THE MARKET ENVIRONMENT
U.S. equity markets finished the second quarter higher, continuing the recovery for the year-to-date period following a difficult 2022. The Russell 1000 Growth Index gained 12.81% versus the Russell 1000 Value Index, which gained 4.07%, led by the technology, consumer discretionary and communication services sectors. Utilities, energy and consumer staples were the only sectors to decline during the quarter. Year to date, the Russell 1000 Growth Index has returned 29.02% and the Russell 1000 Value Index has returned 5.12%, a reversal of the value recovery that occurred last year.
During the quarter, the U.S. government announced an agreement to suspend the debt ceiling until January 2025 that includes nondefense discretionary spending to remain flat throughout the upcoming two fiscal years, which eased concerns about a potential default. The Federal Reserve increased its benchmark interest rate by 25 basis points in May before pausing at its June meeting. Comments from members of the Federal Open Market Committee pointed to further interest rate hikes in the future and rates remaining elevated for some time. The U.S. 10-year Treasury began the quarter yielding around 3.5% and ended the quarter near 4%.
Regardless of the economic backdrop and central bank activity, our disciplined investment process continues to revolve around bottom-up, fundamental research. As long-term investors, we value our companies through the economic cycle and focus portfolio construction on optimizing our best ideas. We attempt to identify growing businesses that are managed to benefit their shareholders and invest in those businesses only when priced substantially below our estimate of intrinsic value.
THE PORTFOLIO
Top Performers:
Oracle’s fiscal-fourth quarter earnings and full-year 2024 outlook were strong, in our view. Total revenue grew 18% in constant currency and 5% ex-Cerner, ahead of consensus expectations. Applications cloud and support revenue grew 11% in constant currency ex-Cerner powered by the “strategic back office,” consisting of Fusion and Netsuite, which together now account for $6.6 billion in runrate revenue. The infrastructure ecosystem grew 15% in constant currency powered by infrastructure cloud services. We see management’s announcement of $2 billion in new Oracle Cloud Infrastructure contracts with 33 AI companies and partnerships with Nvidia and Cohere as a sign that the company will be a leader in AI. Further, CEO Safra Catz guided to total revenue growth of 7-9% in the fiscal first quarter and approximately 30% cloud growth in constant currency in full-year 2024, both ahead of consensus expectations.
Alphabet’s first-quarter search revenue growth accelerated slightly sequentially, which management described as “resilient” against the backdrop of a pullback in advertising budgets. Travel and retail verticals were called out as performing well, offset by declines in finance and media and entertainment. Alphabet’s cloud business reached GAAP profitability this quarter, moving from a -12% margin a year ago to a 3% margin. On the AI front, Alphabet upgraded Bard to run on its more powerful PaLM language model, while also adding the ability to assist with coding and software development. CFO Ruth Porat revised 2023 capital expenditures guidance, driven by higher data center construction and server spending to support AI investments across consumer products, advertiser tools, and the cloud business. Porat reiterated that the company plans to hold expense growth below revenue growth and that it will begin to see the benefits of the company’s cost-reduction initiatives later this year and into 2024. Alphabet hosted its annual developer conference in May where it showcased what we view as an impressive array of new AI-powered consumer tools to be rolled out over the course of the year.
Amazon’s most recent earnings report revealed first-quarter revenue higher than consensus expectations across all segments and business lines. Margins were ahead of consensus for both North America and international retail and roughly in line at Amazon Web Services (AWS) after backing out an unusual charge. Shipping and fulfillment cost metrics improved again, which we view as a key indicator of progress. Although total company headcount was down 10% year-over-year, the improved efficiency is not at the expense of delivery speed, which continues to increase with 2023 on track to be a record year. Management noted a roughly 5% deceleration in AWS growth in April, but we remain confident that over time AWS will re-accelerate. CEO Andy Jassy said he believes large language models and generative AI will be drivers of growth for AWS, as many customer experiences will be invented or reinvented on the cloud. In June, the Federal Trade Commission (FTC) filed a lawsuit against Amazon, alleging that it lured customers into signing up for Amazon Prime and made it challenging to unsubscribe. Later, reports surfaced that the FTC was preparing an antitrust case against Amazon. We do not believe these will result in a material change in value, but we will continue to monitor the situations closely.
