Large-cap equities fell into a sharp correction during the first quarter of 2020 as the COVID-19 pandemic caused a surging public health crisis and brought about a virtual economic standstill. Unprecedented limitations placed on consumer and business activities worldwide have created enormous disruptions to consumption, production and investment, tipping the global economy into a near-certain recession as demand-side effects ripple outward and supply chains suffer blockages. While it is too early to fully gauge the ultimate damage to the global economy or corporate earnings over the next few quarters, at a minimum it is clear that global gross domestic product (GDP) will decline substantially, with negative repercussions for employment, credit quality, capital spending, tax receipts and many other downstream factors. Following a long period of expansion supported by rising debt levels, low interest rates and broad investor confidence, financial asset prices have turned sharply negative in very short order as they have discounted not only the impending economic impact of the pandemic, but also a dramatic shift in risk preferences.
The impact on equity prices during the first quarter was particularly acute among three categories of companies: i) those with primary exposure to the sudden decline in normal demand levels in sectors such as travel, industrial products, and discretionary goods and services; ii) financial services companies, whose earnings and capital cushions are compromised by market declines, lower interest rates and eroding credit quality; and iii) oil and gas companies that are experiencing lower resource demand as well as a collapse in commodity prices. Several of our portfolio companies have direct or indirect exposure to these challenges, as we will discuss later in this update.
Equities’ broad declines since mid-February have occurred with very high levels of synchronicity among stocks and sectors, with measured correlation metrics reaching levels that historically have only been seen during major market selloffs. This suggests that de-leveraging, liquidation, passive fund flows, and programmatic trading have contributed to the speed, severity and often indiscriminate nature of the selloff. Nevertheless, there have been certain pockets of relative strength, not only in typical safe-haven sectors, but also among familiar growth and momentum leaders as well as a subset of companies that are perceived to be potential beneficiaries of the challenging circumstances presented by the pandemic.
The S&P 500 Index declined by -19.60% in the first quarter on a total return basis. By comparison, BBH Select Series – Large Cap Fund (“the Fund”) declined by -19.98%. Since its inception on September 9, 2019 through the end of the first quarter, the Fund declined by -16.67%, which compared to a -12.27% decline for the S&P 500.
Noting our longstanding goal of protecting capital during market declines, the relative performance of the Fund during the first quarter was disappointing, but our team remains very confident in our long-term oriented investment approach and the quality of our portfolio companies. We also believe that there are important contextual factors to note in the current environment. First, as of this writing, we are only six weeks into the market correction, which in our view is a very short time period for the market to fully absorb and evaluate a constantly evolving flow of news regarding the pandemic and the economy. Information contained in asset prices does not always fully reflect complete fundamental information about the underlying companies, and during a period of investor panic and disorderly selling, valuations often detach from the underlying risk-adjusted fair values of companies’ long-term cash flows on a present-value basis. As a related point, we note that larger capitalization stocks with strong liquidity and defensive characteristics can experience disproportionate selling pressures in the early phases of a correction as they are used as funding sources for investors who are raising cash or deleveraging. As the current selloff runs its course, we strongly believe that due consideration of the durability, competitive differentiation, and earnings power of individual companies will regain proper standing in the market’s setting of prices, which we believe may work to the benefit of our portfolio, as it has in prior corrections. Finally, while most of our companies’ share prices did in fact outperform the broader market in the quarter, we had several holdings that experienced significant declines. In certain of these cases, the underlying issue was their specific business exposures, but for others, we believe their higher absolute valuation levels at the beginning of the year and their strong prior gains in 2019 left them somewhat more exposed to short-term downside. Nevertheless, these companies continue to embody a strong degree of fit with our investment criteria, and we believe they have attractive fundamental characteristics and favorable long-term growth opportunities.
The 10 largest performance detractors in the Fund during the first quarter are listed in the table on the right. Note that US Bancorp and Bright Horizons Family Solutions, Inc. were no longer held in the portfolio as of March 31; more information about our exit decisions appears later in this update. In the paragraphs that follow, we will briefly comment on the other companies shown below.
FleetCor Technologies Inc. was our largest portfolio detractor in the first quarter, with shares declining by 35%. In contrast with several of our other holdings whose share price performance was 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 revenue is 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 the business.
