THE MARKET ENVIRONMENT
Similar to the year 2016, 2020 was a year of extremes driven by exogenous factors ranging from the Covid-19 pandemic to Brexit negotiations with elections in between. Most recently, markets reacted favorably to events in the fourth quarter, particularly the approval and emergency use authorization of multiple vaccines aimed at preventing the spread of Covid-19.
Meanwhile, the U.K. and European Union negotiated arduously in the quarter, finally accomplishing an agreement that eliminated the possibility of a hard Brexit outcome. In the U.S., the four-year presidential election cycle produced a more balanced outcome than many had expected. The market proved relieved at both the elimination of uncertainty and the lower probability of big changes. Later in the fourth quarter, President Trump signed the country’s long-debated second economic relief bill into law, sending direct payments to some individuals and families as well as further extending unemployment benefits.
These events propelled equity prices higher across the globe for a strong finish to a year that had earlier experienced a bear market. Ultimately, the Nikkei 225 Index soared to a 30-year high in Japan, the German DAX Index surged to a record figure, and both the Dow Jones Industrial Average and S&P 500 Index closed out the year at record levels.
This year amounted to a volatile 12 months for investors. Though traumatic and difficult to tolerate, we recognize that market instability can unearth investment opportunities for those who are patient and willing to weather the storm. In times when others chase performance or lose conviction based on news headlines and irrational reactions, we remain alert to subsequent opportunities caused by short-term investors to build positions in quality companies that are trading at large discounts to our perception of their intrinsic value. This discipline is deeply embedded in our philosophy and process.
The share price of Lloyds Banking Group rose in the third quarter partly from positive Brexit deal developments. A late-quarter trade agreement between the U.K. and European Union secured a new economic and security partnership, which reassured investors. Lloyds also released third-quarter earnings that we found to be reasonable considering present macroeconomic conditions. For the full fiscal nine-month period, total revenue fell 17% and underlying operating profit declined 85% from a year earlier. Results were significantly impacted by impairment charges that rose dramatically (+334%) for the full period. However, the vast majority of the impairment charge increase occurred in the first two quarters and eased in the third quarter, which helped drive strong sequential growth of underlying operating profit that totaled GBP 1.2 billion. Other important metrics showed evidence of improvement as well, including retail deposits that rose 7%, which resulted in a loan-to-deposit ratio of 98%, reflecting a healthy liquidity position. Importantly, Lloyds’ balance sheet remains strong as its common equity Tier 1 ratio reached 15.2% in the third quarter (up from 14.6% in the second quarter), which exceeded both management’s target of 12.5% and regulatory requirements of roughly 11%. Management cited additional encouraging signs of a business recovery, including increased mortgage activity, that we think positions the company advantageously as the general economy normalizes. As we have expressed previously, we contend that Lloyds possesses a wide range of strengths to draw upon to reinforce its business during current near-term challenges. Even including its strong fourth-quarter stock price performance, we still believe the company’s shares remain undervalued compared with our estimate of intrinsic value.
CNH Industrial’s third-quarter earnings report bested investors’ expectations and was solid, by our measure. Results were driven primarily by the agriculture equipment business where local currency revenue increased by nearly 14% in the third quarter (following a decline of 11% in the first half), helped by higher commodity prices, various government support programs and demand for replacement equipment. Agriculture earnings improved over 80% year-over-year as margins expanded from 6.2% to 10.1%. In addition, segment performance in the near term looks promising as order books are up double-digits in all four regions. In the construction equipment business, performance improved in comparison to the first half of the year, and the Iveco business experienced a strong recovery in the European light truck market, which advanced 7%. Free cash flow amounted to nearly $1 billion in the third quarter, which was an almost $2 billion improvement year-over-year. Later, we discussed the transition to new CEO Scott Wine (former chairman and CEO of Polaris) with Chairman and interim CEO Suzanne Heywood, who believes Wine’s broad experience at Polaris provides the background necessary for his role at the company. CNH’s strategy will remain intact under Wine, reaffirming a commitment to split the on-highway business into a separate company and the aggressive financial targets announced in September of 2019, though the timeline for achieving these goals was pushed back.
