First and foremost, we extend our sincere hope that you and your family, friends, and colleagues are safe and healthy. We are experiencing what can only be described as an unprecedented set of events as COVID-19 has aggressively spread from Asia to Europe, on to the UK and the U.S., and further into nearly every country around the world. Governments are taking actions to mitigate the spread of this highly contagious, novel virus, bringing a vast proportion of economic activity to an abrupt halt. Central Banks and governments are also deploying massive monetary and fiscal programs to help mitigate the likely economic fallout. Following an initial period of complacency early in the quarter, global equity markets sold off sharply, bringing an abrupt end to the long-running bull market which peaked on February 19 of this year. The MSCI World index declined nearly -34% from the market peak to March 23 before rallying in response to vast government stimulus to end the quarter down -21.05%. BBH Global Core Select Class N (“Global Core Select” or “the Fund”) declined -34% from the market peak to March 23 and registered a decline of -21.86% for the first quarter.
When facing market turmoil and economic uncertainty, we are reminded of the importance of the investment criteria that underpin our Global Core Select investment strategy. A critical element of our approach is the focus on financially strong companies with resilient business models and high levels of discretionary cash flow. We believe businesses with strong and sustainable competitive advantages that provide essential products and services are well positioned to withstand economic shocks and subsequent weakness, and it is imperative that our holdings also have the financial strength and flexibility to endure periods of financial-market weakness.
During a period of initial market or economic shock, equity prices can move in tandem, and we have seen high levels of correlation in the market thus far. We expect that over time, however, equity values will reflect companies’ earnings power and cash generation and believe businesses that meet our investment criteria are well positioned to sustain or improve their competitive advantages, reinvest in their businesses, and create value over time. As lockdown measures expanded rapidly across the world halting business activities and shuttering broad swaths of the global economy, market conditions have abruptly changed, underscoring the importance of balance sheet strength and the ability for a business to self-finance operations and growth. Accordingly, we have stress-tested the financial and liquidity conditions of our holdings under various scenarios, and we made some portfolio changes to concentrate our investments in our highest conviction businesses. We recognize that it is unknown how long physical distancing limitations will remain in place and exactly what the exit strategy will look like; we can look to China as a roadmap, but we must recognize that containment and mitigation measures differ and that the seasonal pattern of the virus remains unknown. The economic ramifications will likely be significant and potentially long-lasting, and we are taking a conservative stance in estimating the associated recovery as we contemplate the impact on our holdings. As is our practice, we take a long-term and through-the-cycle view when we analyze and value businesses and expect the strong management teams that guide our portfolio companies will not only effectively manage through this crisis, but also anticipate and adapt to any structural changes that may result.
We have completed a company-by-company analysis and while no business will be immune to the current crisis, we have applied our judgment to arrive at scenarios that include reasonable downside cases for cash flow and valuation. We took advantage of the extreme market volatility during the quarter to add to 11 of our holdings; buy four businesses from our wish list, including SAP, Nike, Kone, and Assa Abloy; and trim or exit positions, including Sanofi, Unilever, and Anheuser-Busch InBev in which we had lower relative conviction or where we saw an unfavorable risk/reward trade-off.
Each of our four new investments are excellent franchises and very strong fits with our investment criteria in our view. SAP is a leading enterprise software vendor in the attractive Enterprise Resource Planning (ERP) software industry. Its products are mission-critical to its customers in managing their financial reporting, supply chain, and production systems and with ~65% recurring revenue, we believe the company is extremely resilient. SAP is currently undergoing a product upgrade and business transition cycle which, while complex, should expand its addressable market with further potential for improved margins and returns. SAP’s difficult-to-substitute and essential products, its recurring revenue base, and recent cost containment initiatives led us to conclude that the company is poised to deliver high levels of free cash flow growth and improve on its already-attractive return on capital. In the current environment, sales cycles will almost certainly be disrupted, and we estimate that approximately 25% of revenues are more cyclically exposed. However, we believe the high proportion of recurring revenue will provide a strong buffer in a downturn. Depending on the length of global shutdowns, we expect to see a loss of revenues attached to corporate spend and a deferral of license sales tied to new customers and product upgrades. We expect that SAP’s customers will move forward with the transition to new products once employees return to work and expect any near-term pressure to give way to higher sales in the medium term as deferred projects are reinstated.
