Dear Core Select Investors,
Our investment team has two main tools for seeking to generate attractive equity returns: (i) selecting high quality businesses that can generate strong financial results with a high level of certainty over many years and (ii) buying and owning businesses when they are trading at a discount to our intrinsic value1 estimates. In our view, business quality and valuation should reinforce each other to moderate losses in weak markets and drive higher returns across a full market cycle. The qualitative characteristics that we look for when selecting businesses that can thrive in both good and bad economic times are: (i) strong competitive advantages, (ii) essential products and services, (iii) high levels of customer loyalty, (iv) leadership in attractive industries, (v) high returns on invested capital, (vi) strong balance sheets, and (vii) high levels of free cash flow. We also look for companies run by skilled managers who are honest and know how to allocate capital intelligently.
With respect to valuation, we aim to buy businesses when they are trading at 75% or less of our intrinsic value estimates. A meaningful discount to intrinsic value seeks to protect against company-specific negative events and broader market downturns, while also creating upside potential as share prices and intrinsic values converge over time. We exit our investments as they approach or reach intrinsic value and then seek to reinvest in other businesses of comparable quality trading at larger discounts. We typically calculate our intrinsic value estimates using discounted cash flow models based on our own proprietary assumptions and our team’s extensive due diligence, analysis, and judgment. We supplement our discounted cash flow calculations with other valuation analyses including free cash flow multiples, change-of-control prices, and internal-rate-of-return calculations.
In order to concentrate our capital in the highest quality names trading at attractive valuations, we prefer a concentrated portfolio of approximately 30 businesses, and we often have individual position sizes of 3-6%. While concentration can cause significant near-term deviations from market indices, we care much more about long-term absolute returns than short-term relative returns. We construct our portfolio from a bottom-up perspective and without considering the sector weights of the S&P 5002 or other indices. Following this approach, Core Select seeks to generate strong absolute returns over full market cycles. Consistent with our “quality plus value” approach, Core Select has generally performed best on a relative basis in down markets while underperforming in certain rising markets, including over the past three years.
As we enter 2016, we believe that equity valuations for most large public companies remain high and that valuations are particularly rich for many of the stocks that have led equity markets higher in recent years. We would also note that since the rebound from the financial crisis began in 2009, value-oriented equity strategies have underperformed growth-oriented equity strategies. This trend continued in 2015 with the Russell 1000 Value Index3 declining -3.8% while the Russell 1000 Growth Index4 rose 5.7%. While this large deviation in returns partly reflects the carnage in the energy sector (most energy-related companies trade at low price-to-book ratios and are thus classified as “value” stocks), high-growth “new technology” companies have clearly been the engines that have led equity markets higher in recent years, while lower-growth value stocks have lagged. Indeed, the two best performing securities in the S&P 500 index during 2015 were Amazon and Netflix, which soared 118% and 134%, respectively, despite starting the year at already high valuation multiples. The gains from these two stocks alone accounted for two-thirds of the S&P 500’s +1.4% return in 2015.
In this letter, we want to emphasize the importance of valuation in driving attractive equity returns and to highlight valuation differences between popular and unpopular businesses. We also comment on a few of our companies whose share prices were down meaningfully in 2015 and the importance of being patient as investor sentiment shifts over time. Lastly, we reiterate the benefits of holding cash when compelling investment opportunities are scarce.
