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.
BNP Paribas reported third-quarter total revenue of EUR 12.31 billion and net income of EUR 2.76 billion, which both outpaced market expectations. More importantly, we were pleased that for the full fiscal nine-month period, the company’s key metrics were in line with our estimates. Excluding the Bank of the West subsidiary results, nine-month revenue rose 9.3% from the same period last year to EUR 36.3 billion and operating income advanced 16.8% to EUR 10.2 billion, while the cost of credit fell 5.3% to EUR 2.3 billion. Notably, despite more difficult market conditions, revenue generation was strong across the core operating divisions, driven by the corporate and institutional segment and commercial and personal banking, which saw year-over-year revenue increases of 14.9% and 9.8%, respectively. In addition, compared with last year, loan and deposit volumes were quite robust in BNP’s primary markets as France (loans +4.3%; deposits +5.7%), Italy (loans +2.7%; deposits +10.3%) and Belgium (loans +14.8%; deposits +9.5%) all experienced a significant acceleration in activity. Lastly, the company’s capital position remains solid with a fully phased common equity Tier 1 ratio of 12.1%. We are satisfied with BNP’s fundamental performance.
Third-quarter results from Allianz were solid, from our perspective, and exceeded our expectations for operating profit and solvency. Both net income and operating profit were also ahead of market forecasts. Notably, total operating profit advanced 7.4% year-over-year, driven by the property and casualty segment where organic operating profit advanced 8.8%. Profits were helped by price increases that management implemented to counteract cost inflation of between 5% and 6% in the third quarter. Nearly all underlying operating entities are growing with the most significant advances occurring in the credit insurance, Allianz Partners (travel) and Allianz Global Corporate & Specialty (business and specialty risk insurance) units as well as in higher inflation geographies. Although the life and health insurance and asset management segments are seeing challenges that weighed on operating profit, we believe these issues can be rectified within the next couple of quarters. In addition, the company’s solvency capitalization ratio is now 199%, which we assess to be very healthy. Management now believes that full-year operating profit will reach the upper end of its EUR 12.4-14.4 billion guidance range. Lastly, Allianz announced a new EUR 1 billion share repurchase plan and indicated that significant capital returns can continue at current levels.
Mercedes-Benz Group’s nine-month update revealed another set of strong results, in our view. Unit sales in the cars segment increased 38% year-over-year in the third quarter, albeit against a prior set of results that were pressured by production challenges. Margins improved year-over-year due to the pricing and volume benefit, despite higher commodity as well research and development costs. Management appeared more optimistic than peers on European demand, noting “continuous good demand” and a long order book that will carry them well into next year. Battery electric vehicle sales rose 183% year-over-year and represented around 7% of total volume, which were supported by the launch of the EQS SUV. The financial services business is seeing continued low credit losses, but credit reserves are increasing due to the weaker macro -outlook. At the same time, penetration is decreasing due to high interest rates and interest margins are under some pressure. Despite this, Mercedes still expects a 16%-18% pre-tax return on equity in 2022.
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, DSV and Intercontinental Exchange. We eliminated Citigroup, Compass Group, Fresenius Medical Care, Grupo Televisa ADR, Keurig Dr Pepper and Richemont from the portfolio.
Past performance is no guarantee of future results.
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