Large cap U.S. stocks experienced a sharp correction during the fourth quarter of 2018 that sent the equity market to its first year of negative returns since 2008. Lacking a specific economic signal or geopolitical risk event, the market’s correction instead appeared to reflect diminished risk appetites in the context of potentially slowing growth, tightening monetary policy and high valuation levels. From the beginning of 2018 through the peak closing level reached on September 20, large cap equities as measured by the S&P 500 index had returned 11.2%, with the gains predominantly driven by the growth segment of the market. In the subsequent fourth-quarter selloff, share price declines were widespread, but for the first time in two years, the value component of the market outperformed its growth counterpart. However, even with this late-year reversal, growth stocks outperformed value by approximately nine percentage points for the full year 2018, continuing a trend that has characterized the market’s performance for the last five years.
The S&P 500 Index declined by -13.52% in the fourth quarter on a total return basis and ended 2018 with a loss of -4.38%. By comparison, BBH Core Select Composite (“Core Select” or “the Strategy”) had a smaller loss during the fourth quarter correction, declining by -10.08%, but finished the year down by -6.33%. Over the last five years, Core Select has compounded at an annualized rate of 5.88% per annum versus 8.49% for the S&P 500 Index. On a through-the-cycle basis, as measured from the prior market peak reached in October of 2007, the Strategy has compounded at 7.2% per annum, which compares to 6.5% for the S&P 500.
With the sharp decline in equity prices during the fourth quarter, Core Select only had three positive contributors: Brown-Forman Corp., Dollar General Corp., and Diageo PLC. Brown-Forman is a new position that we added to the portfolio in late December (a full description of the business and our investment thesis appears below). Favorable timing of our initial purchases vis-à-vis the market’s year-end rally drove the positive contribution for the quarter.
Dollar General shares declined slightly in the quarter, but their contribution to the Strategy’s performance was modestly positive due to the prices at which we made incremental additions to our position in October and December. Since our initial purchase in July 2018, we have been pleased with the company’s overall fundamental performance and its continued progress on key strategic initiatives including the expanded availability of consumable products, improved merchandising and store layouts, and fortification of its distribution infrastructure. Importantly, Dollar General has maintained an aggressive pace of store growth in its current fiscal year, and its recently-disclosed expansion goal for fiscal 2019 was significantly above our initial expectation. While aggressive, the company’s plans are guided by management’s well-developed template for site identification, capital deployment, and modeling of store-level economics, and thus we anticipate attractive incremental profitability and returns as new units enter the base. We remain encouraged by the company’s progress and its attractive positioning in the discount retail industry.
Diageo shares had a slight positive return in the fourth quarter, even as the broad consumer staples sector declined and the U.S. Dollar appreciated further against the British Pound. Diageo continues to work on optimizing its U.S. product portfolio, with the goals of reducing the drag from weaker categories and targeting higher growth areas for investment capital. As the quarter progressed, the performance of Diageo’s major brands helped to drive overall company growth in line with the market after years of below-market growth. The company also announced the sale of several smaller, non-focus brands, which we believe will allow management to concentrate efforts on the most attractive and cash-generative elements of its portfolio – those that have strong consumer franchises with favorable growth opportunities at high rates of return over a long period of time. While Diageo does currently face some challenges in certain markets outside the U.S., we believe the strength and breadth of the company’s portfolio and geographic coverage can allow it to manage through interim headwinds.
For the full year 2018, our largest positive contributors were Zoetis Inc., PayPal Holdings, Discovery Inc., and Henry Schein, Inc. For Zoetis and PayPal, full-year share price returns in the mid-to-high teens were driven by continued revenue growth, strong incremental margins, cash flow production, and consistent strategic execution. Shares of Discovery and Henry Schein recovered from panic-type lows that had occurred in late 2017 and early 2018 as investors fled from companies that were perceived to be on the wrong side of digital disruption. While this topic remains a legitimate and important consideration in our due diligence and thesis underwriting on these companies and others, we felt that the market valuations of Discovery and Henry Schein at various points during the year reflected undue pessimism.
