Commentary

Global Concentrated Strategy

December 31, 2019

THE MARKET ENVIRONMENT
The fourth quarter of 2019 brought a steady recovery in global markets following the volatility that afflicted indexes around the world earlier in the year. As was the case last year, 2019 featured extreme price movements as the latest news, including trade talks, Brexit, European Union political instability and even a political conflict between South Korea and Japan dating back to World War II, influenced stock prices. As an example, while global markets started the year off strong, a few tweets that fueled trade war fears in May sent indexes around the world tumbling. August also saw more measurable declines until markets began to recover and rebound based, in part, on more positive geopolitical headlines.

Other fears that weighed on markets were the possibility of a Jeremy Corbyn victory in the U.K. general election and continued uncertainty surrounding Brexit. With a large, historical victory by the Conservative Party in the U.K., investors’ fears of a Corbyn-led socialist-style government were alleviated for the medium term. Instead, Prime Minister Boris Johnson’s government acted quickly to move its Brexit bill through Parliament in an attempt to ensure a smooth exit from the European Union.

Meanwhile, China and the U.S. de-escalated their trade dispute with an agreement of a “phase-one” trade deal in the fourth quarter. These events boosted global equity market sentiment toward the end of 2019 and entering into 2020. These developments also provided more solid foundations for businesses to make capital allocation and investment decisions going forward as the news pushed key U.S. indexes to all-time high levels. In fact, all 11 GICS sectors in the S&P 500 Index gained value in 2019 and produced double-digit returns for the year. In China, the Shanghai Composite increased 22% for the year, while Japan’s Nikkei 225 Index finished 18% higher in 2019.

Despite the recovery in 2019, we still believe our investment approach offers good upside potential. In fact, our investment philosophy and team have been consistent throughout our history. We continue to look for opportunities to achieve higher returns by estimating business value and buying at a discount. We utilize this strategy with the goal of long-term outperformance for the benefit of our shareholders.

THE PORTFOLIO
Top Performers:
The share price of Lloyds Banking Group benefited from news of a Brexit agreement between the U.K. and the European Union, which is now pending approval by Parliament. In addition, while the company’s third-quarter revenue and underlying operating profit fell short of our estimates, we were pleased that total costs declined over 5% from a year ago and were far below our forecasts, which illustrates to us that management’s efficiency improvements are producing positive results. Importantly, the company expects non-underlying costs to fall below GBP 1 billion in 2020 (down about 70% from 2019) as the compensation period for payment protection insurance claims has lapsed. Therefore, Lloyds no longer needs to set aside funds for this purpose and it can deploy additional cash to achieve other business objectives. In our view, Lloyds is now well positioned for strengthening performance going forward, and it appears the market agrees.

Regeneron Pharmaceuticals delivered strong third-quarter earnings results as exhibited by year-over-year revenue growth of 23%. Specifically, EYLEA net sales grew 14% and DUPIXENT increased 141%. Earnings per share rose nearly 14% from a year earlier to $6.67 and exceeded market expectations of $6.40. Management also announced a $1 billion share repurchase program and indicated its LIBTAYO lung cancer trial was progressing well. We spoke with a member of the company’s management team during the quarter and learned that Regeneron is optimistic the launch of competitor Beovu will afford growth for EYLEA as well. In addition, prescriptions for DUPIXENT are still accelerating with direct-to-consumer advertisements for asthma that will launch soon.