Nike is the largest seller of athletic footwear and apparel in the world. Nike continues to execute and evolve its strategy of superior innovation and marketing by closely following the consumer in a dynamic industry. We believe the company is uniquely positioned to take share in the growing global activewear market and drive value creation over the long term through initiatives related to digital business, inventory management, distribution, and customer experience. Nike has a strong balance sheet and liquidity position and is currently benefitting from investments it has made in recent years enabling agility in an uncertain environment. Nike is seeing the early stages of a recovery in its Chinese business and is prepared to meet the coming challenge as demand disruption spreads to Europe and North America. The company’s financial strength enables it to preserve brand equity by taking back excess inventory from its distribution channels and control the realignment of supply and demand. We view Nike as a very strong fit with our investment criteria and expect the business to demonstrate strength and reinforce its position as we move past the current crisis.
Kone, based in Finland, is the third-largest elevator company globally with a strong and improving competitive position, including a leading market share position in the Chinese new-equipment market. Service and maintenance represent 48% of revenues and 80% of profits, and this business has grown at a faster rate than peers. Services and modernization represent future growth opportunities in markets such as China, where this component of the business is underpenetrated. Kone’s business is impacted by COVID-19, initially in China due to factory closures that have since recovered significantly, and more recently due to limitations on manufacturing and maintenance activity in additional markets. As with other companies, the impact on operating performance this year and next will be a function of the duration of restrictions and the pace at which they are lifted, and we have factored that into our fundamental assessment. However, we view the long-term opportunity as strong and Kone’s competitive advantages as sustainable. The company earns very attractive returns on invested capital, maintains a net-cash balance sheet, and has an attractive dividend yield. We will be opportunistic in looking to build on our initial position.
Assa Abloy is the largest global supplier of access solutions, specifically locks, digital identification systems, doors, gates, and entrance solutions serving commercial, industrial, and residential customers. Assa’s revenue base is larger than the next three industry participants combined, creating significant scale advantages. particularly in research and development (R&D) where it spends two to five times more than its closest peers. The company generates 70% of sales from less-cyclical commercial businesses and roughly two thirds from replacement demand. The company has relatively limited exposure to China (5% of sales, with exports another 5%) and is back to full production with economic activity starting to return in that market. Demand pressure due to slowing economic activity has impacted Assa around the world, and we anticipate continued revenue declines and margin pressure through this year and next, albeit from very high levels, though we expect cash flow to be resilient. Assa’s operating model offers a high level of flexibility and is highly decentralized with 90 factories across the world, allowing factory managers to match production levels to local demand. The company is a strong fit with our investment criteria, generates attractive returns on invested capital and cash flow, and has been an effective acquirer with mergers and acquisitions (M&A) an integral part of topline growth. Assa has a solid balance sheet and liquidity position, and we believe the company is positioned well to weather the current environment.
We sold Sanofi as the share price approached our estimate of intrinsic value following the appointment of a new CEO and a subsequent business review, which drove share price appreciation. However, our review of the new business plan did not lead us to increase our intrinsic value estimate as we found the lack of pipeline productivity to be a headwind to further value creation. The sale of Unilever was largely a function of our level of conviction and view of the fundamental attractiveness of its brands and categories relative to the other consumer products companies that we own. Evaluating the risk/reward against other more attractive opportunities that presented themselves, we exited the position.
We decided to exit Anheuser-Busch InBev late in the quarter, a difficult decision as the shares had declined by -47%, and ABI was one of the more significant detractors from our performance in the quarter. Our investment was underpinned by its leadership position in the global beer market, including leadership positions in the three largest beer profit pools globally, levels of profitability significantly higher than peers, an enhanced strategic framework post the acquisition of SABMiller, and a culture of stock ownership and compensation structure that aligns management with shareholders. In our view, these strengths and the highly cash-generative nature of the business more than compensated for balance sheet leverage that was driven entirely by the SABMiller deal. Management committed to reducing leverage via the initial public offering (IPO) of its APAC business, the extending of debt maturities, and the pending sale of its Australian business. While our longer-term thesis remains intact, the rapid spread of COVID-19 has created a broader range of outcomes in the short-to-medium term.
The COVID-19 outbreak in China – ABI’s fourth-largest profit pool – and subsequent spread to other Asian countries, Europe, and the U.S. pressured shares, more so than other beverage players given its debt load. We ran stress tests on a global basis and our assessment was that the range of outcomes was relatively predictable. However, our risk assessment changed as governments in certain of ABI’s key emerging markets either responded to the spread of the virus in an inadequate manner (e.g., Brazil, ABI’s second-largest source of profit accounting for ~15% of earnings before interest, taxes, depreciation and amortization [EBITDA]) or were too draconian and shut down breweries for the foreseeable future (e.g., Mexico, ABI’s third-largest profit pool at ~12% of EBITDA and South Africa). We believed that the wide range of government responses, when combined with the inherent operating leverage in the industry, the potential for adverse currency movements, and ABI’s financial leverage, created a broader range of potential outcomes than we had anticipated and we decided to exit our investment.