Bottom Performers:
ManpowerGroup reported a slight miss in first-quarter earnings per share and provided weak second-quarter guidance that reflects softening demand and greater selling, general and administrative deleveraging. The company’s revenue base is highly exposed to light manufacturing verticals, leading to topline pressure given recent purchasing managers index weakness. Management is reluctant to cut operating costs significantly because it still sees growth pockets and wants to preserve the business’s ability to capitalize on the next upswing. From a geographic perspective, the U.S. saw a noticeable revenue deterioration as trends harmonize with the European slowdown that began in early 2022. Encouragingly, things do not appear to be getting materially worse in northern Europe or southern Europe, and other regions like Asia and Latin America are still performing well, in our view. From studying past cycles, CEO Jonas Prising thinks we are in a “garden variety” recession that will ultimately be less severe for the company than the last two recessions. His view is informed by the fact that labor markets are still tight, and many companies are retaining more of their workforce this time around. Despite the downcycle for staffers, we are comforted by the fact that we view this management team as experienced, rational, and it has capably navigated through past downturns. We also appreciate that management appropriately prioritizes profit dollars over market share.
Wendy’s reported a strong start to the year, in our view, driven by same-restaurant sales that grew 8% year-over-year in the first quarter. We believe the company benefited from menu innovation, robust international growth, consumers trading down to fast food, and accelerating digital sales, as most key metrics finished ahead of consensus estimates. Restaurant-level margins in the U.S. improved by 270 basis points year-over-year as commodity and labor inflation began to normalize, and we believe mid-single digit pricing actions should lead to a return to pre-Covid-19 levels. We are encouraged by the technology side of the business following the hiring of Kevin Vasconi, the former CIO of Domino’s, in late 2020. Digital sales increased by over 25% in the first quarter and now represent 12% of system sales, with Wendy’s targeting over $2 billion of digital sales in 2025. We believe digital sales lead to better loyalty and targeted marketing, as well as greater efficiency as online orders take labor hours out of the restaurant while enhancing throughput. Management reaffirmed 2023 guidance for 6-8% systemwide sales growth, 6.5-8.5% adjusted earnings growth, and 10-16% adjusted earnings per share growth. Finally, Wendy’s continued to return cash to shareholders with year-to-date repurchases totaling $62 million (1.1% of the share base) along with its 4.3% dividend yield. We believe Wendy’s is executing well and trades at an attractive valuation compared to public peers and recent private market transactions.
We found first-quarter results from Bank of America to be strong, as pre-tax pre-provision income grew 11% sequentially and 27% year-over-year, while reported earnings per share grew 18%. Strong net interest income growth of 25% helped drive overall revenue growth of 13%, as fees grew modestly, which we find impressive given lower nonsufficient funds and asset management fees, and a difficult investment banking environment. Expense guidance was reiterated for the full year and implies declines for the remaining quarters. The company’s common equity tier 1 ratio increased 15 basis points to 11.4% despite paying out $1.8 billion in dividends and $2.2 billion in share repurchases. Management spoke on the call about its deposit franchise, noting that of its $1.1 trillion in consumer deposits, 85% are core operating accounts and over two-thirds of these clients have been with the bank for over 10 years. Furthermore, 85% of consumer banking customers have more than one product with the bank, increasing the stickiness of the relationship. Despite some adverse mix shift this quarter, it also has among the lowest mix of interest-bearing deposits in the industry, resulting in some of the lowest deposit rates. The long duration of deposits and huge amount of liquidity give management confidence that it does not have to do anything material with respect to the banks securities portfolio or change the way it is managed as a result.
During the quarter, we purchased shares of EOG Resources. We eliminated Netflix from the portfolio.
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 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 06/30/2023.
Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.
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.
