Large-cap equities edged towards new all-time highs in the third quarter of 2020, continuing a strong rebound that began following the pandemic-driven market collapse in March. Despite a pullback in September, overall gains for the third quarter reflected investors’ continued optimism regarding the gathering pace of economic recovery, positive news flow related to COVID-19 vaccine development, and a high degree of confidence that monetary policy will remain broadly supportive of asset prices.
Among the major sector groups in the S&P 500, share price performance in the pro-cyclical industries led by a wide margin, while interest rate-sensitive sectors and defensives measurably lagged. On a bottom-up basis, the breadth of gains among Index constituents was favorable, following a similar trend in the prior quarter. However, outsized contributions to the overall market performance again were concentrated in a relatively small group of companies, nearly all of which are leading businesses in the technology and Internet sectors. The performance leadership and high degree of Index influence shown by this cohort is especially evident over longer time periods, as evidenced by double-digit annualized outperformance of the growth subset within the S&P 500 relative to the value component over one-, three-, and five-year periods ended September 30.
The S&P 500 Index returned 8.93% in the third quarter and has risen by 5.57% year to date. By comparison, BBH Select Series – Large Cap Fund (“the Fund”) rose by 9.56% in the quarter and is up by 1.25% thus far in the year. Since its inception on September 9, 2019 through the end of the third quarter, the Fund has risen by 5.14%, which compared to a 14.32% gain for the S&P 500.
In our evaluation of the Fund’s performance in 2020 and over longer periods, we continue to see three distinct patterns:
1) In aggregate, our companies have executed well on their long-term strategies, and they have produced solid growth and fundamental performance while maintaining appropriately conservative capital structures. These achievements are evident at the roll-up portfolio level, where we have observed attractive long-term compounding of revenues, strong profit margins, solid returns on capital, and reasonable debt levels (relative to pre-tax cash flows).
2) Our portfolio has produced attractive absolute performance with lower levels of periodic downside volatility relative to the broader market.
3) We have not captured all of upside in periods of rising markets, particularly in the most recent years as concentration of growth leadership overwhelmingly drove the performance of benchmark indexes.
The third pattern cited above has been the largest drag on our relative performance. Retrospective market risk analysis clearly indicates that large-cap equity performance has been dominated by three factors: earnings growth, revenue growth, and share price momentum. In contrast, valuation (i.e. lower multiples) as a factor has been a massive detractor to performance. There are indeed some legitimate fundamental drivers of this divergence, not only because the large-cap growth leadership cohort has produced attractive financial results and has grown dramatically in terms of index representation, but also because several industry groups that reside in the value segment of the market have experienced material business headwinds that have pressured earnings. However, we also note that years of expansive monetary policy, flows towards passive funds, and the influence of quantitative and trend-following strategies have created an investment zeitgeist in which diversification and a balanced perspective regarding valuation have acted as hindrances to performance.
Our investment approach does not bind us to either ‘side’ of the market – growth or value – and in fact we find such nomenclature to be misleading because the prudent practice of public market equity investing should be focused on the interplay of the two, rather than a binary choice between them. In the establishment of our investment universe and ultimately the selection of our concentrated portfolio, we first examine business quality, industry structure, long-term prospects, financial health, and management capabilities. Only when we deem a company to have met appropriate thresholds on each of those dimensions do we undertake the task of determining entry valuation ranges for which we believe there is reasonable risk-adjusted compensation available to us as investors. If such compensation becomes diminished during the period of ownership, we actively rotate capital towards other opportunities, always with a guiding focus on business quality and long-term conviction. We believe this approach is prudent, transparent, repeatable, and is supported by empirical evidence. It is not designed to beat, nor is it likely to beat, broad index returns over point-to-point periods inside of market cycles, but we remain highly confident that it is the best path to attractive long-term compounding of equity returns for disciplined investors.
Stock-specific performance within the Fund during the third quarter echoed broader trends in the equity market, with solid gains spread across the majority of our holdings. Our largest positive contributors in the third quarter were Copart Inc., Berkshire Hathaway Inc., Zoetis Inc., and Nike Inc.
