U.S. Equity

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. MGM Resorts International reported first-quarter earnings of nearly $764 million and total revenue grew roughly 23% from a year earlier to $2.71 billion, both of which exceeded market estimates. Furthermore, management pointed out that first-quarter diluted earnings per share of $0.36 was triple the $0.12 that the company realized last year. In our view, these results indicate that management remains focused on enhancing the operational strength of MGM Resorts International to maximize shareholder value. In addition, Macau’s gross gaming revenues advanced ahead of market projections in both April and May, reversing recent negative trends in the region. Investors may have found this news noteworthy, as MGM derives nearly 30% of its revenues from the Asia/Pacific region, and the company is expanding its footprint in Macau with the opening of the MGM Cotai property later this year. Oracle delivered positive fiscal fourth-quarter earnings results in June. The report was highlighted by (1) continued cloud software as a service/platform as a service (SaaS/PaaS) growth (+69% in constant currencies including NetSuite), (2) a significant moderation in the rate of decline in new software licenses, (3) steady growth in maintenance revenues (+3%), indicating the stability of the installed base and (4) non-GAAP operating margin improvement that was nearly 200 basis points ahead of consensus, reflecting increased cloud gross margins and well-controlled expenses. We also liked that Oracle announced a new financial reporting structure that provides greater insight into how the underlying businesses are performing. Furthermore, management issued guidance for its fiscal first quarter in excess of market expectations, adding to our confidence in this investment.  

Bottom Performers:
Weatherford’s share price declined from weaker-than-hoped first-quarter results as well as from falling energy prices during the quarter. First-quarter earnings were impacted primarily by low incremental margins in North America (mostly Gulf-region related) and only adequate results from the international segments. We recently met with new CEO Mark McCollum, who impressed us as being a capable and deliberate operator. We find that he is well versed in the structure, processes and incentives necessary to drive performance in the oilfield services business, and his background leading the Baker Hughes-Halliburton integration makes him well suited to streamline Weatherford’s sprawling collection of separate operations. McCollum’s top priorities include deleveraging the balance sheet and reducing debt from $7 billion currently to $3 billion as well as closing the margin gap compared with peers. Overall, we believe McCollum is a solid leader with the right background for Weatherford. Grainger’s first-quarter results were weak, from our perspective, and both revenue and earnings per share also missed market forecasts. The company reduced its full-year sales and earnings per share guidance, citing pricing challenges as the cause. In response, management elected to implement “strategic price reductions” across a wider range of products and customers than originally contemplated. CEO D.G. MacPherson indicated that this adjusted pricing should “accelerate growth with existing customers and attract new customers sooner than planned,” which he expects will work to significantly increase volumes and thus drive higher gross profit. We are hopeful that this strategy will prove advantageous and, in the meantime, we have slightly modified some of our near-term estimates. 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.

During the quarter we initiated positions in Arconic and Under Armour Cl C. There were no final sales during the period.

Past performance is no guarantee of future results.

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