Shares of Berkshire Hathaway Inc. performed roughly in line with the S&P 500 during the quarter, but given its large position size within the Fund, it was among our larger detractors on an absolute basis. As an owner of operating businesses with varied economic exposure and a holder of a large portfolio of securities, Berkshire Hathaway has understandable linkages to the short-term performance of the broader markets. However, with $128 billion in cash, $284 billion in investments, $424 billion in equity capital, and only $38 billion in recourse debt, we judge the company to be one of the best capitalized and most liquid businesses in the world. Berkshire’s operating business are diverse and resilient, in our view. The insurance operations (~30% of operating earnings) offer essential financial services to businesses and consumers, and they generate large amounts of investible float. The railroad subsidiary (BNSF, 22% of operating earnings) is one of two major networks that covers the western U.S., providing critical transportation infrastructure. The utilities segment (11% of operating earnings) provides steady earnings that are relatively well insulated from the economic cycle. The remaining 37% of operating earnings comes from a broad assortment of manufacturing, servicing, and retailing businesses, most of which enjoy competitive advantages in attractive markets and niches. Berkshire’s management team consists of strong operators who have proved to be prudent and disciplined stewards of shareholder capital. In addition, we believe the company has the resources, knowledge, and desire to deploy capital in dislocated markets in exchange for superior risk-reward opportunities. We believe Berkshire is attractively valued on the basis of its assembled interests, and perhaps even more so when considering the embedded option value that relates to its large balance of available cash.
After a period of very strong performance through early 2020, Copart Inc. 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.
Allegion PLC shares fell during the first quarter of 2020 due to several factors. The company reported fourth quarter 2019 financial results and issued new 2020 expectations that were modestly below investors’ views. In addition, while Allegion has relatively modest exposure to China, it has a business model that is broadly influenced by commercial and residential construction, remodeling, and maintenance end markets, all of which have been subject to adverse investor sentiment during the COVID-19 economic slowdown and market correction. We believe it is also fair to attribute some of the decline and underperformance of Allegion’s share price in the past quarter to a fuller valuation entering 2020 after a period of strong stock performance.
Allegion designs, manufactures, and sells locks and other access control security products and systems that are relatively low-cost but essential elements in almost all buildings and homes. These products, at their core, keep people safe, secure, and productive and protect real and personal property, fulfilling essential consumer and business needs and providing a basis for strong through-cycle demand. In addition, the company’s large installed base of existing products in the markets it primarily serves, together with an advantaged new product offering set and keen sense of operating and capital discipline, enable it to generate strong operating margins and returns on capital in an industry that we find attractive. These important product, cultural, operating, and financial attributes, along with the company’s strong balance sheet and financial flexibility on an absolute basis and relative to lending covenants, should in our opinion allow it to persevere through the current economic challenges and generate compounding economic profits in the future.
The weakness and underperformance of the share price 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 expectations of many investors. 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 and focus during the emergence of the COVID-19 led market correction. While these near-term concerns are very real, at both the company-specific and broader sector and market level, we believe they 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 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 on an absolute basis and relative to lending covenants and, importantly, 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 will not only survive this period of severe economic challenge, but is likely to emerge in a stronger competitive position given a now-higher likelihood of economic duress among some of its competitors.
Comcast Corp. shares declined in the quarter as efforts to suppress COVID-19 forced the indefinite closure of its theme parks, stopped production on its film and television projects, and postponed the Tokyo Olympics until 2021. These disruptions will pressure near-term results for both NBCUniversal and Sky, as both businesses have exposure to entertainment and advertising revenue that will be negatively impacted by a slowing global economy. However, we believe the company’s connectivity business is likely to prove more resilient as households subject to shelter-in-place advisories rely on video and broadband services to stay entertained and connected to friends, families, schools, and work. We continue to believe that Comcast’s key competitive advantages derive from its leading scale and advanced cable infrastructure which enable it to offer essential connectivity services at fast broadband speeds. Moreover, we believe that the business is led by a very capable management team and is conservatively capitalized, with sufficient liquidity to withstand current economic conditions. As other purchase opportunities emerged during the quarter, we elected to reduce our position size in Comcast via trims in February and March.