Shares of Copart gained 26% in the quarter to reach new record highs as auto salvage activity continued to recover from depressed levels earlier in 2020. Rising trends in total miles driven and surprisingly high rates of accident frequency have driven volume gains, while insurers’ usage of total loss declarations remain elevated, in part due to backlogs in claims adjustment and repair services. Moreover, auction prices reached record levels, benefiting from the interplay of continued growth in international bidding activity, constrained supply, and a higher mix of newer, less damaged vehicles. In September, Copart reported financial results for its fiscal fourth quarter. Total revenues declined modestly as the effects of the pandemic impacted year-over-year comparisons and a large UK customer continued to shift its vehicle sales volumes towards an agency model. Operating profits, however, grew at a high single-digit rate as strong auction prices and good controls on discretionary spending drove substantive margin expansion. We believe that Copart has managed its business effectively through the recent headwinds and remains well positioned to maintain leadership in a structurally attractive industry setting, while also investing in future growth. Since the Fund’s inception, Copart has been among our top performing holdings. Based on this strong performance and the company’s share price trading closer to our estimate of intrinsic value, we elected to reduce the position size in September as we were making purchases elsewhere in the portfolio.
In our 2Q Quarterly Fund Update, we noted that weakness in Berkshire Hathaway’s share price appeared to be out of step with the resilient fundamental performance of the business, the sharp mark-to-market recovery in its large investment portfolio, and its overall financial strength. As such, the stock’s nearly 20% return in the third quarter offered some validation of our views. While near-term operating earnings in the company’s non-financial subsidiaries remain subdued by pandemic-related headwinds, the insurance segments have continued to report very strong results, and Berkshire’s cash-rich balance sheet stands as a source of defensive strength and potential opportunity.
Zoetis shares rose throughout the quarter, supported by strong overall business results and management’s robust outlook for the remainder of the year. While the company’s livestock segment has been challenged by pandemic-related issues in the U.S. market, the companion animal segment continued to grow at double-digit rates driven by secular trends favoring discretionary spending on domestic pets as well as strong customer uptake of recently-launched products. We continue to view animal health as an attractive and resilient industry, and we commend Zoetis’s management for its strong and consistent execution over many years.
Shares of Nike rose sharply in August and September and ended the third quarter with a gain exceeding 28%. The company’s operating results showed a surprisingly strong rebound through the summer months, recovering from significant declines earlier in 2020. Recent shifts in consumer behavior, such as more time spent at home and a redirection of disposable income away from out-of-home activities, have bolstered already-positive secular trends in fitness and active lifestyles. At the same time, proactive steps taken by management to meet consumer demand have helped guide the business towards higher e-commerce penetration, higher engagement on mobile app platforms, and sharper marketing and innovation – all of which are helping to accelerate change with positive implications for the long term.
The Fund’s largest performance detractors during the third quarter were Perrigo Co. PLC, Fleetcor Technologies Inc., and Baxter International Inc. Investors reacted negatively to Perrigo’s early-August earnings release, in which management elected not to raise its current-year earnings outlook despite the influence of various pandemic-related factors that had boosted the business in the first half of 2020. We attribute this cautious tone largely to general conservatism given lingering economic headwinds that may impact consumer spending and medical access. In addition, Perrigo announced that it had voluntarily recalled an important new product in its prescription generics business. The product, a highly-profitable generic equivalent of the ProAir inhaler, does not appear to have any safety issues, but does have possible flaws in the physical device that can cause clogging. The company did not provide any timelines as to when the product could be re-introduced in the market, but 2020 financial guidance was maintained.
While overall market sentiment on Perrigo remains poor, our view remains more favorable given what we see as an attractive risk-reward tradeoff in the shares. The company’s consumer healthcare business (~80% of revenue) remains well positioned in a growing market, yet in our view it does not receive a look-through valuation that is comparable to other public companies in the consumer sector. Perrigo’s prescription generic business remains a valuable asset that has shown significant financial improvement in recent years; we believe the company remains open to a possible divestiture at an appropriate price. One key non-operating matter that continues to weigh on sentiment is the existence of ongoing tax inquiries with the U.S. Internal Revenue Service and Irish tax authorities. We anticipate a decision on the Irish tax matter (the larger of the two in potential liability terms) in the balance of 2020. At currently low valuation levels, our view is that that the risk-reward on the tax issue is favorable to Perrigo, with meaningful upside if the inquiry is dismissed, and potentially limited additional downside if not.
Baxter shares traded lower following the release of lower-than-expected second quarter financial results, which were pressured by an unprecedented decline in hospital admissions for deferrable surgical procedures due to the COVID-19 pandemic. Our financial models and valuation assume only a gradual recovery in procedure growth, which should benefit the company’s broad range of hospital and surgical products. An additional sentiment overhang affecting the stock has been uncertainty related to the outlook for U.S. public health reimbursement for Theranova, a key pipeline program in Baxter’s important renal care division. We believe that the company’s current stock valuation incorporates unjustifiably modest long-term expectations, particularly given the quality of Baxter’s operations, strong execution by the management team, and the necessity of its products in multiple areas of healthcare. Based on this perspective, we added to our position in mid-September.
