Large cap equities traded higher in the fourth quarter of 2016 with the S&P 500 Index returning 3.8% as investors reacted favorably to political developments in the U.S. and broadly stabilizing economic conditions. The Index achieved a positive total return for the eighth consecutive year, rising by 11.9% in 2016. Notably, the S&P 500 level now sits 236% above its bottom tick reached in March 2009, or 16.7% compounded annually. BBH Core Select Composite (“Core Select” or “the Strategy”) returned 2.1% in the fourth quarter (as adjusted for distributions), and was up by 9.2% for all of 2016. Over the last five years, Core Select has compounded at an annualized rate of 11.3% per annum versus 14.6% for the S&P 500 Index. Measured from the last market peak reached in October of 2007, the Fund has compounded at 7.6% per annum, which compares to 6.4% for the S&P 500.
Our strongest contributors in the fourth quarter were U.S. Bancorp and Wells Fargo. Shares of both banks rose sharply in November following the U.S. elections, as investors speculated that Republican control of the Executive and Legislative branches of government could lead to developments that lessen the severity of regulatory requirements on the financial services sector. In addition, improving economic forecasts and rising expectations of higher base interest rates have fueled positive sentiment toward the banks in general. In December, we modestly trimmed our position in U.S. Bancorp as the stock traded closer to our per-share estimate of intrinsic value.1
Early in the quarter, Wells Fargo’s CEO John Stumpf announced his immediate resignation in the wake of an account opening scandal that put the Company under intense regulatory scrutiny and caused substantial negative press. Timothy Sloan, who had served as Wells Fargo’s President and Chief Operating Officer was named as Stumpf’s replacement. Sloan is a 29-year veteran of the Company and was acknowledged to be the planned successor to Stumpf. Wells Fargo continues to work to rectify the downstream impacts of having opened accounts that were unwanted or misunderstood by customers, but this process will take additional time. Weeks of negative press reports undoubtedly played a role in the recent deceleration in account openings that Wells Fargo has disclosed. Adding to the negative storylines, in December U.S. bank regulators determined that the Company’s ‘living will ’2 plans were insufficient, resulting in the imposition of certain business prohibitions and the potential for further adverse actions if the plans are not satisfactorily resubmitted by March 2017. Despite all of these challenges, Wells Fargo’s shares had a trough-to-peak advance of nearly 30% within the quarter, highlighting not only how inefficient the market can be in the short term, but also the degree to which basket trades, rapid ETF flows and other directional buying can dramatically impact valuations. While the Company is facing meaningful challenges at present, it remains very profitable, well-capitalized and liquid, and we believe the shares still offer reasonable upside relative to our appraisal of fair value.
Two other strong performers in the fourth quarter were Berkshire Hathaway and Celanese. Berkshire’s Class A shares rose by more than 14%, driven by strong quarterly results reported in November, sizable share price advances for certain of its public equity investments including Wells Fargo and American Express and bullish views regarding the potential for lower corporate taxes and higher levels of government infrastructure spending under the Trump administration.
Celanese shares rose by 18% in the quarter, gaining steadily after a solid earnings report in mid-October. The Company is a leading provider of acetic acid and other base chemicals, as well as a large manufacturer of plastic polymers, acetate tow used in filters, and other specialty chemicals. We believe the Company is operating very well in what continues to be a challenging backdrop of lower than normal global industrial production. In the face of these challenges, Celanese’s margin performance and cash conversion have been exemplary, in our view. With its seasoned management team, technological advantages and continued focus on cost and capital discipline, we believe Celanese can continue to create shareholder value with or without a positive step-change in global industrial activity.
For the full year 2016, Core Select’s largest positive contributors were Berkshire Hathaway, Comcast, U.S. Bancorp and QUALCOMM. Notably, the first three names on this list were also our best performers over the last five years. We are pleased with the 2016 gains among this group and the consistently strong business execution that each has shown, however the share prices of all four companies have now edged closer to our estimates of intrinsic value.