Similar to the situation with Berkshire Hathaway noted above, shares of Alphabet Inc. (the parent company of Google) declined by substantially less than the market in the quarter, but as our largest position, it detracted from the portfolio’s performance on an absolute basis. We believe that Google’s products and services have proved to be indispensable in the current environment as both individuals and businesses are relying on digital means to stay connected. While the company’s near-term profits from digital advertising are likely to be pressured alongside a general slowing of the global economy, we anticipate a return to stronger growth as normal activity levels resume. We believe that digital advertising continues to have attractive and durable secular growth characteristics given its return on investment (ROI) advantages and alignment with structural shifts in media consumption. In our view, Alphabet’s strong balance sheet (more than $120 billion in cash and investments) provides ample liquidity and will enable the company to continue investing in its long-term strategic initiatives. We modestly reduced our position in Alphabet in mid-March to free up capital for other investments, but it remained our largest holding at quarter-end.
Booking Holdings Inc., as an intermediary between travelers and lodging providers, has been particularly impacted by the sharp decline in travel due to the global spread of COVID-19. While the demand disruption is severe and unprecedented, we believe that the company can withstand the short-term earnings impact and may be able to improve its competitive position as conditions normalize, mainly due to its cost flexibility and balance sheet position relative to its direct competitors and its travel supplier partners. Booking’s largest expense item is search advertising costs that drive website traffic acquisition, but this spending is variable, and it runs in proportion to hotel booking volume. Therefore, we believe that the company’s margin structure will be relatively resilient despite significant near-term revenue headwinds. Booking’s balance sheet carries a large cash balance and debt maturities that extend several years into the future, putting it in solid standing relative to other online travel competitors and hotel partners that are significantly more levered, supporting our view that the company can satisfy its debt obligations through the pandemic and retain flexibility to make investments that help to widen its competitive moat. As restrictions ease, we anticipate that lodging providers will not only look to Booking’s demand aggregation capabilities to fill rooms, but they also may ease their prior efforts to directly intermediate travel arrangements via their own online presences. Also important is Booking’s ability to fund staffing levels sufficient to offer robust customer support and direct interface with property owners through the crisis, which we believe will enhance customer loyalty and help maintain balance in the industry as the crisis period begins to ebb.
The only two positive contributors to performance for the period were Nike Inc. and Baxter International Inc., both of which were new purchases in the quarter and are further detailed below.
Portfolio Changes and Valuation
During the quarter, we initiated new positions in Nike Inc. and Baxter International Inc. We believe that both companies measure especially well against our investment criteria and that the selloffs in their respective share prices in recent weeks presented attractive opportunities to build our stakes.
Starting with an initial purchase in late February and five subsequent additions during March, we established a position in Nike. The company is the world’s largest seller of athletic footwear and apparel, which are consumer categories that offer attractive secular growth and sustainable margin opportunities tied to brand affinity and functional differentiation, in our view. Nike is both a global brand and a multi-national operator specializing in the design, development, marketing, and sale of products that appeal to broad consumer populations. It has the distinction of being one of the few mass-market brands established over multiple decades that is still as relevant to rising generations as it has been to those that have preceded. The company’s revenue base is spread across all major regions of the world, and it sells its products through a mix of wholesale arrangements, independent distribution, licensing agreements, and a growing direct-to-consumer (DTC) channel that includes branded retail stores and e-Commerce.
We believe that Nike is well positioned to gain share in a growing market and drive attractive long-term value creation through several initiatives related to inventory management, distribution, and customer experience. In our assessment, the company possesses competitive advantages across its entire value chain, with in-house research and development, supply chain management, marketing, sales, and after-sales disciplines working in concert to fortify its long-term product and brand strategies. Nike remains an innovation leader, and it holds one of the largest patent portfolios in the world. Its global supply chain benefits from scale and speed-to-market advantages in an industry that typically contends with long lead times and labor-intensive manufacturing processes. Nike is particularly differentiated by its marketing prowess and its substantial clout with retail partners (for whom Nike often represents the majority of in-store sales). These critical advantages reinforce the company’s core focus on investing in ‘demand pull’ rather than ‘supply push.’ In addition, Nike’s increased investments in DTC channels and after-sales touchpoints give it further room to press its core advantages and drive customer engagement.
Weakness in Nike’s share price during the recent market correction offered us the opportunity to invest in a high-quality, high-return business that not only aligns well with our criteria, but also offers the potential for long-term value creation driven by secular growth, superior operating capabilities, and several strategic enhancements that may not be fully reflected in the stock’s valuation, in our view.
