabet (the parent company of Google), whose Class C shares rose by 25%. The shares benefited from the Company’s October announcement of strong quarterly results and the initiation of a $5.1 billion share repurchase program. Alphabet’s robust top-line growth continues to be driven by mobile search, YouTube and programmatic advertising, as well as a continued narrowing of the ‘cost per click’ gap between desktop and mobile-initiated queries. Better expense discipline throughout 2015 coupled with benefits from weaker foreign currency translation have led to slower-than-expected growth in operating expenses and slightly improved operating margins. While the share repurchase announcement marked a significant shift in Alphabet’s financial strategy, we believe Management continues to view capital expenditures and acquisitions as the top priorities for capital allocation, and the Company’s significant holdings of cash and securities ($72.8 billion at the end of the third quarter) as a strategic asset. However, given the substantial free cash flow generation of the core business and current liquidity that likely exceeds the medium term investment needs of the business, we welcome the decision to return part of this excess cash to shareholders. Following sizable gains in 2015 that pushed Alphabet’s shares closer to our estimate of intrinsic value per share, we elected to reduce our position for Core Select during the fourth quarter.
Two of our healthcare holdings, Zoetis and Baxalta, also contributed strongly in the fourth quarter, rising by 18% and 25%, respectively. Both companies bounced back from sharp selloffs that occurred in September as sentiment toward the overall healthcare industry had soured due to a political backlash against prescription drug price escalation in the U.S. and a view that the sector’s brisk merger activity could taper. Zoetis reported strong quarterly results in November and raised its three-year financial targets. The Company also announced the acquisition of PHARMAQ, a leader in the small but growing aquatic animal health industry. We believe that Zoetis continues to be viewed as a potentially attractive acquisition candidate, but our investment thesis is primarily based on favorable secular trends in animal health and solid prospects for continued margin expansion and capital returns.
Baxalta also reported strong quarterly results in November highlighted by double-digit growth rates (adjusted for currency movements) in its core hemophilia and immunology product lines. The Company continues to make progress in its smaller oncology business, where it has made two key acquisitions to complement a significant ramp in organic research and development spending. In August of 2015, Shire PLC had approached Baxalta with an all-stock merger proposal, which Baxalta rejected on the grounds of valuation and deal structure. Recent reports suggest that the two companies have continued to discuss a business combination that may involve a cash component and ultimately a higher price than what was originally proposed. Even in the absence of any such deal, our investment in Baxalta stands on its own merits given our positive view of the Company’s product portfolio, growth opportunities and strong management team.
Other solid performers in the fourth quarter included Wells Fargo, Celanese and PayPal. Wells Fargo, which remains among our largest holdings, rose by 7% buoyed by improving visibility into the normalization of Federal Reserve interest rate policy as well as continued strong underlying credit and loan growth performances. Celanese shares rose by 14% driven by a series of positive developments, including an on-time startup of its new methanol facility in Texas, continued strong earnings performance despite multiple headwinds in certain end markets and a well-received November meeting with the investment community that highlighted the Company’s innovation, cost discipline and attractive prospects for organic and inorganic capital allocation.
For the full year 2015, our top contributors included Alphabet, Chubb, Microsoft, Progressive and Baxalta, with share price gains in excess of 20% for each company. With the exception of Baxalta, which was a spinoff from our former position in Baxter International, we have held these positions for several years, and in each case we have experienced wide periodic swings in investor sentiment and share prices during our time as shareholders. Returning to a point made above, we are well accustomed to this feature of the equity markets – stocks, sectors and investment styles go in and out of favor over time, but we feel strongly that our guiding principles of business selectivity, long-term ownership and investing with a margin of safety will ultimately shape our returns at the company-specific level and for the portfolio overall.