Given the tremendous share price appreciation of Amazon and Netflix in 2015, several clients have asked why Core Select has not owned these companies or other popular, high-growth companies such as Salesforce and Facebook. The answer is that, while we have studied most of these businesses carefully and view them as competitively advantaged disruptors led by capable managers, their current market capitalizations are in most cases discounting a decade or more of high growth in sectors where technology is changing rapidly, competition is fierce, and future financial models are uncertain. Amazon, for example, has established itself as the nation’s dominant online retailer and a leading cloud services provider. Its founder, Jeff Bezos, is widely regarded as a remarkable and visionary CEO. At year-end, though, Amazon had a market capitalization of $317 billion and was trading at approximately 118x consensus adjusted earnings for 2016. To justify this valuation most sell-side analysts are assuming sustained double digit-revenue growth—high-teens annual growth for Amazon’s North American retail business and significantly stronger annual growth for Amazon Web Services over the next five years—and rapidly rising profit margins. Given its leadership position in retailing and cloud services, Amazon may be able to achieve these projections, but the future is uncertain and there is still much that could go wrong. It is amazing how rapidly sentiment can shift when a widely owned stock that virtually everyone is bullish about disappoints. Fortunately, we do not have to bet for or against Amazon. Since we do not have a differentiated view of Amazon’s two core businesses and are not confident that the shares are trading today at a meaningful discount to intrinsic value, we have not purchased Amazon for Core Select.
A final point to make regarding Amazon, Netflix, and other popular stocks is that one of the worst reasons to buy a business is because its share price has risen recently. A higher share price does not mean a company’s shares will continue to rise or even necessarily that the company is performing well operationally – it simply indicates that there are more investors willing to buy at higher prices and fewer investors willing to sell at lower prices. Sometimes those investors are well informed about the underlying business’s prospects and are buying—or not selling—because they believe the shares are undervalued. In other instances they are institutional investors feeling compelled to own a popular stock because they do not want to trail an index, or they are retail investors piling in to a well-performing exchange traded fund or index fund with a large weight in that stock. In our experience, the most favored stocks at the end of a bull market are often the most overvalued.
As value investors, we prefer buying shares of companies with solid fundamentals when they are trading at large discounts to our intrinsic value estimates. In today’s highly valued market, that means buying when shares have fallen recently or are out-of-favor with other investors. Taking a contrarian investment position is psychologically difficult for many investors. There are usually legitimate concerns when a company’s share price falls sharply and investors’ perceptions can be heavily influenced by the estimates and actions of others. We have often noted that when a company’s stock is down, most sell-side analysts and commentators delight in identifying challenges and risks, whereas if the same business were in fashion, they would highlight the positives. In our opinion, one of our Core Select team’s strengths is that we are independent thinkers and we always strive to make rational and fact-based investment decisions weighing both the positive and negative factors.
One example of an unpopular and out-of-favor company that Core Select owns today is Oracle, which we first purchased in 2014 and added to on weakness in 2015. Oracle is a great fit with our investment criteria. It is a leading provider of enterprise database and application software with a large installed base of approximately 420,000 customers with particular strength in the public sector and among transaction-intensive industries such as financial services, retail, and telecommunications. Due to the essential functionality of its software and relatively high switching costs, Oracle enjoys high customer retention rates and approximately $21 billion of recurring support and subscription software revenues. Oracle’s scale and financial strength have enabled it to invest heavily in research and development and rebuild all of its core software products as cloud-native applications while also generating over $12 billion in free cash flow in each of its last three fiscal years. Management has used that cash to pay a dividend and shrink Oracle’s shares outstanding by 11% over that time. Oracle maintains a strong balance sheet with approximately $10 billion of net cash.
Despite Oracle’s many operating and financial strengths, its share price has been a laggard, falling nearly -18% in 2015 and trading only slightly above where it was in 2011. The bear case on Oracle is that (i) the company’s revenues have been flat-to-down in recent quarters because it is an “old technology” company, (ii) unlike Amazon and Salesforce, Oracle is not a cloud leader and most of its revenues still come from on premise applications rather than cloud applications; and (iii) Oracle faces increased competition from smaller, cloud-based pure-plays. The two main reasons for Oracle’s recent revenue weakness, however, have been the strong U.S. dollar, which impacts all U.S.-based multinationals and a shift away from perpetual upfront license fees to ongoing subscription fees for certain of its software products. This transition to subscription revenues is one that many other software firms, including Microsoft, have already undergone successfully. The immediate impact is always lower revenues and profits, but longer term it should result in more stable revenues and faster growth. Importantly, Oracle continued to report very strong software bookings and free cash flow generation, and we believe Oracle is making significant progress with its cloud offerings and in maintaining its dominant position in the high-end database market. One interesting fact is that Amazon, despite promoting its own cloud-based database offerings, continues to use Oracle’s on premise database software for transaction processing on its retail website.
