BBH U.S. Large Cap Equity Quarterly Strategy Update – 3Q 2021

Portfolio Managers, Michael Keller & Nicholas Haffenreffer, discuss how the U.S. Large Cap Equity portfolio companies performed over the most recent quarter-end.

Large-cap U.S. equities extended year-to-date gains in the third quarter of 2021 despite bouts of intermittent volatility that reflected investors’ uncertainty over the duration of economic recovery, mixed views on the persistence of inflationary pressures, the timing of monetary policy normalization and the risk of a slowdown in the Chinese economy.

Sector performance within the S&P 500 showed a relatively low level of dispersion compared to the past several years, and while economically-sensitive categories such as Energy, Materials and Industrials lagged the overall market based on the sentiment factors noted above, the general pattern of performance was mixed, with no single sector achieving more than a low single-digit return. Were it not for the performance contribution of several mega-cap technology and Internet companies, the S&P 500 would have shown a negative return for the quarter, demonstrating the market’s continued dependence on this group’s outsized influence. In certain respects, these mega-cap growth leaders have become somewhat of an asset class unto themselves, providing an ersatz safe haven into which many investors have continually directed capital in pursuit of both growth and defensiveness. While the underlying fundamental performance of these companies remains quite strong and deserving of robust valuations, we continue to view these structural dynamics of the current market environment as a point of caution.

The S&P 500 Index gained 0.58% in the third quarter on a total return basis. By comparison, the BBH U.S. Large Cap Equity strategy (the “Strategy”) rose by 1.55%. Over the last five years, the Strategy has compounded at an annualized rate of 14.15% versus 16.90% for the S&P 500.

Performance as of September 30, 2021
  Total Returns Average Annual
Total Returns
  3 Mo.* YTD* 1 Yr. 3 Yr. 5 Yr. 10 Yr. Since
Inception
Gross of Fees 1.55% 13.84% 26.62% 14.70% 14.15% 14.09% 11.09%
Net of Fees 1.30% 13.00% 25.39% 13.57% 13.03% 12.97% 10.00%
S&P 500 0.58% 15.92% 30.00% 15.99% 16.90% 16.63% 10.39%
               
*Returns are not annualized.
Past performance does not guarantee future results.
The S&P  500 is an unmanaged weighted index of 500 stocks providing a broad indicator of stock price movements. The composition of the index is materially different than the Fund's holdings.
The index is not available for direct investment.
Sources: BBH & Co. and S&P

Portfolio Contribution

Our largest positive contributors in the third quarter were Alcon Inc., Alphabet Inc. and Oracle Corp. Shares of Alcon rose sharply in August after the Company reported strong second quarter financial results driven by continued recovery in the ophthalmic surgery market, new product launches and strong commercial execution. Notably, all product categories within Alcon’s Surgical and Vision Care segments have achieved revenues exceeding pre-COVID levels despite continued headwinds related to the pandemic, with particular strength in the U.S. helping to offset slower recoveries internationally. The Company noted broad market share gains as a key factor driving the faster-than-expected revenue recovery from last year’s depressed levels. Alcon’s Management raised its targets for full-year 2021 revenue, core operating margins and earnings per share growth even as higher levels of investment spending, pressures from sales mix and inflationary effects have impacted the near-term outlook.

Alphabet shares rose by 6% in the third quarter, adding to strong 2021 gains that totaled more than 52% at the end of September. The Company has shown very strong year-on-year growth in revenue and profitability in recent quarters as the business laps the worst of the pandemic period in 2020. However, even when compared to the second quarter of 2019, Alphabet’s revenues have now grown at an annualized rate of 26%, representing an acceleration from pre-pandemic growth rates despite the Company’s significantly larger size. The continued shift of advertiser budgets towards digital platforms remains the largest single factor driving not only Alphabet’s outstanding financial performance, but also its accumulation of commercial and behavioral data that in turn improves the efficacy of its customers’ marketing activities and customer acquisition. In our view, this beneficial ‘flywheel effect’ remains the engine of the Company’s success and the basis of its clear competitive advantages. We maintain our optimistic view of Alphabet’s long-term prospects for growth in revenues and free cash flows as it leverages its leadership position in the core advertising business and gains further traction in enterprise cloud computing, content, hardware and applications. We modestly trimmed our position size in August as we deployed capital elsewhere in the portfolio, but the Company remained our largest holding at the end of the third quarter.

Oracle shares traded to all-time highs during the quarter as investors reacted favorably to the Company’s recent earnings results and forward outlook. Looking beyond the solid headline figures for revenue growth and profitability, we have been encouraged to see an improvement in Oracle’s growth mix, with higher-quality subscription revenues outgrowing episodic licensing sales and feeding a larger backlog of visible future earnings. At the same time, the Company’s characteristic operational discipline and capital allocation rigor continue to yield benefits in the form of margin improvement and accretive share repurchases. We believe that investors have begun to recognize Oracle’s notable progress against its three key strategic initiatives of cloud ERP migration, customer conversion to Autonomous Database and greater uptake of its cloud infrastructure platform.