The U.S. dollar (USD) share prices of our other investments in the alcoholic beverage industry, Diageo (-22.6%), Campari (-20.8%), and Heineken Holding (-21.6%), were under pressure in the quarter as well due to closures of bars and restaurants globally and restrictions on social gatherings of all sizes. Revenues will be adversely impacted while these measures are in place, only partially offset by increased purchases of spirits and beer for at-home consumption. However, these are fundamentally strong businesses with sustainable competitive advantages and structural growth dynamics in most markets in which they operate. These businesses have demonstrated relative resiliency and maintained attractive levels of profitability, returns, and cash flow during previous recessionary periods, and we would expect them to behave similarly if and when economic weakness takes hold once restrictions are lifted. While we recognize there is a range of potential outcomes for earnings this year and next, these companies have strong balance sheets which afford them financial flexibility. Our investment theses and long-term outlooks for Diageo, Campari, and Heineken Holding are unchanged at this time, and we added modestly to all three positions at prices that we view as attractive.
We also added to our positions in Alcon, MasterCard, Deutsche Boerse, Nestlé, Costco, and Fuchs Petrolub during the quarter. We modestly trimmed our positions in Alphabet and Alimentation Couche-Tard though both remain large holdings in the Fund. We trimmed Oracle and Fairfax Financial Holdings to fund investments in what we view as compelling opportunities elsewhere.
Regarding performance during the first quarter, of the 36 investments we held in the Fund during the period, the majority outperformed the MSCI World index. However, we did have several holdings whose share prices declined by 30% or more. The most significant detractors from performance were Lloyds Banking Group, Anheuser-Busch InBev, Copart, FleetCor Technologies, Alimentation Couche-Tard, Fairfax, and Celanese.
European banks were under significant pressure in the first quarter, and Lloyds was our worst performer, declining -52.1% in USD terms (-48.8% in local currency). We believe the extraordinary decline reflects the market’s view that the banking sector will be amongst the hardest hit by COVID-19, subject to high levels of impairments and reduced income due to lower margins and near-zero interest rates. While Lloyds is well capitalized, regulators further weighed on sentiment by preventing all UK banks from paying a final dividend. This added another layer of risk for investors beyond COVID-19, as regulatory uncertainty is now an additional consideration. Lloyds is trading at 0.6x tangible book value despite an underlying return on tangible equity of 14.8% in 2019, suggesting the market views a capital raise as highly likely. When we stress-test our model for loan impairments substantially higher than the peak level experienced during the Global Financial Crisis, we still expect Lloyds to be profitable this year and for capital levels to remain well above regulatory requirements. Lloyds continues to be a simple, focused UK retail bank with enormous scale relative to peers. While the company will undoubtedly be less profitable in the medium term due to COVID-19 and lower interest rates, we believe the market has over-corrected in this instance. We are cognizant, however, that government actions, including both fiscal measures designed to support the broader economy and stave off loan losses and the potential for a rapidly changing regulatory framework, will be a key factor in how banks perform over time.
After a period of very strong performance through early 2020, Copart shares declined by almost -25% in the quarter as broad limitations on travel and commerce reduced the number of automotive miles driven, which will likely reduce accident frequency and thus the number of salvage cars moving through the company’s network. Despite this near-term reduction in supply, we do not foresee any impairment of Copart’s longer-term sources of demand – particularly from international buyers – nor do we believe that there has been any structural change in the necessity of its offerings to the auto insurance industry. The company remains a global leader in the growing market for salvage vehicle auction services, with a high-margin business model that does not consume significant working capital. In March, Copart made a precautionary drawdown of funds from its revolving credit facility to ensure financial flexibility through the period of the pandemic.
FleetCor shares declined by -35.2%, though contrasting with several of our other holdings whose share price performances were influenced by pandemic-related concerns, the primary headwind facing FleetCor and the reason for its underperformance in the quarter was the steep decline in crude oil prices. The company’s underlying commodity price exposure has lessened since our initial investment in 2016; however, roughly 18% of revenues are still tied to the price of gasoline and diesel fuel. FleetCor’s fuel card products help companies administer commercial purchases of fuel, and just as a general-purpose card issuer receives interchange fees for facilitating consumer purchases, so too does FleetCor receive interchange tied to fuel purchases. Interchange fees are levied on dollar volumes, so as fuel prices fall, FleetCor’s revenues are impacted. Nevertheless, revenues directly related to fuel prices make up less than half of total fuel card revenues, and the company instead earns most of its revenue from fuel card program fees, data analysis features, and late fees. As such, we believe the selloff in the share price does not necessarily correlate to FleetCor’s true exposure to lower gasoline and diesel prices. Importantly, even if today’s low fuel prices persist, the company’s overall business remains quite diversified and very profitable; its Corporate Payments, Lodging, Tolls, Gift, and Other segments are primarily linked to business-related spending, not consumer leisure travel or dining. We believe that FleetCor’s balance sheet is solidly positioned, and to the credit of the management team, this is partially due to a low level of acquisition activity in the last two years as the valuation environment for payment-related assets was prohibitive. The company’s leverage ratios are within manageable ranges in our view, and they are supported by the recurring nature of its revenue and profit streams. As well, we believe that FleetCor has sufficient access to additional funds if the current downturn persists in a way that further pressures specific parts of the business.