Baxter is a diversified global provider of essential healthcare products for renal and hospital-based care. The company has market-leading positions (#1 or #2 share) in each of its major end markets, including dialysis equipment and consumables, medication delivery pumps and solutions, acute-care pharmaceuticals, clinical nutrition, surgical support products, and acute renal therapies. The two major elements of our positive investment thesis are: i) the durability and growth within Baxter’s portfolio of medically essential products that support and sustain critically important healthcare system functionality; and ii) the potential for continuing benefits from the company’s multi-year business transformation process under the leadership of the CEO Joe Almeida, who joined in 2016. Baxter’s ongoing business review is focused in the areas of portfolio and innovation management, operational efficiency enhancements, and optimal capital allocation. The outcome of these efforts thus far has been positive in our view, with adjusted operating margins doubling in five years, return on invested capital (ROIC) growing by 10 percentage points, and free cash flow expanding from $860 million in 2015 to $1.4 billion in 2019. During the same period, the company deployed $6 billion of capital in the form of share buybacks and dividends.
Looking ahead, we believe that Baxter can accelerate sales growth and achieve further margin expansion driven by newly-launched products while continuing to add incremental value through its transformation agenda and shareholder-friendly capital allocation. Product innovation remains a top priority for management in its pursuit of positive mix shift and margin accretion, and one particularly encouraging area of growth is in home-based hemodialysis, a leadership market for Baxter that has broad government support and clear lifestyle benefits for patients. Baxter will also continue to look externally for technology-driven acquisition opportunities that can leverage and enhance the existing product portfolio. The recent market volatility in Baxter’s shares created what we viewed to be an attractive entry point for us to re-establish a position.
Along with the new purchases noted above, we also added to our existing holdings of A.O. Smith Corp., Booking Holdings Inc., Costco Wholesale Corp., Mastercard Inc., Arthur J. Gallagher & Co., Alcon Inc., Diageo plc, Celanese Corp., and Waste Management Inc. In each case, our aim was to take advantage of downside volatility during the market correction and build our position sizes in durable, well-managed businesses with sound balance sheets and leading competitive positions in their respective industries.
We began trimming our position in US Bancorp in February and continued selling our shares in March, moving to a full exit by mid-month. As the COVID-19 pandemic widened and capital markets began experiencing sharp dislocations, U.S. Treasury rates came under pressure across the yield curve, and we perceived a greater risk of new and aggressive monetary easing by the U.S. Federal Reserve, which conflicted with our prior baseline expectation of conditions that could support stable net interest margins for lenders. Moreover, a heightened risk of economic recession presented challenges to our outlook for US Bancorp’s near- to intermediate-term loan growth, credit losses, capital markets activities, and performance in attractive fee-based businesses such as payments and wealth management. We did not lose sight of the company’s competitive strengths or its admirable track record of financial stewardship, but we felt that the confluence of disruptions to the financial system and to the broader economy could precipitate deterioration in the operating environment and potentially slow the future recovery in bank earnings, which could limit the prospects for US Bancorp’s premium valuation to re-emerge over a foreseeable timeframe.
In March, we made the difficult decision to exit our position in Bright Horizons as the sudden impact of the COVID-19 pandemic caused a material widening of the potential range of outcomes for the business. Our investment in the company was underpinned by its unique positioning as a provider of essential childcare solutions for working households in partnership with employers. We felt that the business offered a high degree of visibility due to multi-year employer contracts and the recurring day-to-day needs of families. To provide its services, Bright Horizons relies on its physical footprint of child care centers across the U.S., United Kingdom, and the Netherlands. The rapid spread of COVID-19 and the actions taken by governing bodies and corporations to curb the rate of infection led to a decision by the company to shut down more than half of its centers in the U.S. through the end of April 2020, directly impacting its core business model of delivering care for groups of children in physical locations. As such, we could not gauge with reasonable confidence the depth and duration of the attendant business disruption. Moreover, we were uncertain as to whether multi-year contract terms and prepayments would be enforceable under these unique circumstances. Bright Horizons has historically operated with reasonably high financial leverage given the recurring and contract-driven nature of its revenue stream. While our view was that the balance sheet could likely withstand temporary disruption, the unprecedented and evolving set of events widened the range of possible outcomes pertaining to the company’s capital position and ability to service its debt. The ultimate impact of the indefinite period of facilities closures combined with the aforementioned uncertainty regarding contract terms led to a situation in which we no longer felt that our investment was protected with a sufficient degree of certainty.
