THE MARKET ENVIRONMENT
Major global markets continued to experience pressure and volatility in the third quarter as investors reacted to prevailing challenges facing economies across the world. Efforts by central banks to reign in elevated inflation by tightening financial conditions were at the forefront of financial discourse with investors reducing exposure to assets, such as equities, as interest rates climb at aggressive paces. In the U.S., the Federal Reserve raised its benchmark interest rate by 75 basis points in July and again in August to 3.00–3.25%. Importantly, rhetoric following each decision was noticeably hawkish as Fed Chair Jerome Powell looked to emphasize the Federal Open Market Committee’s commitment to regaining price stability with further rate hikes, even at the expense of economic hardship. The Bank of England, Bank of Canada and European Central Bank all increased their respective benchmark rates in September by 50, 75 and 75 basis points, respectively. China and Japan’s central banks opted for more accommodative policies. Major currencies including the pound, yen, euro, Australian dollar and Swiss franc all depreciated against the dollar throughout the quarter.
Late in the quarter, newly elected U.K. Prime Minister Liz Truss created some volatility in markets when she announced plans for an unfunded tax cut totaling GBP 45 billion per year in hopes of easing citizens financial burdens and spurring economic growth. The 30-year yield for a U.K. government bond jumped nearly 150 basis points in under a week to nearly 5% before settling at around 3.8%. The Bank of England reacted by purchasing gilts to stabilize the market and delayed its planned quantitative tightening program of selling gilts.
While we do not overlook the negative impacts the war in Ukraine, tightening financial conditions, energy crisis and volatile currencies will continue to have, we remain cognizant that a company’s value is derived from its longer term cash flows discounted back to the present day. As share prices fall across the board, we rely on our disciplined approach to identify exceptional businesses overpenalized by share price activity. In our view, risk is not synonymous with owning equities during times of market turmoil. Rather, we believe owning companies that meet our rigorous criteria at discounted levels offers an attractive opportunity on a risk to reward basis.
HCA Healthcare’s second-quarter results were strong, in our view, with revenue and earnings that surpassed market expectations. Investors were positively surprised that management maintained its full-year guidance, especially in light of the pre-announcement that reflected underperformance from Universal Health Services and dampened health care sector expectations. HCA realized year-over-year same facility gains in equivalent admissions and revenues for equivalent admissions and inpatient admissions. Expenses for salaries, benefits and supplies were lower than market projections, which led to an earnings margin that was 140 basis points better than had been predicted. Management commented that the company’s various cost initiatives are working as planned and should alleviate concerns about labor cost pressure. In addition, HCA bought back $2.7 billion worth of shares in the second quarter and had $3.8 billion remaining under its current repurchase authorization. Finally, CEO Sam Hazen and CFO Bill Rutherford stated they are pleased with the progress made in contract negotiations with payers, particularly with respect to pricing for inflation over the next couple of years. Importantly, management reiterated confidence that HCA’s long-term growth and margin profiles remain unchanged.
Amazon’s second-quarter results showed accelerating revenue growth for the retail segment and further progress in its effort to control variable costs, despite inflationary pressures. Total revenue for the period grew 7% year-over-year, including 33% for Amazon Web Services (AWS) and 3% for retail. Management believes that as demand accelerates with restrained investment, higher network utilization should improve margins. Guidance calls for 13-17% year-over-year sales growth for the third quarter. AWS continues to show strength, in our view, with impressive growth and a 29% margin, which was temporarily pressured by the building of new data centers to support the accelerating cloud transition. We see secular megatrends in e-commerce and cloud computing, where it remains a leader in both industries, continuing as tailwinds for the company’s growth, in our view, offering a compelling reason to own.
In our view, Fiserv delivered good second-quarter earnings results in July, including 12% organic revenue growth that remained ahead of analysts’ estimates. We appreciate that each segment performed well, led by the merchant acquiring business, which achieved 17% organic growth. In addition, the fintech segment grew 7%, and the payments and networks division accelerated to 8%. Despite a challenging inflationary environment that pressured margins, Fiserv anticipates a recovery in the second half of the year and also increased its 2022 organic revenue guidance. In our view, Fiserv is benefiting from the continued secular shift toward electronic payments and digital banking. We think the mission-critical nature of Fiserv’s products and its positive track record in down markets gives us confidence in the company’s ability to withstand today’s headwinds and thrive into the future. We believe the company has been unfairly penalized by the market as “buy now pay later” and other payments companies have seen their multiples compressed. We see this as an attractive opportunity based on our belief that it is a solid business with an attainable path to healthy growth.
Charter Communications reported second-quarter revenue of $13.6 billion and adjusted earnings of $5.5 billion, both of which outpaced market expectations. Revenue rose 6.2% from a year earlier and earnings grew 9.7%. However, investors may have focused on the company’s broadband subscriber net loss of 21,000 (which included the reduction of 59,000 government subsidy customers). Management attributes the weak broadband results largely to low residential relocation activity and the return of college seasonality. In addition, while capital expenses were 5% higher than the market had predicted, capital expenses from core cable operations continue to decline and are trending well below our maintenance forecast. Furthermore, just prior to the company’s earnings release, a Texas jury awarded $7 billion in damages to the family of a customer who was murdered by an off-duty technician. Later, a judge reduced the settlement to $1.15 billion. Charter plans to appeal and stated that a criminal background check conducted on the employee showed no arrests, convictions or other criminal behavior. We are following the situation closely and will adjust our metrics as appropriate.
Credit Suisse expectedly delivered a set of disappointing first-half results, due to both financial markets headwinds and company-specific factors. Despite this, we appreciated that the core wealth management franchise had strong performance and loan loss provisions are tracking well below estimates. Importantly, capital levels were a bit higher than expected with the company’s common equity tier 1 ratio at 13.5% and management expecting it to remain near that level for the second half of the year. Operating expenditures were elevated due to several factors, although management reiterated its belief that it will reach its goal for the medium term, aided by its anticipated savings of CHF 650 million from digitalization initiatives and over CHF 200 million from procurement initiatives. The company also announced the departure of CEO Thomas Gottstein who will be replaced by its former Head of Asset Management Ulrich Körner. In addition, the company is looking closely into its investment banking segment through a strategic review where it is likely to make substantial cuts to transform it into a capital-light, advisory led banking business with a reduced absolute cost base in the medium term. We appreciate management’s effort to reduce tail risk by shrinking and simplifying the investment banking segment and allocating more capital toward the higher returning wealth management franchise. In our view, the market is over-penalizing Credit Suisse due to its past errors, and on a forward-looking basis, we believe the franchise has attractive assets and an attainable path toward stronger performance that will benefit current shareholders.
Given the Chinese lockdowns and difficult macro environment, recent results for Alibaba Group were suppressed as well as for Chinese internet companies in general. Despite the difficult background, Alibaba Group’s first-quarter results beat consensus estimates for revenue and adjusted earnings. Last quarter, management noted its intentions to begin cutting costs and focusing more on quality growth and efficiency, which was evident in this quarter’s results. Losses in many businesses were reduced and margins increased 390 basis points sequentially. The company’s CFO stated that cost cutting would continue throughout the year and expectations are for earnings and margins to improve. We appreciate the steps management is taking to improve what they can control, while respecting that the company’s topline will remain uncertain given the tough environment. However, we believe the company is well positioned to grow per share value for shareholders over the long term.
During the quarter, we purchased shares of Kering and Warner Bros. Discovery. We eliminated Comcast and Toyota Motor from the portfolio.
Past performance is no guarantee of future results.
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