The largest performance detractors in the fourth quarter were Perrigo Co., Oracle Corp., and Alphabet Inc. Perrigo shares fell sharply in late December after the company disclosed details of a large retroactive tax assessment that had been levied by the Irish government. The assessment equates to roughly $1.9 billion, or $14 per Perrigo share. Even if it were split into installments, the scope of the potential payment required of Perrigo would necessitate meaningful changes to the company’s balance sheet and financial planning. The assessment is predicated on an assertion by Irish tax authorities that Perrigo should have been paying a capital gains tax rate of 33% rather than an earned income rate of 12.5% for royalties received on sales of Tysabri (a leading drug used to treat Multiple Sclerosis) during the period from Perrigo’s 2013 acquisition of Elan Corp. (a partial owner of Tysabri royalty rights) until the sale of these rights to Royalty Pharma in February 2017. Perrigo and its auditors believe that the tax method used for the royalty revenues was appropriate and consistent with applicable laws and precedent in Ireland. The company will appeal the assessment, and a final resolution that would require cash payments could potentially take several years, in our view.
Separate from the issue of the Irish tax assessment, Perrigo shares declined throughout the year as the company struggled with delayed product launches, supply disruptions, and some problem areas in overall commercial execution. Perrigo’s prescription generic drug business, while solidly profitable and reasonably well differentiated from a competitive standpoint, has nevertheless been a significant drag on the consolidated business results. Like-for-like price erosion is a characteristic element of the generic drug industry, and trends over the last few years have been within the range of management’s expectations. Likewise, we believe that volume levels for Perrigo’s existing base of generic drugs have been stable. However, without sufficient growth from new launches to offset price erosion, the generic drug model falters. This has been the key issue for Perrigo over the last year – regulatory approval delays, unanticipated competitive entries, and a lull in pipeline productivity have not only hurt reported growth for the segment, but also damaged management’s credibility given that the company has not been able to meet its publicly-stated forecasts, disappointing investors multiple times in 2018. We note that an internal strategic review of the generics segment has been underway over the last year, and it is conceivable that management distraction and uncertainty played a role in the operational and forecasting missteps.
In contrast to the issues on the generic drug segment, Perrigo’s over-the-counter (OTC) businesses have performed reasonably well, and the U.S. private-label consumer healthcare products business continues to be the area in which the company’s industry leadership and long-term opportunity set are most promising, in our view. Perrigo’s new CEO Murray Kessler and the Board of Directors have set a strategic plan to separate the business by 2H19 and spin-off or divest the prescription generic drug segment in order to re-focus the organization on the OTC businesses, with a clarified mandate to add production capacity, introduce new products, pursue tuck-in acquisitions, and more proactively collaborate with retail partners (both physical and online). The updated vision for Perrigo is to be a consumer-oriented company focused on a large and growing opportunity set in “self-care” products. We support this endeavor insofar as it plays to many of the company’s existing strengths, but we are also mindful of the attendant risks related to execution and cultural change.
Oracle shares declined by 12% during the quarter as investor sentiment toward large cap technology companies turned sharply negative. Nevertheless, the fundamental performance of the business remains strong, highlighted by mid-single digit revenue growth in the subscription-based cloud services and maintenance reporting line, positive operating leverage, double-digit free cash flow growth, and an aggressive capital return program (with a $10 billion share repurchase in the most recent quarter). Another important data point from the company’s recent earnings report was 7% growth in the overall applications ecosystem (aggregating cloud-based and on-premise modalities), which helped drive an overall cloud-based revenue growth rate that we estimate to be in the mid-teens.
Our view of these results, combined with our recent customer and competitor checks, form the basis of our positive assessment of the health of the business and its long-term prospects. We believe that Oracle is executing well against its two key strategic imperatives: growth in the Cloud application business and sustained technology leadership in the database market – both of which are augmented by productive investments in Cloud-based infrastructure and the supporting commercial infrastructure including sales resources and new pricing strategies. Despite rising adoption of public Cloud services for various infrastructure workloads, we believe that Oracle’s focus on the security, availability, speed, and continuity of its Cloud offerings is the right approach, and one that will facilitate migration of its existing customer base over time.
Alphabet shares fell by 13% during the fourth quarter amidst a broad selloff in technology stocks. We believe that the share price weakness was purely market driven and not reflective of the fundamental performance of the business, which continues to be very strong not only in the core advertising-related businesses, but also in emerging growth areas such as cloud computing and first-party hardware. Alphabet grew its revenues by more than 20% in each of the last four quarters while also generating net margins well in excess of 20% and producing free cash flow of nearly $23 billion over that time period despite significant capital investments to support future growth. The company remains among our highest-conviction investments given its long runway for core business growth, its dynamic resources in both human capital and technology, its financial strength (more than $100 billion in net cash on the balance sheet), and several embedded options on emerging businesses. Despite these singular attributes, we believe the shares trade at an attractive valuation vis-à-vis the full lifecycle cash generation potential of the business.
