Commentary

U.S. Equity Strategy

December 31, 2019

THE MARKET ENVIRONMENT
At the outset of the fourth quarter, investors faced a continuation of some unresolved difficulties that started the year. In typical fashion, markets reacted to news that was mainly driven by “Deal or No Deal” issues, such as U.S. trade disputes with China along with Mexico and Canada. Late in the quarter, the U.S. and China reached a partial trade deal, and a new version of an agreement between the U.S., Mexico and Canada moved toward implementation in 2020. Because these developments have provided more solid foundations for businesses to make capital allocation and investment decisions going forward, 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.

Economic indicators also influenced markets, with positive news largely outweighing negative news. Disappointing data included gross domestic product growth of only 2.1% in the third quarter, well short of comparable 2017 and 2018 quarters as well as policy-makers’ targets. In addition, the Institute for Supply Management indicated that manufacturing activity continued to contract as new orders declined in November for the fourth consecutive month. Meanwhile, the unemployment rate remained at a multi-decades low level, new residential home sales rose nearly 17% year-over-year in November and November construction of new homes grew 3.2%, which reflected a 12-year high level. Furthermore, in a survey conducted by Bankrate, the country’s top economists revealed that although some areas of the economy have slowed, there is only about a 35% chance that a recession will occur within the next year as trade war-related threats have moderated. Importantly, consumer spending, a key economic growth driver, was strong. Retail industry experts reported November sales increased 2.1% from a year ago with record-setting Black Friday and Cyber Monday online holiday spending followed by Super Saturday spending that exceeded $34 billion, making it the largest single retail sales day in U.S. history.

Owing to our experience, we are prepared to confidently navigate a wide array of macro environments. We apply the same disciplined investment approach when markets advance as well as when markets retreat. Throughout our history, we have implemented a consistent philosophy and an intensive research process. We continue to stay alert for attractive investment opportunities while ensuring that our clients’ goals remain at the forefront.

THE PORTFOLIO
Top Performers:
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.

Charter Communications delivered solid third-quarter earnings results as strong residential broadband subscriber net additions amounted to 351,000 (compared with market expectations for net additions of 277,000), which led to a subscriber growth rate of 5.4% (the highest since 2017). In addition, capital intensity continues to decline. Management expects cable segment capital expenditures will be lower than previous guidance and anticipates a further capital intensity decline in 2020. Furthermore, recent price increases are not yet reflected in the income statement, and we think price growth should drive further margin expansion next year. Charter also repurchased 2.5% of its shares outstanding in the third quarter, adding to our confidence in its commitment to adding value for its shareholders.

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.

Following news in October that the United Automobile, Aerospace and Agricultural Implement Workers of America (UAW) union ended its strike against General Motors (GM), the company issued third-quarter results with total revenue and earnings per share that surpassed market expectations. We believe the quarterly report illustrated that GM’s underlying business remains strong (led by the crucial North American truck/SUV franchise). And although the UAW strike resolution took longer and was more contentious than had been anticipated, it did not impair the company’s competitiveness, flexibility or earnings power. Management sized total strike-related costs at approximately $3 billion and revised some full-year estimates lower, which may have unnerved investors. In addition, news that GM filed a racketeering lawsuit against competitor Fiat Chrysler in November surprised investors. The company accused Fiat of bribing the UAW to achieve lower labor costs and operational advantages. The market is speculating that it will be hard for GM to win damages and may escalate spending for legal fees. In our view, the company’s competitive position remains solid owing to its “transformative cost cutting program,” a strong new product platform, and leadership in autonomous and electric vehicles.

During the quarter, we initiated a position in Berkshire Hathaway. There were no final sales during the quarter.

Past performance is no guarantee of future results.