Portfolio Changes and Valuation
During the third quarter, we initiated new positions in Amazon.com Inc., Visa Inc., and Thermo Fisher Scientific Inc. Each of these companies represents a strong degree of fit with our investment criteria based on their strong competitive positioning, attractive long-term earnings power, and durable secular growth drivers.
Amazon is a pioneering technology company that has consistently parlayed first-mover advantages into an ever-broadening set of services for consumers and businesses. The company has leading market positions in e-commerce and cloud computing – both of which have visible long-run structural growth attributes, in our view. Amazon’s long history of innovation and internal reinvestment has allowed it to build significant competitive barriers in markets that require tremendous scale. We believe that the many advantages conferred by this unique positioning combined with sustainable future growth and demonstrable levers for profitability offer a compelling opportunity for Amazon to create substantial additional growth in shareholder value over a long time horizon.
Amazon has long been a company on our investment wish list, but in 2020 our investment thesis evolved in two significant ways as a result of the COVID-19 pandemic. First, recent earnings results confirmed that Amazon can achieve high levels of cash flow generation when operating at higher levels of capacity utilization across its vast infrastructure. Second, the pandemic has increased our confidence that Amazon’s present and prospective market share in both e-commerce and cloud computing is not only higher than previously estimated, but also will benefit from ‘front-loading’ effects related to the pandemic itself. The company’s second quarter results benefited from a large acceleration in e-commerce spending and cloud computing demand but did not show a one-for-one expansion in investment spending. This dynamic resulted in Amazon driving large incremental amounts of profitable business volumes across its asset base, creating an illustrative proof point about the future state of the business and its inherently attractive margin and return potential as growth investments eventually taper. Importantly, given the secular growth powering several of its businesses (and the underlying investments that will be required), we still assume that the true tipping point for scaled margin liftoff lies well in the future. Nevertheless, the dynamics at play in the second quarter helped to de-risk the potential range of profitability outcomes for the business at maturity, in our view.
In addition, we believe that the COVID-19 pandemic has accelerated e-commerce and cloud computing demand by several years, suggesting that key parts of Amazon’s business not only have been re-based higher, but are now more likely to grow at higher rates prospectively. We believe the company’s competitive position is therefore strengthening as the result of the pandemic, and its hold on the customer is increasing. As well, the continued struggles or outright failures of many traditional retailers may further bolster the online shift, to the benefit of Amazon as the largest e-commerce platform. For the cloud computing segment, the pandemic also has confirmed the value and appeal of the ‘app economy’ and streaming services, both of which are major customer groups for Amazon Web Services. Noting the points above, we believe that 2020 has brought about a unique set of circumstances that have structurally improved Amazon’s growth profile and competitive position, giving us even greater confidence in the company’s ability to take market share and achieve strong compounding of financial value going forward.
In September, we initiated a new position in Visa, which together with our existing position in Mastercard Inc. raised our total portfolio exposure to the card networks to approximately 6%. Visa owns and operates technology platforms that enable electronic payment transactions worldwide, connecting millions of merchants to billions of consumer credit and deposit accounts. Visa’s secure global infrastructure and multi-party, open-loop network provide authorization and settlement of credit and debit card payments, with value-added overlays such as fraud protection and currency translation. In its role as a critical intermediary, Visa also sets rules, standards and pricing that govern card transactions between merchants, consumers, banks, and other participants.
Our investment case for Visa is predicated on favorable secular trends that underpin growth in electronic payments, the competitive stability of the industry and the existence of very constructive network economics that we believe will continue to drive high margins and returns on capital for the market leaders. Electronic payments remove friction from the point of sale and offer enhanced speed, safety, spending power, and interoperability with other technologies. These attributes have driven ‘share of tender’ gains for decades, but we believe there is substantial room for additional growth. Visa and Mastercard operate as a stable duopoly, and the scale and ubiquity of their respective brands and networks make it unlikely that new entrants could feasibly replicate their market positions, in our view. Notably, while the two companies do compete for business and seek to gain the edge in technology development, they have long avoided the use of destructive pricing actions in the core processing business, and they focus their brand investments and market messaging on driving the shift of payments towards cards. As such, they both have enjoyed a long run of very profitable growth while also growing their claims on the total addressable market.
We view Visa’s core business as being attractive for the described growth and competitive positioning, but the company is also capturing nascent opportunities outside its core that represent additional upside. Visa has invested significantly in the software layer that enables business-to-business transactions, and that market significantly expands the company’s addressable market beyond traditional consumer payments. The inter-corporate market is minimally penetrated by cards, creating headroom for the card networks to offer a variety of solutions that reduce all-in transaction costs and speed the movement of funds. Even a relatively small incremental capture of the vast corporate payments market creates the potential for material upside to our long-term cash flow forecasts, and thus the prospective value of the business.
