THE MARKET ENVIRONMENT
Despite significant market volatility that carried forward from the first quarter, key U.S. indexes rebounded and finished higher for the second quarter. Notably, the S&P 500 Index logged its best quarterly performance in more than two decades. Investors took solace from incremental news that science and medicine continued to make headway developing coronavirus treatments and vaccines. At the same time, several states have seen record increases in coronavirus infections and some authorities have reinstated pandemic-related restrictions, which reignited a degree of investor anxiety. Businesses have been resuming operations in fits and starts and unemployment claims have appeared to stabilize, which points to a convalescing real economy. Even so, policymakers projected that the U.S. economy will likely shrink by 6.5% in 2020 and at year-end, the unemployment rate will be about 9.3% (compared with 11.1% today). Also, while the Federal Reserve pledged to implement extraordinary measures in the near term to support economic recovery, Chairman Jay Powell stated that key interest rates will probably remain near zero for two more years.
Simultaneously, heightened recognition of racial inequities and injustices prompted large-scale protests (and, in several cases, riots) to break out across the country and around the world. Surging protest activity that lasted weeks interrupted newly reopened businesses just emerging from pandemic-induced shutdowns, which led to further market volatility. The widespread call for change caused many organizations to publicly implement practices to fight racism, emphasize diversity, and eliminate offensive images, symbols and product brand names.
Although U.S. equity prices fluctuated throughout the second quarter, we contend that the long-term fundamentals of the companies we own held relatively steady. In fact, market upheaval presented us with a greater than average number of new investment candidates and we initiated positions in new holdings that met our investment criteria. In addition, we have been increasing shares of current holdings that became more discounted compared with our intrinsic value estimates. And we have trimmed share counts of holdings with prices that have gained a healthy amount of value. Our focus remains trained on using market circumstances advantageously to strengthen our clients’ portfolios, which has led to an elevated level of activity in recent months. However, we believe strategizing in this way can lead to meeting our goal of effectively positioning portfolios to benefit as the market improves.
Thor Industries issued a business update early in the quarter and indicated that the company’s European production facilities resumed operations in mid-April and North American operations were planned to resume at varying levels of production in early May. The company is abiding by enhanced safety protocols for employees across its facilities as production restarts. Furthermore, management stated that dealer sales in the U.S. remain restricted in many of Thor’s largest markets and many dealers have shifted to providing customers with online purchase options and home deliveries. In Europe, dealers reported a strong pipeline of retail sales awaiting delivery when outlets reopen. The company’s inventory position appears to be healthy as management cited that a suspension in production coupled with ongoing dealer sales have worked to maintain balanced inventory levels. Thor issued another operational update in May that revealed the company is increasing production levels to meet greater demand than originally anticipated. Dealers continued to sell retail units while the company’s production facilities were temporarily shut down in March and April and inventory levels for certain products in the U.S. became low. In response, Thor recalled furloughed employees and restored compensation to original terms. Later, the company’s fiscal third-quarter earnings report showed that earnings per share ($0.43 vs. -$0.25) and revenue ($1.68 billion vs. $1.64 billion) bested consensus estimates.
Alphabet’s share priced tracked a general recovery in the U.S. equities market. In addition, the company delivered reassuring first-quarter results in April as exhibited by a 13% increase in total revenue. Both the YouTube and cloud segments grew 33% and 52%, respectively, as YouTube finished March at a high single-digit growth rate. CFO Ruth Porat also indicated the company is already seeing “very early signs of recovery” in search advertising. In our view, the return to more commercial behavior among users is a sign that things are moving in the right direction. Notably, Alphabet executed $8.5 billion in share repurchases in the first quarter versus $3.0 billion for the first quarter in 2019 and indicated it intends to maintain the increased pace of buybacks for the duration of the year.
Facebook’s first-quarter earnings report included year-over-year increases in revenue and earnings per share of 18% and 101%, respectively. Management stated that the current pandemic has produced increased engagement on the platform as averages of daily active users rose 11% and monthly active users increased 10%. However, management indicated that demand for advertising had declined and pressured pricing for ads in the latter part of the first quarter. We found it noteworthy that for the first time CEO Mark Zuckerberg stated his intention to expand margins over the long term and that management is looking for ways to control expenses over time. The company continues to invest heavily in products and new engineering talent, which we think could pave the way for future growth. In May, Facebook announced it is adding an online shopping to its platform. Facebook Shops will allow sellers to create digital storefronts on Facebook or Instagram and thereby place the company in direct competition with Amazon and eBay. In a news interview, Zuckerberg expressed that he had accelerated the shopping launch to take advantage of the rise in online shopping during the coronavirus pandemic. Furthermore, we find that WhatsApp is one of the most important global communication networks in existence and the monetization of this platform is still in its infancy. However, Facebook’s proven ability to monetize assets gives us confidence in its ability to drive significant long-term revenue growth at WhatsApp.
Throughout the second quarter, the management team at Southwest Airlines provided incremental updates on operational and revenue trends as the coronavirus pandemic severely curtailed the company’s business. While passenger demand and bookings were weak early in the quarter, the company experienced modest improvement beginning in early May 2020 when new passenger bookings outpaced trip cancellations, which reversed net negative booking trends in March and April. Southwest also realized somewhat higher passenger demand and bookings for June. The company estimated that May 2020 year-over-year operating revenues declined in a range of 85-90%, capacity fell roughly 64% and the load factor was about 30%, which all aligned with management’s previous projections. Nevertheless, we find news of booking trends encouraging and are hopeful that it points to a developing recovery. Importantly, management indicated that based on current cash balances, daily expenditures, short-term investments and proceeds from recent sale-leaseback transactions, Southwest has approximately 20 months of liquidity. In addition, the company is the only U.S. airline with an investment-grade rating by all three rating agencies, which allows for access to credit, if necessary.
Early in the second quarter, General Electric announced expectations for its first-quarter adjusted earnings per share to fall below previous guidance for $0.10 earnings per share given the impact of challenges from the coronavirus on its aviation business. The company also retracted its full fiscal-year guidance. Upon official release of first-quarter earnings results, earnings per share amounted to $0.05, less than the market’s expectations for $0.08 earnings per share. In May, General Electric sold its lightbulb business to Savant Systems for approximately $250 million according to The Wall Street Journal. Later, the company landed a $180.6 million contract with the U.S. Navy. In addition, General Electric reopened parts of its $3 billion debt offering. We think that while the company may face some short-term obstacles, its long-term outlook remains promising.
Carlisle’s first-quarter revenue and earnings per share from continuing operations both declined from a year earlier by roughly 4% and 18%, respectively. We were pleased that earnings results in the key roofing segment, Carlisle construction materials (CCM), were strong, in our estimation, and partially offset poor results in the auto, mining and aerospace segments. However, the company expects business in the CCM segment will fall 20% in the second quarter, owing to coronavirus-related construction restrictions in many of its markets. Even so, Carlisle had a record CCM segment backlog at the start of March and it sees demand rebounding relatively quickly once the fallout from the virus recedes, which can sustain segment profitability. In the company’s other three segments, management is now expecting more than $50 million of restructuring costs to maintain or expand profitability once demand recovers. Importantly, Carlisle’s balance sheet remains in good shape, in our assessment, with cash on hand of $1.2 billion and no debt due until the end of 2022.
During the quarter, we initiated positions in General Dynamics, HubSpot, T-Mobile and Walt Disney. We eliminated Apple, Cummins and Diamondback Energy from the portfolio.
Past performance is no guarantee of future results.