Commentary

Global All Cap Strategy

December 31, 2019

THE MARKET ENVIRONMENT
The fourth quarter of 2019 brought a steady recovery in global markets following the volatility that afflicted indexes around the world earlier in the year. As was the case last year, 2019 featured extreme price movements as the latest news, including trade talks, Brexit, European Union political instability and even a political conflict between South Korea and Japan dating back to World War II, influenced stock prices. As an example, while global markets started the year off strong, a few tweets that fueled trade war fears in May sent indexes around the world tumbling. August also saw more measurable declines until markets began to recover and rebound based, in part, on more positive geopolitical headlines.

Other fears that weighed on markets were the possibility of a Jeremy Corbyn victory in the U.K. general election and continued uncertainty surrounding Brexit. With a large, historical victory by the Conservative Party in the U.K., investors’ fears of a Corbyn-led socialist-style government were alleviated for the medium term. Instead, Prime Minister Boris Johnson’s government acted quickly to move its Brexit bill through Parliament in an attempt to ensure a smooth exit from the European Union.

Meanwhile, China and the U.S. de-escalated their trade dispute with an agreement of a “phase-one” trade deal in the fourth quarter. These events boosted global equity market sentiment toward the end of 2019 and entering into 2020. These developments also provided more solid foundations for businesses to make capital allocation and investment decisions going forward as the news pushed key U.S. indexes to all-time high levels. In fact, all 11 GICS sectors in the S&P 500 Index gained value in 2019 and produced double-digit returns for the year. In China, the Shanghai Composite increased 22% for the year, while Japan’s Nikkei 225 Index finished 18% higher in 2019.

Despite the recovery in 2019, we still believe our investment approach offers good upside potential. In fact, our investment philosophy and team have been consistent throughout our history. We continue to look for opportunities to achieve higher returns by estimating business value and buying at a discount. We utilize this strategy with the goal of long-term outperformance for the benefit of our shareholders.

THE PORTFOLIO
Top Performers:
Tenet Healthcare delivered strong third-quarter earnings results with net operating revenue ($4.57 billion vs. $4.46 billion), adjusted earnings ($631 million vs. $626 million) and earnings per share ($0.58 vs. $0.31) that exceeded market expectations. Importantly, year-over-year net operating revenue increased 1.8%, adjusted earnings rose 9.4% and earnings per share doubled from a year earlier. In addition, management’s guidance for Tenet’s fourth quarter met analysts’ estimates, and the company raised fiscal year guidance for revenue and earnings per share. Later, the Centers for Medicare and Medicaid Services revealed its transparency rules for hospital pricing that followed an executive order issued in June that seeks to address the matter and are intended to become effective in January 2021. In the meantime, we believe Tenet possesses significant inherent strengths and has a history of smart capital allocation, including significant share repurchases at what we consider attractive prices.

The share price of Lloyds Banking Group benefited from news of a Brexit agreement between the U.K. and the European Union, which is now pending approval by Parliament. In addition, while the company’s third-quarter revenue and underlying operating profit fell short of our estimates, we were pleased that total costs declined over 5% from a year ago and were far below our forecasts, which illustrates to us that management’s efficiency improvements are producing positive results. Importantly, the company expects non-underlying costs to fall below GBP 1 billion in 2020 (down about 70% from 2019) as the compensation period for payment protection insurance claims has lapsed. Therefore, Lloyds no longer needs to set aside funds for this purpose and it can deploy additional cash to achieve other business objectives. In our view, Lloyds is now well positioned for strengthening performance going forward, and it appears the market agrees.

Bank of America issued third-quarter results with revenue and earnings per share that slightly exceeded market expectations. From our perspective, the company continues to execute well despite the low interest rate environment. Year-over-year average deposit balances rose 4% and strong mortgage origination activity led to average core loan growth of 6%. Consumer checking accounts grew 2.3%, new credit card applications were up 5% and net new household growth in the Merrill Lynch wealth management segment was robust at 27%. Management returned $9.3 billion of capital to shareholders through dividend payments and share repurchases. We found it especially notable that Bank of America continues to take market share in nearly every business segment, and CEO Brian Moynihan expressed expectations that these trends will continue.

Bottom Performers:
The share price of Liberty Global declined mainly in November when the company reported third-quarter operating cash flow from continuing operations of $1.21 billion, which undershot market expectations of $1.28 billion. However, total revenue was in line with forecasts and management left full-year targets for operating cash flow, adjusted free cash flow, and property and equipment additions unchanged. Lutz Schüler, the new CEO of Virgin Media, presided over the earnings conference call and stated that the quarter was very challenging. Revenue generating units (RGU) at Virgin Media, a key asset for Liberty, declined by 53,000 in the third quarter compared with an addition of 105,000 in the year-ago quarter. Video and telephone RGUs dropped by roughly 50,000 and 9,000, respectively, while broadband RGUs increased by 5,000. RGU losses were due to Virgin Media implementing a larger and earlier than usual price increase this year, which caused a higher amount of client churn; a weak macro environment in the U.K., which resulted in falling RGU growth across the entire industry; and the company intentionally not marketing to low-end video subscribers. Nevertheless, Schüler implied that RGUs would improve in the fourth quarter and he also expects fully enacted price increases will work to boost revenue.

Along with its third-quarter trading update, Rolls-Royce Holdings stated that full-year free cash flow and earnings would be at the low end of the previously issued guidance range, which weighed on its share price. Management expects that 2019 free cash flow and earnings will be closer to GBP 600 million, owing to design fixes for the Trent 1000 engine and higher costs associated with the Trent 1000 TEN engine. Even so, management maintained full-year 2020 free cash flow guidance at GBP 1 billion. Shortly after releasing the trading update, the U.S. Navy awarded Rolls-Royce a $1.21 billion contract to provide maintenance, repair and other services for the V-22 AE1107C aircraft engine. Later, Bradley Singer, COO at activist firm ValueAct Capital, resigned from the Roll-Royce Board of Directors after serving for three years. We spoke with Singer who expressed that he is comfortable with the other board members and the direction management is taking considering the positive changes enacted at the company, including better accounting practices, improved key performance indicators and a significant cost efficiency program.

Investors were surprised by news that Oracle’s CEO Mark Hurd took a leave of absence for health-related reasons in September and then unexpectedly passed away in October. In addition, the company’s fiscal second-quarter revenues were slightly shy of market expectations, while earnings per share were marginally ahead of forecasts. Year-over-year total revenue grew 1%, operating income grew 4% and earnings per share grew 13%, all in constant currency. However, investors may have been disappointed that the gross margin missed forecasts by roughly 30 basis points. The sales team reorganization in North America that was initiated in the first quarter hampered results somewhat, though CEO Safra Catz stated that the process is going well and should be completed in the near future. Catz also expressed expectations for ongoing double-digit earnings per share growth rates owing to strong performance in the ERP segment of the cloud applications business. Management issued third-quarter revenue growth guidance of 1%-3% and earnings per share in the range of $0.96-0.98, which represents an increase of between 10%-12% from the prior year period. Lastly, Oracle repurchased $5 billion worth of shares in the second quarter, which matched the amount of buybacks conducted in the first quarter. In our view, the company’s fundamental execution remains solid.

During the quarter, we initiated a position in Rolls-Royce Holdings and eliminated Diageo from the portfolio.

Past performance is no guarantee of future results.