Commentary

Global Concentrated 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:
Glencore’s share price finished the second quarter higher than the first quarter even though first-quarter production of copper, cobalt, coal and ferrochrome was lower than a year earlier, while zinc, nickel and oil output increased. Management reduced full-year production guidance across commodities and elaborated on the state of the business given effects of the coronavirus. Operational disruptions were slightly ahead of what we had expected. However, in our assessment, owing to the level of assets impacted, the effects will not be material. Furthermore, we found it surprising that overall costs declined when we had expected them to increase. The combination of cost-cutting efforts, lower input prices (particularly diesel fuel) and currency exchange rates helped reduce the cost position across a number of operations, which led to management decreasing full-year capital expenditures guidance to $4-4.5 billion compared to the original guidance of $5.5 billion. Later, reports in June indicated the company would supply Tesla with up to 6,000 tons of cobalt per year for two new car plants in China and Germany. Despite the challenging operating environment, we think Glencore’s balance sheet is much improved, leaving the company well positioned to withstand a downturn.

Daimler’s first-quarter earnings report bested market expectations as exhibited by revenues (EUR 37.22 billion vs. EUR 34.18 billion) and adjusted earnings (EUR 719 million vs. EUR 648 million). Management confirmed its previous outlook for a decline in total revenue and earnings for 2020 compared to the year-ago period. The company also noted it planned to gradually accelerate production. To that point, Daimler resumed manufacturing passenger cars in two German plants at the end of April. We recently spoke with CEO Ola Källenius and CFO Harald Wilhelm and discussed some short-term measures enacted to boost profitability, which include utilizing a short-time work program in coordination with the German government to reduce payroll expenses. Importantly, management committed to not postponing any projects that are important for the future of Daimler, including production of the new Mercedes-Benz S-Class vehicle (which accounts for 3-4% of volumes and 15% or more of profits) and electrification (Daimler’s battery plant in Germany is the only plant globally that has never shut down, despite coronavirus challenges). In our determination, management has a solid plan for the future and we believe the investment can continue to provide value for our shareholders over the long term.

Alphabet’s share priced tracked a general recovery in the U.S. equities market. In addition, the company delivered reassuring first-quarter results in April as exhibited by a 13% increase in total revenue. Both the YouTube and cloud segments grew 33% and 52%, respectively, as YouTube finished March at a high single-digit growth rate. CFO Ruth Porat also indicated the company is already seeing “very early signs of recovery” in search advertising. In our view, the return to more commercial behavior among users is a sign that things are moving in the right direction. Notably, Alphabet executed $8.5 billion in share repurchases in the first quarter versus $3.0 billion for the first quarter in 2019 and indicated it intends to maintain the increased pace of buybacks for the duration of the year.

Bottom Performers:
Lloyds Banking Group’s first-quarter results included net income and underlying profit that declined 11% and 74%, respectively, from the prior year period and also far undershot market expectations. Although quarterly underlying profit missed our estimates by roughly 7%, after adjusting for a number of one-time items, we assessed that underlying profit is in line with our full-year expectations. Along with the earnings release, CEO António Horta-Osório commented that owing to current challenging and uncertain economic conditions associated with the coronavirus pandemic, the company’s original full-year guidance is no longer appropriate. We later spoke with Horta-Osório who sees scope for material cost savings by redirecting resources and eliminating other expenses, such as travel. We believe that numerous positive factors should help the company’s net interest margins over the medium term and current coronavirus-related challenges are transitory in nature. In addition, in our view, net interest margins could benefit from lower liability costs and the U.K. government’s 100% guarantees on incremental small- and medium-enterprise loans that provide attractive interest rate spreads for lenders. Overall, we find that Lloyds is trading at a large discount to our estimate of the company’s intrinsic value.

Berkshire Hathaway reported a first-quarter earnings per share loss of $20.44 compared with a gain of $8.81 issued a year earlier. Management stated that earnings per share results are the consequence of accounting rules that require the company to include changes in unrealized gains/losses of equity security investments as a component of investment gains/losses in its earnings statements. Nevertheless, the company’s first-quarter operating results and management’s near-term outlook were generally consistent with what we had expected. Importantly, Chairman and CEO Warren Buffett confirmed that the company has no material exposure to coronavirus-related matters in the insurance business that might lead to sizeable negative outcomes. Buffett indicated that Berkshire Hathaway has historically reserved funds conservatively and he has no reason to think the company will incur losses beyond what it has already reserved. Overall, we remain pleased with the fundamental performance of Berkshire Hathaway.

Toyota Motor issued fiscal full-year results that included year-over-year earnings per share growth of 13% and net income growth of 10%. However, both revenue and operating income declined as fallout from the coronavirus impacted business mainly in March. Furthermore, management’s fiscal 2021 guidance for revenue and operating income far undershot market forecasts. Toyota previously announced intentions to cut June auto production in Japan by 40%, owing to the unlikelihood of a demand recovery in North America. The company reduced output by about 20% in early April after shutting down seven production lines in five plants used mainly for models intended for overseas markets. We decided to sell our shares in favor of other holdings that we believe possess stronger upside potential.

During the quarter we initiated a new position in Samsung Electronics and eliminated Toyota Motor from the portfolio

Past performance is no guarantee of future results.