U.S. Equity

December 2016

THE MARKET ENVIRONMENT
Immediately following the presidential election, U.S. index futures plunged, and at one point, futures for the Dow Jones Industrial Average dropped nearly 900 points. Surprisingly, as investors absorbed the implications of this political sea change, key indexes rebounded and ended higher on November 9. The Dow went on to close at a record high level on November 10 and finished up for the quarter. Financials led the advance, first benefiting from investors’ hopes that the new Republican administration would roll back industry regulations and second from the Federal Reserve’s decision to raise short-term interest rates for the first time in 2016. Citing signs that the economy has improved, the Fed also stated it intends to raise rates three times in 2017. Similarly, optimism that policy makers will carry through on promises of considerable infrastructure spending helped share prices in the industrials and materials sectors, and the pledge to expand domestic oil and gas production boosted shares of energy companies. 
 
Conversely, the health care, consumer staples and real estate sectors largely declined for the quarter. The now uncertain future of the Affordable Care Act hurt the health care sector, and a shift to cyclical stocks pressured defensive names in the consumer staples sector. Investors’ concerns about the real estate sector were twofold. First, future interest rate increases could lead to higher mortgage rates, which might hamper growth in the sector. Also, owing to vows from the president-elect, possible mass immigrant deportations could drive a construction labor shortage and thus push real estate building costs higher.
 
Improving market conditions have prompted investors to realize the earnings potential of some otherwise overlooked companies. We appreciate when the market begins to recognize our perception of the intrinsic values of our holdings. Yet, our approach remains steadfast even when market sentiment turns pessimistic. We know that several policy-related issues are now in flux, and the outcomes of these could have large economic effects that move markets. Therefore, we remain prepared to capitalize on the opportunities that these events provide for the benefit of our investors.

THE PORTFOLIO
Top Performers:
In the days following the presidential election, Goldman Sachs was one of the four largest contributors to the Dow Jones Industrial Average Index’s rise to surpass 19,000 for the first time ever. We liked that Goldman Sachs’ third-quarter earnings report released in October showed that strengths spanned a range of business segments as net revenue more than doubled in Investing and Lending, Institutional Client Services was up 17%, and the asset management business had $14 billion of net inflows. In addition, revenue increased in three of four business segments, return on equity reached 11.2% and earnings per share ($4.88) handily beat analysts’ outlook ($3.82). In our view, all of the company’s most important capital ratios improved on a quarter-over-quarter basis. Furthermore, the company announced that current CFO Harvey Schwartz and co-Head of the Investment Banking Division David Solomon would take over as new co-COOs upon current COO Gary Cohn’s departure. Overall, we like that the company’s leadership team remains focused on maintaining its historically strong and liquid balance sheet, while also adding value via share repurchases and dividends. Management and partners own a larger portion of the company than their peers, adding to our confidence in leadership’s vested interest in Goldman’s success.

Expectations for improved economic conditions and increased interest rates under the upcoming Trump administration propelled JPMorgan Chase during the quarter. As a result, the company was also one of the four most influential participants in the Dow Jones’ climb to a new record high. In our view, JPMorgan delivered strong third-quarter earnings results that exhibited good expense controls and quality loan growth. In comparison to the second quarter, we like the improvements in the outlook for oil-related loan losses and better trading activity. We find that most business segments are growing in excess of the competition at good returns, with leading indicators in the core consumer businesses suggesting a continuation of above average growth. In addition, we think JPMorgan is one of the best-managed U.S.-based universal banks and has its interests aligned with shareholders, all of which afford a compelling reason to own.

Although Wells Fargo was previously hurt by news regarding its illegal sales practices and the resulting fine, its October customer activity report and satisfaction scores were in line with management’s expectations. Importantly, the report showed that accounts are still growing, with new primary checking customers up 3.9% year-over-year. Wells Fargo’s third-quarter earnings release was largely as we expected, with the company registering $5.6 billion of net income and revenues increasing 2% from the year-ago period. Moreover, expectations that a Trump administration would translate to more normalized levels of interest rates benefited companies in the sector. The Federal Reserve did in fact raise short-term interest rates late in 2016 and stated it intended to raise rates three times in 2017. We recently spoke with the company’s new Chairman Stephen Sanger and CEO Timothy Sloan in December and found that the long-term value of the company remains intact.

Bottom Performers:
Hertz Global’s third-quarter earnings per share of $1.58 fell short of market expectations by about 42%. This result was especially surprising as one of its chief competitors reported strong results for the same reporting period. Management also reduced the full-year earnings guidance at the midpoint by about $300 million. Subsequently, CEO John Tague announced plans to retire at year end and three directors resigned. These changes caused us to reevaluate our investment in this holding, and we sold our Hertz Global shares in favor of other names that we believe provide a better risk-reward profile.

Considering the pace of Medtronic’s organic revenue growth rate during the past several years, fiscal second-quarter organic growth of only 2.3% (+4% total growth) disappointed investors and pressured its share price. Management attributed the slowdown partly to awaiting approval for new product introductions, particularly in the Cardiac and Vascular Group and Diabetes. In addition, implantable cardioverter defibrillator (ICD) revenues declined owing to weak replacement sales. However, we think this issue is cyclical, as Medtronic gained U.S. market share for ICDs in the quarter. CEO Omar Ishrak stated confidence that Medtronic would achieve mid-single digit constant currency revenue growth and double-digit constant currency earnings per share growth for the current fiscal year and on a sustained basis into the future.

Baxter International’s exposure to hospitals pressured its share price during the quarter, as questions surrounding changes to the Affordable Care Act (ACA) under the Trump administration loomed following the election. While some benefits from healthcare reform may be eliminated, we expect Baxter to acclimate well. The company’s third-quarter revenues were slightly above market estimates, and Baxter’s earnings per share of $0.56 exceeded expectations by approximately 24%. In addition, management increased its full-year earnings per share guidance to a range of $1.88-$1.91 from $1.69-$1.74 and expects revenues to grow about 2%. Overall, we believe CEO Jose Almeida has the right skill set to improve Baxter’s margins and portfolio of assets, and find that the company is selling at a large discount to intrinsic value.
 
During the quarter we initiated positions in Bank of America, Nestlé  ADR, Oracle and Priceline. We eliminated E*TRADE, Hertz Global, Lam Research and Microsoft from the portfolio.

Past performance is no guarantee of future results.

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