General Motors (GM) issued third-quarter results that were very strong, in our assessment. Total revenue of $35.5 billion met market forecasts, while adjusted earnings of $5.3 billion and adjusted earnings per share of $2.83 were impressively double the amounts the market had expected. Compared with last year, revenue was unchanged, though adjusted earnings advanced 78% and adjusted earnings per share increased 65%. All segments outperformed our estimates, mainly driven by business in North America and the GM Financial segment that was helped by credit loss provision reversals. Management’s preliminary 2021 outlook is in line with its original pre-pandemic expectations for 2020. We believe these strong results serve as a positive proof point that GM’s business model is far more resilient than expected thanks to the strength of its core truck franchise and management’s aggressive cost-cutting actions taken both pre- and post-pandemic. In addition, GM decided against taking an equity stake in electric vehicle startup Nikola after a short-seller accused Nikola’s management team of fraud. GM will continue to supply Nikola with fuel-cell technology. Overall, we see this decision as prudent.
Alibaba Group released fiscal second-quarter earnings results that were mixed, in our view, though revenue, adjusted earnings and earnings per share all outpaced market forecasts. Highlights included total revenue growth of 30% from last year, partly driven by a 20% revenue advance in the core e-commerce business that exceeded overall market growth of 17%. Adjusted earnings rose 28% year-over-year and annual active consumers increased 9%. However, we found it disappointing that the operating margin contracted from a year ago, which management attributed to business reinvestments. Later, Alibaba’s share price declined sharply as the company faced regulatory challenges that stemmed from the new anti-monopoly law in China. In addition, the suspension in November of the highly anticipated initial public offering of Ant Group, in which the company holds an approximately one-third ownership stake, also caused investor concern. The increased regulations on both Alibaba and Ant are still in the consultation phase and have not yet been finalized. While we find it difficult to accurately quantify the associated risks, we believe it is likely Alibaba will face greater regulatory scrutiny and slower growth going forward. However, the company remains an important driver of innovation in China and even considering the slower growth, we believe its valuation is compelling. In the meantime, we continue to monitor the situation, which remains fluid.
Bayer’s share price dropped significantly at the beginning of the fourth quarter when management issued preliminary 2021 guidance that upset the market. While management sees 2021 revenue roughly unchanged from 2020 levels, despite ongoing Covid-19 challenges, expectations for constant currency earnings per share were roughly 10% lower than market forecasts. Furthermore, the company plans to write-down crop science intangible asset values by an amount in the range of mid- to high-single-digit billions of euros, which negatively surprised investors. However, we like that management introduced a new, incremental EUR 1.5 billion annual savings program (as of 2024) to rightsize operational infrastructure. Later, Bayer released third-quarter results that included total revenue, adjusted earnings and earnings per share that all missed market expectations. We saw the company’s results as mixed with improvement in pharmaceutical operations and ongoing robust performance in the consumer health business offset by weakness in the crop sciences segment. We were pleased that management effectively controlled costs and that the company confirmed full-year 2020 currency adjusted total revenue and earnings guidance. We recently spoke with Norbert Winkeljohann, who became chairman of the Supervisory Board early in 2020. Winkeljohann is focused on increasing the pace of execution, clarifying the company’s strategy and improving delivery on non-execution issues, such as litigation. He plans to enhance organizational alignment and agility by utilizing key performance indicator measures at deeper operational levels in the business. We think these initiatives can strengthen Bayer’s performance going forward.
During the quarter, we initiated positions in Keurig Dr Pepper and Novartis. We eliminated CoreLogic, Live Nation Entertainment, Pinterest and Southwest Airlines from the portfolio.
Past performance is no guarantee of future results.
The Nikkei Stock Average (Nikkei 225) is a price-weighted average of 225 Japanese companies listed in the First Section of the Tokyo Stock Exchange. Constituents are selected based on liquidity and industry representation. This index is unmanaged and investors cannot invest directly in this index.
The Deutsche Boerse AG German Stock index is an equity index that measures the share performance of the 30 largest German companies in terms of exchange turnover and market capitalization, and is thus an established indicator for the performance of the German economy as a whole. This index is unmanaged and investors cannot invest directly in this index.
The Dow Jones Industrial Average is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities. This index is unmanaged and investors cannot invest directly in this index.
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.
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