Our largest detractors in the fourth quarter were Perrigo, Nestle, FleetCor Technologies and Novartis. Pharmaceutical stocks had a challenging year in 2016, with the S&P Pharmaceuticals Select Index declining by almost 24%, and 12% in the fourth quarter alone. The key issues affecting the sector have been drug price pressures, regulatory scrutiny and growing concerns that a rollback of parts of the Affordable Care Act could lead to broadly lower healthcare utilization. Novartis continued to face headwinds from generic drug competition, adverse currency movements and a lengthy period of underperformance within the Alcon business unit. On the positive side, Novartis has executed well on its cost management initiatives, while sales from newer products generated solid double-digit growth within the core Innovative Medicines division. Despite the various pressures on the business, Novartis generated $6.5 billion in free cash flow for the first three quarters of 2016, which represented 18% of revenue and 107% of reported net income. We took advantage of the share price weakness and added to our holdings in late November.
The weakness in Perrigo shares in the fourth quarter was not catalyst driven, but rather reflected a continuation of price pressures in the generic drug business and disappointing trends in the European branded healthcare products segment. Importantly, the performance and outlook for the core private label Consumer Healthcare business remains very solid. Perrigo’s management team is undertaking a company-wide evaluation of its assets, focusing particularly on the generic prescription drug business and the non-core Tysabri royalty stream. The Company expects to conclude this work in the first quarter of 2017, at which point a sale of one or both assets and a redeployment of the proceeds are potential scenarios. Given our view that Perrigo’s valuation level reflects little benefit from potentially positive catalysts and that the core private label business remains sound, we added to our position in late November.
FleetCor shares declined by 19% in the fourth quarter. In late December, FleetCor's major competitor WEX announced it had successfully bid for Chevron's private label credit card processing business, which will transition away from FleetCor in 2018. This contract accounts for less than 3% of current year revenues, had not grown for a number of years, and presumably was less profitable than the Company average. Nevertheless, the loss of the contract exacerbated already negative investor sentiment following a somewhat lackluster quarterly earnings report in early November. We made a small additional purchase of FleetCor shares during the quarter.
Nestle’s U.S.-listed ADRs slid by 9% in the quarter. Like many of its peers in the global food and beverages business, Nestle’s top-line results have been pressured by macroeconomic weakness, price deflation, currency headwinds and changing consumer habits. We also believe the recent move in the ADRs had some degree of linkage to the increase in U.S. Treasury rates, which tend to influence equity dividend yields, particularly for companies in areas such as consumer staples. In October, Nestle lowered its expectations for 2016 revenue growth, citing the fragile operating environment. However, targets for margin performance and core EPS growth were maintained. Notwithstanding the current set of challenges, we believe the Company’s long-term strategic focus and willingness to invest in innovation and operational improvements over time remain key strengths. Nestle’s growing focus on health and wellness should position it well to capitalize on consumer trends and changing demographics. We also note that Nestle is undergoing a significant management transition with the current Chairman Peter Brabeck-Letmathe retiring, the current CEO Paul Bulcke moving to the Chairman position, and an external hire, Ulf Mark Schneider, being appointed as CEO. We believe these changes could facilitate favorable strategic and efficiency-related actions over the next few years.
Portfolio Changes and Valuation
The fourth quarter was an active period for portfolio changes in Core Select. Most notably, we concluded a multi-quarter process of analysis and re-vetting of the energy sector and ultimately decided to exit our three remaining investments in that area: EOG Resources, Occidental Petroleum and Schlumberger. Our decision to move away from the sector was not driven by bearish views about the near-term prospects for the three businesses, but rather was the result of our re-assessment of the industry’s degree of fit with the Core Select investment criteria.
