THE MARKET ENVIRONMENT
Major global markets generally finished the second quarter higher, continuing the relief for the year-to-date period following a challenging 2022. In the U.S., the Russell 1000 Growth Index gained 12.81% versus the Russell 1000 Value Index, which gained 4.07% as technology and AI-related companies led the advances. While the U.S. and Europe equity markets showed strength on the back of better than expected economic data, Asian markets were mixed with China equities finishing lower and Japanese equities reaching 30-year highs.
Central banks continued to focus on reining in inflation, which remains elevated across most regions. The U.S. Federal Reserve increased its benchmark interest rate by 25 basis points in May before pausing at its June meeting. Comments from members of the Federal Open Market Committee pointed to further hikes in the future and interest rates remaining elevated for some time. The European Central Bank and Bank of England both increased their respective interest rates in May and June, reaching 4.00% and 5.00%, respectively, while Japan and China opted for more accommodative monetary policies. In the face of tightening financial conditions, inflation fell from prior year levels during the quarter throughout most of the world.
Regardless of the economic backdrop and central bank activity, our disciplined investment process continues to revolve around bottom-up, fundamental research. As long-term investors, we value our companies through the economic cycle and focus portfolio construction on optimizing what we believe are our best investment opportunities. We attempt to identify growing businesses that are managed to benefit their shareholders and invest in those businesses only when priced substantially below our estimate of intrinsic value, then patiently wait for the gap between share price and our estimate of intrinsic value to converge. We believe this approach best serves our goal of growing our clients’ capital over the long term.
Alphabet’s first-quarter search revenue growth accelerated slightly sequentially, which management described as “resilient” against the backdrop of a pullback in advertising budgets. Travel and retail verticals were called out as performing well, offset by declines in finance and media and entertainment. Alphabet’s cloud business reached GAAP profitability this quarter, moving from a -12% margin a year ago to a 3% margin. On the AI front, Alphabet upgraded Bard to run on its more powerful PaLM language model, while also adding the ability to assist with coding and software development. CFO Ruth Porat revised 2023 capital expenditures guidance, driven by higher data center construction and server spending to support AI investments across consumer products, advertiser tools, and the cloud business. Porat reiterated that the company plans to hold expense growth below revenue growth and that it will begin to see the benefits of the company’s cost-reduction initiatives later this year and into 2024. Alphabet hosted its annual developer conference in May where it showcased what we view as an impressive array of new AI-powered consumer tools to be rolled out over the course of the year.
Amazon’s most recent earnings report revealed first-quarter revenue higher than consensus expectations across all segments and business lines. Margins were ahead of consensus for both North America and international retail and roughly in line at Amazon Web Services (AWS) after backing out an unusual charge. Shipping and fulfillment cost metrics improved again, which we view as a key indicator of progress. Although total company headcount was down 10% year-over-year, the improved efficiency is not at the expense of delivery speed, which continues to increase with 2023 on track to be a record year. Management noted a roughly 5% deceleration in AWS growth in April, but we remain confident that over time AWS will re-accelerate. CEO Andy Jassy said he believes large language models and generative AI will be drivers of growth for AWS, as many customer experiences will be invented or reinvented on the cloud. In June, the Federal Trade Commission (FTC) filed a lawsuit against Amazon, alleging that it lured customers into signing up for Amazon Prime and made it challenging to unsubscribe. Later, reports surfaced that the FTC was preparing an antitrust case against Amazon. We do not believe these will result in a material change in value, but we will continue to monitor the situations closely.
