Commentary

Global All Cap Strategy

March 31, 2020

THE MARKET ENVIRONMENT
At the start of 2020, it appeared market activity would continue in familiar fashion and would largely support global 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 virus quickly disrupted economic activity across geographies and sectors from large global enterprises to Main Street businesses. Significant travel restrictions, the shutdown of typical group gathering activities and orders by officials in many countries for citizens to stay home upended daily life. Even the 2020 Olympic Games were postponed. Unemployment began to rise, with the U.S. seeing a record three million jobless claims filed in a one-week period and the United Nations estimated that virus-prompted job losses could exceed 25 million worldwide. To stem the economic impact, policymakers around the world enacted significant economic stimulus measures and leaders of industrial nations vowed to work in tandem to support the global economy. Though some funding levels have already reached trillions, 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:
Prudential reported full-year 2019 results that included adjusted operating profit of GBP 5.31 billion, which reflected growth of 20%, compared with a year earlier, and exceeded market forecasts by about 4%. Adjusted operating profit from continuing operations rose in both Asia (+14%) and the U.S. (+20%), its largest revenue-generating markets. In addition, total profit from new business outpaced market expectations and our estimates, driven by better than projected results in Asia, while new business profit in the U.S. undershot forecasts. However, management announced a partial initial public offering (IPO) of the U.S. business potentially by the end of the year although it is subject to market conditions. As equity markets remain under pressure, additional cash reserves may be necessary to support Prudential’s annuity business in the U.S. While a partial IPO is short of a complete sale or a spinoff of the business, we think it demonstrates progress as this move will boost capital without a cash infusion from the holding company. While current events have prompted uncertainty, we have confidence that Prudential’s current leadership team can navigate near-term challenges effectively.

Late in 2019, Prosus released its first set of financial reports and its share price rose early in the first quarter. The company also engaged in a high-profile bidding war to acquire Just Eat in recent months and in January, the company received positive reviews from some market analysts. We subsequently decided to exit this position in favor of other investments that we believe offer better upside potential.

Bottom Performers:
Fourth-quarter results from Lloyds Banking Group fell short of market projections as revenue, underlying profit and pretax income all underperformed forecasts. For the fiscal full year, total revenue fell 4%, underlying profit fell 7% and pre-provision profit declined 3% from a year earlier, all of which were weaker than our estimates. The operating environment in 2019 was dominated by uncertainty surrounding Brexit and the formation of a U.K. government, which resulted in both corporate and individual investors postponing investment decisions. This circumstance pressured economic and loan growth and the Bank of England responded with keeping base interest rates low, putting further pressure on bank profitability. Along with the earnings release, management offered a more optimistic view of the U.K. economy. However, the coronavirus pandemic has created new concerns and we recently discussed these with CEO António Horta-Osório. In response to evolving events, Lloyds quickly implemented a contingency plan and now roughly 60,000 employees are able to work from home. In addition, Horta-Osório believes that coordinated efforts between the banking system and regulators will be directly helpful and reduce the need to increase the company’s capital level. Overall, we are comfortable with Lloyds’ approach to managing matters under its control.

CNH Industrial released fourth-quarter results with revenue that missed market expectations, while earnings per share met market forecasts. Overall, results for the full year were weaker than our estimates as revenue and earnings from industrial operations declined from the prior year. In the key agriculture segment, revenue declined in excess of both our forecasts and management’s expectations, in part owing to lower market volumes for row crop equipment. However, CNH successfully managed its row crop inventory position in North America, which was 16% lower year over year. Concurrently, row crop net pricing stayed consistently strong and remained over 2.5% higher in 2019. In other segments, construction and powertrain results were also weak, while results in the Iveco segment outperformed our estimates. Later, CNH announced the resignation of CEO Hubertus Mühlhäuser and CFO Max Chiara. Board of Directors Chairwoman Suzanne Heywood assumed the role of interim CEO until a permanent CEO is identified and Oddone Incisa was appointed CFO after leading the company’s financial services segment since 2013. We spoke with Heywood who explained the board’s intent to improve execution, especially with regard to immediate issues, such as trade wars, cost reductions and now the coronavirus pandemic. We think new leadership can build on prior incremental progress and bring about better shareholder value.

Daimler’s fiscal full-year results aligned with management’s pre-announcement issued early in the first quarter. Revenue rose across industrial business segments and produced total revenue growth of 1.2% from a year ago, while the operating margin largely met our expectations. However, earnings, net profit and earnings per share all fell in excess of 60% year over year, owing to litigation costs and electric vehicle production initiatives. Importantly, Daimler produced EUR 1.4 billion of free cash flow from industrial operations in 2019, which far exceeded our cash flow forecasts and provides evidence that management remains committed to increasing free cash flow and reaching net industrial liquidity of more than EUR 10 billion. We later spoke with CEO Ola Källenius and CFO Harald Wilhelm and discussed recent management and operational changes. These include some adjustments specific to the Mercedes-Benz division (Wilhelm became CFO and Markus Schaefer was appointed COO), which are intended to drive a much leaner corporate function at the division level, improve financial control and speed decision-making. We also discussed impacts from the coronavirus as the company suspended the majority of its production in Europe. As a consequence, we reworked some of our near-term revenue and margin estimates, though we remain comfortable with Daimler’s ability to weather this unprecedented pandemic event successfully.

During the quarter, we initiated positions in EOG Resources, Envista Holdings, Pinterest and Prudential. We eliminated Prosus and Under Armour from the portfolio.

Past performance is no guarantee of future results.