THE MARKET ENVIRONMENT
Major global markets generally experienced relief in the fourth quarter after equity markets had declined meaningfully throughout the first three quarters of 2022. Conditions in markets turned more favorable as there were early signs that central bank increases in interest rates, improving supply chain conditions, and lower energy prices would lead to reductions in the level of inflation in many countries. International equities benefitted from most international currencies strengthening relative to the dollar during the quarter, though most major currencies still ended the year down 5-15% versus the dollar. European equities led the world in returns in the fourth quarter by being up almost 20%, or about double those in the U.S. and emerging markets.
The size of the U.S. Federal Reserve’s hikes to its benchmark interest rate slowed in December to 50 basis points, following 75 basis point increases in June, July, September and November. The Bank of Canada increased its benchmark rate by 50 basis points in October and December, while the European Central Bank and Bank of England both hiked their respective rates by 75 basis points in November and 50 in December. The Bank of Japan continued its accommodative policy stance on interest rates, but surprised markets by doubling its cap on 10-year yields from 0.25% to 0.50%. The Japanese central bank said the reason was to enhance the sustainability of monetary easing, but many investors speculated it to be a sign of a potential exit from its decade-long stimulus policy. As a result, the yen appreciated against other currencies and Japanese government bonds fell. Elsewhere, China backpedaled from its “Zero-Covid” policy and subsequently saw a sharp increase in the number of positive Covid-19 cases.
While we recognize the challenge facing investors with the current state of financial markets, we believe that the lower and more widely dispersed valuations in the market today have allowed us to redeploy capital into increasingly attractive investments. We are optimistic that these decisions will sow the seeds of future outperformance. As always, we remain focused on building a high conviction portfolio of undervalued businesses that we believe will provide both a margin of safety and the potential for attractive risk-adjusted returns over the long term.
CNH Industrial reported strong third-quarter results, in our view, particularly in light of continued supply chain pressures, inflation, and higher research and development costs, which were up 36% year-over-year. Industrial sales increased 30% year-over-year in local currency and earnings margins increased by 270 basis points, resulting in a roughly 60% increase in earnings. The construction equipment segment also showed strength with 20% sales growth in local currency. While the third quarter has typically been one with negative free cash flow, the company generated $202 million as working capital outflows were outweighed by profitability. Management expects to generate in excess of $1 billion in free cash flow in the fourth quarter due to substantial inventory depletion, some of which is seasonal and some of which is due to completing an abnormal amount of semi-finished goods. The company increased guidance for the year and repurchased $76 million in shares during the quarter with plans to continue repurchasing more.
American International Group (AIG) reported a decent set of third-quarter results, in our view, with quarterly earnings per share of $0.66 and an ending adjusted book value of $73.30. Highlights from the release included the 88.4% accident year combined ratio with general insurance at 83%, and impacts from Hurricane Ian and a large typhoon in Asia that led to a 900 basis points increase to the company’s overall combined ratio of 97%. We believe the property and casualty business is performing well and anticipate CEO Peter Zaffino will turn this into a top performing business in the industry. Another key development during the quarter was the partial initial public offering of Corebridge Financial, with AIG now owning 77% of its former life and retirement unit. Corebridge’s net income was down 35%, but this was expected as investment income was down substantially due to the weakness in financial markets. In our view, core trends are solid as higher rates should be a positive for new business and investment income going forward. Finally, the company continued to aggressively repurchase shares with the share count down 100 million shares year-over-year to 740 million, and management guided to around 600-650 million shares when Corebridge is fully separated.
The share price of Prosus rose after reporting fiscal second-quarter results. The company’s revenue of $3.78 billion reflected a 23% advance from the $3.07 billion achieved in the prior year. Also, while overall second-quarter earnings declined $70 million, the decrease was far less than the loss in the previous year of $304 million. Furthermore, Prosus completed its acquisition of iFood, a food delivery, quick commerce and financial technology company based in Brazil, from Just Eat in November. Larry Illg, CEO of Prosus Food, stated, “There is substantial opportunity for further expansion in both the restaurant food delivery business and through building out the platform in areas such as grocery and quick commerce.” We are optimistic about the potential benefits that owning this business can bring. Lastly, Prosus spent more than $645 million to buy back roughly 9.5 million shares in December in keeping with management’s commitment to continue repurchases while shares remain discounted.
