The BBH U.S. Large Cap Equity Strategy (“the Strategy”) declined -15.06% in the second quarter, modestly outperforming the benchmark S&P 500’s decline of -16.10%. It is fair to characterize the portfolio’s “outperformance” as something of a pyrrhic victory given the magnitude of the absolute decline and our objective of outperforming in down markets. From a sector perspective, Consumer Staples was the most defensive as a group, while Consumer Discretionary was the least; sector performance broadly mirrored the market’s defensive posture. At the security level, Dollar General (DG) and Progressive (PGR) were the top portfolio contributors, while Amazon (AMZN) and Alphabet (GOOG) were the primary detractors. At quarter-end, the portfolio held 30 positions, 1.79% cash, and a price to intrinsic value1 of approximately 72%. During the quarter we purchased shares of the dominant digital media software provider Adobe (ADBE) and exited our investment in Starbucks (SBUX).
Shares of discount retailer Dollar General were a standout performer for the quarter after gaining approximately 10%. Shifting spending patterns have been a heightened concern to investors as it relates to retailers; however, Dollar General’s recent results served to quell some of these concerns and highlighted the resilience of the business, with the majority of its revenue generated from the sale of consumables (food, cleaning, pet, etc.) categories. Despite broad based inflation, Dollar General’s management expressed a view that their customers are holding up well. This is supported by healthy levels of employment across all demographics served while also noting a slight increase in traffic from higher income customers, suggesting a trade down that is positive for the business. With over 18,000 stores across the U.S., Dollar General is well positioned to continue serving its customers through a unique combination of value and convenience, especially in a more challenging economic environment.
At the other end of the spectrum, shares of e-commerce giant Amazon declined 35% for the quarter. In April, Amazon reported its slowest quarterly growth in two decades and its first quarterly loss since 2015. A return to in-person shopping, difficult comparisons, and a shift in consumption to other discretionary categories such as travel have contributed to declining traffic across many large e-commerce sites, including Amazon. Additionally, the company’s investments in warehouse capacity and labor weighed on profit margins. While investors have typically rewarded Amazon for making these strategic investments, the current economic environment has produced a more skeptical view. Encouragingly, Amazon Web Services (AWS) and digital ads, the primary sources of the company’s profits, have continued showing signs of strong growth.
Amazon has shown an exceptional ability to innovate, effectively allocate capital and build wide competitive moats around its core businesses. While there’s a slowdown in the retail business, we believe e-commerce will continue to gain share of the broader retail market with Amazon becoming a main player in the space. As the leader in cloud computing services, AWS is particularly well positioned. Amazon’s advertising business also continues to be a beneficiary of the secular shift from print, radio, and TV to digital advertising. Finally, there is a strong continuation of Amazon’s innovative, tenacious, and customer-centric culture under the new CEO, Andy Jassy. We believe Jassy’s focus on execution and profitability will continue to support shareholder value creation in the long term.
During the quarter we initiated a position in Adobe. Adobe is an enterprise software company with leading applications that address the fundamental needs of creative professionals and knowledge workers to create and distribute content through three segments: Creative Cloud which offers a suite of design, illustration, photo, and video editing software; Document Cloud which includes document management and publishing tools such as Adobe’s well known Acrobat PDF reading and publishing software and Adobe Sign which enables signatures and contract management capabilities; and Digital Experience which includes digital marketing and e-commerce products that generate sales and improve checkout workflows.
Each segment benefits from powerful competitive advantages and attractive industry growth tailwinds that augment the consolidated company’s excellent margin profile, strong free cash flow generation, and attractive returns on invested capital. Adobe’s consolidated unit economics are among the most attractive in software because of structural cost advantages at the gross margin level, product status as the standard for its users which contributes to strong customer retention, and exceptional brand recognition which lowers Adobe’s customer acquisition costs. We believe recent market weakness, particularly in the Information Technology sector, presents an attractive opportunity to purchase shares of industry leader Adobe at an attractive price.
We exited our investment in Starbucks primarily due to governance concerns associated with an unexpected and protracted leadership transition. Additionally, an uncertain backdrop driven by deteriorating labor relations, increasing investments, and the resurgence of strict COVID restrictions in China are further challenges the business must navigate in the near term that may lead to a wider range of outcomes than we had anticipated. We continue to recognize the attractive long-term attributes of the business but believe it’s more prudent to deploy the capital elsewhere while the company navigates its current challenges.
Finally, Signature Bank (SBNY) has recently come under considerable pressure due to what we believe to be misplaced anxiety about the stability of its deposit base. Signature is a leading regional bank with an outstanding long-term record of growth and risk management. Of the bank’s $109 billion in deposits, roughly $29 billion comes from participants in the cryptocurrency ecosystem including various exchanges, investors, and deposits backing (non-algorithmic) stablecoins.2 All the deposits emanating from these sources are cash, so the company has no exposure to the underlying cryptocurrencies. Critically, the company also has no crypto-related credit exposure. However, given the precipitous drop in the value of cryptocurrencies and the turmoil engulfing that ecosystem, there is a fear that Signature’s crypto-related (or digital) deposits will leave the bank and drain liquidity and future earnings power. When evaluating that risk, there are several key considerations. First, during the bank’s most recent update at the mid-point of the second quarter, the bank’s digital deposit balances were unchanged. Second, Signature has a cash balance of $26 billion which is available to fund any potential deposit outflows. Because that cash balance has been earning very little interest, the impact of cash outflows on the company’s earnings is likely to be very limited. Third, the company has $27 billion in short-duration, high credit quality securities and well over $30 billion of untapped borrowing capacity, all of which can be used to fund deposit outflows. Therefore, we do not believe that outflows of digital deposits, were they to occur, would have a profound impact on the company’s liquidity or prospective earnings power. Even without any digital deposits, we believe the company’s shares are significantly undervaluedThe BBH U.S. Large Cap Equity (“the Strategy”) declined -7.67% during the first quarter, underperforming the benchmark S&P 500 by -3.07%. The primary sources of underperformance included the market’s hard rotation from growth to value which impacted some of the Strategy’s higher-multiple holdings, an absence of Energy holdings which led the benchmark by a wide margin, and adverse share price movements among our economically sensitive Industrial and Materials holdings. Responding positively to higher interest rates, our top portfolio contributors were Financials, which include Berkshire Hathaway, Progressive, and Arthur J. Gallagher. Primary detractors were a more diverse group, including animal health company Zoetis, paint and coatings manufacturer Sherwin-Williams, and A.O. Smith, a diversified industrial manufacturer. Each of the detractors had been strong performers in the prior year.
To date, the primary source of market weakness has been multiple compression in response to rising rates. Looking to the second half of the year, we believe earnings growth will take center stage. Consensus estimates remain, in our view, optimistic. Our portfolio holdings are not immune to inflationary pressures or economic cycles, but we believe they are well positioned compared to the broader market. As a whole, the portfolio’s earnings growth, cash flows, and balance sheet health are superior to that of the S&P 500. At the risk of repeating a cliché, we remind ourselves and our investors that bear markets and market cycles are a process characterized not only by magnitude, but also by duration. By historical averages, the current cycle is mature, but attempting to time the market, an individual security, Federal Reserve actions, or the probability of a recession is not only futile, but counterproductive. During periods of market stress, the natural response of most investors is to shorten their time horizon, react to headlines and dwell on price rather than value. Our focus remains on the long-term economic value generated by your portfolio companies. From this perspective, we believe the Strategy outlook is excellent.
Michael R. Keller