Our largest detractors in the fourth quarter were Southwestern Energy, Bed Bath & Beyond and Novartis. Southwestern shares fell 47% in the quarter and were down by 75% in 2015. We are clearly disappointed by the substantial capital erosion we have experienced in this investment. While we can attribute much of the share price slide to the extremely negative cyclical backdrop in the oil and gas industry, where both demand and supply factors have driven commodity prices to very low levels, we also acknowledge that we could have taken a more skeptical stance regarding certain developments over the last few quarters, including i) the Company’s large increase in borrowings to finance a late-2014 asset purchase, ii) risks to the value of Southwestern’s core Fayetteville shale production given the rapid development of lower cost gas in the northeast U.S., and iii) the potential for politically-linked timing delays affecting a key gas pipeline that could help to reduce oversupply in the Marcellus production region. Currently high storage levels and a mild winter heating season lead us to believe that price realizations for natural gas will remain weak for the foreseeable future, while pricing for natural gas liquids will be restrained by excess supply. These factors will likely result in continued cash flow pressures for Southwestern. Longer term, we believe that demand drivers for natural gas remain broadly positive and that the forced discipline presented by lower cash flows and scarcer capital will help to balance the market and allow natural gas prices to trend toward the marginal costs of production in 3-5 years. Starting with those assumptions, the key issue on which we have focused is the Company’s ability to survive the lean period and meet its balance sheet obligations. We have had a good dialogue with Management and believe they are making the right moves to optimize the Company’s drilling program and capital plan while delivering cost and productivity improvements. In contrast to certain financially stressed peers in the natural gas industry, we believe that Southwestern’s debt obligations are manageable and that its capital structure is not unduly dependent on variable sources of capital. Nevertheless, the market appears to be valuing Southwestern with a fairly high probability of a financial reorganization or highly dilutive equity issuance. We have significantly lowered our estimate of the Company’s intrinsic value per share but have chosen to maintain what is now a small investment.
Bed Bath & Beyond shares declined by 15% during the quarter amid a weakening environment for in-store retail sales and very bearish investor sentiment towards traditional retailers. The Company has continued to face challenges on several fronts, notably including difficult trends in consumer spending, a crowding-out effect as consumers have shifted their purchases toward big-ticket items, intense competition from both traditional and online-only competitors in home furnishings and a sustained period of significant internal investments in technology and infrastructure. These headwinds were evident in Bed Bath & Beyond’s August quarter results (reported in October) and were reconfirmed as the Company announced lower-than-expected sales and earnings results for its November quarter and the holiday season. While we do not expect trends to improve materially for traditional retail sales in the near term, we continue to believe that the management team has a good grasp of the challenges and is responding appropriately by bolstering the Company’s online and multi-channel capabilities, reassessing the store base and constantly raising the bar for customer experience. One clear bright spot offsetting weak store traffic and flat-to-down same-store sales comparisons has been online sales growth of more than 20% for the last few quarters, which suggests that Bed Bath & Beyond’s e-commerce initiatives have been fruitful. In addition, Bed Bath & Beyond continues to make accretive repurchases of its stock at very low trading multiples.
We do not anticipate a quick turn in general economic conditions or an improvement in investor sentiment toward Bed Bath & Beyond and other retailers, including our Core Select holding Wal-Mart, but we do have a sense that the market’s current distaste for the sector fits a pattern we have seen at other times in the past wherein many investors extrapolate negative trends far into the future. Our view is that well-established retailers in attractive categories with differentiated customer value propositions will prove to be durable businesses over the long term if they carefully execute their traditional in-store model and successfully build their multi-channel strategies. We believe both Bed Bath & Beyond and Wal-Mart can meet those objectives. As such, we added to our holdings in both companies during the fourth quarter to take advantage of sizable discounts to our estimates of intrinsic value per share.
Novartis declined by 6% in the quarter largely due to continued earnings headwinds in its Alcon eye care business, which is experiencing competitive pressures and a slowdown in surgical equipment sales both in developed and emerging markets. The Company’s other major businesses in pharmaceuticals and generics have maintained solid operating performance, while continued improvements in productivity and procurement have boosted Novartis’s margins and returns. However, we believe the disappointing developments at Alcon have caused investors to reevaluate what had been a somewhat full valuation for the overall company.
For the full year 2015, Southwestern and Bed Bath & Beyond were our largest detractors, followed by Qualcomm, Berkshire Hathaway and Oracle. Qualcomm, which was down by 31% during the year, faced significant headwinds in both its chip business, where price pressures have escalated and a major customer moved to an in-house solution, as well as its licensing business, in which a regulatory challenge in China and related non-compliance by certain parties impaired the prospects for this high-margin source of revenue. During the fourth quarter, Qualcomm was able to resolve some of the non-compliance issues with specific manufacturers in China, but new disclosures of additional regulatory pressure from Korea, Taiwan and the EU have again clouded the outlook for the licensing segment. Another key development in the fourth quarter was the conclusion of Qualcomm’s review of its corporate structure. We believe the Company made the right decision in opting to keep its chip business and licensing business together given the sizable strategic and operating synergies shared between the two segments. While 2015 proved to be a difficult year for Qualcomm with several headwinds that we had not foreseen, we do not believe that the Company’s vital role in the global wireless ecosystem or its top-caliber engineering and intellectual property position have been diminished. Moreover, we believe the secular growth opportunities in mobile technology and related areas remain compelling. At their current valuation, we believe that Qualcomm’s shares are expressing an unduly pessimistic outlook.