At $36 per share, Oracle has a market capitalization of $151 billion and, on a cash-adjusted basis, is trading at approximately 8x our estimate of 2016 Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) and 12x our estimate of 2016 after-tax free cash flow. Most of Oracle’s “new technology” competitors such as Amazon, Salesforce, and Workday are trading at dramatically higher valuation levels. Oracle also trades at a substantial discount to more traditional peers such as SAP and Microsoft. Our intrinsic value estimate for Oracle using a discounted cash flow analysis is well above the current share price and assumes just low single-digit revenue and free cash flow growth. Based on our analysis, Oracle’s current valuation implies essentially no future free cash flow growth, which we view as highly unlikely given the company’s existing base of recurring revenues and continued success winning new business. Oracle’s senior management team owns a substantial amount of stock and understands the importance of capital allocation for creating shareholder value. Oracle has a strong track record of not overpaying for acquisitions and the company has been an astute re-purchaser of shares when they have traded at depressed levels. Accordingly, we are very pleased to have been able to build Oracle into a top-five holding for Core Select.
Another example of an out-of-favor stock that we purchased for Core Select in 2015 is Discovery Communications. Best known in the U.S. for its many popular cable television channels (Discovery, Animal Planet, TLC, Science, and ID), Discovery is the global leader in non-fiction programming and the largest multichannel programmer as measured by total subscribers, with nearly 3 billion in over 220 countries and territories. Two of Discovery’s key competitive advantages are its global reach and ability to create compelling content that can be monetized in many markets. Discovery also generates a substantial percentage of its revenues from recurring, long-term affiliate fee contracts with cable and satellite distributors. Discovery enjoys attractive financial margins 32% earnings before interest (EBIT) margins and generates high levels of after-tax free cash flow (nearly $1 billion in 2015) that it has used to buy back shares. Discovery is controlled by its Chairman John Malone, who has a great long-term track record of creating value for shareholders in the media industry.
Despite its many positive attributes, Discovery’s shares have fallen from a peak of $43 in 2014 to $25 per share at year-end 2015. We bought shares for Core Select in the second half of 2015 when the shares were trading in the mid and high $20s. The main reasons for the steep decline in Discovery’s share price were (i) industry-wide concerns about weak U.S. television ratings and advertising revenues, (ii) increasing usage of Netflix, Amazon Prime, YouTube, and other “over-the-top” services, (iii) the potential for declines in cable network subscribers in the U.S., and (iv) long-term threats to the current cable network ecosystem and affiliate fee model. While there is no question that the media industry is changing, we expect the changes to take place over time as opposed to all at once, and we believe that Discovery is particularly well positioned to manage this transition and thrive in the future. As noted above, Discovery has an extremely strong global footprint and is able to create nature, science, and other content with global appeal. Discovery also owns the popular and growing Eurosport network, which provides leverage in European affiliate fee negotiations. Discovery already generates over half of its revenues from international markets and we believe that the company is in the early innings of growth internationally. With respect to Discovery’s U.S. business, its ratings have held up much better than most of its peers and it has healthy relationships with most of its key distributors. For example, Discovery recently signed a long-term extension of its affiliate fee contract with Comcast, its largest distributor, which includes steady annual price escalators. From the distributors’ perspective, Discovery channels are actually a bargain – they account for approximately 13% of all viewership but Discovery receives just 6% of total U.S. affiliate fees. Accordingly, we believe that Discovery’s core networks will likely be included in any low-priced “skinny bundles” offered by cable and satellite distributors. Management’s view, which we share, is that as long as Discovery creates compelling video content, it will be able to monetize that content effectively.
