For the third quarter ended September 30, 2020, the BBH Partner Fund —International Equity (the “Fund”) returned +8.11%. Over the same period, the MSCI EAFE Index1 (the “Index”) returned +4.80%.
Select Equity Group, L.P., the Fund’s sub-adviser, assumed management of the Fund on February 24, 2017. Since that date through the third quarter of 2020, the Fund has generated a net annualized return of +11.20%, outperforming the Index’s annualized return of +4.30% by approximately +690 basis points2 (“bps”) per annum. The Fund has generated a net cumulative return of +46.6% over the same period, outperforming the Index’s cumulative return of +16.4% by approximately +3,020 bps.
International equity markets continued to recover in the third quarter following the sharp sell-off witnessed in February and March 2020. Unlike the near-uniform, double-digit declines and subsequent bounce in stocks that characterized the first and then second quarters of the year, we are now witnessing a divergence in market opinion on the fates of individual businesses in a post-pandemic world. Stocks perceived as COVID-19 beneficiaries (particularly in the Technology sector) have experienced rapid share-price appreciation and, in many cases, have already surpassed their pre-pandemic highs. Conversely, many companies that operate in non-digital domains — particularly in those sectors most directly negatively impacted by coronavirus-related restrictions on consumer behavior (notably travel and leisure and brick-and-mortar retail) — have seen their shares languish, and markets overall remain down on the year as of this writing (unsurprisingly, given the global economic recession wrought by the virus). This uneven recovery in equities is presenting us with opportunities on both sides. While we remain invested in many outstanding companies that have continued to grow cash earnings and/or earnings power through the ongoing downturn, we have been gradually rotating capital into what we believe are high-quality growth companies on our approved list whose shares remain relatively depressed (and, thus, offer compelling valuations).
In the third quarter of 2020, the Fund’s returns continued to be broad-based. In a period during which the Index gained +4.80% in just three months, the Fund’s contributors outnumbered its detractors by more than four to one. In the third quarter, we had 10 positions that contributed greater than +0.20% each to the Fund’s returns, including six that contributed greater than +0.50% each. We had two positions that detracted more than -0.10% each during the period, one of which detracted greater than -0.20%.
Our largest contributor to performance in the third quarter was Alibaba Group (9988 HK), a company that we have been studying since its initial public offering (IPO) in 2014. Alibaba operates the largest online commerce platform in China and one of the two largest in the world. Its Taobao (consumer-to-consumer) and Tmall (merchant-to-consumer) e-commerce sites account for a staggering 18% of all consumption in the Chinese economy, up from 10% just five years ago. Alibaba exhibits one of the best financial profiles in our universe, maintaining over 20% operating margins and more than 25% free cash flow margins, while organically growing revenue more than 30% annually. Over the last five years, Alibaba has compounded cash earnings per share at a 45% compound annual growth rate (CAGR). Despite its unique blend of high growth and strong cash-flow generation, Alibaba trades at a pronounced valuation discount to the well-known, publicly traded technology and Internet giants in the U.S. We significantly increased our existing holding in Alibaba earlier this year, making it a top five position, when rising U.S.-China geopolitical tensions caused the stock to trade off to a 3% free cash flow yield. At the time, notwithstanding trade tensions (which have very little impact on Alibaba’s predominantly domestic Chinese operations), we observed that China’s economy was experiencing the closest thing to a “V-shaped” economic recovery of any large country in the world thanks to its relative success in avoiding a second nationwide outbreak of the coronavirus. At the same time, we viewed Alibaba as a natural beneficiary of changing consumer behavior post-COVID-19, as more purchase behavior across a wider spectrum of product categories shifted to e-commerce from brick-and-mortar retail. During the third quarter, Alibaba reported very strong quarterly results with revenue growing 34% year over year (YoY) and operating profit growing 37% YoY. The company subsequently hosted a three-day virtual Investor Day, at which management reassured investors that it would likely deliver strong overall group profitability by investing in a disciplined manner in its numerous money-losing, non-core business lines. The stock appreciated +32% (in USD) during the quarter, contributing roughly +130 bps to the Fund’s performance. We believe Alibaba remains significantly undervalued, and the position ended the quarter as our second-largest holding.