Since 2005, we have had a reasonable degree of success investing in the energy industry on both an absolute return basis and also relative to the sector’s performance within the S&P 500 Index. However, in recent years, dramatic swings in oil and natural gas commodity prices have highlighted the challenge we face in assessing the long-term range of outcomes for the businesses given their capital intensity and the constant need to replace depleting reserves. Despite the careful and consistent approach we have used to identify best-in-class operators with advantaged assets and prudent capital strategies, the inherent lack of long-term visibility and the consequently wide range of confidence intervals around our estimates of intrinsic value appeared increasingly untenable within the Core Select framework. Moreover, we have noted key structural developments on both the supply and demand side of the market, including changes in commercial behavior by OPEC member countries and the greater penetration of renewable energy, more efficient combustion and conservation mandates that could ultimately reduce global growth in oil consumption.
With the sizable rebound in oil and gas prices during 2016, the shares of our three energy investments had all approached our baseline estimates of intrinsic value per share. As such, in November we elected to begin selling our positions, and were able to complete the exit by month-end. We redeployed the proceeds into other existing positions that were trading at similar or greater discounts to intrinsic value. In all, we added to 12 existing holdings, fully replacing the approximately 7 percentage points of portfolio value that had been previously deployed in the three energy companies.
During the quarter, we initiated new positions in Liberty Global and Nielsen Holdings. Liberty Global is a leading broadband communications provider of video, high-speed data, voice, and mobile services in 12 European markets including the UK, Germany, and Netherlands. Having previously owned shares of the Company between 2006 and 2011, we know Liberty Global and the European cable industry well and have a high degree of confidence in the management team and the Board of Directors. Over the past 18 months, Liberty Global’s shares have dropped by more than 40% due to rising fears of slower revenue and cash flow growth, competitive intensity in certain markets, adverse currency translation, and concerns regarding the Company’s new build strategy. From our perspective, however, Liberty Global continues to possess the best infrastructure for delivering broadband access, which in today’s world is an essential service. Similar to what Comcast has done in the U.S., Liberty Global has also had success in service bundling and up-selling, and is placing greater focus on penetrating the small and mid-sized business market. We also expect continued margin benefits from Liberty Global’s cost savings initiatives and the achievement of operating synergies from recent business consolidations. We believe that the Company’s solid recurring revenue base and improving cash flow conversion over the next three years will allow it to maintain its levered capital structure while also creating room for returns of capital via share repurchases. We made our initial purchase in October and subsequently added to the position twice in November.
In late December, we initiated a position in Nielsen Holdings, a global leader in media and retail measurement and analysis services. Nielsen provides mission-critical data and insights that are highly valued by media companies, advertisers, consumer packaged goods companies and other customers. In both of its business segments, Watch (47% of revenue) and Buy (53% of revenue), Nielsen is a large global player, with significant competitive advantages resulting not only from the breadth and quality of its data and analytics, but also from the embedded nature of these services within customers’ day-to-day workflows and their longer-term strategic planning activities. In the Watch segment, Nielsen’s entrenched market position is further reinforced by the fact that its ratings are the de facto ‘currency’ by which buyers and sellers of media transact. Roughly 70% of the Company’s revenues are recurring, with contract terms averaging five years.
Nielsen’s share price fell sharply in the fourth quarter after the Company reported weaker than expected growth in certain project-based and discretionary offerings within the Buy segment. Much of this shortfall occurred within parts of the business that Management considers non-core, and in light of the weaker trends, the Company has stated its intention to discontinue or divest some of these areas. This will create some additional revenue pressure, but the impact on margins should be favorable. Nielsen is also making additional investments behind the rollout of its Connected System, a next-generation subscription-based platform that integrates purchasing data with multi-channel media measurement to help clients more effectively plan, execute and measure their marketing strategies. We believe that Connected System will improve the business mix of the Buy segment and also expand the addressable market. To a certain extent, weaker investor sentiment has also reflected fears related to audience fragmentation affecting core parts of the Watch segment, most notably linear television. Our perspective is that television viewing, both live and time-shifted, still has a long life ahead of it given its superior reach and effectiveness from the perspective of advertisers. Moreover, Nielsen’s significant investments and successful penetration of digital platforms provide more measurement opportunities and act as an effective hedge against changing dynamics in media viewership. Despite some competitive concerns pertaining to audience measurement in the traditional TV market, as the only player able to provide comparable metrics across linear and digital video, we believe Nielsen is well placed to become a strong player, if not the eventual ‘currency’ within digital. We view Nielsen as a profitable, scalable business with strong free cash flow generation, a well-constructed balance sheet and better-than-average forward visibility. Our baseline intrinsic valuation model suggests meaningful potential upside in the shares.