Our largest performance detractors for the full year 2018 were Perrigo, Nielsen Holdings, Wells Fargo & Company, and Liberty Global PLC. We sold our position in Nielsen in August as adverse developments in the company’s operational and financial performance compromised its fit with our investment criteria and impaired the visibility of long-term outcomes. Wells Fargo shares traded lower due to continued regulatory scrutiny and increasingly skeptical investor sentiment towards banks generally as fears of an economic slowdown and flattening lending spreads pressured valuations for the group. We continue to believe that Wells Fargo has a durable core franchise as a leading deposit-gathering bank with a strong track record of loan underwriting and an attractive composition of earnings, and that it will be able to move past the regulatory issues that arose in the wake of the account opening scandal two years ago. Liberty Global shares were weak throughout the year due to a combination of factors, including: i) escalating competitive pressures in Switzerland and Belgium as smaller players have pursued ‘land grab’ type strategies, ii) high (albeit declining) levels of capital spending in support of network expansion, advanced customer equipment and improved speeds, iii) continued uncertainty surrounding the eventual use of proceeds from Liberty Global’s pending $13 billion sale of its German and Central European businesses to Vodafone, and iv) pervasive negative sentiment towards traditional media companies, including both distributors and content producers. We continue to see Liberty Global as being a well-positioned provider of increasingly indispensable recurring revenue-based services in several key European markets, and we view Management as being good operators and long-term capital allocators.
Portfolio Changes and Valuation
During the quarter, we initiated new positions in Copart Inc., KLA-Tencor Corp., and Brown-Forman Corp. These companies embody a strong degree of fit with our investment criteria, largely due to their respective competitive positioning, growth opportunities and ability to compound long-term shareholder value driven by solid returns on capital. Broad weakness in the equity market throughout the quarter gave us opportunities to make these purchases at attractive discounts to our estimates of intrinsic value per share.
Copart is a global leader in the salvage vehicle auction services industry. The company processes and stores vehicles that have been deemed a total loss by insurance companies and conducts online auctions to sell them to business and retail customers. While insurance companies are the main channel for Copart’s auction inventory, the company also processes and sells vehicles for banks, finance companies, charities, fleet operators, dealers, and individual owners. Copart primarily acts on an agency basis and earns revenue from fees that are paid by both the buyer and seller at auctions. The company’s proprietary online auction platform links buyers and sellers around the world, creating a network for sellers to liquidate their total loss vehicles, while allowing more than 750,000 registered buyers (which include dismantlers, dealers, body shops, salvage buyers, and individual consumers), to find, bid on, and win vehicles. The salvage industry has grown at an accelerated pace in recent years given increased accident frequency and severity (largely due to higher occurrences of distracted driving) and rising costs to repair commonly damaged vehicle sections. We expect these trends to continue, even as vehicle safety systems gain penetration in the auto fleet. Importantly, the salvage auction industry is effectively a duopoly (between Copart and IAA, a division of KAR Auction Services), with high barriers to entry such as permitted land requirements, density of registered buyers, and the operational complexity of the titling process, making it difficult for new entrants to unseat the incumbents.
We believe Copart represents a very strong fit with our Core Select investment criteria given: i) the defensiveness of the business (accidents are minimally sensitive to economic conditions), ii) sustainable growth opportunities that exist both domestically and in select international markets, iii) strong network effects that are inherent to the auction model, iv) the embedded nature and high value-add of its service offering within the regular workflow of its insurance company partners, and v) its long-tenured management team that runs the business with an owner-operator mindset. The company earns high returns on invested capital, is highly cash generative, and has a conservative balance sheet with minimal borrowings. We purchased Copart shares in October and December at prices that we believed offered attractive levels relative to our estimate of intrinsic value per share. The company reported solid earnings results in late November, with revenue and profits up by double-digit percentages. Trends in auto accident frequency and severity continue to support solid volume growth for the salvage industry, while the network of bidders expanded as well. These concurrent trends reinforced our positive view of Copart’s strong positioning and its ability to compound economic value.
