Commentary

Concentrated Strategy

September 30, 2020

THE MARKET ENVIRONMENT

Key U.S. indexes gained value in the third quarter as the broad economy continued to struggle toward a full recovery. The country’s annualized gross domestic product plunged by a record 31.7% in the second quarter, fueled by a drop in consumer spending, the primary economic growth driver, which fell 34.1%. In the third quarter, many corners of the economy remained distinctly weak, especially face-to-face businesses, such as restaurants, airlines and travel enterprises, hotels, and recreation/entertainment establishments. Retailers were also distressed as store closings, liquidations and bankruptcies reached all-time high numbers. In contrast to this dismal news, the S&P 500 and NASDAQ indexes closed near peak levels in the quarter. Certain businesses, such as e-commerce companies, seemingly thrived in recent months as online sales advanced 31.8% from the first to the second quarter. Housing was another area of strength. New home sales rose 43.2% year-over-year in August, while existing home sales were up 10.5% from the prior year, marking the most significant growth achieved since December 2006. In addition, the unemployment rate fell each month since April and finished August at 8.4%

In response to today’s extraordinary circumstances, the Federal Reserve reiterated its pledge to keep key interest rates near zero for the foreseeable future and to maintain low borrowing costs and improve corporate liquidity by continuing to support the corporate bond and short-term liquidity markets. At the same time, economic matters have been overlaid by social unrest that stayed at the forefront in many communities and by the impending presidential election. We expect developments on both of these fronts could put businesses and investors on alert and bring about market volatility in coming months.

Signs of stabilization led to the recent boost in equity prices. Growth stocks benefited most while value stocks continued to be largely underappreciated by the market. This disconnect has provided us with select opportunities to enhance our portfolios. We use our fundamental research approach to distinguish between businesses with balance sheets that have been (and may continue to be) weakened by high debt levels compared with those of well-capitalized businesses whose long-term earnings power remain intact. As new economic remedies continue to unfold we remain dedicated to our tried and true value philosophy and process.

THE PORTFOLIO

Top Performers:
Pinterest’s share price soared late in July upon the release of its second-quarter earnings report. Revenue ($272.5 million vs. $250.4 million) and adjusted earnings ($-34.0 million vs. $-81.1 million) were better than market expectations. Monthly active users totaled 416 million, which reflected an increase of 39% year-over-year, and topped consensus estimates by roughly 10%. Management did not provide full-year guidance but did relay expectations for third-quarter revenue growth in the mid-30% range year-over-year. Following the review of Pinterest’s solid results, we increased some of our near-term valuation metrics. We like management’s strategic approach, which we believe can provide shareholder rewards going forward.

HCA Healthcare delivered strong second-quarter earnings results, by our standards, with total revenue of $11.07 billion, which was nearly 10% higher than market forecasts. Adjusted earnings, including the CARES Act stimulus, reached $2.67 billion, which was twice the amount the market had expected, and excluding stimulus, earnings outpaced market estimates by 72%. Inpatient admissions improved throughout the quarter as government restrictions eased. We also like the company’s efforts to cut costs during this period of disruption. Later, investors became anxious that the pending appointment of a new Supreme Court Justice may put the future of the Affordable Care Act at risk, which could impact HCA’s business. However, the company’s current liquidity position is strong with several billion dollars in positive free cash flow expected this year. In addition, we find HCA’s management team is increasingly confident about its ability to scale the business up or down in response to a range of scenarios.

Charter Communications released second-quarter earnings results that were solid as revenue grew by 3.1% compared with last year, driven by residential revenue growth of 4.1%, mobile revenue growth of 96.1%, and small- and medium-sized business (SMB) revenue growth of 2.0%. Adjusted earnings reached $4.5 billion (+7.3%) and net income attributable to shareholders totaled $766 million, compared to $314 million during the same period last year. The company continued to benefit from increasing residential and SMB customer relationships, which advanced by 755,000 in the most recent quarter from 203,000 during the second quarter of 2019. At a recent communication services conference, CEO Tom Rutledge noted that broadband subscriber growth is accelerating and the company remains focused on capitalizing on the opportunity to grow its customer base. Cable companies in the U.S. are seeing strong demand for high-speed internet access. In many markets, Charter currently has the only fiber-rich network capable of providing internet speeds that align with that demand. In our view, the company is favorably positioned to grow its business and expand its market presence as new participants would need to invest considerable capital to compete.

Bottom Performers:
Citigroup’s share price declined as Covid-19-related concerns pressuring the financial sector persisted. However, despite a difficult operating environment, the company reported second-quarter results that reflected solid execution, from our perspective, and were generally consistent with our expectations. While revenue grew 5% from a year ago, earnings per share declined, though both surpassed market forecasts. Expenses decreased modestly, which led to a 13% increase in pre-provision net revenue, and accelerated trading and investment banking activity drove an advance of 68% in fixed income revenues. Nevertheless, investors may have been concerned that global consumer banking revenues fell 10% as spending slowed materially due to the pandemic. It is important to note that Citigroup has remained profitable throughout the Covid-19 crisis and continues to operate with significant excess capital relative to regulatory minimums even though the company added more than $10.5 billion to credit reserves year-to-date. In our assessment, the management team is suitably equipped to navigate the near-term challenges brought about by the Covid-19 pandemic.

American International Group realized second-quarter after-tax income per share of $0.66, which exceeded market forecasts of $0.50. However, its adjusted per share book value of $55.90 fell from the $56.89 achieved a year ago. In our view, the company’s results were acceptable given the recent sale of Fortitude Re and the reversal of hedging gains from the first quarter due to a market recovery. To us, the most important component of quarterly performance was the continued improvement in the general insurance business, reflected by a year-over-year decline of 120 basis points in the accident year combined ratio. Even so, investors were disappointed that progress was not greater considering that premiums in the global commercial insurance market rose 16%. The main reason for the lag was that most of the rate growth will occur over the next year. Furthermore, Covid-19 losses were $364 million in the quarter, and while we expect additional losses in future quarters, we think these will remain manageable for the company. We spoke with CFO Mark Lyons who expressed confidence that the anticipated rate increases will be well in excess of loss trends and that current conditions place this market among the strongest for pricing that he has seen in 20 years.

Keurig Dr Pepper issued second-quarter results that were solid, in our assessment. Organic revenue grew 2.9% from a year earlier, adjusted earnings rose 10.4% as margins expanded by 210 basis points and earnings per share advanced 10%. In addition, both total revenue and earnings per share were ahead of market expectations. Performance in coffee systems and packaged beverages was strong with net revenue growth of 5% and 6%, respectively, which offset losses from beverage concentrates and the Latin America beverages business. Management reiterated full-year guidance that calls for organic revenue growth of 3-4% and adjusted earnings per share growth of 13-15%. However, investors appeared disappointed that management did not raise these forecasts, which weighed on the company’s share price. In our view, CEO Robert Gamgort and his team are executing very well in today’s challenging environment and management’s long-term guidance and our value drivers remain intact.

During the quarter, we initiated positions in Automatic Data Processing and Keurig Dr Pepper and we eliminated Regeneron Pharmaceuticals during the quarter.

Past performance is no guarantee of future results.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.

The NASDAQ Composite Index is a broad-based market-capitalization weighted index of all common type stocks on the NASDAQ Stock Market, including common stocks, American depositary receipts, ordinary shares, shares of beneficial interest or limited partnership interests, and tracking stocks. The index includes all NASDAQ listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures. This index is unmanaged and investors cannot invest directly in this index.

The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s Concentrated Value Equity composite as of 09/30/20.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.