Amazon’s share price fell following its third-quarter earnings report that provided a disappointing outlook for the fourth quarter. Management guided to $140-148 billion of revenue, which is a 5% increase year-over-year (10% increase in constant currency) and 6% below consensus. This deceleration compares to 15% growth in the third quarter. Management said third-quarter retail sales decelerated throughout the quarter as inflation is hurting discretionary retail budgets. We believe this is a macro issue as Amazon gained market share during the quarter. Retail profitability for the quarter was disappointing at -$2.9 billion, and earnings guidance was only slightly better for next quarter. Retail capital expenditures are being cut and the company is implementing various changes to improve margins. Amazon Web Services (AWS) revenue was up 28% year-over-year and 3% below consensus. Demand decelerated throughout the quarter as customers reduced or optimized usage. Margins were below consensus and declined 400 basis points year-over-year as AWS absorbed operating leverage for customers. Management said AWS margins can “fluctuate over time” and they are still investing as the backlog grew 57% year-over-year. While overall profitability was disappointing and a recovery in margins may take longer than expected, we appreciate that management is focused on it, and retail is gaining share. We remain confident in the investment over the long term as the business drivers appear healthy and the lower guidance seems to be mostly a macro and timing issue.
Alphabet’s third-quarter earnings results came in light of consensus expectations on sales and margins and the company’s share price fell following the release. In addition, reported earnings per share were hurt by a nearly $3 billion hit from mark to market losses in equity and debt securities. Despite this, total revenue grew 11% in constant currency and 6% reported to more than $69 billion. Management described fundamental performance in the search segment as “healthy” and attributed the slowdown to foreign currency pressure and current figures going up against strong figures from this time last year. Total operating margin declined to 25% from 32% due to growth in research and development and general and administrative expenses, which was led by headcount growth, promotions, and higher sales and marketing spend on advertisements. We appreciated that both CEO Sundar Pichai and CFO Ruth Porat noted on the call that the company is “sharpening focus” on the biggest growth priorities and “moderating operating expense growth” for 2023.
Credit Suisse Group’s third-quarter headline results of a CHF 4.03 billion net loss for the quarter included a CHF 3.7 billion impairment of deferred tax assets (DTA). The DTA is attributed to the group’s securitized products segment, which is expected to be spun-off from the company and prompted the charge. Outside of the DTA write down, we believe the third-quarter results show the core franchises continue to perform acceptably despite the uncertainty associated with the strategic review and constant negative headlines. In our view, Credit Suisse’s recently announced restructuring plan appears to be quite methodical and well contemplated, reinforcing our belief that the new leadership team is a material upgrade. We appreciate that the company is increasing the amount of capital allocated toward the higher quality franchises and away from the lower quality investment bank, which we believe will result in a stronger franchise with greater earnings power. We were disappointed that the capital raise was larger than we had expected. However, given the size of the DTA impairment and the desire for a new investor to come in, we believe this will leave Credit Suisse in a strong capital position. We have lowered our intrinsic value estimate following the announcement, partially driven by the dilutive capital raise the company plans to issue.
During the quarter, we purchased shares of Capital One Financial and eliminated Citigroup from the portfolio.
Past performance is no guarantee of future results.
The MSCI World Index (Net) is a free float-adjusted, market capitalization-weighted index that is designed to measure the global equity market performance of developed markets. The index covers approximately 85% of the free float-adjusted market capitalization in each country. This benchmark calculates reinvested dividends net of withholding taxes. This index is unmanaged and investors cannot invest directly in this index.
The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s Global Concentrated composite as of 12/31/2022.
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