Berkshire Hathaway shares declined by 12% for the year, which in our view reflected a combination of factors including i) weaker performance at GEICO in the first half, ii) macroeconomic and foreign exchange headwinds that affected the industrial businesses, iii) concerns regarding the potential for lower railcar loadings due to slowdowns in manufacturing and onshore oil production, and iv) mark-to-market declines in the value of Berkshire’s publicly traded investments. We are not overly concerned by any of these factors, as we view them to be largely cyclical or transitory in nature. With its diverse range of high quality businesses, strong balance sheet and shrewd approach to capital allocation, Berkshire remains a very good fit with our criteria and is our second-largest holding. We believe the Company’s shares are attractively valued at less than 1.3x book value.
Oracle declined by 18% in 2015 as it remained out of favor with investors largely due to top-line growth concerns and a general malaise toward ‘legacy’ technology vendors that are perceived to be threatened by cloud-computing upstarts. Our view is that underlying trends in the business are actually encouraging as the Company continues to report solid bookings and customer retention, while its own cloud efforts continue to gain traction. Our analysis suggests that Oracle’s valuation implies flat or even negative growth in free cash flow in perpetuity, which we view as unlikely given the essential nature of the Company’s core infrastructure software products and services in a world that is becoming ever more dependent on the collection, retention and analysis of massive amounts of data.
Along with the additions to our holdings of Bed Bath & Beyond and Wal-Mart noted above, we modestly increased our position in Oracle in the mid $30s, which represents a sizable discount to our estimate of intrinsic value. Oracle is now our third-largest position in Core Select. As discussed above, we trimmed our positions in Alphabet and Microsoft as the share prices surged and approached our valuation appraisals. Both stocks were among the top five performers in the S&P 500 Index for 2015 and are now trading at valuation multiples substantially higher than where we built our positions. Reviewing the full year, we initiated a new position in Discovery Communications and exited three others: California Resources Corp., Target and Baxter International. Our trading activity was notably higher in the second half of the year as the market slide in August gave us opportunities to buy. Even so, our portfolio turnover for the year remained below 8%.
At the end of the year, we had positions in 31 companies with 48% of our assets held in the ten largest holdings. Core Select ended 2015 trading at 80% of our underlying intrinsic value estimates on a weighted average basis, compared to 76% at the end of the third quarter and 86% at the end of 2014. We ended the year with a cash position of 12%. As broad market sentiment remains volatile and temperamental, we are hopeful that buying opportunities may emerge for us in 2016. As always, we will remain patient in our deployment of capital and will continue to favor high-conviction businesses into which we have better visibility regarding the range of potential outcomes.
Following seven years of gains in the equity markets amid a somewhat feeble recovery in developed market economies and now-slowing conditions in emerging markets, we believe equity investors should expect relatively low prospective returns. Years of excess liquidity provision and rate suppression by central banks provided a steady flow of fuel for financial markets and credit expansion, some of which no doubt flowed into the ‘real’ economy, but we see real risks that these actions may have represented a false prosperity that not only borrowed from the future, but also set up a greater danger of a damaging debt crisis. We have been cautious about these issues for several quarters as we have taken note of uncomfortably high valuation levels, deteriorating market breadth, commodity price declines and mixed macroeconomic indicators. We view this environment as one that calls for patience and prudence on the part of long-term, value-oriented investors.
Our consistent approach for Core Select remains long-term ownership of well-run, high quality businesses at discounts to our appraisal of their intrinsic value. We carefully underwrite and stress test each investment based on fundamental due diligence and a keen focus on value. We are confident that this approach will continue to best position us to protect capital and deliver attractive absolute returns over full market cycles.
The Core Select investment team appreciates your continued interest and support. We look forward to providing further updates as 2016 progresses.
Timothy E. Hartch
Michael R. Keller, CFA