Commentary

Global Strategy

September 30, 2020

THE MARKET ENVIRONMENT

During the third quarter, global markets continued to contend with the economic ramifications of Covid-19 as worldwide fatalities surpassed the grim 1 million mark. In August, the U.S. Federal Reserve announced a policy change that indicated it would not necessarily increase interest rates upon an improvement in unemployment figures, even if inflation is above the group’s traditional 2% target. At its September meeting, the Fed maintained near zero interest rates and publicized intentions to keep them at this level through 2023. Meanwhile, both the S&P 500 Index and the NASDAQ Index closed near peak levels in the quarter. Ultimately, the Fed raised its forecast for full year-2020 gross domestic product (GDP) from a 6.5% contraction to a 3.7% contraction.

Similarly, both the European Central Bank and the Bank of Japan opted to keep interest rates steady in September. In Japan, the Nikkei 500 Index reached a record high, while industrial profits in China increased 20% in July and 19% in August. Conversely, the U.K. moved into a technical recession following a roughly 20% contraction in GDP in the second quarter, the largest on record, which followed an approximately 3% contraction in the first quarter. As of the end of the third quarter, the country had yet to secure a Brexit trade deal with the European Union. Furthermore, continued Covid-19 concerns and Saudi Arabia’s plans to cut oil prices translated to a decline in both West Texas Intermediate crude and Brent crude to less than $40 per barrel.

On the vaccine front, China indicated a Covid-19 vaccine may be ready for public consumption as early as November. Meanwhile, a leading vaccine candidate from the University of Oxford and AstraZeneca was halted again in September when a participant in its trial became ill. On the other hand, Johnson & Johnson’s vaccine candidate moved into Phase 3 of its clinical trials, the first single-dose vaccine in the U.S. to do so.

In our view, there is a lot of value in the market today. Though the near-term macro outlook may be mixed, positive vaccine developments or further signs of economic recovery from the initial shock of Covid-19 could improve market sentiment. In the meantime, we are finding good opportunities from a valuation perspective and think it is a ripe environment to be picking stocks.

THE PORTFOLIO

Top Performers:
Considering the operating environment, we found Daimler’s second-quarter earnings results to be acceptable. Though year-to-date Mercedes-Benz cars and vans volumes are down 22% and 29%, respectively, we appreciate that revenue in the segment is only down 14.8%. We think this reflects significant product mix benefits within both markets as well as resilient pricing dynamics. China also contributed with 17% year-over-year growth, despite the overall Chinese auto market being down 4%. Free cash flow was also significantly stronger than had been expected and we believe this is a result of management’s stringent focus on improving cash flow generation. As a result, Daimler ended the second quarter with a strong net financial position and provided earnings guidance that was better than had been anticipated. We believe these results reflect well on the new management team. Later, Daimler announced that it reached an agreement in principle with various U.S. authorities to settle civil and environmental claims regarding emissions control systems on about 250,000 diesel passenger cars and vans in the U.S. The company also reached an agreement with the plaintiffs’ counsel to settle the ongoing class action lawsuit. Importantly, the costs associated with the settlements are covered by existing provisions, which removes a material area of uncertainty for Daimler.

Second-quarter results from Berkshire Hathaway far exceeded market forecasts. Total net income rose 87% from a year earlier to $26.3 billion. Earnings per share (Class B) advanced year-over-year by about 90% to $10.88 compared with market projections of $2.12. The company achieved this strong financial performance despite realizing a goodwill write-down of nearly $10 billion in aerospace parts supplier Precision Castparts. Berkshire implemented some corrective measures in this business, such as aggressive restructuring to cut costs and workforce reductions amounting to 30% of year-end 2019 headcount. In addition, management’s share repurchase activity has accelerated. The company bought back $1.7 billion worth of shares in the first quarter, $5.1 billion in the second quarter and another $2.7 billion in July. Lastly, the company purchased initial public offering shares of Snowflake, a cloud database firm, as well as additional shares from another stockholder. While this purchase is seemingly out of character for Berkshire because CEO Warren Buffett usually avoids new stock offerings, the investment works to expand the company’s technology exposure. Notably, the purchase was immediately profitable as Snowflake’s price rose by about 111% when trading began on the open market, which increased Berkshire’s stake to about $1.55 billion from the approximate $730 million initial investment.