At year-end, Discovery had a market capitalization of $17 billion and was trading at approximately 9x our estimate of 2016 EBITDA and 12x our estimate of 2016 free cash flow. As with Oracle—and in sharp contrast to a company like Netflix—the current valuation for Discovery assumes little or no future growth. We view that as unlikely since Discovery’s already substantial international business appears poised for significant long-term growth and its U.S. business remains stable and very profitable. In fact, management recently guided for double-digit annual free cash flow growth over the next three years and has stated that the company should have over $10 billion in excess capital to deploy in share buybacks and acquisitions over the next five years. Accordingly, we think that on a stand-alone basis Discovery is trading at a large discount to its intrinsic value. We also believe that consolidation is likely in the media industry and that there could be several potential acquirers for Discovery given its unique portfolio of content assets and leading international distribution platform.
When Bad Things Happen to Good Companies
With both Oracle and Discovery, we believe we have executed well in taking advantage of negative investor sentiment to establish substantial positions in resilient, competitively advantaged companies at attractive prices. In our view, the capital we have invested in both businesses is well protected and we are looking forward to the progress these companies will make in the coming years. Since we typically own businesses for multiple years, though, there will inevitably be instances where existing portfolio companies that meet our stringent business and valuation criteria suffer negative developments that depress their share prices and, in some instances, require us to lower our intrinsic value estimates or even to exit our positions. During 2015, a few of our Core Select portfolio companies encountered meaningful challenges. When that happens, we carefully evaluate our original investment thesis and due diligence work, as well as reassess our valuation analysis and the current risks and range of potential outcomes. We also focus very carefully on the actions of senior management since companies require strong leadership at moments of stress.
One portfolio company that faced several unexpected challenges in 2015 was Qualcomm, which is a leading global provider of intellectual property and semiconductor products that enable wireless communication and mobile computing. With essential patents, long-term relationships with virtually all large mobile carriers and most handset manufacturers, an efficient operating model, and a strong balance sheet, Qualcomm is a strong fit with our investment criteria. We first purchased shares for Core Select three years ago at $59 per share and have added periodically since then on weakness. Over the past 18 months, however, Qualcomm’s shares have fallen from $80 to $50 due to a series of operating disappointments and regulatory challenges, including (i) an anti-trust investigation of Qualcomm’s business practices by Chinese authorities, (ii) lower profits from its chip business due to customer mix shifts, low-end price pressure in China, and Samsung’s decision to insource a key component, (iii) delays in reaching licensing agreements and being paid by certain Chinese handset manufacturers, and (iv) additional “copycat” anti-trust regulatory inquiries in Japan, Korea, and Europe. Coming one after another, these negative developments pressured Qualcomm’s profits in 2015 and hurt Qualcomm’s standing with investors.
Fortunately, Qualcomm was able to resolve most of the challenges listed above during the calendar year, including (i) ending its dispute with the Chinese anti-trust authorities and signing an agreement on relatively favorable terms, (ii) reporting a rebound in chip revenues and profits for its fiscal fourth quarter, as well as the successful release of its next-generation Snapdragon 820 processor, and (iii) announcing royalty-bearing patent agreements with six Chinese manufacturers that had been delaying payment and under-reporting sales. Unfortunately, the regulatory issues in Korea, Taiwan, and Europe remain outstanding and, given the arbitrariness of anti-trust laws, there is certainly a possibility of a negative ruling or additional regulatory inquiries. From our perspective, however, Qualcomm continues to occupy a vital role in the telecom industry and is well positioned to benefit from the proliferation of smartphones and other mobile devices worldwide and the continuing migration to more advanced technologies covered by the company’s patents. At the request of certain activist shareholders, Qualcomm also conducted a strategic review of its business in 2015. While identifying significant opportunities for reducing costs, Qualcomm’s management and board of directors decided against splitting its businesses into two public companies. We strongly agree with that decision since we view Qualcomm’s licensing and chip businesses as complementary and, based on our own in-person meetings and feedback from knowledgeable industry participants, we have a favorable view of senior management.
