Commentary

Global 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:
BNP Paribas delivered a positive third-quarter earnings report with total revenue of EUR 10.90 billion, pretax income of EUR 2.81 billion and net income of EUR 1.94 billion, all of which exceeded market forecasts. For the full fiscal nine-month period, underlying results were good, by our measure, with constant currency revenue growth from core divisions of 2.8% and operating expenditure growth of only 0.8%. In addition, loan growth for the third quarter increased 5.5% year-over-year. Importantly, the company generated operational leverage across all three segments following low growth in operating expenditures in the first half of the year. In our view, BNP continues to benefit from its 2020 Transformation Plan, which has now generated cumulative savings of EUR 1.5 billion since 2017 and is on track to generate EUR 3.3 billion in savings through 2020. The company’s CET1 ratio expanded 10 basis points sequentially to 12.0%, in line with management’s target, which, in our view, positions it for an increased scope of shareholder capital returns. We believe that BNP is a solid investment that should reward shareholders into the future.

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.

Hilton Worldwide released third-quarter results that we saw as solid, despite a slowdown in the overall macro environment. Adjusted earnings and earnings per share rose 9% and 13% year-over-year, respectively, and exceeded market forecasts. Management slightly raised the full-year guidance range for earnings per share (from 3.78-$3.85 to $3.81-$3.86) and slightly adjusted earnings guidance (from $2.28-$2.31 billion to $2.285-$2.305 billion). The company continues to gain market share across all brands and regions and full-year 2019 is on pace to be the fifth consecutive year of net unit growth in excess of 6%. Importantly, Hilton’s development pipeline remained robust through the third quarter (with more than 2,530 hotels consisting of nearly 379,000 rooms throughout 111 countries and territories) and was tracking modestly above management’s expectations.

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.

The share price of Liberty Global declined mainly in November when the company reported third-quarter operating cash flow from continuing operations of $1.21 billion, which undershot market expectations of $1.28 billion. However, total revenue was in line with forecasts and management left full-year targets for operating cash flow, adjusted free cash flow, and property and equipment additions unchanged. Lutz Schüler, the new CEO of Virgin Media, presided over the earnings conference call and stated that the quarter was very challenging. Revenue generating units (RGU) at Virgin Media, a key asset for Liberty, declined by 53,000 in the third quarter compared with an addition of 105,000 in the year-ago quarter. Video and telephone RGUs dropped by roughly 50,000 and 9,000, respectively, while broadband RGUs increased by 5,000. RGU losses were due to Virgin Media implementing a larger and earlier than usual price increase this year, which caused a higher amount of client churn; a weak macro environment in the U.K., which resulted in falling RGU growth across the entire industry; and the company intentionally not marketing to low-end video subscribers. Nevertheless, Schüler implied that RGUs would improve in the fourth quarter and he also expects fully enacted price increases will work to boost revenues.

During the quarter, we initiated a position in Berkshire Hathaway and eliminated Danone and General Electric from the portfolio.

Past performance is no guarantee of future results.