THE MARKET ENVIRONMENT
The fourth quarter saw a recovery in U.S. equity markets with all three major indexes finishing higher following declines in the first three quarters of the year. Energy continued to outperform, along with industrials, materials and financials, while consumer discretionary and communication services were the two sectors to have negative absolute returns. Elsewhere, the U.S. 10-year Treasury yield increased 8 basis points to 3.89%. The U.S. Dollar Index declined by over 7.5% after five consecutive quarters of gains. WTI crude remained near $80, which was around its level at the beginning of 2022 and prior to Russia’s invasion of Ukraine.
Investor focus appeared to remain on the Federal Reserve and its efforts to tighten financial conditions, primarily through increases to the federal funds rate and quantitative tightening. The size of rate hikes slowed in December to 50 basis points, following the 75 basis point increases in June, July, September and November. Some economic indicators have offered reason for optimism for those expecting the Fed to pivot, such as lower commodity prices and lower than expected inflation numbers. However, unemployment remains resilient at below 4% and the Consumer Price Index for November came in at 7.1% year-over-year, significantly above the Federal Reserve’s 2% target.
We believe our edge is our process for identifying undervalued businesses with growing values and good management teams and then positioning portfolios with conviction and discipline based on that process. We value companies as if they will have to weather macro-related bumps in the road without trying to be precise as to when this happens. This helps us divorce the investment decision from an attempt to time a business cycle. We believe this approach, paired with our longer time horizon and broad definition of value, enables us to uncover attractive investment opportunities during times of volatility.
THE PORTFOLIO
Top Performers:
HCA Healthcare reported third-quarter earnings that generally came in slightly above consensus estimates after removing various one-time items and reiterated full-year guidance for 2022. The core business drivers are healthy, and management is executing well, in our view. Next year, the company will face around $500 million in headwinds to adjusted earnings from various non-recurring items. In addition, volume growth looks like it will be around 1-2% compared to the typical 2-3% due to this year’s higher Covid-19 volumes. We believe underlying volume trends are solid and both acuity and payer mix are stable. Further, HCA is getting traction with payers on passing through price increases for inflation. Contract labor costs appear to be beginning to ease already, and we believe capacity constraints are likely to improve over the next couple of years. We think these dynamics, coupled with the flow through of higher pricing to reflect inflation, should provide tailwinds to adjusted earnings growth.
Oracle reported fiscal second-quarter results that were solid, in our assessment. Total revenue reached $12.28 billion and drove earnings per share of $1.21, both of which were at the high end of management’s guidance and also exceeded market expectations. Impressively, total revenue grew 25% year-over-year in constant currency and organic revenue (excluding effects from the Cerner merger) increased over 9%. Positive momentum continued to be strong across the business. Revenues from the applications segment rose 9% in constant currency driven by Fusion (+28%) and NetSuite (+29%). Infrastructure segment revenue also rose 9% in constant currency and reached a new high level for quarterly growth, driven by Oracle Cloud Infrastructure and Autonomous Database. Total cloud revenue advanced 48% in constant currency. Notably, CEO Safra Catz stated expectations that organic cloud revenue (ex-Cerner) should grow by greater than 30% in constant currency for the full year. We found Catz’s outlook to be especially meaningful considering the macroeconomic backdrop and commentary from competitors.
American International Group (AIG) reported a decent set of third-quarter results, in our view, with quarterly earnings per share of $0.66 and an ending adjusted book value of $73.30. Highlights from the release included the 88.4% accident year combined ratio with general insurance at 83%, and impacts from Hurricane Ian and a large typhoon in Asia that led to a 900 basis points increase to the company’s overall combined ratio of 97%. We believe the property and casualty business is performing well and anticipate CEO Peter Zaffino will turn this into a top performing business in the industry. Another key development during the quarter was the partial initial public offering of Corebridge Financial, with AIG now owning 77% of its former life and retirement unit. Corebridge’s net income was down 35%, but this was expected as investment income was down substantially due to the weakness in financial markets. In our view, core trends are solid as higher rates should be a positive for new business and investment income going forward. Finally, the company continued to aggressively repurchase shares with the share count down 100 million shares year-over-year to 740 million, and management guided to around 600-650 million shares when Corebridge is fully separated.
Bottom Performers:
Amazon’s share price fell following its third-quarter earnings report that provided a disappointing outlook for the fourth quarter. Management guided to $140-148 billion of revenue, which is a 5% increase year-over-year (10% increase in constant currency) and 6% below consensus. This deceleration compares to 15% growth in the third quarter. Management said third-quarter retail sales decelerated throughout the quarter as inflation is hurting discretionary retail budgets. We believe this is a macro issue as Amazon gained market share during the quarter. Retail profitability for the quarter was disappointing at -$2.9 billion, and earnings guidance was only slightly better for next quarter. Retail capital expenditures are being cut and the company is implementing various changes to improve margins. Amazon Web Services (AWS) revenue was up 28% year-over-year and 3% below consensus. Demand decelerated throughout the quarter as customers reduced or optimized usage. Margins were below consensus and declined 400 basis points year-over-year as AWS absorbed operating leverage for customers. Management said AWS margins can “fluctuate over time” and they are still investing as the backlog grew 57% year-over-year. While overall profitability was disappointing and a recovery in margins may take longer than expected, we appreciate that management is focused on it, and retail is gaining share. We remain confident in the investment over the long term as the business drivers appear healthy and the lower guidance seems to be mostly a macro and timing issue.
Alphabet’s third-quarter earnings results came in light of consensus expectations on sales and margins and the company’s share price fell following the release. In addition, reported earnings per share were hurt by a nearly $3 billion hit from mark to market losses in equity and debt securities. Despite this, total revenue grew 11% in constant currency and 6% reported to more than $69 billion. Management described fundamental performance in the search segment as “healthy” and attributed the slowdown to foreign currency pressure and current figures going up against strong figures from this time last year. Total operating margin declined to 25% from 32% due to growth in research and development and general and administrative expenses, which was led by headcount growth, promotions, and higher sales and marketing spend on advertisements. We appreciated that both CEO Sundar Pichai and CFO Ruth Porat noted on the call that the company is “sharpening focus” on the biggest growth priorities and “moderating operating expense growth” for 2023.
Salesforce released third-quarter earnings that included revenue growth of 19% in constant currency and margins that were 170 basis points above market estimates. However, fourth-quarter guidance for 12-13% organic revenue growth seemingly displeased investors even though management previously commented on the matter and backlog growth trends that have been slowing. The macro environment for software has softened and short-cycle companies, like Salesforce, are feeling the effects. Despite this, we appreciate that margins continue to improve as the company reported a 12% adjusted earnings margin, the highest in company history, and management raised its full-year adjusted earnings margin guidance by 20 basis points. Conversely, we were disappointed that Co-CEO Bret Taylor announced his resignation as he was a vocal advocate in the push for better profitability. Nevertheless, we believe the initiative extends far beyond any one executive and appreciated remarks from co-CEO Marc Benioff and CFO Amy Weaver about profitability being a top organizational priority. Subsequent to the announcement, certain market analysts downgraded the company, which pressured its share price further in December.
During the quarter, we added Intercontinental Exchange to the portfolio. We eliminated our positions in LivaNova, Meta Platforms Cl A and Visa Cl A.
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 12/31/2022.
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.
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