KLA-Tencor (KLA) manufactures and services process control and yield management solutions for the semiconductor and related nanoelectronics industries. The company’s inspection and metrology equipment is used to identify defects during the fabrication of integrated circuits (chips) and to measure the critical dimensions of components on those chips. Given the capital intensity and high degree of competitiveness in the semiconductor fabrication industry, chipmakers rely on KLA’s highly specialized products to make their facilities more efficient and profitable by reducing the percentage of defective chips produced. KLA’s key competitive advantages stem from two primary sources: first, its substantial research and development spending and leading market share in high-end equipment reinforce the technical superiority and resultant high profitability of its products; and second, its in-house service and maintenance business benefits from captive customers who need expert assistance to repair, update, and tune their KLA equipment, because they are typically unable to do so themselves. The confluence of these dynamics results in KLA being an indispensable partner to the semiconductor industry, in our view, as it both enables technological advancement and increases its customers’ profitability.
For a variety of reasons that pertain to technological innovation, spending patterns, time-to-market pressures, and generally poor competitive discipline, the semiconductor industry overall is highly cyclical and tends to produce disappointing economic returns over time. Chipmakers that bring new, more capable chips to market first enjoy high prices and healthy margins. However, as competitors quickly follow and grow capacity, prices inevitably drop. The cadence of innovation requires chipmakers to constantly invest in equipment that improves their manufacturing capability. Despite these challenging dynamics for chipmakers, KLA’s dominance of a very attractive niche within the Wafer Fabrication Equipment (WFE) market and its ability to help customers improve their profitability insulates it somewhat from the cycle, in our view. Moreover, given its ongoing investments in research & development (R&D) to keep pace with chip advances and the accumulated benefit of existing technical know-how in metrology and inspection, we believe that KLA can maintain a leading position in process control with very little foreseeable likelihood of competitive displacement.
We built our KLA position in October as investor sentiment towards the semiconductor industry became incrementally more negative in the context of a general market selloff and a view that the negative phase of the industry’s inventory cycle was beginning. Our KLAC investment is not predicated on timing the industry cycle, but instead recognizes the company’s critical value-add to semiconductor manufacturers and the attendant secular growth benefits that should persist over the long-term.
Brown-Forman is a leading premium spirits producer with a primary focus on the American whiskey category sold globally with its Jack Daniel’s brand. The company participates in the premium and above categories broadly with American whiskey, bourbon, tequila, scotch, Irish whiskey, and vodka brands supplemented by a small wine portfolio. Brown-Forman has narrowed its focus and investments over the years towards spirits given the stronger margins, growth, and returns of the category relative to others. In our view, the company’s spirits portfolio includes some of the world’s strongest brands with high customer loyalty and significant barriers to entry. We believe the company can leverage its segment-leading Jack Daniel’s brand and the distribution infrastructure it has built over the last several years to harness the increasing penetration of American whiskey and other western-style spirits globally – particularly in emerging markets – as well as ongoing premiumization trends occurring in the spirits industry.
Brown-Forman participates in attractive, high-margin product categories that are viewed as broadly essential to on-premise (i.e. bars and restaurants) and off-premise (i.e. retailer) customers in its markets. We believe the company has defensible or dominant market share positions in key geographies and categories, particularly in American whiskey. While Brown-Forman arguably has only one truly global brand (Jack Daniel’s), it maintains a portfolio of brands that have smaller consumer bases in their core markets, but operate in global categories (e.g., Herradura tequila, Woodford Reserve bourbon). The company has built brand equity and customer loyalty over time through effective marketing, advertising, and trade promotion. The Jack Daniel’s franchise has been established for decades, and management has made targeted investments to reinforce and expand the brand, allowing it to grow it faster than its markets despite macroeconomic cycles and evolving consumer preferences.
Brown-Forman’s key strategic goals are to maintain leadership in the American whiskey market and to augment that position with additional brands that can improve returns and reinforce profitability in select markets. The company’s strategy of brand-driven leadership and scaling through acquisition, brand creation, and broadening distribution have allowed it to be profitable and growing while also improving returns, even in more mature markets like the U.S. and Western Europe. We believe the long-term results of this brand-led approach and broadening distribution opportunity will be attractive rates of revenue and profit growth over full economic cycles. We initiated our position in Brown-Forman in December at a price that offered an attractive discount to our appraisal of per-share intrinsic value.
Along with the new purchases noted above, we also added to our existing holdings of Dollar General, Allegion PLC, Linde PLC (formerly Praxair), Fleetcor Technologies, and US Bancorp during the fourth quarter. These businesses are among our highest conviction investments in each of their respective sectors, and we view them as durable franchises with attractive structural attributes and sustainable value-creation potential. As such, we saw the broad equity selloff during the quarter as a good opportunity to strengthen our portfolio by adding to these names.