Beyond the 12 additions we made to existing positions as part of the redeployment of proceeds from our exiting the energy sector, we also added to our holdings of Oracle early in the fourth quarter. Oracle shares have been volatile around quarterly earnings announcements, and this was again the case following the Company’s fiscal first quarter report in mid-September. Foreign currency headwinds continued to dampen results relative to expectations, as did a steepening decline in upfront software licensing as Oracle’s transition to cloud-based software accelerated. Our view is that this transition has reached a point at which the dollar amount of revenue declines in the legacy business will be outpaced by revenue dollar gains in the cloud business, creating a higher likelihood that the Company will return to consolidated revenue growth during the current fiscal year.
In early October, we modestly trimmed our position in QUALCOMM as the shares approached our estimate of intrinsic value. Throughout 2016, the Company’s valuation benefited from the resolution of an intellectual property dispute with Chinese regulators and improved fundamental performance in both the licensing and chip businesses. In September, QUALCOMM shares rose further on reports that the Company was considering an acquisition of NXP Semiconductors, a Dutch provider of digital and mixed-signal chips that are used in consumer and industrial applications. The companies reached a definitive agreement in late October. In December, we reduced our positions in U.S. Bancorp, Microsoft and Progressive based on valuation.
At the end of the year, we had positions in 28 companies with 52% of our assets in the ten largest holdings. Core Select ended 2016 trading at 86% of our underlying intrinsic value estimates on a weighted average basis, compared to 84% at the end of the third quarter and 80% at the end of 2015. We ended the year with a cash position of 11%, down from 12% at the end of the third quarter as our new purchases and selected additions were outweighed the full exit from our energy sector stocks and trims in other holdings.
With the seeming likelihood of volatile trading patterns and broad sentiment shifts continuing, we are alert to the possibility that early 2017 may present some opportunities if investors begin to adjust their risk exposures, potentially widening valuation discounts at the stock-specific level within Core Select. As always, we will be 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.
The Investment Environment
Despite the equity market’s handsome gains in 2016, we end the year with a continued sense of caution about the sustainability of broadly elevated valuation levels and the speed with which many investors seem to have formed bullish economic views related to the change in political regime in the U.S. On the latter point, we do believe there are some ways in which a break from the fiscal and regulatory orthodoxy of the last two decades could bring about an inflection in ‘animal spirits ’3 in the economy, but the political path to such outcome is uncertain to say the least. Also, the rising refrains of economic populism and protectionism may in fact work against any gains made elsewhere. We also note that there are certain structural factors in the economy such as developed-world demographics, globalization of supply chains and technology-driven substitution of labor that may prove too powerful for even the most growth-friendly set of policies to overcome. All that being said, we believe that over the long term the U.S. economy will continue to prosper despite periodic recessions and setbacks, both on an absolute and a relative basis.
Turning to valuation, as we take stock of the market’s remarkable run since 2009, we see that the benchmark S&P 500 Index has appreciated by 16.7% per annum from its lows, without a single down year on a total-return basis. In the last five years, the Index has compounded at 14.6%. To the extent this five-year number might be considered a mid-cycle return, we note that it is more than 40% higher than the S&P 500’s compound return of 10.2% over the last 50 years. Underlying S&P 500 earnings per share have grown by 14% over the last five years, which might appear to suggest a nice symmetry with the contemporaneous market performance, except for the fact that the 14% return is for the entirety of the period, and only equates to 2.7% annualized. To rectify the large divergence between the equity market performance and underlying corporate earnings, we need look no further than trading multiples, which have consistently expanded throughout the bull market. Even if we put aside the consideration of net earnings and simply look at the ratio of the aggregate equity market value of all publicly-traded U.S. businesses to nominal U.S. GDP, we note that today’s levels have only been exceeded once in history – namely the 2000 Internet bubble.