Early in the fourth quarter, investors responded favorably to Bayer’s third-quarter earnings report. Revenue (EUR 9.83 billion vs. EUR 9.70 billion), adjusted earnings (EUR 2.29 billion vs. EUR 2.27 billion) and earnings per share (EUR 1.16 vs. EUR 1.12) exceeded analysts’ expectations. Later, the company announced the approval of usage from the U.S. Food and Drug Administration of XARELTO to help prevent blood clots. We met with CFO Wolfgang Nickl in November and reviewed progress made to integrate Monsanto’s processes with Bayer. Despite the overhang of glyphosate litigation, Nickl emphasized that surveys conducted on customer and employee engagement are scoring well. Although Bayer is ahead of schedule on merger synergies, the company’s gross synergy forecasts for the medium term remain unchanged, which is in line with our expectations. In December, Bayer received marketing approval in Europe for its Neptra ear drop solution. Later, the U.S. Food and Drug Administration authorized the company’s MEDRAD Stellant FLEX CT Injection System for expanded use in contrast-enhanced mammography. We appreciate that Bayer is a leading global provider of over-the-counter consumer health products and possesses a robust portfolio of brands that supports a healthy level of continuing cash flow, in our estimation.

Bottom Performers:
American International Group issued third-quarter results that were slightly weaker than we had estimated, owing to higher than expected catastrophe losses and an actuarial adjustment in the life insurance business that depressed quarterly earnings per share. However, adjusted book value per share rose about 1% to $57.60 (from $56.89 in prior quarter). Notably, the adjusted return on equity (ROE) reached 4.1% (compared with -2.4% in the year-ago period), which marks progress toward reaching the company’s strategic near-term goal for core ROE of at least 10%. In December, CEO Brian Duperreault, CFO Mark Lyons and CEO of General Insurance Peter Zaffino spoke at an investor conference. They reaffirmed guidance for a double-digit adjusted return on equity by the end of 2021, mainly driven by core results from the general insurance segment. In addition, AIG plans to complete the sale of most of Fortitude Re in mid-2020 and intends to use the proceeds to pay down debt and continue deleveraging the balance sheet in keeping with management’s near-term strategic capital allocation objectives. We continue to believe the company’s leadership team is taking the right steps to enhance shareholder value.

Constellation Brands’ fiscal second-quarter total revenues met market estimates and earnings per share (including a loss related to the Canopy Growth Corporation business) were better than forecasts. However, revenue and operating profit in the wine and spirits business contracted and were weaker than investors had projected. Management attributed the segment’s underperformance largely to the pending sale of low-end wine brands to Gallo. From our perspective, Constellation’s results were solid and its performance has been tracking well compared with our expectations. The core beer business (which accounts for over 80% of earnings) continues to build market share and this segment’s earnings margin expanded to a record 41.8%. Like-for-like adjusted beer volume depletions rose 7.5%, despite comparable prior-period results that were elevated from the rollout of Corona Premier and Corona Familiar brands last year. In a later regulatory filing, Constellation stated expectations for a fiscal third-quarter equity income loss related to its ownership stake in Canopy Growth. The company will realize an equity impact of $46 million on a reported basis (-$71 million on a comparable non-GAAP basis), which translates to a 14% decline in core earnings or an earnings per share reduction of $0.30. While Constellation’s results in the near term may suffer from this issue, our long-term assessment of the company remains unchanged.

Following news in October that the United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) union ended its strike against General Motors (GM), the company issued third-quarter results with total revenue and earnings per share that surpassed market expectations. We believe the quarterly report illustrated that GM’s underlying business remains strong (led by the crucial North American truck/SUV franchise). And although the UAW strike resolution took longer and was more contentious than had been anticipated, it did not impair the company’s competitiveness, flexibility or earnings power. Management sized total strike-related costs at approximately $3 billion and revised some full-year estimates lower, which may have unnerved investors. In addition, news that GM filed a racketeering lawsuit against competitor Fiat Chrysler in November surprised investors. The company accused Fiat of bribing the UAW to achieve lower labor costs and operational advantages. The market is speculating that it will be hard for GM to win damages and may escalate spending for legal fees. In our view, the company’s competitive position remains solid owing to its “transformative cost cutting program,” a strong new product platform, and leadership in autonomous and electric vehicles.

There were no new purchases or final sales during the quarter.

Past performance is no guarantee of future results.