At various points in the fourth quarter, we trimmed our holdings of Discovery Communications, Kroger Co., and Wells Fargo. Our trims in Discovery and Kroger were mainly portfolio related, as we took advantage of strong share price rebounds for both companies to make room for other purchases. We sold a portion of our Wells Fargo position to fund a like-sized addition to US Bancorp. During the market selloff, US Bancorp shares had underperformed relative to Wells Fargo and the broader banking sector despite its strong financial characteristics and what we see as a lower degree of regulatory risk. In November, we completed our exit of Dentsply Sirona Inc., for reasons that we discussed in our Core Select quarterly Strategy update last quarter.
At the end of the year, we had positions in 29 companies with 53% of our assets held in the 10 largest holdings. As of December 31, Core Select was trading at 75% of our underlying intrinsic value estimates on a weighted-average basis, which was nine percentage points lower than the prior quarter due to the market correction.
The market selloff during the fourth quarter was notable not only for its speed and severity, but also because it represented a sharp counterpoint to the trading paradigm that has defined the last several years – namely, a broad preference for growth stocks, a presumption of easy monetary conditions, tolerance of rising valuations, and faithful adherence to a “buy the dips” approach. We have often argued that such a paradigm runs the risk of becoming self-defeating as widespread positive sentiment and loosening attitudes towards risk inevitably lead to asset mis-pricings. During bull markets, investor sentiment at some point decouples from the fundamental long-term realities of growth, economic cycles, competition, productive capacity, and the possibility of unforeseen exogenous risks. We cannot yet say whether September 2018 marked such a precipice, or whether the subsequent correction through year-end was sufficient to bring sentiment back to center. Thankfully, our investment approach doesn’t require any such guesswork. The Core Select team believes that companies’ competitive differentiation, growth, profitability, capital productivity, and reinvestment strategies are the critical long-term drivers of shareholder value creation, and thus share prices. Therefore, erratic market behavior and periodic corrections become welcome opportunities for us to optimize our portfolio by putting money to work in high-conviction businesses with attractive levels of potential upside.
Investment Team Update
We are pleased to report that Nakul Chaturvedi joined the Core Select investment team in December as a senior analyst focused on the Consumer sector. Prior to joining BBH, Nakul had worked on equity teams at Wasatch Advisors and Voya Investment Management. Earlier in his career, Nakul worked in management consulting and also held strategy and finance roles in the energy industry. Nakul has a degree in computer science from North Carolina State and an MBA from the NYU Stern School of Business.
We appreciate your continued interest and support, and we look forward to providing further updates on our portfolio as 2019 progresses.
Michael R. Keller, CFA
Holdings are subject to change. Totals may not sum due to rounding.
Price/Earnings (P/E) ratio is a company’s current share price divided by earnings per-share.
Turnover ratio is the rate of trading in a portfolio; higher values imply more frequent trading.
Contribution figures are presented gross of fees and do not include cash and cash equivalents.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Purchase and sale information provided should not be considered as a recommendation to purchase or sell a particular security and that there is no assurance, as of the date of publication, that the securities purchased remain in a fund's portfolio or that securities sold have not been repurchased.
The strategy is ‘non-diversified’ and may assume large positions in a small number of issuers which can increase the potential for greater price fluctuation.
Data presented is that of a single representative account ("Representative Account") that invests in the strategy. It is the account whose investment guidelines allow the greatest flexibility to express active management positions. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the proposed investment strategy.
For purpose of complying with the GIPS® standards, the firm is defined as Brown Brothers Harriman Investment Management ("IM"). IM is a division of Brown Brothers Harriman & Co. ("BBH"). IM claims compliance with the Global Investment Performance Standards (GIPS®). To receive a list of composite descriptions of IM and/or a presentation that complies with the GIPS standards, contact Craig Schwalb at (212) 493-7217, or via email at email@example.com.
Gross of fee performance results for this composite do not reflect the deduction of investment advisory fees. Actual returns will be reduced by such fees. "Net" of fees performance results reflect the deduction of the maximum investment advisory fees. Performance calculated in U.S. dollars.
The Composite is a fully discretionary, fee-paying accounts over $5 million that invest in a portfolio of approximately 20-30 companies with market capitalizations greater than $5 billion that are headquartered in North America, as well as in certain global firms located in other developed regions. This strategy is benchmarked to the S&P 500 Index.
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