Commentary

U.S. Equity Strategy

March 31, 2020

THE MARKET ENVIRONMENT

At the start of 2020, it appeared market activity would continue in familiar fashion and largely support key benchmark levels achieved from prior bull market advances. However, by mid-January, developments concerning the coronavirus came to light. What began in late 2019 as an outbreak localized to China spread swiftly and by mid-March, the World Health Organization officially deemed the coronavirus a global pandemic. Equity markets declined precipitously in conjunction with increasingly dire news about the accelerating rate of illness.

The coronavirus quickly disrupted economic activity throughout the country and across sectors from large global enterprises to Main Street businesses. Significant travel restrictions, the shutdown of typical group-gathering activities and orders by many municipalities for residents to stay home upended daily life. U.S. unemployment began to rise with a record three million jobless claims filed in a one-week period, and some economists speculate that the unemployment rate could reach 30%. At the same time, crude oil prices posted the largest quarterly percentage drop on record, owing to a production dispute between OPEC members and Russia. To stem the economic impact, Congress passed a historic $2.2 trillion stimulus package and the Federal Reserve committed to unlimited purchases of Treasurys and other asset-backed securities. Though these actions are extraordinary, economists expect that even more stimulus may be necessary.

Over our decades of experience, we have witnessed other market-rattling crises, each uniquely different from each other. No one knows how this particular issue will be resolved as there is not enough data today to reach specific conclusions. Yet, please be assured that our framework for dealing with exogenous risks like this is to attempt to determine the impact on business value rather than extrapolate near-term costs in perpetuity. In our assessment, equity share price declines have reached levels that are in excess of the actual value declines of businesses we hold. One proactive action we adopt under adverse circumstances is to rebalance our client portfolios. We take advantage of lower equity prices to increase share weightings of companies that, according to our estimates, have become even more undervalued. Although the current situation is changing rapidly, as long-term investors, we focus on rational decision-making and avoid making emotionally driven investing choices. Our investment team remains on vigilant watch for appropriate opportunities today that we believe can yield shareholder rewards over our typical five- to seven-year holding timeframe.

THE PORTFOLIO
Top Performers:
Regeneron Pharmaceuticals issued fourth-quarter results that were stronger than our estimates as well as market forecasts. Total revenue rose 13% from a year earlier to $2.17 billion, propelled by U.S. EYLEA® revenue that grew 13% for the quarter and advanced 14% for the full year. Dupixent® revenue growth was also strong and increased 136% on a global basis in the fourth quarter. Despite a notable increase in operating expenses from drug pipeline expansion and launch investments, full-year earnings climbed 4%. In addition, management conducted its first stock repurchase in the fourth quarter, buying back $250 million worth of shares. Later, news surfaced that BEOVU®, developed by Novartis as a competitor product to EYLEA, was found to cause serious side effects. Investors reacted favorably to market analysts’ reports that this development effectively negates BEOVU’s ability to meaningfully compete with EYLEA. Furthermore, Regeneron has made progress creating a medication to treat coronavirus. With Sanofi, it has entered into a clinical trial program for KEVZARA®, which targets patients diagnosed with severe disease conditions. We are hopeful that Regeneron’s efforts can produce positive outcomes.

Fourth-quarter earnings results from Netflix included paid net additions of 8.8 million, which had exceeded management’s guidance for 7.6 million net additions for the quarter, and for the full year, net additions amounted to 27.8 million. Notably, all regions outside of the U.S. and Canada realized subscription additions in the fourth quarter. Fourth-quarter revenue grew 23% in the U.S. and 40% internationally (not adjusted for currency), which met market forecasts. For the full-year period, earnings margins expanded 300 basis points to 13%, and management reiterated guidance for another 300 basis point expansion in 2020. At the time of the earnings release and prior to the coronavirus pandemic, the company issued expectations for 7 million paid net additions in the first quarter. We continue to believe that Netflix is well positioned for future growth.

We initiated a position toward the end of the first quarter in Reinsurance Group, which is a holding company that is among the largest life reinsurers in the U.S. Fears about fallout from the coronavirus pandemic have depressed the share price of this company, which we now believe incorporates a nearly worst case scenario. In our assessment, Reinsurance Group possesses strong and improving fundamentals. The life reinsurance business accounts for slightly more than half of the company’s net income and faces limited competition. The company’s global financial services business, which includes longevity reinsurance, capital solutions and asset-intensive coverage, is seeing steady growth. In addition, we like the approach of the leadership team at Reinsurance Group, many of whom have spent decades with the company, and we trust that building shareholder value remains a priority for management.

Bottom Performers:
American International Group (AIG) reported fourth-quarter results that included pre-tax income and earnings per share that outperformed market expectations. Notably, pre-tax income and earnings per share recovered from losses realized in the year-ago period and full-year pre-tax income grew nearly three times over what the company achieved in 2018. AIG’s total book value increased 15% from last year to $74.93 and outpaced market forecasts. While these results illustrated reasonable progress, the company’s share price dropped as investors became increasingly concerned about effects from the coronavirus pandemic. In addition, the U.S. Federal Reserve cut key interest rates in response to pandemic-related economic impacts, which prompted market anxiety about the effects lower rates would have on AIG’s earnings. Investors also had fears about the likelihood of impairment to AIG’s large investment portfolios, which consist primarily of bonds. However, we find the company’s bond portfolios still have large embedded gains. Although the ultimate fallout that the coronavirus will have on life and general insurance is unknown, we continue to believe AIG is an attractive investment and are watching the situation closely.

Fourth-quarter results from MGM Resorts International were far weaker than we had expected. Casino revenue in Las Vegas fell 4% year over year, primarily due to an 18% decrease in winnings at table games driven by a decline in the highly lucrative ultra-premium Far East baccarat business. Management withdrew its 2020 targets, citing industry-wide challenges related to the coronavirus outbreak that made near-term results “unpredictable within an appropriate range of accuracy.” The fallout includes large-scale event cancellations, the shutdown of casinos in Macau and curtailed tourism around the world. In addition, MGM announced CEO Jim Murren will step down upon the appointment of his replacement. The cumulative effect of these issues proved overwhelming to investors, who reacted by selling shares of the company. However, quarterly results also had some positive aspects, such as MGM’s continued efforts to monetize its real estate holdings by using the proceeds to de-risk the balance sheet and provide material shareholder returns. The company bought back $1 billion worth of shares in 2019 and the board of directors announced an additional $3 billion share repurchase program while raising the dividend by 15%. We are presently reassessing our valuation metrics and, in the meantime, we remain committed to our investment in MGM.

General Motors (GM) reported fourth-quarter revenue that missed market expectations by roughly 1%, while adjusted earnings per share of $0.05 were four times higher than market projections of $0.01. For the full year, although some metrics modestly trailed our estimates, we viewed overall results as adequate in light of fallout from the strike by United Auto Workers. We later spoke with CEO Mary Barra and CFO Dhivya Suryadevara and discussed coronavirus impacts. Management cites preserving liquidity as a priority and the company’s current liquidity position is solid, by our measure, as total liquidity stands at $31-32 billion. In addition, GM is aggressively cutting costs and is prepared to eliminate $2-3 billion of expenses as a result of plans that it proactively developed to hedge against downturns. Even though an unpredictable macro environment may prove challenging to the company in the near term, we think its leadership team has the wherewithal to handle issues under its control.

During the quarter, we initiated positions in Reinsurance and Workday. We eliminated Aon, American Airlines and Axalta Coating Systems from the portfolio.

Past performance is no guarantee of future results.