While this recognition has clearly benefited us as shareholders, we also acknowledge that our investment thesis therefore has become less unique. Additionally, Oracle’s share price has moved into the higher end of our range of intrinsic value[1] estimates. Noting these considerations, we cut our position size by roughly one-fourth during the third quarter.

Other notable positive contributors in the third quarter included Costco Wholesale Corp., Thermo Fisher Scientific Inc. and Arthur J. Gallagher & Co.

The BBH U.S. Large Cap strategy’s largest performance detractors during the third quarter were A.O. Smith Corp., Brown-Forman Corp. and Progressive Corp. Shares of A.O. Smith dipped in September driven by investor concerns regarding the state of the residential property market in China as well as a deceleration in water heater shipments across the industry as the post-pandemic sales rebound began to normalize. In our view, investors are rightly attuned to the importance of the Chinese market given its absolute size and the strong brand positioning that A.O. Smith enjoys there. However, we believe that the Company’s long-term opportunity in China is driven more by demographic changes and urbanization rather than speculative activity in the residential construction market. In addition, we continue to view A.O. Smith’s larger U.S. market business as having structurally advantageous attributes including replacement-driven demand, consistent pricing power and a strong degree of customer loyalty in the professional plumbing channel.

Holdings As of September 30, 2021
Alphabet Inc (Class C) 8.1%
Berkshire Hathaway Inc (Class A) 5.8%
Amazon.com Inc 4.8%
Zoetis Inc 4.7%
Arthur J Gallagher & Co 4.6%
Linde PLC 4.4%
Copart Inc 4.3%
Alcon Inc 4.0%
Mastercard Inc 3.9%
Celanese Corp 3.4%
Costco Wholesale Corp 3.4%
Nike Inc (Class B) 3.1%
Oracle Corp 3.1%
Thermo Fisher Scientific Inc 2.9%
Progressive Corp 2.9%
Abbott Laboratories 2.6%
S&P Global Inc 2.6%
Waste Management Inc 2.5%
Sherwin-Williams Co/The 2.3%
Colgate-Palmolive Co 2.3%
Starbucks Corp 2.3%
Brown-Forman Corp (Class B) 2.3%
Baxter International Inc 2.3%
A O Smith Corp 2.2%
Diageo PLC ADR 2.1%
Booking Holdings Inc 2.1%
Graco Inc 2.0%
Dollar General Corp 1.9%
Visa Inc 1.8%
Nestle SA ADR 1.6%
KLA Corp 1.6%
Comcast Corp (Class A) 1.5%
Cash & Cash Equivalents 0.8%
Holdings are subject to change.

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.

Representative Account
Equity Weighting
As of September 30, 2021
Common Stocks 99.2%
Cash & Cash Equivalents 0.8%
Total 100.0%
Representative Account
Portfolio Characteristics
As of September 30, 2021
Composites Assets (mil) $987.8
Number of Securities Held 32
Average P/E 33.1
Average Market Cap (bil) $262.3
Turnover (Rolling 12-Months) 20.53%
Excludes cash equivalents.
Representative Account
Sector Weighting
As of September 30, 2021
Communication Services 9.7%
Consumer Discretionary 14.3%
Consumer Staples 11.8%
Energy 0.0%
Financials 16.1%
Health Care 16.6%
Industrials 11.0%
Information Technology 10.4%
Materials 10.2%
Real Estate 0.0%
Utilities 0.0%
Total 100.0%
Reported as a percentage of portfolio securities.
Representative Account
Top 10 Companies
As of September, 2021
Alphabet Inc 8.1%
Berkshire Hathaway Inc 5.8%
Amazon.com Inc 4.8%
Zoetis Inc 4.7%
Arthur J Gallagher & Co 4.6%
Linde PLC 4.4%
Copart Inc 4.3%
Alcon Inc 4.0%
Mastercard Inc 3.9%
Celanese Corp 3.4%
Total 47.9%
Reported as a percentage of total portfolio.

Holdings are subject to change. Totals may not sum due to rounding.

Intrinsic value is an estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.

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.

 


1 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.

RISKS

Investors should be able to withstand short-term fluctuations in the equity markets in return for potentially higher returns over the long term. The value of portfolios changes every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

The strategy may assume large positions in a small number of issuers which can increase the potential for greater price fluctuation.

Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.

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. It is the largest account as of the end of the most recent quarter.

Brown Brothers Harriman Investment Management (“IM”), a division of Brown Brothers Harriman & Co (“BBH”), claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. To receive additional information regarding IM, including a GIPS Composite Report for the strategy, contact Craig Schwalb at (212) 493-7217, or via email at craig.schwalb@bbh.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. Returns include all dividends and interest, other income, realize and unrealized gain, are net of all brokerage commissions and execution costs. Results will vary amount client accounts. Performance calculated in U.S. dollars.

The Composite is fully discretionary, fee-paying accounts over $5 million that invest in a portfolio of approximately 25-35 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.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2021. All rights reserved.

Not FDIC Insured                            No Bank Guarantee                       May Lose Money

IM-10157-2021-10-20                  Exp. Date 01/31/2022

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