Accordingly, while we did lower our intrinsic value estimate for Qualcomm during the year to reflect greater regulatory challenges and reduced licensing fees longer term, we continue to think Qualcomm will be a successful investment for Core Select and we added to our position three times during the year. We would also note that Qualcomm’s shares are currently trading at approximately 11x free cash flow and 7x EBITDA, which are very low multiples for a competitively advantaged and high-return business. Given the low share price and Qualcomm’s substantial free cash flow, management has committed to a massive $15 billion share buyback plan, which represents approximately 20% of Qualcomm’s market capitalization at current price levels.
A second example of existing portfolio companies facing significant headwinds in 2015 is that of our four energy companies: EOG Resources, Occidental Petroleum, Southwestern Energy, and Schlumberger. For the whole energy sector, the main challenge has been the collapse in oil and natural gas prices as a result of (i) strong growth in North American oil and natural gas production due to better technology and greater operational efficiency, (ii) Organization of the Petroleum Exporting Countries (OPEC) decision in late 2014 to increase oil production rather than constrain supply, and (iii) increased uncertainty around future demand growth following slowdowns in key emerging market economies. In the case of Southwestern, which is primarily a producer of natural gas in the eastern U.S., the pressure from low prices has been exacerbated by a large acquisition made in late 2014 that increased the company’s debt levels and large pricing differentials for some of Southwestern’s production due to limited take-away capacity.
We have always recognized that oil and natural gas prices are volatile and can move to extremes, but we did not anticipate the greater-than-50% decline in oil and natural gas prices that has occurred over the past 18 months. Fortunately, part of our strategy in the oil and gas sector has always been to focus on companies with long-lived reserves, strong balance sheets, and low exploration and production costs. Those attributes should help our three exploration and production companies survive in the current low-price environment longer than most of their peers and, in the case of EOG and Occidental, potentially take advantage of distressed asset sales by other energy companies. With respect to our investment team’s view on oil and natural gas prices, we believe that current prices of less than $40 per barrel of oil and approximately $2 per million British thermal units (BTU) for natural gas are meaningfully below the marginal cost of production. Accordingly, drilling activity in North America should continue to decline since it is currently unprofitable (the number of rigs in production has fallen by over 65% since 2014), leading eventually to significant production declines and meaningfully higher oil and natural gas prices over time.
In reassessing the intrinsic value estimates of our energy companies and stress-testing their balance sheets, we have looked at a wide range of possible future energy price levels and industry cost structures. Under most of those scenarios, the current share prices of our companies look attractive today. From a balance sheet perspective, Southwestern is the energy company in our portfolio that has the most leverage and would have the greatest need for additional equity capital if energy prices were to move even lower for an extended time period. Not surprisingly, it was also the worst performer in our portfolio, falling 74% in 2015. Nevertheless, we still view Southwestern as a well-managed exploration and production company with excellent acreage and reserves. We also believe that it has a stronger financial position than many other leading natural gas producers do.
Our initial reaction when oil and natural gas prices began falling in mid-2014 was to add modestly to our energy holdings. As commodity prices moved still lower, however, we began reassessing the likely severity of the downturn and the implications for industry participants and equity valuations. Accordingly, even though share prices for all of our energy companies have fallen substantially in 2015, we have not made any further purchases since January 2015. We also sold in January our shares of California Resources Corp (CRC), which we had received as a spin-out from Occidental Petroleum. Unlike Occidental, CRC is a relatively high-cost producer with a fair amount of debt. During 2015, our energy team focused on re-underwriting our four remaining investments—with a particular focus on Southwestern and its balance sheet and funding needs—and evaluating downside scenarios. Our findings to date have been thesis affirming, although we certainly cannot rule out further losses if oil and natural gas prices remain at depressed levels.
