Commentary

Concentrated Strategy

December 31, 2020

THE MARKET ENVIRONMENT

Despite ongoing economic impacts from Covid-19, key U.S. indexes touched record high levels in the fourth quarter and both the Dow Jones Industrial Average and S&P 500 closed out the year at record levels. Reports mid-quarter about the greater than 90% efficacy of two vaccine candidates and the subsequent emergency use authorizations and inoculation rollout led to increased investor confidence that a recovery was within sight. The certification of presidential election results and the creation of a new stimulus program likely further soothed investor anxiety.

Even though a forward-looking market proved advantageous to investors, near-term conditions for the real economy, especially Main Street businesses, remained challenging. However, we took note of some positive indicators, such as accelerated manufacturing activity that reached its highest level in 17 years in October, according to the Institute for Supply Management. In addition, the National Association of Realtors disclosed that existing home sales jumped 26.6% in October from the prior year helped by near record low mortgage rates, while home prices increased due to tight inventory. Also, consumer sentiment climbed past economists’ expectations in November and early December. At the same time, retail sales fell in October and November. Nevertheless, the National Retail Federation projected holiday spending will increase between 3.6% and 5.2% compared with last year, owing to limited travel and entertainment spending along with low energy costs. While we await final holiday retail data, we are hopeful that the shift to online purchasing, which was predicted to surge up to 34% above 2019 levels, compensated for dramatically reduced in-person shopping due to Covid-19 circumstances.

A recent survey conducted by the National Association for Business Economics revealed that 73% of its 48-member panel of professional forecasters expects the economy will return to a pre-pandemic level by late 2021. This latest survey reflects greater optimism than the results from the prior survey, when just 38% of respondents said they thought a full recovery could occur before 2022. We, too, are optimistic about the future and contend that pent-up demand today for face-to-face experiences, such as travel, restaurant dining and event attendance, can lead to an outsized economic rebound after restrictions are lifted. We have worked diligently throughout 2020 to best position our portfolios to benefit from the eventual turnaround. Meanwhile, we continue to opportunistically seek out new investment candidates and rebalance portfolios when appropriate.

THE PORTFOLIO

Top Performers:
Alphabet’s third-quarter earnings results bested consensus expectations across the board. Total revenue increased 15% in constant currency to $46.2 billion (vs. expectations of $42.9 billion) and operating income increased 22% to $11.2 billion (vs. expectations of $8.45 billion). Search revenue grew over 7% in constant currency as advertiser spend began to pick back up in August, while YouTube advertising revenue and the cloud business grew 33% and 46% in constant currency, respectively. In addition, management executed $7.9 billion in share repurchases in the third quarter to bring the year-to-date total to $23 billion. In October, the U.S. Department of Justice filed an antitrust suit against Alphabet. Later, new accusations emerged against Google from the state of Texas and a multistate coalition was filed in December. The lawsuit cites multiple violations of federal and state antitrust and consumer protection laws. In addition, the Commission Nationale Informatique & Libertés, a data protection agency in France, fined Google $121 million for installing cookies without users’ consent. The ongoing litigation and investigation activity is not surprising to us considering Alphabet’s extensive technological reach and the high-profile nature of its business. As we have stated previously, we remain pleased with the company’s fundamental performance during current challenging conditions.

Late in October, CBRE Group’s third-quarter earnings report bested consensus estimates, including adjusted earnings per share ($0.73 vs. $0.42) and adjusted earnings ($442 million vs. $300 million). Realized gains on divestitures led to a $52 million earnings increase in the development segment, which we find encouraging in such a challenging operating environment. The advisory business also performed well, in our view, as revenue only declined 24%, despite an implosion in industrywide transaction activity and signaling a share gain for CBRE. Notably, margins increased 490 basis points and earnings grew 47% in the outsourcing segment as the company focused on cost reductions during this period of slow growth. Moreover, CBRE generated $800 million in free cash flow in the third quarter, leaving the company with effectively zero net debt and capacity for mergers and acquisitions (M&A). On the latter, management noted that “the M&A pipeline is building” and they are “actively evaluating opportunities for strategic deployment to further strengthen the long-term trajectory.” Our investment thesis for CBRE remains intact.

Lear reported third-quarter revenue, core operating income and earnings per share that all exceeded market forecasts. Total reported revenue rose about 2% from last year to $4.90 billion and adjusted earnings per share increased 5% to $3.73, while adjusted core operating income fell roughly 3% to $327.2 million. Although management’s full-year guidance for revenue and core operating income aligned with market projections, guidance for capital expenditures was better than forecasts and free cash flow guidance in the range of $125-$175 million was more than triple what the market had anticipated. Later, Lear participated in the Credit Suisse Industrials Conference where management expressed positive sentiment regarding fourth-quarter performance, including the possibility of revenue that may reach the higher end of guidance. The company is targeting increased market share in seating and is expecting a margin recovery in the e-systems segment. Our investment thesis for this company remains intact as we believe its management team is working to enhance shareholder value.

Bottom Performers:

Moody’s reported third-quarter total revenue and earnings per share that exceeded market expectations by 11% and 29%, respectively. In spite of these favorable results, the company’s share price dropped early in the fourth quarter. In our view, results were solid as revenue grew 9% from last year to $1.36 billion, primarily from particularly strong debt issuance activity. Furthermore, earnings rose 17% and earnings per share advanced 25%. Performance in the company’s non-ratings business was also robust with 9% year-over-year organic revenue growth and 15% earnings growth. We attribute these healthy advances chiefly to the acquisition of Bureau van Dijk, which was completed in 2017. The procurement of this enterprise expanded Moody’s presence in compliance data for businesses across the world. Despite the current economic environment, we believe this business has proven to be value enhancing and durable. In addition, COO Robert Fauber became CEO upon the retirement of Ray McDaniel at the end of 2020. We recently spoke with Fauber and found him to be a charismatic leader who expressed a thoughtful approach about both team alignment and financial goals. We think Fauber is well equipped to employ an effective capital allocation strategy and can make a positive cultural impact.

During the quarter, we initiated a position in CDK Global and eliminated Pinterest 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 Dow Jones Industrial Average is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities. 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 12/31/20.

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.