Brown-Forman shares declined by 10% in the third quarter as rising input cost pressures continued to weigh on the Company’s near-term profitability outlook. After experiencing a multi-quarter period of gross margin headwinds related to rising costs of barrel wood and agave as well as European Union tariffs, Brown-Forman had previously expected gross margin to trough and begin to improve slightly in the upcoming fiscal year. Agave cost inflation in particular had been projected to moderate as an increase in plantings several years ago was expected to help align supply with demand. However, exceptionally strong consumer demand for tequila and other agave-based spirits has led to a slower moderation in agave costs, while other input cost pressures have been exacerbated by supply chain disruptions and rapid increases in transport, logistics, glass and aluminum costs. Despite the supply chain and input cost uncertainties in the foreseeable future, we are encouraged that the Company continues to invest in international distribution to support future growth. Meanwhile, its premium brands and products are driving strong revenue growth across whiskeys and tequilas. Overall, we believe that Brown-Forman continues to execute well, and we expect it to adapt to the challenging environment by taking bolder actions such as the recent announcement of price increases to offset what have proved to be more persistent cost pressures.
Shares of Progressive slipped by 8% during the quarter as insured loss costs continued to trend higher in the passenger auto segment of the business. As the U.S. economy has emerged from the worst phases of the COVID-driven lockdown, aggregate vehicle miles traveled have increased apace, while accident frequency rates have also continued to trend higher. These factors along with heavy one-time losses related to Hurricane Ida have caused a meaningful recent increase in loss instances for the auto insurance industry and have been compounded by inflationary pressures affecting vehicle repair and replacement costs. The resultant pressure on Progressive’s short-term earnings path is material, and policy pricing adjustments will take time to catch up to extant loss cost patterns. Importantly, we view these periodic fluctuations in profits (whether due to loss patterns or catastrophe events) as being a normal dynamic within the industry, and ultimately one that is far less important from an investment perspective than controllable structural factors such as the quality of underwriting, brand value, customer experience and operational efficiency. On each of these elements, we continue to view Progressive as a clear standout within the industry, and we expect that the Company will prove able to gain additional market share and create attractive shareholder value over time.
Portfolio Changes and Valuation
In late 2020 and early 2021, we made a substantial number of changes to the portfolio as economic disruption and market volatility gave us opportunities to add new companies and adjust our positioning within sectors, with funding provided by trims and exits in other holdings based on our relative conviction levels and views regarding valuation. In contrast, the last two quarters have been less active as we have made a relatively small number of incremental moves, but have not added any new companies or exited from others. As we noted last quarter, the BBH U.S. Large Cap investment team had anticipated reaching this somewhat more settled, lower-turnover state based on our view that the long-term benefits of investing in high-quality, uniquely positioned compounder-type businesses at attractive prices are best achieved when a manager has the patience to allow the companies’ fundamental performance to play out over time as the key determinant of long-term shareholder value creation. Nevertheless, we will continue to make well-reasoned portfolio adjustments as and when opportunities present themselves, and we maintain an active pipeline of portfolio candidates that have been extensively researched by our team members.
In July, we added to our existing holdings of KLA Corp., Booking Holdings Inc. and Visa Inc. as part of an adjustment within our technology sector investments (opposite the trim of Oracle noted above). We continue to view KLA as being very well positioned in structurally attractive segments of the market for semiconductor capital equipment. Tight conditions throughout the semiconductor supply chain imply that capacity is fully subscribed at KLA’s customers, which benefits the Company’s run rate of tool placements and service activity and provides important clarity regarding the sustainability of growth. KLA’s financial results during the post-pandemic rebound have been consistently strong, demonstrating not only the underlying resiliency of demand for semiconductors, but also the Company’s leading competitive position, indispensability to customers and effective operational execution. For both Visa and Booking Holdings, our view remains that their respective businesses have additional embedded revenue and earnings upside linked to the gradual re-opening of global travel, and we see their valuations as being relatively attractive at recent levels.
At various points during the quarter, we also added to our holdings of Amazon.com Inc., Colgate-Palmolive Co., Celanese Corp. and Nike Inc. driven by our respective assessments of underlying business strength and attractive upside to our baseline intrinsic value estimates.
In addition to the trims of our Alphabet and Oracle positions as detailed above, we also reduced our holdings of A.O. Smith and Diageo plc during the third quarter at price levels in the approximate range of our fair value assessments.
At the end of the third quarter, we had positions in 32 companies with 48% of our assets held in the ten largest holdings. As of September 30, the Strategy was trading at 87% of our underlying intrinsic value estimates on a weighted-average basis, which compared to 93% at the end of the prior quarter, with the difference being attributable to the aforementioned portfolio activity and updates to our valuation models. We ended the quarter with a cash position of 0.8%, which was slightly higher than the prior quarter’s level.
Portfolio Management Update
We are pleased to announce that on October 4, Nicholas Haffenreffer joined the U.S. Large Cap Equity team as a Portfolio Manager. Nicholas is a deeply experienced, fundamentally oriented investor with more than 30 years of experience. Prior to joining BBH, he had been Principal, Chief Investment Officer and Portfolio Manager at Torray LLC, overseeing the TorrayResolute Concentrated Large Growth strategy and the TorrayResolute Small/Mid Cap Growth strategy. Previously, Nicholas had founded Resolute Capital Management in 1998 and merged the company with Torray in 2010. Earlier in his career, Nicholas held positions as Director of Research at Farr Miller & Washington, equity analyst at T. Rowe Price Associates, Inc. and equity analyst for Select Equity Group, Inc. Nicholas received a BA from Brown University in 1990.
Nicholas has achieved a strong long-term investment track record, and his philosophy and approach are very well aligned with BBH’s equity investment culture in which we seek to buy and hold high quality companies that possess distinct competitive advantages, resilient business models and attractive long-term growth opportunities. While our core investment philosophy and key objectives will remain broadly consistent with the past, we do expect that Nicholas’s approach and the tools and techniques he has successfully employed in his career will enhance our investment execution and be additive to our research, portfolio construction and long-term performance.
In the coming months, Nicholas will work alongside me as a Portfolio Manager of U.S. Large Cap Equity. Importantly, our existing team of talented and experienced analysts remains in place, providing the intellectual underpinning of our investment decisions as always. Over time, we plan to transition full portfolio management responsibilities to Nicholas. We look forward to introducing you to Nicholas in the near future.