It is important to point out that every year, a few of our approximately 30 Core Select companies will experience disappointments and setbacks that meaningfully impact their share prices. From that perspective, the challenges that Qualcomm has faced this year are not particularly extraordinary. Having said that, we do try to learn from our setbacks and one of the takeaways from Qualcomm’s experiences in 2015 is that the international regulatory environment has become much more hostile in recent years, particularly for U.S. technology companies. The more hostile environment in part reflects (i) foreign governments’ displeasure at the way the U.S. government used many American technology companies to spy around the world, (ii) payback for the way the U.S. has aggressively fined and sanctioned many foreign companies operating in the U.S., and (iii) a desire to advance local business interests. We are incorporating those lessons into how we assess and value multinational U.S. companies.
As we think about the prospects for our investments in the energy sector today, we see strong parallels to the financial services sector during the 2008-2009 Financial Crisis. As most of us will remember, the share prices of most banks and insurance companies fell precipitously as the crisis unfolded and several prominent institutions failed. With the benefit of hindsight, we know that most large U.S. banks and insurance companies survived and their share prices have since increased dramatically. Many investors at the time felt that the sector was “uninvestable” given the real systemic stress and waves of selling that had resulted in so much capital destruction. Today, the energy sector is going through a similar destructive period and many investors – both professional fund managers and retail investors alike – have exited their positions in disgust. In fact, many portfolio managers have had no choice but to sell since most funds with large holdings in the energy sector have experienced large losses, which in turn have prompted investor redemptions and, in some cases, fund closings. This level of technical selling and extreme bearishness may be an indication of a market bottom for the energy sector. One key distinction between the Financial Crisis and the current energy industry downturn is that the collapse in energy prices should actually be a positive for most consumers and businesses (other than those in the energy or related industries). In contrast, the Financial Crisis was almost universally negative for near-term global economic activity.
Contrarian investments require firm conviction in the long-term merits of an investment and the patience to hold until negative investor sentiment subsides and market prices and intrinsic values converge. While we had our fair share of challenging investments during 2015, we also had a number of big successes in which patience over several years led to large gains. A great example is Chubb, a leading property and casualty insurance company that we first purchased for Core Select in 2007 at $54 per share and which we added to at lower prices in late 2008. Our original investment thesis was that Chubb had one of the few differentiated insurance brands, a leading position in high-end personal lines, a disciplined underwriting culture, and excess insurance reserves. Over the past eight years, these positives have helped Chubb quietly generate consistently high profits, which management used to grow its book value per share, pay a dividend, and reduce by over 40% the company’s outstanding shares. Along the way, Chubb weathered a number of significant challenges including: (i) the 2008 financial crisis, (ii) Hurricane Sandy in 2012, which was the second-costliest hurricane in U.S. history and battered the Northeast states where Chubb is particularly strong, and (iii) most recently, significant price weakness and increased competition in commercial insurance. Any one of these challenges could have scared us into selling, but we stayed invested because of our team’s conviction in Chubb’s competitive position and superb management team. In June 2015, Chubb announced that it was being acquired by ACE Limited for cash and stock worth approximately $125 per share and the deal is expected to close in early 2016.
Another 2015 success was Microsoft, which Core Select has now owned for over ten years. During that period, Microsoft’s shares have moved up and down and we have adjusted Core Select’s position size accordingly, building when the shares were out of favor and trading at a large discount and then trimming when they were in fashion and trading close to our intrinsic value estimate. Three years ago in late 2012, investor sentiment had reached a low point with personal computer sales slumping, Microsoft’s incredibly profitable Windows franchise under threat, and a beleaguered Steve Ballmer presided at the helm. Revenues were flat and earnings were down. At the time, however, Microsoft was investing heavily in its enterprise and hybrid cloud platform and data services and was also introducing an impressive range of innovative consumer devices and services. Over the past three years, and particularly since Satya Nadella became CEO in 2014, Microsoft has been able to capitalize on its many inherent strengths and regain its momentum. Following a string of successes with Windows 10, Office 365, and its Azure cloud platform, Microsoft’s shares returned +22.7% in 2015 and have now more than doubled since December 2012.