The COVID-19 pandemic has had opposing effects on Visa’s near-term earnings power. Widespread travel restrictions and changes in consumer behavior have sharply reduced the run-rate of cross-border card payments at the physical point of sale. Because of the increased fraud detection requirements inherent in a cross-border transaction, these are Visa’s highest-yielding transactions in terms of ad valorem fees and thus profit margins. Gains in cross-border e-commerce transactions have provided some degree of positive offset, but not to an extent that could replace the portion that is dependent upon physical travel. As such, the company’s revenue and earnings have been pressured during 2020.
Conversely, the pandemic has precipitated a step-change in online shopping penetration, which is a favorable trend for Visa. Because electronic payments represent nearly 100% share of e-commerce transactions (cash is not an option online), the accelerated growth and share of e-commerce also accelerates the consumer shift of cash to cards and the aggregate market share of electronic payments. Visa’s revenue yield and profit margins are higher for online transactions given the need for enhanced fraud prevention and other services, and thus the upward rebasing of e-commerce and the likelihood of continued strong growth are positive earnings catalysts for the business. In addition, COVID-19 has provided a boost for contactless payment adoption, which the card networks view as an important step toward capturing greater market share in small-value transactions. The value proposition for card payments for larger transactions is self-evident, as consumers generally prefer not to carry large amounts of physical cash. However, cash has long represented a persistently high share of smaller transactions. The pandemic has increased consumers’ perception of cash as unhygienic, while electronic payments (especially ‘tap to pay’ methods) avoid a physical exchange. Even if COVID-19 is brought under control globally, we believe that this shift in consumer behavior will endure given the convenience and control elements. As a result, we have accelerated the timeline and increased our market share expectations for electronic payment penetration.
Later in September, we purchased shares of Thermo Fischer Scientific, a vertically-integrated provider of biopharmaceutical equipment, services, and consumables that are used by hospitals, drug developers, diagnostic labs, universities, research institutions, and government agencies around the world. Given its position as a well-managed industry leader that serves attractive and growing end markets, Thermo Fisher represents an especially good fit with our investment criteria. The company’s diversified range of tools and services are critical to both medical innovation and the everyday functioning of clinical and laboratory settings, offering a compelling balance of defensive revenue characteristics with enhanced growth prospects that are directly tied to rising global expenditures on medical research in novel therapeutic categories. We believe Thermo Fisher can grow sales above the rate of its end markets on a sustainable basis driven by market share gains and a revenue mix shift towards faster growing categories. When combined with our expectation of incremental margin improvements and judicious capital allocation (including continued industry consolidation), we believe this revenue growth can drive attractive long-term compounding of per-share free cash flow and returns on capital.
Key to our positive investment thesis for Thermo Fisher is our view that drug development is an area within healthcare that will continue to grow at very attractive rates, fueled by the need to develop effective therapies for diseases with still-large unmet medical need. Additionally, the COVID-19 pandemic has heightened the need for continued investments in the industry. In our view, the market for research-driven laboratory products and services offers attractive exposure to drug development in a top-down, holistic way that avoids the binary event risks that are otherwise inherent to the industry.
Thermo Fisher’s long-term opportunity set is also tied to its customers’ need to the enhance the efficiency of their research and development (R&D) spend. Despite years of collective efforts to streamline drug discovery, the rate of return on investment within the biopharmaceutical industry remains in secular decline and is well below the cost of capital. One explanation of this industry challenge is the shift away from ‘small molecule’ drugs toward more complex biologic products have longer development timelines. Another explanation is a higher overall regulatory burden, with higher hurdles to achieve product approval. While most industries have transformed themselves through the use of technology to become more efficient, biopharma companies have been slower to adopt these technologies relative to other industries given the unique complexities of drug development. Additionally, the availability of relevant and readily-usable proprietary data is limited, and it often takes significant time to clean, identify, and extract the data required to enable artificial intelligence as an effective tool. Information often resides within individual companies in multiple locations and across functions, and data relevant to a given target or drug may be limited or hard to access. Consequently, we believe the industry will continue to rely upon highly-scaled, highly-capable partners such as Thermo Fisher, creating an attractive setting for growth over time.
Along with the purchases noted above and our addition to Baxter International, during the third quarter we also added to our existing holdings of Progressive Corp. and Diageo plc. Progressive, a new position in the Fund this year, has achieved strong financial results over the last several months, with policy growth, premiums and loss rates all trending positively despite general economic pressures related to the pandemic. In early September, we slightly increased our Diageo position, swapping a like amount from our holdings of Brown-Forman Corp. as we judged the prevailing valuation discount in Diageo to be excessively pessimistic when considered against the long-term durability of the business and the appeal of its brands and distribution.
