THE MARKET ENVIRONMENT
The fourth quarter saw a recovery in U.S. equity markets with all three major indexes finishing higher following declines in the first three quarters of the year. Energy continued to outperform, along with industrials, materials and financials, while consumer discretionary and communication services were the two sectors to have negative absolute returns. Elsewhere, the U.S. 10-year Treasury yield increased 8 basis points to 3.89%. The U.S. Dollar Index declined by over 7.5% after five consecutive quarters of gains. WTI crude remained near $80, which was around its level at the beginning of 2022 and prior to Russia’s invasion of Ukraine.
Investor focus appeared to remain on the Federal Reserve and its efforts to tighten financial conditions, primarily through increases to the federal funds rate and quantitative tightening. The size of rate hikes slowed in December to 50 basis points, following the 75 basis point increases in June, July, September and November. Some economic indicators have offered reason for optimism for those expecting the Fed to pivot, such as lower commodity prices and lower than expected inflation numbers. However, unemployment remains resilient at below 4% and the Consumer Price Index for November came in at 7.1% year-over-year, significantly above the Federal Reserve’s 2% target.
We believe our edge is our process for identifying undervalued businesses with growing values and good management teams and then positioning portfolios with conviction and discipline based on that process. We value companies as if they will have to weather macro-related bumps in the road without trying to be precise as to when this happens. This helps us divorce the investment decision from an attempt to time a business cycle. We believe this approach, paired with our longer time horizon and broad definition of value, enables us to uncover attractive investment opportunities during times of volatility.
THE PORTFOLIO
Top Performers:
Oracle reported fiscal second-quarter results that were solid, in our assessment. Total revenue reached $12.28 billion and drove earnings per share of $1.21, both of which were at the high end of management’s guidance and also exceeded market expectations. Impressively, total revenue grew 25% year-over-year in constant currency and organic revenue (excluding effects from the Cerner merger) increased over 9%. Positive momentum continued to be strong across the business. Revenues from the applications segment rose 9% in constant currency driven by Fusion (+28%) and NetSuite (+29%). Infrastructure segment revenue also rose 9% in constant currency and reached a new high level for quarterly growth, driven by Oracle Cloud Infrastructure and Autonomous Database. Total cloud revenue advanced 48% in constant currency. Notably, CEO Safra Catz stated expectations that organic cloud revenue (ex-Cerner) should grow by greater than 30% in constant currency for the full year. We found Catz’s outlook to be especially meaningful considering the macroeconomic backdrop and commentary from competitors.
Amid volatile markets and currency fluctuations, BlackRock’s third-quarter revenue and operating income surpassed market expectations, and adjusted earnings per share of $9.55 were 35% higher than projections. The company’s assets under management reached $8 trillion, which was somewhat below our forecasts. However, total net inflows were positive at $17 billion for the quarter and would have been stronger if not for the $40 billion in money market outflows that offset decent results for the rest of the firm. Investors de-risking during the reporting period, especially with regard to international stock exposure, also contributed to outflows. We think fourth-quarter net inflows will show improvement as BlackRock still has some institutional mandates to fund and the fourth quarter has been historically strong for ETF flows. Furthermore, management estimated 2022 expense growth of 14%, a downward revision from 20% previously, which to us reflects effective cost control for the year thus far. Late in the year, BlackRock disclosed that after contemplating the acquisition of Carlyle Group, management decided against pursuing the purchase. Our confidence in management’s decision-making ability remains intact.
HCA Healthcare reported third-quarter earnings that generally came in slightly above consensus estimates after removing various one-time items and reiterated full-year guidance for 2022. The core business drivers are healthy, and management is executing well, in our view. Next year, the company will face around $500 million in headwinds to adjusted earnings from various non-recurring items. In addition, volume growth looks like it will be around 1-2% compared to the typical 2-3% due to this year’s higher Covid-19 volumes. We believe underlying volume trends are solid and both acuity and payer mix are stable. Further, HCA is getting traction with payers on passing through price increases for inflation. Contract labor costs appear to be beginning to ease already, and we believe capacity constraints are likely to improve over the next couple of years. We think these dynamics, coupled with the flow through of higher pricing to reflect inflation, should provide tailwinds to adjusted earnings growth.
Bottom Performers:
Amazon’s share price fell following its third-quarter earnings report that provided a disappointing outlook for the fourth quarter. Management guided to $140-148 billion of revenue, which is a 5% increase year-over-year (10% increase in constant currency) and 6% below consensus. This deceleration compares to 15% growth in the third quarter. Management said third-quarter retail sales decelerated throughout the quarter as inflation is hurting discretionary retail budgets. We believe this is a macro issue as Amazon gained market share during the quarter. Retail profitability for the quarter was disappointing at -$2.9 billion, and earnings guidance was only slightly better for next quarter. Retail capital expenditures are being cut and the company is implementing various changes to improve margins. However, these will likely take some time as cost efficiencies will be hard to implement during the holiday season and the company said it does not want to sacrifice customer services to rush profitability measures. Amazon Web Services (AWS) revenue was up 28% year-over-year and 3% below consensus. Demand decelerated throughout the quarter as customers reduced or optimized usage. Margins were below consensus and declined 400 basis points year-over-year as AWS absorbed operating leverage for customers. Management said AWS margins can “fluctuate over time” and they are still investing as the backlog grew 57% year-over-year. While overall profitability was disappointing and a recovery in margins may take longer than expected, we appreciate that management is focused on it, and retail is gaining share. We remain confident in the investment over the long term as the business drivers appear healthy and the lower guidance seems to be mostly a macro and timing issue.
Alphabet’s third-quarter earnings results came in light of consensus expectations on sales and margins and the company’s share price fell following the release. In addition, reported earnings per share were hurt by a nearly $3 billion hit from mark to market losses in equity and debt securities. Despite this, total revenue grew 11% in constant currency and 6% reported to more than $69 billion. Management described fundamental performance in the search segment as “healthy” and attributed the slowdown to foreign currency pressure and current figures going up against strong figures from this time last year. Total operating margin declined to 25% from 32% due to growth in research and development and general and administrative expenses, which was led by headcount growth, promotions, and higher sales and marketing spend on advertisements. We appreciated that both CEO Sundar Pichai and CFO Ruth Porat noted on the call that the company is “sharpening focus” on the biggest growth priorities and “moderating operating expense growth” for 2023.
Warner Bros. Discovery’s third-quarter results were hampered by additional restructuring costs. Despite this, we appreciated that management reiterated 2022 adjusted earnings guidance of $9.0-$9.5 billion, especially considering we estimate they are facing about $400 million of incremental headwinds from foreign currency impacts, merger-related charges and a weakening advertising market. The company also reiterated its full-year free cash flow guidance despite these headwinds, which we believe indicates very healthy free cash flow in the fourth quarter. Importantly, cost synergies from the merger and corrective measures are taking hold, which we believe will lead to improved long-term revenue and earnings growth. We expect the company’s content catalog to be profitably monetized over time—whether through the company’s own streaming services or through licensing content to other platforms.
During the quarter, we initiated positions in American Express, EOG Resources, Fortune Brands Innovations, Masterbrand (spin-off from Fortune Brands), and TE Connectivity. We eliminated Huntington Ingalls, Keurig Dr Pepper, Regeneron Pharmaceuticals, and T-Mobile US from the portfolio.
Past performance is no guarantee of future results.
EBITDA refers to Earnings Before the deduction of payments for Interest, Taxes, Depreciation and Amortization which is a measure of operating income.
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The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000® companies with lower price-to-book ratios and lower expected growth values. This index is unmanaged and investors cannot invest directly in this index.
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