HCA Healthcare delivered strong second-quarter earnings results, by our standards, with total revenue of $11.07 billion, which was nearly 10% higher than market forecasts. Adjusted earnings, including the CARES Act stimulus, reached $2.67 billion, which was twice the amount the market had expected, and excluding stimulus, earnings outpaced market estimates by 72%. Inpatient admissions improved throughout the quarter as government restrictions eased. We also like the company’s efforts to cut costs during this period of disruption. Later, investors became anxious that the pending appointment of a new Supreme Court Justice may put the future of the Affordable Care Act at risk, which could impact HCA’s business. However, the company’s current liquidity position is strong with several billion dollars in positive free cash flow expected this year. In addition, we find HCA’s management team is increasingly confident about its ability to scale the business up or down in response to a range of scenarios.

Bottom Performers:
We saw Bayer’s second-quarter results as satisfactory, driven by year-over-year revenue growth in the crop sciences segment of 3.2% (+4.6% for the fiscal first half). While quarterly revenue declined in the consumer health segment, fiscal first-half growth of 5.7% showed strong year-to-date momentum mainly from nutritional products sales that rose 14.4% in the quarter and 23.7% for the fiscal first half. Notably, margins expanded across segments compared with the prior year and were better than our estimates in the crop sciences and pharmaceuticals segments. We spoke with CEO Werner Baumann who expressed that results largely aligned with management’s expectations. With regards to Covid-19, Baumann believes that although negative effects may linger in the pharmaceuticals and crop sciences segments, consumer health should continue to realize benefits from enhanced demand for over-the-counter medications/products. Later, Bayer confirmed 2020 guidance and stated expectations that total 2021 revenue will remain roughly unchanged from 2020 and core earnings per share will be slightly below 2020 levels at constant exchange rates. While revenue forecasts largely met market forecasts, earnings per share undershot estimates by about 10%, which proved disappointing to investors.

BNP Paribas reported second-quarter results that we saw as solid. Although net income fell 6.8% from a year earlier to EUR 2.30 billion, it far outpaced market expectations for EUR 1.46 billion. Total revenue and profit before tax were also stronger than predictions. Results were driven in part by a surge in fixed income trading revenues with a strength in corporate and institutional banking that offset weakness in retail banking (due to lower interest rates) and international financial services (from weaknesses in insurance and wealth management coupled with negative currency effects). Results were also helped by lower than forecast provisions for bad loans, which investors found concerning, and market analysts questioned whether BNP had enough capital reserves to cover the expected losses from loan defaults. The company booked EUR 1.5 billion of loan loss provisions in the second quarter after reserving EUR 1.4 billion in the first quarter and increased its full-year cost of risk by EUR 800 million over the prior year. We note that it is difficult to predict precisely how much capital to set aside for credit losses and trust that management will make adjustments as warranted. Meanwhile, BNP’s common equity tier 1 ratio increased by 40 basis points from the prior quarter and finished the second quarter at 12.4%, which indicates to us a strengthening capital position.

Citigroup’s share price declined as Covid-19-related concerns pressuring the financial sector persisted. However, despite a difficult operating environment, the company reported second-quarter results that reflected solid execution, from our perspective, and were generally consistent with our expectations. While revenue grew 5% from a year ago, earnings per share declined, though both surpassed market forecasts. Expenses decreased modestly, which led to a 13% increase in pre-provision net revenue, and accelerated trading and investment banking activity drove an advance of 68% in fixed income revenues. Nevertheless, investors may have been concerned that global consumer banking revenues fell 10% as spending slowed materially due to the pandemic. It is important to note that Citigroup has remained profitable throughout the Covid-19 crisis and continues to operate with significant excess capital relative to regulatory minimums even though the company added more than $10.5 billion to credit reserves year-to-date. In our assessment, the management team is suitably equipped to navigate the near-term challenges brought about by the Covid-19 pandemic.

During the quarter, we initiated new positions in Automatic Data Processing, Fresenius Medical Care and Keurig Dr Pepper. We eliminated our positions in Kuehne + Nagel, Reckitt Benckiser Group, Regeneron Pharmaceuticals and Taiwan Semiconductor.

Past performance is no guarantee of future results.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.

The NASDAQ Composite Index is a broad-based market-capitalization weighted index of all common type stocks on the NASDAQ Stock Market, including common stocks, American depositary receipts, ordinary shares, shares of beneficial interest or limited partnership interests, and tracking stocks. The index includes all NASDAQ listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures. This index is unmanaged and investors cannot invest directly in this index.

The Nikkei 500 Stock Average is a price-weighted average of 500 Japanese companies listed in the First Section of the Tokyo Stock Exchange. Constituents are selected based on liquidity and industry representation. 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 composite as of 09/30/20.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.