A third top performer in 2015 was Alphabet, formerly known as Google, which returned a remarkable +44.6% during the year and was Core Select’s biggest single positive contributor5. A year ago, however, we were receiving a lot of questions from investors about why Google’s shares were down in 2014 and whether escalating regulatory pressures, lower mobile search monetization rates, and increasing in-app search volume meant Google’s best days were behind it. Over the past year, these fears have largely dissipated as Alphabet has posted robust financial results due to strength in mobile search, YouTube, and programmatic campaigns, as well as improved expense control and the expectation of greater transparency on its non-core investments. While some of the risks that investors were worrying about a year ago remain, the market’s focus today is on Alphabet’s many competitive strengths.
In December, we trimmed our positions in both Microsoft and Alphabet. While both companies remain large positions for Core Select and we raised our intrinsic value estimates for them during 2015, we see less upside today than a year ago. With respect to Chubb, we have sold down our position significantly since the ACE transaction was announced because we think the current share price fully values the combined company. Just as we were patient in waiting for Alphabet, Chubb, and Microsoft to appreciate, we also want to be disciplined sellers when our investments approach and reach our intrinsic value estimates.
Core Select’s cash position at year end 2015 was 12% and has averaged approximately 11% over the past two years. The primary reason for the elevated cash levels is that we have trimmed or exited a number of investments that have approached or reached our intrinsic value estimates. Meanwhile, although we did make one new purchase in 2015 (Discovery) and we added to ten existing positions—including Oracle and Qualcomm—we made fewer purchases than sales during the year. Since the formation of our Core Select investment team in October 2005, we have been strict about only purchasing shares of new or existing portfolio companies when they were trading at 75% or less of our base case intrinsic value estimates. This discipline has worked well for our investors over the past decade and we are not inclined to alter our approach today simply because equity valuation multiples have increased meaningfully over time. We also have to take into account position weights in the portfolio, common risk factors across different positions (e.g. oil and gas prices in the energy sector), and our percentage ownership of the underlying companies. Our experience is that equity prices can be surprisingly volatile and the passage of time always brings compelling new investment opportunities.
After seven consecutive years of near-zero interest rates and rising equity markets, the share prices of most U.S. large cap companies appear expensive to us. In our view, the high valuations suggest that equity returns over the next seven years will likely be sub-par. Consistent with our Core Select investment philosophy, we are focused on resilient, competitively-advantaged companies that provide essential products and services and have strong financial positions. We are also consciously avoiding many of the most popular, high growth companies that have recently led equity markets higher since they are likely overvalued. Instead, we are buying and adding selectively to a few out-of-favor companies where we still see value, as well as reverting to cash when we cannot find such opportunities. We are confident in our approach and believe that over the long term, valuation will continue to matter in investing.
On behalf of the Core Select investment team,
Timothy E. Hartch Michael R. Keller
Co-Portfolio Manager Co-Portfolio Manager
 BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
 S&P 500 is an unmanaged, market capitalization weighted index of 500 stocks providing a broad indicator of stock price movements. The index is not available for direct investment.
 Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The index was developed with a base value of 200 as of August 31, 1992.
 Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The index was developed with a base value of 200 as of August 31, 1992.
 Alphabet has multiple classes of stock. Its Class C shares (GOOG) returned +44.6% and its Class A shares (GOOGL) returned +46.6% during 2015.
BBH Core Select Fund — Holdings as of December 31, 2015
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Expiration Date 4/30/2016