Commentary

U.S. Equity Strategy

September 30, 2022

THE MARKET ENVIRONMENT

U.S. markets continued to experience pressure and volatility in the third quarter as investors digested the effects of tightening financial conditions across the globe. By mid-August, the S&P 500 was up nearly 15% quarter-to-date but gave up those gains and then some over the following six weeks. This is the second largest intra-quarter gain the S&P 500 has backpedaled from to end with a loss in its history.

In response to the continued presence of elevated inflation in the U.S., the Federal Reserve raised its benchmark interest rate by 75 basis points in both July and August to reach its current range of 3.00–3.25%. While some economic indicators offered reason for optimism, such as lower commodity prices and better than expected consumer confidence, unemployment remains resilient at below 4% and the latest inflation report for August came in at over 8% year-over-year. Fed Chairman Jerome Powell and various other members of the Federal Open Market Committee reiterated their commitment to reigning in inflation, even if that risks economic hardship. At the Jackson Hole Symposium in August, Powell stated, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.” In addition, the Federal Reserve’s quantitative tightening program proceeded on schedule and accelerated from $47.5 billion to $95 billion per month in September.

We believe environments like this are when active managers, such as ourselves, get to create the most value for our shareholders. Through our disciplined process and philosophy, we aim to see through the clouds of short-term macro events and identify businesses that have had their share prices unfairly penalized. Rather than try to time the market, which, in our opinion, is a fool’s errand, we use times of volatility to reposition our portfolios for long-term success.

THE PORTFOLIO

Top Performers:
Pinterest’s second-quarter earnings impressed investors due to stabilizing engagement trends and guidance for mid-single digit revenue growth in the upcoming quarter, despite foreign currency exchange pressures and disappointing recent guidance from peers. In addition, mobile app users, which account for the vast majority of revenue and impressions, increased 8% year-over-year. CEO Bill Ready indicated that the company will return to “meaningful margin expansion” in 2023 and noted that he would evaluate how best to deploy the company’s $2.7 billion in net cash for the benefit of shareholders. Our conversation with Ready and CFO Todd Morgenfeld after the release furthered our belief that they have the capability and appropriate vision to benefit the company and shareholders over the long term.

Second-quarter results from Netflix were solid, in our assessment, and largely better than investors had expected. Although the company lost roughly one million global streaming subscribers, the loss was only about half of what management had projected. Revenue in constant currency rose 13% year-over-year and management projects third-quarter revenue will rise by 12% in constant currency. While currency exchange rates also affected earnings, margins are tracking slightly ahead of prior guidance adjusted for currency impacts. Importantly, viewer engagement, which we see as a key metric, remains strong. In the U.S., Netflix had as much viewing time in the 2021-22 season as the top two cable networks combined (CBS and NBC) and total share of TV time reached a record in June, according to Nielsen. Along with the earnings release, management stated that progress is being made on the company’s advertising and password sharing initiatives. Cash content costs for the next two to three years are expected to be unchanged at roughly $17 billion as Netflix continues to invest in high-quality content creation. Management forecasts the net addition of one million global streaming subscribers in the third quarter, and we remain pleased with the company’s fundamental performance.

We remain impressed with Carlisle’s business fundamentals as second-quarter revenue increased 57% year-over-year to $1.9 billion and adjusted earnings per share increased 85% year-over-year to $6.15. A key driver of success continues to be the construction materials segment, which saw revenue accelerate 54% organically and its adjusted earnings margin increase 1000 basis points to 33%. Following the purchase of Henry last year, Carlisle removed several waterproofing businesses that were housed in construction materials and created a weatherproofing technologies segment that grew 24% organically with an 18% adjusted earnings margin. Pricing has been strong and a key factor in performance. CEO Chris Koch has done an impressive job, in our view, of taking advantage of the business’s pricing power to both increase revenue and achieve attractive margins. In September, the company implemented another mid-single digit price increase in the construction materials business. Given the announced price increases so far in 2022, we estimate that the business’s revenue will grow around 8% even without any volume growth.

Bottom Performers:
Charter Communications reported second-quarter revenue of $13.6 billion and adjusted earnings of $5.5 billion, both of which outpaced market expectations. Revenue rose 6.2% from a year earlier and earnings grew 9.7%. However, investors may have focused on the company’s broadband subscriber net loss of 21,000 (which included the reduction of 59,000 government subsidy customers). Management attributes the weak broadband results largely to low residential relocation activity and the return of college seasonality. In addition, while capital expenses were 5% higher than the market had predicted, capital expenses from core cable operations continue to decline and are trending well below our maintenance forecast. Furthermore, just prior to the company’s earnings release, a Texas jury awarded $7 billion in damages to the family of a customer who was murdered by an off-duty technician. Later, a judge reduced the settlement to $1.15 billion. Charter plans to appeal and stated that a criminal background check conducted on the employee showed no arrests, convictions or other criminal behavior. We are following the situation closely and will adjust our metrics as appropriate.

Alphabet’s second-quarter results were better than previously feared as concerns over a slowdown in industrywide advertisement spending mounted in recent months. Compared with last year, total revenue grew 16% in constant currency to nearly $70 billion, driven by revenue increases in the Cloud (+39%) and Search (+18%) segments. YouTube advertising revenue also grew 9% in constant currency. However, operating income fell approximately 4% short of market expectations and earnings per share were 5% below projections. The total operating margin declined to 28% from 31%, mainly owing to investments across several segments, including research and development, sales and marketing, and general and administrative along with negative currency effects. When discussing the near-term outlook, management noted “pullbacks in spending by some advertisers” and “uncertainty in the global macro environment,” which may have unnerved some investors. By our measure, Alphabet’s fundamentals are solid and it remains an attractive holding.

Comcast’s second-quarter financial results were strong, by our standards. Cable segment earnings rose 5.3% from a year ago (exceeding our full-year estimate of 4%), which built upon gains of 14.5% and 5.5% in the second quarters of 2021 and 2020, respectively. Capital expenditures were also lower than our forecasts. Compared with market expectations, Comcast’s revenue, adjusted earnings and earnings per share all outpaced projections. Management revealed that the cable segment achieved the highest adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) margin on record, despite a difficult macroeconomic environment. However, net additions of broadband subscribers amounted to zero in the quarter, which prompted a sell-off of shares. It is important to note that the second quarter is seasonally the weakest for cable growth due to college disconnects over the summer and an expected return August/September. Importantly, management expressed that subscriber churn remains “well below 2019 levels” and they are also not seeing churn increases in the fixed wireless or fiber segments. We believe Comcast can maintain healthy business trends amid challenging economic conditions.

During the quarter, we initiated positions in Capital One Financial, ConocoPhillips, Intercontinental Exchange and Warner Bros Discovery. We eliminated Lamb Weston, NOV and Post Holdings 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.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.

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.

The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s U.S. Equity composite as of 09/30/2022.

Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.