THE MARKET ENVIRONMENT
Similar to the year 2016, 2020 was a year of extremes driven by exogenous factors ranging from the Covid-19 pandemic to Brexit negotiations with elections in between. Most recently, markets reacted favorably to events in the fourth quarter, particularly the approval and emergency use authorization of multiple vaccines aimed at preventing the spread of Covid-19.
Meanwhile, the U.K. and European Union negotiated arduously in the quarter, finally accomplishing an agreement that eliminated the possibility of a hard Brexit outcome. In the U.S., the four-year presidential election cycle produced a more balanced outcome than many had expected. The market proved relieved at both the elimination of uncertainty and the lower probability of big changes. Later in the fourth quarter, President Trump signed the country’s long-debated second economic relief bill into law, sending direct payments to some individuals and families as well as further extending unemployment benefits.
These events propelled equity prices higher across the globe for a strong finish to a year that had earlier experienced a bear market. Ultimately, the Nikkei 225 Index soared to a 30-year high in Japan, the German DAX Index surged to a record figure, and both the Dow Jones Industrial Average and S&P 500 Index closed out the year at record levels.
This year amounted to a volatile 12 months for investors. Though traumatic and difficult to tolerate, we recognize that market instability can unearth investment opportunities for those who are patient and willing to weather the storm. In times when others chase performance or lose conviction based on news headlines and irrational reactions, we remain alert to subsequent opportunities caused by short-term investors to build positions in quality companies that are trading at large discounts to our perception of their intrinsic value. This discipline is deeply embedded in our philosophy and process.
Early in the quarter, Glencore released a nine-month production update with output for copper and zinc that outpaced market expectations, while nickel, coal, ferrochrome and oil fell short of forecasts. Management adjusted full-year guidance for coal to be lower and left all other projections unchanged. We found nothing remarkable in the update, and management’s guidance remained largely aligned with our estimates. Later, Glencore and China-based GEM announced a five-year partnership extension for the supply of cobalt. During its annual investor update in December, Glencore revealed the upcoming retirement of current CEO Ivan Glasenberg in June of 2021. While we did not find the announcement itself surprising, the timing is earlier than we had anticipated. The company attributed the short timeline to the combination of the establishment of the next generation of management (all internal appointments) with the recovery and strength of the business today. We appreciate that the newly appointed CEO Gary Nagle has a history in the coal business (similar to Glasenberg) and has been with Glencore his entire career. The company noted the emphasis on decarbonization will benefit Glencore as the International Energy Agency’s transition scenario anticipates demand for copper to double from 2019 to 2050. In our view, the company remains attractively priced given positive market trends and the potential to unlock value internally.
CNH Industrial’s third-quarter earnings report bested investors’ expectations and was solid, by our measure. Results were driven primarily by the agriculture equipment business where local currency revenue increased by nearly 14% in the third quarter (following a decline of 11% in the first half), helped by higher commodity prices, various government support programs and demand for replacement equipment. Agriculture earnings improved over 80% year-over-year as margins expanded from 6.2% to 10.1%. In addition, segment performance in the near term looks promising as order books are up double-digits in all four regions. In the construction equipment business, performance improved in comparison to the first half of the year, and the Iveco business experienced a strong recovery in the European light truck market, which advanced 7%. Free cash flow amounted to nearly $1 billion in the third quarter, which was an almost $2 billion improvement year-over-year. Capital expenditures also remain below our expectations as the company is focusing on cash conservation. Furthermore, CNH raised its guidance for industrial sales and industrial free cash flow. Later, the company announced Scott Wine, former chairman and CEO of Polaris, as its new CEO, and we discussed the transition process with Chairman and interim CEO Suzanne Heywood. Heywood believes Wine’s broad experience at Polaris provides the background necessary for his role at the company. CNH’s strategy will remain intact under Wine, reaffirming a commitment to split the on-highway business into a separate company and the aggressive financial targets announced in September of 2019, though the timeline for achieving these goals was pushed back.
The share price of Lloyds Banking Group rose in the third quarter partly from positive Brexit deal developments. A late-quarter trade agreement between the U.K. and European Union secured a new economic and security partnership, which reassured investors. Lloyds also released third-quarter earnings that we found to be reasonable considering present macroeconomic conditions. For the full fiscal nine-month period, total revenue fell 17% and underlying operating profit declined 85% from a year earlier. Results were significantly impacted by impairment charges that rose dramatically (+334%) for the full period. However, the vast majority of the impairment charge increase occurred in the first two quarters and eased in the third quarter, which helped drive strong sequential growth of underlying operating profit that totaled GBP 1.2 billion. Other important metrics showed evidence of improvement as well, including retail deposits that rose 7%, which resulted in a loan-to-deposit ratio of 98%, reflecting a healthy liquidity position. Importantly, Lloyds’ balance sheet remains strong as its common equity Tier 1 ratio reached 15.2% in the third quarter (up from 14.6% in the second quarter), which exceeded both management’s target of 12.5% and regulatory requirements of roughly 11%. Management cited additional encouraging signs of a business recovery, including increased mortgage activity, that we think positions the company advantageously as the general economy normalizes. As we have expressed previously, we contend that Lloyds possesses a wide range of strengths to draw upon to reinforce its business during current near-term challenges. Even including its strong fourth-quarter stock price performance, we still believe the company’s shares remain undervalued compared with our estimate of intrinsic value.
Alibaba Group released fiscal second-quarter earnings results that were mixed, in our view, though revenue, adjusted earnings and earnings per share all outpaced market forecasts. Highlights included total revenue growth of 30% from last year, partly driven by a 20% revenue advance in the core e-commerce business that exceeded overall market growth of 17%. Adjusted earnings rose 28% year-over-year and annual active consumers increased 9%. However, we found it disappointing that the operating margin contracted from a year ago, which management attributed to business reinvestments. Later, Alibaba’s share price declined sharply as the company faced regulatory challenges that stemmed from the new anti-monopoly law in China. In addition, the suspension in November of the highly anticipated initial public offering of Ant Group, in which the company holds an approximately one-third ownership stake, also caused investor concern. The increased regulations on both Alibaba and Ant are still in the consultation phase and have not yet been finalized. While we find it difficult to accurately quantify the associated risks, we believe it is likely Alibaba will face greater regulatory scrutiny and slower growth going forward. However, the company remains an important driver of innovation in China and even considering the slower growth, we believe its valuation is compelling. In the meantime, we continue to monitor the situation, which remains fluid.
Fresenius Medical Care realized third-quarter revenue that met market expectations, while earnings and earnings per share exceeded market forecasts by 2% and 5%, respectively. We saw results as mixed. The international and care coordination segments returned to growth, but Covid-19 weighed on treatment volumes in the U.S. Total revenue was relatively unchanged from the prior year, while net income rose 6% and earnings per share advanced 9%. However, organic revenue growth in the core North American dialysis service business contracted, which reflected a deceleration from the second quarter and partly stemmed from lower than normal referral rates, which investors found concerning. Although we view this issue as temporary because patients will eventually need dialysis services, the current slowdown dampens Fresenius’ pipeline and softens near-term growth.
During the quarter, we initiated positions in Restaurant Brands International and Roche Holding. We eliminated Baidu and Ferguson from the portfolio.
Past performance is no guarantee of future results.
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