In order to fund the three new purchases and other portfolio additions detailed above, during the third quarter we exited our positions in Unilever NV and Novartis AG and trimmed our holdings of Alphabet Inc., Booking Holdings Inc., Oracle Corp., and Copart. In each case, these trim and sale decisions represented normal and constructive ‘competition for capital’ within our portfolio rather than any significant change in investment theses or valuation extremes.
At the end of the third quarter, we had positions in 31 companies with 47% of our assets held in the 10 largest holdings. As of September 30, the Fund was trading at 89% of our underlying intrinsic value estimates on a weighted-average basis, which compared to 87% at the end of the prior quarter. We ended the quarter with a cash position of 0.5% (versus 1.1% at the end of the second quarter) as our portfolio purchases exceeded trims and sales.
Continuing progress towards economic normalization following the COVID-19 lockdown and recession has cheered investors in recent months, even as the risk of resurgence and the timing of broadly-available rapid diagnostics and preventive treatments remain uncertain. Similarly, investors seem to have taken great comfort in the market backstop provided by the Federal Reserve’s (Fed) stated commitment to low rates and its continued absorption of public and private debt instruments, but there appears to be relatively little concern about some of the more pernicious long-run implications of monetary debasement and excess borrowing.
Along with these important open questions and sources of uncertainty, we also would add the following:
· The pending U.S. election and potential changeover in political power could reopen a broad set of debates on tax policy, with potential negative effects on businesses and investors. In particular, higher tax rates on capital gains would raise the de facto cost of equity capital, undermining the efforts of the Fed to propagate low discount rates through the financial economy.
· The Fed’s tactical pivot towards average inflation targeting and its sustained low-rate policy could have counterproductive downstream effects in at least three ways: i) the survival of uncompetitive or financially unsound companies could sustain excess capacity in the economy, thereby suppressing price levels; ii) federal government borrowings could reach unserviceable levels and displace funding of productive economic sectors; and iii) competitive devaluations by other major central banks could add to price competition in cross-border goods markets, pressuring the prices of intermediate and final goods.
· Narrowing stock market leadership within technology and growth companies in recent years has some grounding in the strong financial performance of these groups, but valuations are inherently forward-looking, and winners and losers will become evident over time. The technology sector is characterized by dynamism, intense competition, a free market of ideas and in many cases, relatively low capital requirements to gain traction. As such, it is critical to keep in mind that high valuations and heady returns introduce price risk and induce creative destruction.
· Troubling social fragmentation and large disparities in individuals’ financial security and earnings ability may push U.S. lawmakers to consider new types of entitlement spending such as universal income payments, which would almost certainly require further blending of fiscal and monetary policy in ways that are more overt and potentially inflationary.
These types of macroeconomic and policy uncertainties are as notable for their level of potential impact as they are for their impossibility to predict with any degree of accuracy. We are not making top-down calls regarding their resolution, and we will not attempt to steer our portfolio positioning based on path-dependent scenarios. Nevertheless, in the context of such a preponderance of impactful big-picture issues juxtaposed against generally expensive valuation levels across asset classes, we ask ourselves the basic question of what type of equity portfolio can provide the right balance of safety and opportunity? And here we can answer definitively: we believe high-quality businesses that fit our demanding set of investment criteria are ‘scarce assets’ by virtue of their competitive advantages, their long-term growth opportunities, and their ability to earn sustainable economic profits. Owning a high-conviction portfolio of such businesses with a balanced approach to valuation is the governing principle that will continue to guide our analysis and decision making for the Fund.
Please note that Tripp Blum, an analyst on the Core Select team, has left Brown Brothers Harriman & Co. as of September. We are grateful to Tripp for his many contributions to BBH, and we wish him well. Tripp’s responsibilities within the Consumer sector have been absorbed by other members of the Core Select team.
Michael R. Keller, 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.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Purchase and sale information provided should not be considered as a recommendation to purchase or sell a particular security and that there is no assurance, as of the date of publication, that the securities purchased remain in a fund's portfolio or that securities sold have not been repurchased.
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.
For more complete information, visit www.bbhfunds.com for a prospectus. You should consider the fund's investment objectives, risks, charges and expenses carefully before you invest. Information about these and other important subjects is in the fund's prospectus, which you should read carefully before investing.
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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-08534-2020-10-09 BBH003056 Exp. Date 01/31/2021
 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life