Commentary

Concentrated Strategy

March 31, 2020

THE MARKET ENVIRONMENT
At the start of 2020, it appeared market activity would continue in familiar fashion and largely support key benchmark levels achieved from prior bull market advances. However, by mid-January, developments concerning the coronavirus came to light. What began in late 2019 as an outbreak localized to China spread swiftly and by mid-March, the World Health Organization officially deemed the coronavirus a global pandemic. Equity markets declined precipitously in conjunction with increasingly dire news about the accelerating rate of illness.

The coronavirus quickly disrupted economic activity throughout the country and across sectors from large global enterprises to Main Street businesses. Significant travel restrictions, the shutdown of typical group-gathering activities and orders by many municipalities for residents to stay home upended daily life. U.S. unemployment began to rise with a record three million jobless claims filed in a one-week period, and some economists speculate that the unemployment rate could reach 30%. At the same time, crude oil prices posted the largest quarterly percentage drop on record, owing to a production dispute between OPEC members and Russia. To stem the economic impact, Congress passed a historic $2.2 trillion stimulus package and the Federal Reserve committed to unlimited purchases of Treasurys and other asset-backed securities. Though these actions are extraordinary, economists expect that even more stimulus may be necessary.

Over our decades of experience, we have witnessed other market-rattling crises, each uniquely different from each other. No one knows how this particular issue will be resolved as there is not enough data today to reach specific conclusions. Yet, please be assured that our framework for dealing with exogenous risks like this is to attempt to determine the impact on business value rather than extrapolate near-term costs in perpetuity. In our assessment, equity share price declines have reached levels that are in excess of the actual value declines of businesses we hold. One proactive action we adopt under adverse circumstances is to rebalance our client portfolios. We take advantage of lower equity prices to increase share weightings of companies that, according to our estimates, have become even more undervalued. Although the current situation is changing rapidly, as long-term investors, we focus on rational decision-making and avoid making emotionally driven investing choices. Our investment team remains on vigilant watch for appropriate opportunities today that we believe can yield shareholder rewards over our typical five- to seven-year holding timeframe.

THE PORTFOLIO
Top Performers:
Regeneron Pharmaceuticals issued fourth-quarter results that were stronger than our estimates as well as market forecasts. Total revenue rose 13% from a year earlier to $2.17 billion, propelled by U.S. EYLEA® revenue that grew 13% for the quarter and advanced 14% for the full year. Dupixent® revenue growth was also strong and increased 136% on a global basis in the fourth quarter. Despite a notable increase in operating expenses from drug pipeline expansion and launch investments, full-year earnings climbed 4%. In addition, management conducted its first stock repurchase in the fourth quarter, buying back $250 million worth of shares. Later, news surfaced that BEOVU®, developed by Novartis as a competitor product to EYLEA, was found to cause serious side effects. Investors reacted favorably to market analysts’ reports that this development effectively negates BEOVU’s ability to meaningfully compete with EYLEA. Furthermore, Regeneron has made progress creating a medication to treat coronavirus. With Sanofi, it has entered into a clinical trial program for KEVZARA®, which targets patients diagnosed with severe disease conditions. We are hopeful that Regeneron’s efforts can produce positive outcomes.

Fourth-quarter earnings results from Netflix included paid net additions of 8.8 million, which had exceeded management’s guidance for 7.6 million net additions for the quarter, and for the full year, net additions amounted to 27.8 million. Notably, all regions outside of the U.S. and Canada realized subscription additions in the fourth quarter. Fourth-quarter revenue grew 23% in the U.S. and 40% internationally (not adjusted for currency), which met market forecasts. For the full-year period, earnings margins expanded 300 basis points to 13%, and management reiterated guidance for another 300 basis point expansion in 2020. At the time of the earnings release and prior to the coronavirus pandemic, the company issued expectations for 7 million paid net additions in the first quarter. We continue to believe that Netflix is well positioned for future growth.

Pinterest’s share price rose during the quarter. This company is an online communication services company that serves as a personal discovery engine. We believe Pinterest is in the early stages of its monetization plan and we like that it differentiates itself from other social networking platforms as its user base of more than 300 million actively seeks relevant content. Pinterest provides users with access to products and services available to purchase, while its advertisers display products and services to a more captive audience than do traditional social networking platforms. We think it is notable that the company generates revenue not by trying to keep users on the platform as long as possible with advertisements, but rather by providing users the information they are seeking that naturally includes advertisements, which aligns the objectives of both users and advertisers. In our assessment, Pinterest offers investor upside potential.

Bottom Performers:
Hilton Worldwide released fourth-quarter results that we viewed as solid. For the year, both adjusted earnings and earnings per share surpassed management’s expectations, growing 10% and 14% year over year, respectively. We were pleased to see that the company’s brands continued to perform well and achieved the strongest market share gains in a decade. However, concerns surrounding the coronavirus impacted global markets and pressured its share price. In conjunction with issuing 2020 guidance, Hilton’s management team addressed these concerns. Based on the company’s assumptions for the duration of the disruption, management stated the full-year impact would be a potential 1% decrease in revenue per available room and a 0.5% decrease in net unit growth. Although this is a challenging time for the industry, we maintain confidence in the resiliency of Hilton’s business model. The company’s strong balance sheet, with more than $2 billion in immediate liquidity, should help it weather the storm. We remain impressed with CEO Chris Nassetta’s track record, which includes successfully navigating through previous downturns, such as the global financial crisis. We continue to believe management is working to enhance shareholder value and our investment thesis for Hilton remains intact.

CBRE Group’s fourth-quarter results included adjusted earnings per share (EPS) growth for the full year of 13.2%, which marked 10 consecutive years of double-digit EPS growth. Fourth-quarter total revenue rose 13% from the prior year, which surpassed market expectations, and adjusted earnings increased nearly 6%. In our assessment, the company’s results were solid across most segments with particular strength in outsourcing, where revenues grew 14% and earnings increased 25% as margins expanded by 120 basis points. However, stress from the coronavirus filtered into the real estate market during the quarter and pressured CBRE Group’s share price. Brokers reported decreased activity amidst the pandemic’s uncertainty and we have reduced our estimates of 2020 leasing volumes and capital markets volumes as a result. Nevertheless, with a net debt to trailing 12-month adjusted earnings ratio of only 0.42 and significant liquidity, we believe the company is well positioned to face the downturn. In our opinion, management has an impressive track record, and we believe they will successfully navigate through this market environment.

American International Group (AIG) reported fourth-quarter results that included pre-tax income and earnings per share that outperformed market expectations. Notably, pre-tax income and earnings per share recovered from losses realized in the year-ago period and full-year pre-tax income grew nearly three times over what the company achieved in 2018. AIG’s total book value increased 15% from last year to $74.93 and outpaced market forecasts. While these results illustrated reasonable progress, the company’s share price dropped as investors became increasingly concerned about effects from the coronavirus pandemic. In addition, the U.S. Federal Reserve cut key interest rates in response to pandemic-related economic impacts, which prompted market anxiety about the effects lower rates would have on AIG’s earnings. Investors also had fears about the likelihood of impairment to AIG’s large investment portfolios, which consist primarily of bonds. However, we find the company’s bond portfolios still have large embedded gains. Although the ultimate fallout that the coronavirus will have on life and general insurance is unknown, we continue to believe AIG is an attractive investment and are watching the situation closely.

During the quarter we initiated positions in Reinsurance Group and Workday. We eliminated Aon, American Airlines and Axalta Coating Systems during the quarter.

Past performance is no guarantee of future results.