As we have noted in prior updates, we believe that equity valuations in the current bull market have been heavily influenced by three major non-fundamental factors: i) central bank rate policies and liquidity mechanisms, which have altered the market’s natural discounting mechanism and caused a stampede for yield; ii) hundreds of billions of dollars in asset flows going toward passive products, creating far greater risks of a self-reinforcing spiral of over-valuation within Indexes and certain factor-based styles; and iii) a high rate of corporate share repurchases, totaling nearly a half of a trillion dollars in 2016 alone. To these three market drivers we could also add the growing influence of trend-based strategies such as risk parity or various momentum-driven styles. Taken together, it is not difficult to see how this blend of factors played such a large role in expanding market valuations. With an abundance of low-cost money deployed in increasingly mechanistic ways and seemingly validated by favorable backtests, the path of least resistance for equity prices has been upward.
At a very high level, one can think of equity market prices as being a function of the cost of money, the cost of risk, and expectations regarding future corporate earnings and cash flows. To a certain degree, the three elements interface with each other in self-correcting ways that help to preserve rationality in equity markets. For example, an accelerating earnings growth environment would tend to lift the market’s valuation, but rising inflationary expectations and higher resultant interest rates (i.e. the cost of money) would eventually act as a counterweight. Similarly, if the price of risk was running very high in the midst of recessionary economic conditions and fearful investor sentiment, fiscal and monetary stimulus might help to lower the cost of money and reignite economic hopes, helping to prop up lagging valuations.
Our purpose in laying out this simple thought exercise is to offer it as a barometer of where we stand today. The cost of money remains very low, but it appears increasingly likely that an inflection point has passed and rates may begin at least a modest rise. The cost of risk has also been fairly low, whether one simply observes market volatility (not our preferred measure of risk, it should be noted) or today’s very low implied equity risk premium derived from the capital asset pricing model (also not a perfect measure of risk). Earnings growth expectations appear to be moving higher as investors contemplate factors such as the changing political trends, a potential rise in capital spending and prospects of a tax holiday on foreign earnings repatriation. Taking all of these factors together, we are left to wonder what can propel equity markets higher from here in the near term. Trading multiples are already high by most objective measures. Can earnings accelerate without any accompanying offset from higher rates or higher risk premiums? Can interest rates remain at unprecedented lows if economic tailwinds create natural pressures on wage and input cost inflation? For the last several years, markets have rewarded a “yes, you can have it all” mindset among investors, but history has repeatedly shown that this view, while seductive at times, tends to collide with reality sooner or later as unsustainable excesses build and imprudent risks taken during the run-up begin to manifest themselves, leading to oftentimes dramatic turns in sentiment and flows.
We continue to believe that equity investors should remain alert to the embedded price risks that have built up in today’s market. We acknowledge that our increasingly cautious posture has hurt our relative performance compared to the S&P 500 Index in the last few years as we have shunned richly-valued ‘popular’ stocks and themes, maintained normalized discount rates in our valuations and built up cash in the portfolio as we reduced our exposures to stocks that approached our intrinsic value estimates. Nevertheless, we remain focused on our long-held set of core investment principles that are built on absolute, fundamentals-driven business value rather than predictions about market sentiment and macroeconomic influences. Our top priorities remain capital preservation and attractive full-cycle compounding through the ownership of high quality businesses at attractive valuations.
We appreciate your investment and look forward to providing you with further updates on the progress of our companies in 2017.
Timothy E. Hartch
Michael R. Keller, CFA
1 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
2 A living will refers to a bank’s liquidation and bankruptcy planning.
3 Animal spirits describe human emotion that drives consumer confidence.