Another top contributor during the quarter was Merck KGaA (MRK GY), a company we have been studying for nearly 20 years. Headquartered in Germany, Merck’s multinational portfolio includes 250 different science and technology businesses. In aggregate, this portfolio has delivered consistent and resilient growth over time with revenue and cash earnings growing at 10-year compound annualized rates of 8% and 11%, respectively. Merck’s Life Sciences segment, which supplies chemicals and tools to labs, research institutions and the wider pharmaceutical production value chain, represents approximately half of the company’s revenue and profits today. Approximately 90% of Merck’s Life Sciences products are recurring consumables that can be delivered within 48 hours anywhere in the world, and Merck exacts 100 bps to 200 bps of annual pricing power on these products against a market backdrop of predictable 4%-5% volume growth. In fact, the Life Sciences division is composed mainly of two formerly public companies that Merck KGaA acquired (Millipore and Sigma-Aldrich) that Select Equity studied extensively and admired since the early 2000s. Most high-quality, publicly traded life sciences companies have seen their stock market valuations rerate dramatically higher this year, both as resilient growth companies and on expectations for significant multi-year increases in spending as the world combats the COVID-19 pandemic. Surprisingly to us, Merck KGaA’s share price initially lagged the performance of its listed peers in the immediate aftermath of the global market sell-off. We added to the position on sustained price weakness in the second quarter of this year. during continued weakness in Q2. We expected accelerating results not only in Life Sciences but also in the company’s Materials Science segment, driven by strong end-market demand and an improving business mix following the acquisition of listed semiconductor materials supplier Versum Materials (another business we have studied for years that we regard highly). During the most recent quarter, Merck reported solid results with management signaling a strong outlook for the second half of the year (led by high-single-digit growth in Life Sciences). Merck’s stock ultimately gained +26% (in USD) during the period, contributing roughly +90 bps to the portfolio’s performance.
The largest detractor from our third quarter performance was Shiseido (4911 JP), a Japanese maker of premium skincare products and cosmetics. Prestige beauty care is a value chain that Select Equity has studied and appreciated for many years, which exhibits defensible, price-supported high-single-digit growth, particularly in developing Asian markets like China. Shiseido’s brand portfolio has been well-positioned to take advantage of this market growth, but the company suffered from chronic mismanagement until 2014 when Shiseido hired Masahiko Uotani, the company’s first externally sourced CEO in its 140-year history. Since then, the business has right-sized its cost structure and returned to profitable growth. In the five years preceding Uotani’s hiring, revenue grew at an anemic 2% annually, and operating margins declined by 50%. By contrast, from 2014 to 2019, Shiseido grew revenue 9% annually and operating profit 30% annually. We began building a position in Shiseido nearly two years ago when fears of a slowdown in China’s economy temporarily weighed on shares and presented an attractive valuation opportunity. As Shiseido’s second-largest market, China is its most important long-term growth driver, as premium beauty-care products are significantly underpenetrated on a per-capita basis relative to developed markets and even versus other emerging economies. As China’s “V-shaped” economic recovery from COVID-19 progresses, we expect Shiseido’s earnings outlook to continue to improve over the next five years, buoyed by a rebound in demand as well as management’s ongoing efforts to raise profit margins closer to the levels enjoyed by well-managed global peers. Notably, Shiseido’s share price has meaningfully underperformed that of its listed premium beauty competitors in the U.S. and Europe this year. During the third quarter, the shares fell nearly -10% (in USD), detracting roughly -30 bps from performance. We believe the company remains significantly undervalued as of the end of the third quarter, and we added to our Shiseido position on weakness during the period.
Another notable detractor in the quarter was Safran (SAF FP), a France-based leader in commercial and military aerospace propulsion and equipment that we have studied since 2017. The company supplies niche components to newly sold aircraft and provides aftermarket engine services to aircraft currently in service. Safran’s engines power over half of all Airbus A320s and all Boeing 737s currently in service, producing predictable, high-margin, recurring aftermarket revenue. Over the last 10 years, Safran has grown its revenue by 9% annually, while compounding cash earnings growth at more than 20% annually with double-digit returns on both total capital employed and shareholders’ equity. Going forward, Safran’s design wins on newer platforms, such as the Airbus A320neo and Boeing 737 Max, should ensure continued growth and aftermarket revenue until at least 2060. Safran is an excellent example of one of the companies left behind in the equity market’s unbalanced recovery this year; its shares sold off more than -60% (in USD) in the first quarter market meltdown, as global air travel ground to a halt, and ended the third quarter with its shares still more than -40% (in USD) lower year to date. Despite a material reduction in near-term demand, Safran should maintain double-digit operating margins this year, as the company accelerates restructuring efforts. Over the long term, we expect that global air travel will recover to its previous highs by 2023-2024 with Safran benefiting from a large snap back in organic revenue growth next year. Having initiated a position in Safran during the Q1 sell-off, we continued to add to the position on weakness in Q3 with the company trading at a discount of more than 50% to our estimate of intrinsic value3. The shares fell by approximately -5% in EUR (a decline of just over -1% in USD) in the quarter, detracting approximately -15 bps from performance.