Capital One Financial reported solid first-quarter results, in our view, with its capital and liquidity position remaining healthy and deposits growing 5% during the quarter with 78% overall being insured by the Federal Deposit Insurance Corporation. The company’s common equity tier 1 (CET1) ratio was 12.5% at quarter end and 10.5% after incorporating losses from the available-for-sale portfolio, which is still well above Capital One’s regulatory requirement. As credit quality remains Capital One’s main focus, the company built $1.1 billion in allowances to reflect continued economic uncertainty and worsening credit metrics in the card business, pushing quarterly earnings below expectations. Card delinquencies are back to pre-pandemic levels, and management expects that card charge-offs will return to a 2019 baseline later this year, remaining cautiously optimistic on the health of the U.S. consumer. We believe Capital One’s card business is strong, with 6% purchase growth and 20% loan balance growth year-over-year normalizing off a low base. Net interest margin compressed to 6.6% as the company is holding more cash than normal following strong deposit growth. Management reiterated guidance that the operating efficiency ratio for the full year should be in line with the previous year. Lastly, Capital One spent $150 million on share repurchases during the first quarter. We believe the company remains well capitalized to endure even a severe recession.
Bayer reported first-quarter results that fell short of consensus expectations, particularly in the crop and pharma segments. Within the crop segment, glyphosate normalization is materializing more completely than management’s expectations. Management guided to a EUR 1.7 billion revenue headwind in 2022 versus the EUR 0.9 billion prior guidance, effectively unwinding windfall price surges recently achieved during a period of shortages. The rest of the core crop segment is performing well, in our view, growing 8% during the quarter with the help of price increases, particularly in corn which grew 16%. The pharma business experienced challenges driven by China due to Covid-19 and volume-based procurement, which also weighed on Adalat. Xarelto declined 13% during the quarter, which management also attributed to China. Management expects growth to sequentially improve following the first quarter driven by the China headwind fading and strong growth drugs increasing in relevance. This was the final earnings report under CEO Werner Baumann, who was replaced by Bill Anderson on June 1, 2023.
NAVER reported first-quarter results that we believe showed management’s strength in navigating a difficult environment. The core search business grew 5%, despite the broad contraction in advertising spending. Display advertisements fell 13% due to the weak macro environment and a high base effect as the first quarter last year included the Olympic Games and a presidential election in South Korea. Management expects to see display advertising recover during the second half of 2023 as its cost per thousand impressions improves. Further, during the second half of 2023, NAVER intends to release an update to its search business that will feature more AI recommendations and content. This summer, the company plans to also release its large language model, HyperClovaX, which will be the third worldwide. Revenue in the e-commerce business grew at a faster rate than gross merchandise volume (GMV) as NAVER continues to improve its mix of services. Poshmark GMV was up 8%, leading the e-commerce industry, and it reached positive adjusted earnings one year ahead of its 2024 target due to cost cutting and revenue synergies brought on by NAVER. Regarding capital allocation, management noted that over the next three years the company will pay out 15-30% of free cash flow back to shareholders in the form of dividends, allowing flexibility to opportunistically invest more into AI and capital expenditures.
Fiscal 2023 results from Prosus showed healthy growth across business lines with online classifieds growing at 20%, food delivery at 35%, payments at 52% and edtech at 21%. In every business line, Prosus is growing faster than the peer average. Despite the strong growth, spending has also been reduced from the prior year and we believe Prosus is on track to achieve profitability in the first half of fiscal 2025. In addition, management announced a change to corporate structure which eliminates the cross holding between Prosus and Naspers. While we await the full details, we believe it appears to be a fair solution as it reduces complexity, maintains ownership of the assets for both Prosus and Naspers, does not have tax consequences, and allows for continued share repurchases for each company. We met with Chief Investment Officer Ervin Tu after the release, and we believe he is aware of potential areas of improvement at the company and understands the reasons it trades at a discount to its net asset value. He plans to continue reducing complexity, focus on generating attractive returns then crystallizing value, attaining profitability at the major assets, and continue to repurchase shares by selling shares of Tencent.
During the quarter, we purchased shares of ConocoPhillips, Danaher and KKR. We eliminated Berkshire Hathaway Cl B, Bookings Holdings and HCA Healthcare 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 06/30/2023.
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