THE MARKET ENVIRONMENT
During the third quarter, global markets continued to contend with the economic ramifications of Covid-19 as worldwide fatalities surpassed the grim 1 million mark. In August, the U.S. Federal Reserve announced a policy change that indicated it would not necessarily increase interest rates upon an improvement in unemployment figures, even if inflation is above the group’s traditional 2% target. At its September meeting, the Fed maintained near zero interest rates and publicized intentions to keep them at this level through 2023. Meanwhile, both the S&P 500 Index and the NASDAQ Index closed near peak levels in the quarter. Ultimately, the Fed raised its forecast for full year-2020 gross domestic product (GDP) from a 6.5% contraction to a 3.7% contraction.
Similarly, both the European Central Bank and the Bank of Japan opted to keep interest rates steady in September. In Japan, the Nikkei 500 Index reached a record high, while industrial profits in China increased 20% in July and 19% in August. Conversely, the U.K. moved into a technical recession following a roughly 20% contraction in GDP in the second quarter, the largest on record, which followed an approximately 3% contraction in the first quarter. As of the end of the third quarter, the country had yet to secure a Brexit trade deal with the European Union. Furthermore, continued Covid-19 concerns and Saudi Arabia’s plans to cut oil prices translated to a decline in both West Texas Intermediate crude and Brent crude to less than $40 per barrel.
On the vaccine front, China indicated a Covid-19 vaccine may be ready for public consumption as early as November. Meanwhile, a leading vaccine candidate from the University of Oxford and AstraZeneca was halted again in September when a participant in its trial became ill. On the other hand, Johnson & Johnson’s vaccine candidate moved into Phase 3 of its clinical trials, the first single-dose vaccine in the U.S. to do so.
In our view, there is a lot of value in the market today. Though the near-term macro outlook may be mixed, positive vaccine developments or further signs of economic recovery from the initial shock of Covid-19 could improve market sentiment. In the meantime, we are finding good opportunities from a valuation perspective and think it is a ripe environment to be picking stocks.
Considering the operating environment, we found Daimler’s second-quarter earnings results to be acceptable. Though year-to-date Mercedes-Benz cars and vans volumes are down 22% and 29%, respectively, we appreciate that revenue in the segment is only down 14.8%. We think this reflects significant product mix benefits within both markets as well as resilient pricing dynamics. China also contributed with 17% year-over-year growth, despite the overall Chinese auto market being down 4%. Free cash flow was also significantly stronger than had been expected and we believe this is a result of management’s stringent focus on improving cash flow generation. As a result, Daimler ended the second quarter with a strong net financial position and provided earnings guidance that was better than had been anticipated. We believe these results reflect well on the new management team. Later, Daimler announced that it reached an agreement in principle with various U.S. authorities to settle civil and environmental claims regarding emissions control systems on about 250,000 diesel passenger cars and vans in the U.S. The company also reached an agreement with the plaintiffs’ counsel to settle the ongoing class action lawsuit. Importantly, the costs associated with the settlements are covered by existing provisions, which removes a material area of uncertainty for Daimler.
Pinterest’s share price soared late in July upon the release of its second-quarter earnings report. Revenue ($272.5 million vs. $250.4 million) and adjusted earnings ($-34.0 million vs. $-81.1 million) were better than market expectations. Monthly active users totaled 416 million, which reflected an increase of 39% year-over-year, and topped consensus estimates by roughly 10%. Management did not provide full-year guidance but did relay expectations for third-quarter revenue growth in the mid-30% range year-over-year. Following the review of Pinterest’s solid results, we increased some of our near-term valuation metrics. We like management’s strategic approach, which we believe can provide shareholder rewards going forward.
TE Connectivity’s fiscal third-quarter earnings report showed the company outgrew production by 600 basis points in the automotive segment through the first three quarters of the fiscal year. New business wins are at a record high in auto, so we believe this outgrowth should be sustainable, especially as electric vehicles continue to grow as a percentage of the overall fleet. CFO Heath Mitts noted that TE Connectivity has about two years left on its last major restructuring effort and that margins should be above past peak levels when revenue returns to levels seen in 2018. Later, TE Connectivity entered into an agreement to purchase two subsidiaries from First Sensor in the U.S. and France for EUR 40.3 million. Overall, we believe the company’s balance sheet remains in good shape and appreciate that management continues to execute share repurchases.
Rolls-Royce Holdings issued a trading update in July, which proved disappointing to investors. The company indicated it will experience a GBP 3 billion cash outflow in the first half and expects a GBP 4 billion outflow for the entire year, which was worse than we had expected. Rolls-Royce also anticipates a 55% decline in wide-body flight hours this year, which was also a larger decrease than we had expected. We spoke with management early in September and learned it wanted to execute an equity raise as a buffer given the huge amount of uncertainty related to the timing of a recovery. Ultimately, Rolls-Royce opted not to sell a stake in the company to a sovereign wealth fund, but did announce a ten-for-three issuance at GBP 0.32 per share to raise approximately GBP 2 billion. This is part of a GBP 5 billion recapitalization package meant to strengthen its balance sheet and ensure adequate liquidity even if flight hours show only modest improvement versus current trends in 2021. Although we continue to believe that Covid-19 will cause a material and long-lasting disruption to the company’s civil business, we also think its power systems and defense business faced less disruption. While we still hold a position in Rolls-Royce, we are monitoring the situation closely.
Lloyds Banking Group’s fiscal-year results fell short of expectations as revenue fell 4%, underlying profit fell 7% and pre-provision profit declined 3% from a year earlier. We attributed these results to a very difficult 2019 operating environment with uncertainty surrounding Brexit and the formation of a U.K. government. First-half results were also disappointing as key metrics fell far short of our estimates, largely owing to impacts from Covid-19. Total revenue from core operations declined 16% from a year ago and operating profit realized a loss of GBP 281 million, driven by a significant impairment provision charge. Management stated the larger than anticipated provision amount was due to a significant deterioration in the forward-looking economic outlook. However, Lloyds’ loan book continues to perform well, in our view, and actual defaults to date remain stable. Despite the difficult operating environment, we find that the company is well capitalized with a common equity Tier 1 ratio of 14.6% and GBP 11.8 billion in excess capital relative to minimum regulatory requirements. In our view, the company possesses a wide range of strengths that it can draw on to reinforce its business during current near-term challenges.
We saw Bayer’s second-quarter results as satisfactory, driven by year-over-year revenue growth in the crop sciences segment of 3.2% (+4.6% for the fiscal first half). While quarterly revenue declined in the consumer health segment, fiscal first-half growth of 5.7% showed strong year-to-date momentum mainly from nutritional products sales that rose 14.4% in the quarter and 23.7% for the fiscal first half. Notably, margins expanded across segments compared with the prior year and were better than our estimates in the crop sciences and pharmaceuticals segments. We spoke with CEO Werner Baumann who expressed that results largely aligned with management’s expectations. With regards to Covid-19, Baumann believes that although negative effects may linger in the pharmaceuticals and crop sciences segments, consumer health should continue to realize benefits from enhanced demand for over-the-counter medications/products. Later, Bayer confirmed 2020 guidance and stated expectations that total 2021 revenue will remain roughly unchanged from 2020 and core earnings per share will be slightly below 2020 levels at constant exchange rates. While revenue forecasts largely met market forecasts, earnings per share undershot estimates by about 10%, which proved disappointing to investors.
During the quarter, we initiated a position in Anheuser-Busch InBev. We eliminated CoreLogic, EOG Resources, LafargeHolcim and Taiwan Semiconductor from the portfolio.
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