As of the end of the third quarter, our portfolio’s valuation represented approximately 10%-15% upside to our estimate of is intrinsic value, broadly unchanged over the last three months. As of quarter-end, our cash balance was roughly 5%, down from 10% last quarter. We seized opportunities to deploy capital in three new positions during the period, in each case in companies that we have studied for most of the past decade and which were trading at still-attractive valuations amidst the overall market’s one-sided recovery. We ended the period owning 45 companies, up from 42 holdings last quarter. We continue to concentrate the portfolio in our highest-conviction opportunities. Our 15 largest positions comprised 55% of the portfolio, and our top 20 positions comprised 66% — figures that, in both cases, represent a historically high level of concentration.
The Investment Environment
We write this quarterly letter in the midst of rapidly escalating COVID-19 cases, along with hurriedly reactionary local and national restrictions, and following a U.S. election of pivotal significance not only nationally but also globally. Brexit negotiations are at a make-or-break point, and Q3 earnings season is underway with signs of a decelerating global economic rebound. In fewer words, the near term could not be less clear.
The unbalanced recovery we have observed across different types of business models has also proven true of different geographies. Roughly seven months since the pandemic accelerated globally, economic outlooks vary by country, depending on the relative efficacy of the public health policy response. Of the major economies, only China has managed to overcome COVID-19 sufficiently to return to growth with gross domestic product (GDP) estimated to rise 1.9% this year and 8.2% next, according to the International Monetary Fund. Japan (-5.3% this year and 2.3% next year) and the more advanced Asian economies, such as Taiwan and South Korea, come next. Aggressive fiscal stimulus cushioned the economic impact of the first wave of COVID-19 in the U.S. (-4.3% this year and 3.1% next year), but a flawed public health policy response leaves it vulnerable to a second wave. The eurozone (-8.3% this year and 5.2% next year) has also been unsuccessful at preventing a second wave, though its willingness to cross the Rubicon and issue mutual debt helps protect against downside risks. The UK (-9.8% this year and 5.9% next year), unfortunately, not only produced the most bungled health response in Europe but also faces the most uncertain outlook thanks, as ever in recent years, to Brexit and poor leadership.
The poor public health response risks squandering and reducing the efficacy of the fiscal and monetary stimulus delivered thus far, threatening the pace of recovery and potentially necessitating additional stimulus, adding to the ultimate cost that will need to be repaid. Central banks have so far delivered $6.6 trillion in monetary stimulus to date, more than four times the amount in the five years following the Global Financial Crisis. By our count, announced fiscal measures total almost $16 trillion as of September 30th (a staggering 19% of world GDP), split $13.4 trillion in the developed world (24% of GDP) and $2.5 trillion in emerging markets (9.2% of GDP). This level of stimulus is unlikely to be repeated and will be painful to retract — creating a likely multi-generational headwind of normalization ahead for future savers, pensioners and economies. Many of the fiscal stimulus programs enacted are likely to prove less effective than expected, yet governments have less room to enact further measures in the future. With global sovereign indebtedness high, future governments appear to have little choice but to raise taxes. Coupled with the much greater role of the state in society and the capital markets, unintended consequences are inevitable with any return to capital market “normality” unlikely for many years.
In many ways, 2020 is a mirage with massive fiscal and monetary stimulus papering over large pandemic-induced cracks in the structural foundations of the global economy. With many of the world’s equity markets near or above their February highs — despite the aftershocks from this economic “earthquake” yet to be felt — there are reckonings still to occur. In other words, this remains a stock picker’s market, and we believe we are well-positioned to take advantage of it.
The Fund seeks to generate attractive returns over time but does not attempt to mirror a benchmark or index. The composition of the MSCI EAFE Index is materially different than the Fund’s holdings.
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 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.
Foreign investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging markets securities can be significantly more volatile than the prices of securities in developed countries and currency risk and political risks are accentuated in emerging markets. 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. The Fund also invests in derivative instruments, investments whose values depend on the performance of the underlying security, assets, interest rate, index, or currency and entail potentially higher volatility and risk of loss compared to traditional stock or bond investments.
Asset allocation decisions, particularly large redemptions, made by BBH&Co., whose discretionary investment advisory clients make up a large percentage of the Fund's shareholders, may adversely impact remaining Fund shareholders.
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.
Shares of the Fund are distributed by ALPS Distributors, Inc. and is located at 1290 Broadway, Suite 1000, Denver, CO 80203.
Select Equity Group, L.P. acts as the sub-adviser to the Fund.
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-08786-2020-11-24 BBH003102 Exp. Date 01/31/2021
 The MSCI EAFE Index is designed to represent the performance of large- and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, and excluding the U.S. and Canada. The index is available for a number of regions and market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 21 countries. The Index is not available for direct investment.
 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
 The sub-adviser's estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.