Couche-Tard’s share price declined by -26.3% in USD terms exacerbated by relative weakness in the Canadian dollar, in local currency the shares declined by -19.4%. While the business initially benefitted from COVID-19-related stock up purchases earlier in the quarter and while the dramatic decline in fuel prices is accretive to Couche-Tard’s fuel margins, the decline in miles driven suppressed demand for fuel and negatively impacted both fuel volumes and related in-store purchases. In most communities in which Couche-Tard operates it is deemed an essential retailer and as such has not been required to close stores. The company generates strong free cash flow from attractive returns on invested capital and moderate capex requirements. Couche-Tard has made progress in deleveraging its balance sheet with leverage now at 1.8x EBITDA with ample liquidity. We believe it remains well positioned to continue to consolidate the convenience store industry and sustain its competitively advantaged market position.
Fairfax ended 2019 on a strong note, with over $2 billion in earnings and per-share book value growth in line with its long-term target of 15%. However, we were disappointed with the composition of earnings, which relied on realized and unrealized capital gains. For the second year in a row, the core insurance operations underperformed relative to our expectations despite a rapidly hardening market and strong volume growth. The main culprits were adverse developments related to legacy asbestos-claims liabilities in Fairfax’s run-off business. With management unable to provide sufficient comfort that these claims would soon end, and with the non-insurance operations also underperforming our expectations, we began to reduce our position despite the strong headline performance. Another consideration was the unexpected retirement of President Paul Rivett, a strong investor whom we viewed as a potential successor to Chairman and CEO Prem Watsa. As the coronavirus pandemic spread, we accelerated our share sales in anticipation of material losses across Fairfax’s non-insurance operations, which include restaurants, travel, retail, and other economically sensitive assets. We expect this will create a material headwind even though the broader insurance franchise should be relatively resilient in the current environment. Fairfax declined -33.9% in the first quarter in USD terms (-27.7% in local currency).
The share price decline of (40%) of Celanese Inc. during the first quarter can be attributed to the accumulation of multiple factors, some company-specific and others more broadly sector- and market-based. Celanese reported fourth quarter 2019 financial results and issued initial 2020 financial projections that were modestly below many investors’ expectations. In addition, the company has substantial activities in China and a business model that is exposed to cyclical end markets that attracted severely negative investor attention during the COVID-19-led market correction. While these near-term concerns are very real at both the company-specific and broader sector and market levels, we believe investors fail to fully recognize the powerful through-cycle earnings and cash flow generating power that we see in Celanese. End-market product applications for most Celanese formulations are essential to everyday consumer life as well as industrial and commercial use, and in some material product categories they are characterized by habitual end-market consumption dynamics. In addition, the company’s Engineered Materials business develops and produces a broad and differentiated portfolio of specialty, polymer-based products, more than 70% of which are customer-specified and require stringent process and performance validation, underscoring their high switching costs and essential nature. While Celanese’s business is clearly exposed to and influenced by normal cyclical forces, the durability of its highly advantaged franchise remains intact, in our view. In addition, we believe the company has a strong balance sheet, sufficient financial flexibility and a world-class management team that has a demonstrated track record of operational excellence and prudent stewardship of shareholder capital. Consequently, we believe that Celanese not only will survive this period of severe economic challenge, but also may emerge in a stronger competitive position given a now-higher likelihood of economic duress among some of its competitors.
The only positive contributors to performance in the quarter were Kone, SAP, and Nike, all new purchases as discussed earlier.
We ended the quarter with 33 portfolio companies and 43.5% of the portfolio concentrated in the top 10 positions, a cash position of 3.8% and our weighted average price to intrinsic value was 75%. The Global Core Select team is diligently focused on continually underwriting our investments with strict adherence to our investment discipline and will continue to look for opportunities to take advantage of market volatility.
On behalf our entire investment team, we thank you for being an investor with us in Global Core Select. Please feel free to contact us with any questions or suggestions.
Regina Lombardi, CFA
Holdings are subject to change. Totals may not sum due to rounding. Price/Earnings (P/E) ratio is a company’s current share price divided by earnings per-share. Turnover ratio is the rate of trading in a portfolio; higher values imply more frequent trading.
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