Concentrated

June 2017

THE MARKET ENVIRONMENT
Key U.S. indexes reached record high levels during the quarter amid episodes of solid advances followed by significant retreats. Technology shares started out particularly strong, pushing the Nasdaq Index to achieve a series of high closing levels. However, the tech sector became increasingly volatile, as investors appeared concerned that these names have become fully valued. Meanwhile, we cheered news that all 34 of the country’s largest banks—some held in our portfolios—passed the current round of the Federal Reserve’s stress tests. Consequently, these banks are now able to return capital to shareholders, and market analysts’ projections that dividend payments and stock repurchases may reach unprecedented high levels boosted the share prices of financials.
 
On the whole, the economy is still showing signs of strengthening. Job growth continued, and the unemployment rate fell to 4.3% in May, marking a 16-year low. The tightening labor market has helped build year-over-year wage growth, while consumers are enjoying low price inflation and gasoline prices that have reached the lowest levels since 2005. Newly constructed home sales rose 8.9% in May compared with a year earlier, sales of existing homes increased to the third highest monthly level in a decade, and the median price for existing homes reached an all-time high owing to an ongoing inventory shortage. Correspondingly, the Federal Reserve stated confidence that the economy is on solid ground, and, as widely anticipated, raised its key interest rate by one-quarter point in the three-month period. 
 
We are pleased that these economic improvements are working to enhance the profitability of businesses; the most recent quarterly earnings issued by approximately 75% of S&P 500 Index companies were ahead of market estimates, and another 7% aligned with forecasts. We are also hopeful that, like us, the market will continue to focus on economic and business advances, despite considerable noise from outside geopolitical factors. Even though stock prices have climbed thus far in 2017, we are still finding opportunities to purchase shares of high-quality companies at discounted prices with the aim of delivering benefits to our investors.

THE PORTFOLIO
Top Performers:
Baxter International’s first-quarter results included earnings per share that exceeded market forecasts for the fourth consecutive quarter. In addition, revenues were better than market predictions in three of the past four quarters. The company’s revenues for the first quarter grew 4% from last year to $2.48 billion, and earnings per share rose 61% to $0.58. Although international revenue was largely unchanged from a year earlier, revenues generated in the U.S. advanced 11%. For full-year 2017, management expects reported sales growth of 1-2% and adjusted earnings per share in the range of $2.20 to $2.28; these projections are largely on track with our long-term estimates. Subsequently, the company raised its quarterly dividend by 23% to $0.16. Overall, we find that Baxter International continues to perform well under the direction of CEO Jose Almeida, who possesses the right skill set to improve the company’s margins and portfolio of assets. Caterpillar delivered strong first-quarter earnings results by our standards, as revenue and cash flow both exceeded our expectations. The company’s business mix, abnormally low period costs, and cost absorption on building inventory levels worked to expand margins, especially in the Construction Industries and Resource Industries segments. In addition, management increased its guidance for fiscal year 2017 earnings per share by about 29% to $3.75, in excess of consensus estimates. In our view, management’s increased guidance is still on the conservative side for revenue and earnings. Recent retail statistics reports point to accelerating sales, and Caterpillar’s report for May showed month-over-month total machine sales improved across geographic regions. Caterpillar later increased its quarterly dividend to $0.78 per share from $0.77. We believe that Caterpillar is making the tough decisions necessary to sustain improvement and that operational discipline is becoming ingrained in the culture. Alphabet’s first-quarter earnings per share ($7.73 vs. $7.38) and revenue ex-traffic acquisition costs ($20.12 billion vs. $19.76 billion) exceeded analysts’ estimates. Constant currency earnings growth was 24% and U.S. growth was 25%. Additionally, paid clicks were up 44%, including 53% on Google properties. The company also disclosed that YouTube achieved one billion hours watched per day. We consider YouTube to be a source of unappreciated value within Alphabet, and this disclosure helped validate our thinking. We maintain our confidence in this investment, as we believe Alphabet will manage the business in a way that assures long-term growth in per share value. 

Bottom Performers:
The share price of General Electric (GE) was weak due to the company’s exposure to energy end markets (which was increased via the merger with Baker Hughes, a contrarian acquisition we believe will prove to be well-timed). Its price also suffered when a market analyst downgraded the company, citing concerns that GE’s cash flows have lagged the company’s reported profits. In our view, this concern will prove to be irrelevant to the long-term investment case, as two of GE’s longest cycle businesses (Aviation and Power) are both in the midst of their largest new product launches ever, which require large investments in inventory and other working capital accounts that will reverse over time. GE has recently worked to reinvent its portfolio and possesses a renewed focus on achieving appropriate capital returns. The company completely revamped its variable compensation plan for thousands of employees who are now paid on a number of scored factors that emphasize improving its return on invested capital, which we believe will lead to much better performance. In our view, GE’s long-term outlook remains promising. CommScope’s first-quarter earnings results included earnings per share and revenue figures that were largely in line with analysts’ estimates. However, the company’s guidance for its second quarter was weaker than consensus expectations, and its full-year guidance was revised downwards. Reasons for the lower outlook included concerns about (1) “more cautious spending patterns” from U.S. operators, (2) integration challenges in Broadband Network Solutions that hurt service levels and limited the ability to meet demand for greater capacity and (3) softness in the Indoor Network Solutions business. In our estimation, the share price decline seems excessive as much of the shortfall appears to be timing related and ultimately recoverable. Additionally, we appreciate that international markets are beginning to see some improvements after recent softness. We continue to believe CommScope is undervalued relative to its normalized earnings power. HCA Healthcare released its final first-quarter revenue and earnings per share results, which were consistent with the pre-release issued in April; however, adjusted total earnings of $2.01 billion were slightly lower than market expectations. On a same facility basis, equivalent admissions grew 1.6% and revenue per equivalent admission grew 1.7%, which was modestly below internal forecasts due to unfavorable changes in payer mix. Management cited various one-off reasons for market softness in the quarter and expects its prior volume growth trend of 2-2.5% to resume. HCA also announced agreements to acquire five hospitals in Texas in addition to the recent purchase of two hospitals in Georgia. Collectively, these acquisitions will add over 2,000 beds and increase revenues by $1.5 billion. These transactions are notable to us, as HCA’s revenue per bed is 50% higher than a typical hospital. Later in the reporting period, investors responded favorably to Senate Republicans’ proposed health care bill to replace the Affordable Care Act. Analysts especially appreciated the sizeable allotment in the plan for the stabilization of insurance exchanges. Lastly, management repurchased 5.1 million shares for $424 million in the first quarter and reaffirmed full-year 2017 guidance, adding to our confidence in this investment. 


During the quarter we initiated positions in Blue Buffalo Pet Products, Lamb Weston Holdings and Oracle. We eliminated Cummins, Tiffany and Tribune Media from the portfolio.

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