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.
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.
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.
First-quarter results from BNP Paribas were mixed with headline revenue growth up only 1.4%. After adjusting for the partial consolidation of Bank of the West, we find revenue grew about 5.3% year-over-year, mainly driven by strong performance in commercial and personal banking and corporate and institutional banking, which grew 5.9% and 4.0% year-over-year, respectively. The company reported a common equity tier 1 ratio of 13.6%, which grew 130 basis points year-to-date. Notably, BNP generated positive jaws of 30 basis points across its three operating segments as gross income growth exceeded expense growth. Management confirmed its 2022-2025 targets, noting that it was ahead of schedule to reach its net income and earnings per share compound annual growth rates of 9% and 12%, respectively. BNP initiated EUR 2.5 billion in stock buybacks in early March and expects to begin the remaining EUR 2.5 billion of its authorization in September. The company’s EUR 5 billion in buybacks and its dividend of EUR 3.90 per share will result in a total capital return yield of 14.1% in 2023, while remaining significantly overcapitalized. Beyond 2023, we appreciate that management plans to return 60% of earnings to shareholders with strong net income growth.
Sentiment in Chinese equities has degraded after the initial excitement from China’s reopening earlier in the year. Incremental macroeconomic data coming out of China indicates that the Covid-19 re-opening bounce is fading, and the economy is struggling to sustain healthy growth. As the largest e-commerce platform in China, Alibaba’s share price has been caught up in this storm. The company has also continued to face intense competition from the likes of short video players and traditional e-commerce companies. Despite these negative factors, Alibaba remains an extremely important platform in China and continues to generate significant free cash flow. In the most recent completed fiscal year, the company generated $25 billion of free cash flow, which is 12% of the current market capitalization. Its core commerce business trades at approximately 5x adjusted earnings, a valuation we deem much too cheap, even with the headwinds noted above. Alibaba’s management team has been aggressive with share repurchases and recently formed a capital management committee. In addition, the company recently announced a major restructuring that will effectively break up the company and separately list various businesses within Alibaba. Today, the market is assigning little to no value to these businesses and having a market quote may force investors to give Alibaba value for these assets. Irrespective of whether the restructuring works or not, we appreciate management’s efforts to help unlock value in what, we see, is clearly an undervalued stock.
Worldline reported first-quarter results largely in line with prior guidance. Organic growth was up 9.2% with merchant services continuing to drive growth, up 12.6%, due to continued strong transaction volume growth in store (11%) and online (19%). Going forward we expect merchant growth to benefit from the lapping of the 2% Russia-exit headwind and pricing initiatives. In addition, a rebound of Chinese travel to Europe should prove beneficial as Worldline is Europe’s top partner for UnionPay, Alipay, and WeChat Pay. Financial services grew 2.3%, in line with management’s expectations; and full-year guidance reiterated 8-10% organic revenue growth, a 100-basis point margin improvement, and 46-48% free cash flow conversion. Management noted that Worldline’s new partnership with Credit Agricole (CA) will allow the company to enter the French merchant acquiring market, which we view as an attractive opportunity. France is a EUR 700 billion payment volume market that has been closed to non-bank merchant acquiring, and CA holds around 25% market share within France. We recently met with Worldline’s CEO and CFO, Giles Grapinet and Gregory Lambert, who remain optimistic on the company’s ability to reach its organic growth target for 2023 despite the potential macro headwinds. Management plans to focus on improving margins and utilizing a more structured capital allocation framework which should shift growth to be primarily organic. Further, the reduction of costs from merger and acquisition integration and platform consolidation should result in an acceleration in margin improvement. As the company finishes its asset integration in 2024, management noted the duplicative costs of the business should come down, and its efforts to move workloads to the cloud will lead to additional cash cost reductions.
Kering reported first-quarter results with revenue growth of 1% year-over-year in constant currency, against a 21% increase for the same period the year prior. The business improved sequentially throughout the quarter with March retail sales up 12%. Total growth was weighed down by an accelerated pullback from the wholesale channel at Yves Saint Laurent (YSL) and Bottega Veneta and a 32% drop at the other houses segment. Balenciaga grew in the first quarter, despite the brand still recovering from its controversial campaign last November, driven by double-digit growth in Asia. Management expects mid-single-digit growth this year for Gucci after its 1% growth during the first quarter and is pleased with the progress in elevating the brand. Management reiterated that for the full year, growth in Gucci will be flat to slightly up, YSL is expected to expand, and other houses may be driven down by wholesale rationalization.
During the quarter, we purchased shares of Danaher, IQVIA Holdings and Kroger. We eliminated Booking Holdings 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.
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