In addition to the portfolio trims and sales already discussed above, we also elected to reduce our position weights in Unilever NV, Oracle Corp., and Novartis AG. The shares of all three companies substantially outperformed the broader market during the first quarter, and we continue to view each of them favorably on their respective fundamental merits and defensive characteristics. Nevertheless, with other valuation opportunities arising elsewhere in the portfolio, we used a portion of each position as a source of funds.
At the end of the first quarter, we had positions in 30 companies with 48% of our assets held in the 10 largest holdings. As of March 31, the Fund was trading at 71% of our underlying intrinsic value estimates on a weighted-average basis, which compared to 91% at the end of 2019. During the quarter, the price-to-intrinsic value metric had dipped into the high 60% range. We ended the quarter with a cash position of 2.1% (versus 1.9% at the end of 2019) as our trims and sales modestly exceeded purchases, but we remained essentially fully invested.
The COVID-19 crisis that has gripped the world is above all a human tragedy, presenting not only great personal costs, but also a severe test of the foundations of societal functioning and commerce. By extension, it has also presented profound challenges for our highly interconnected and highly leveraged system of global financial markets. We do not take any of these issues lightly, but it is our responsibility and commitment to maintain a steady hand and make well-reasoned decisions based on the best information we have available.
The investment approach that we use for the BBH Select Series – Large Cap Fund has always prioritized a long-term perspective. We know that the economy, specific sectors, and individual businesses will experience periodic cyclical pressures and unforeseen operational challenges, and as such, both our companies and our portfolio will encounter bouts of intermittent downside. However, one of our key guiding principles is that underlying business quality is a structural and durable concept, and it is ultimately a function of each company’s competitive positioning, necessity to customers, secular growth opportunities, and ability to execute. In our view, these factors overwhelmingly determine companies’ resilience in recessions, their ability to grow through full economic cycles, and their prospects for long-term compounding of shareholder value. That is precisely why we have always used them as the basis for our strict investment criteria. Of course, valuation also plays a key role. We believe that companies’ intrinsic business values are conceptually much more stable than their intermittently volatile public market share prices, so we focus on building long-term, cash flow-based valuation models that make reasoned estimates of each business’s full-lifecycle growth, profitability, and capital needs. Based on our observations over many years, opportunities can arise when stocks’ valuations begin to overly discount short-term earnings headwinds and underweight the likely period of recovery towards prior levels of activity. We are mindful of such opportunities in the present context, and they have influenced many of the portfolio actions discussed above. Regardless of the prevailing economic environment or the mood of the broader market, we aspire at all times to have our portfolio best embody the intersection of our qualitative judgments of durable business quality and the company-by-company risk-reward tradeoffs that we perceive.
The Select Series – Large Cap Fund team is fully engaged and active as we continually re-underwrite our portfolio of high-quality businesses by stress-testing our assumptions and staying alert to risks that may emerge as the COVID-19 crisis evolves. We have examined first-order demand impacts as well as upstream and downstream effects in the companies’ supply chains and their dependencies on discrete customers or suppliers. We also have undertaken a company-by-company balance sheet review of the portfolio, assessing each business’s liability composition, funding needs, debt covenants, interest coverage, and other credit-related considerations. Despite the material business headwinds that currently exist, our present assessment of our companies’ financial wherewithal and their ability to endure a sustained period of earnings disruption is broadly favorable. We will continue looking for further investment opportunities that may arise as erratic market valuations detach from the underlying intrinsic values of our existing holdings and companies on our ‘wish list.’
We appreciate your continued interest and support, and we wish good health and better times ahead to all of our clients and friends.
Michael R. Keller, CFA
Investors in the Fund should be able to withstand short-term fluctuations in the equity markets and fixed income markets in return for potentially higher returns over the long term. The value of portfolios change every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.
The Fund is ‘non-diversified’ and may assume large positions in a small number of issuers which can increase the potential for greater price fluctuation.
International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards.
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Brown Brothers Harriman & Co. ("BBH"), a New York limited partnership, was founded in 1818 and provides investment advice to registered mutual funds through a separately identifiable department (the "SID"). The SID is registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. BBH acts as the Fund Administrator and is located at 140 Broadway, New York, NY 10005.
Not FDIC Insured No Bank Guarantee May Lose Money
IM-07783-2020-04-10 BBH002928 Exp. Date 07/31/2020
 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life