Commentary

Global All Cap Strategy

June 30, 2020

THE MARKET ENVIRONMENT
Major global markets finished higher for the second quarter, despite pockets of volatility dispersed throughout the reporting period. Businesses continued to grapple with the effects of the coronavirus pandemic on economic activity in the second quarter. In the U.K., gross domestic product sank 20.4% in April following a 5.8% decline in March. In Germany, industrial output dropped a record 17.9% in April after an 8.9% descent in March. In June, the International Monetary Fund (IMF) lowered its previous forecast for a 3.0% global economic contraction to a 4.9% global economic contraction for full-year 2020. The IMF also anticipates that the Japanese economy will shrink 5.8% in 2020, which is in excess of the 5.4% contraction the country experienced in 2009.

By the end of June, confirmed global coronavirus cases topped 10 million and global deaths from the virus surpassed the grim 500,000 mark. The U.S. accounted for over 25% of both global cases and deaths, with more than 35 states experiencing an increase in new cases by the end of June. Daily cases in the country eclipsed the 40,000 mark multiple times during the second quarter. Brazil trailed only the U.S. in both cases and deaths at more than 1.3 million and 55,000, respectively.

Meanwhile, heightened recognition of racial inequities and injustices prompted large-scale protests (and, in several cases, riots) to break out around the world. Surging protest activity that lasted weeks interrupted newly reopened businesses just emerging from pandemic-induced shutdowns, which led to further market volatility. The widespread call for change caused many organizations to publicly implement practices to fight racism, emphasize diversity, and eliminate offensive images, symbols and product brand names.

As is the case in any period of volatility, we find that the price of a business is an important aspect of what makes a stock attractive. Investing in a business at a fraction of what we think its underlying value is presents an opportunity to create value for our shareholders. In times like these, we look for high-quality companies with over-penalized share prices as investors disregard strong balance sheets and free cash flow and instead base investment decisions on market sentiment.

THE PORTFOLIO
Top Performers:
Mastercard’s first-quarter revenue ($4.01 billion vs. $3.96 billion) and earnings per share ($1.83 vs. $1.72) results bested analysts’ estimates. Though the company experienced a large fall-off in mid-March, switched volumes showed improvement from mid-April onwards. In our view, the coronavirus pandemic should accelerate the secular shift from cash/checks to electronic payments. Card-not-present spending accounted for 50% of switched volumes in April and contactless payments increased 40% in the first quarter. Later, Mastercard released a second-quarter update, which indicated the beginnings of a transition from the “stabilization” to the “normalization” phase in which consumer spending is expected to improve, given lifted restrictions on consumer movement. Despite near-term coronavirus-related challenges, the conversion from paper-based to electronic forms of payments continues to benefit Mastercard.

Late in June, CoreLogic received an acquisition offer from Cannae Holdings and Senator Investment Group for $65 per share. In response, CoreLogic’s share price soared from an amount well below the offer price to more than $67 per share as some investors speculate that $65 per share is merely an “opening bid.” In our view, CoreLogic is performing well this year with accelerated organic revenue growth, and we appreciate that CEO Frank Martell expanded margins over 300 basis points since 2017. We look forward to discussing the potential transaction with management, but we do find the initial proposed offer to be attractive.

TE Connectivity’s fiscal second-quarter earnings results proved reassuring to investors and included revenue ($3.20 billion vs. $2.94 billion) and earnings per share ($1.29 vs. $1.01) that surpassed market estimates. The company’s business was boosted from pre-buys in the auto segment, though we acknowledge this activity might pressure third-quarter results. Late in May, TE Connectivity indicated positive fiscal third-quarter trends, including orders and sales that were in line with expectations through the first two months of the quarter. Owing to aggressive cost-cutting actions, management continues to expect an operating margin at a rate in the high teens when auto production returns to above 80 million units per year. Despite current challenges, management reiterated that fiscal-year 2020 free cash flow will exceed $1 billion and intends to continue issuing the quarterly shareholder dividend. We find that TE Connectivity’s balance sheet is in good shape and appreciate management’s ability to navigate through the difficult operating environment.

Bottom Performers:
At its annual shareholder meeting in May, Rolls-Royce Holdings stated expectations for a significant net cash outflow during the second quarter. The company did not provide full-year guidance owing to the substantial disruption to the global aerospace industry caused by the coronavirus pandemic. Earlier in the year, management implemented a number of measures intended to produce a cash flow benefit of at least GBP 750 million. At the meeting, management indicated the company had made better progress than anticipated and now expects to deliver up to GBP 1.0 billion of cash savings in 2020. While we are encouraged that management is taking considerable actions to counter current circumstances, we think the pandemic may result in a long-lasting disruption to the company’s civil aerospace business, which generates roughly half of its total revenue. Fortunately, Rolls-Royce has other businesses, namely power systems and defense, which combined are nearly the same size as its civil business and have seen much less coronavirus-related disruption. Although we revised our earnings forecast to be lower for the company’s civil business, we believe the market’s reaction was overdone and did not take into account the total value of the entire business.

Throughout the second quarter, the management team at Southwest Airlines provided incremental updates on operational and revenue trends as the coronavirus pandemic severely curtailed the company’s business. While passenger demand and bookings were weak early in the quarter, the company experienced modest improvement beginning in early May 2020 when new passenger bookings outpaced trip cancellations, which reversed net negative booking trends in March and April. Southwest also realized somewhat higher passenger demand and bookings for June. The company estimated that May 2020 year-over-year operating revenues declined in a range of 85-90%, capacity fell roughly 64% and the load factor was about 30%, which all aligned with management’s previous projections. Nevertheless, we find news of booking trends encouraging and are hopeful that it points to a developing recovery. Importantly, management indicated that based on current cash balances, daily expenditures, short-term investments and proceeds from recent sale-leaseback transactions, Southwest has approximately 20 months of liquidity. In addition, the company is the only U.S. airline with an investment-grade rating by all three rating agencies, which allows for access to credit, if necessary.

Grupo Televisa issued weak first-quarter results that far undershot our estimates. Total revenue was relatively unchanged from the same period last year. However, the company reported a net income loss of MXN 9.65 billion compared with the gain of MXN 541.7 million realized a year ago. The content segment continued to struggle due to underperformance from the advertising business where revenue declined 28% year-over-year. Considering ongoing impacts from government advertising spending cuts and the coronavirus pandemic, we lowered our estimates for full-year advertising revenue growth. Conversely, revenue growth strengthened from network subscriptions and licensing and syndication, which advanced 9% and 11%, respectively. Sky revenues rose 2%, mainly from broadband services growth, and cable revenues increased 9% as revenue-generating units grew 6% and average revenue per unit grew 3%. Even though Grupo Televisa is facing some challenges from an uncertain macro environment, our investment thesis for this company stands.

During the quarter, we initiated positions in Alibaba Group, Compass Group and Flowserve. Additionally, we received shares of Howmet Aerospace when Arconic, Inc. split into two publicly traded companies. We eliminated Hirose Electric and Reckitt Benckiser Group from the portfolio.

Past performance is no guarantee of future results.