U.S. Equity

March 2017

THE MARKET ENVIRONMENT
Investor sentiment was notably positive coming into 2017 and U.S. markets built on this momentum in the first quarter, pushing key indexes to reach all-time highs during the period. However, the rally halted late in March after the new administration failed to repeal the Affordable Care Act. The Dow Jones Industrial Average fell for eight consecutive sessions, stemming from investors’ skepticism about the Republican Party’s ability to get other initiatives passed quickly through the legislature. Even so, benchmarks ended in positive territory for the past three months. 
 
Also in the quarter, the Federal Reserve raised interest rates for only the third time in a decade. We see this move as long overdue, as we believe rates have been artificially low for too long. The Fed cited evidence of broad-based economic improvement over the past several months as its basis for action now. Job gains continued at a brisk pace, and February marked the third-best month for private sector job increases in the past seven years. Housing metrics reflected growth in new construction, and low inventory of existing homes pushed prices to a 31-month high in January. Other measures, including manufacturing output, retail sales and consumer confidence, have all reached healthy growth levels. Furthermore, the CEO Economic Outlook Index (a survey of chief executives from about 200 of the largest U.S. companies) showed that CEO optimism about near-term sales, capital spending and hiring rose to a three-year high in the first quarter. We think mounting positive trends will ultimately benefit investors and companies alike, as business activity accelerates to meet increasing demand.
 
Investors are constantly looking for what comes next. Hopes are high that the current administration will keep its large-scale pledges pertaining to infrastructure spending, decreased regulation and tax reform. Both the emotions of investors and real economic outcomes hinge on these political actions. Our approach now, as it has always been, is to maintain a rational view. We seek to build portfolios with shares of companies that meet our stringent investment criteria and that will grow shareholder value regardless of the macro environment.

THE PORTFOLIO
Top Performers:
HCA Holdings’ fourth-quarter revenues, adjusted earnings and earnings per share grew 5%, 4% and 24%, respectively. Same facility equivalent admissions and revenue per equivalent admission both increased as well against a difficult comparison to strong results in 2015. In contrast to most hospital groups, HCA’s volumes were well ahead of the industry, which we attribute to the company’s favorable geographic mix. Furthermore, cash flow increased 19% due to good working capital controls and some tax benefits, and management’s guidance for 2017 was largely in line with our expectations. Lastly, in tandem with many other hospital stocks, HCA’s share price was volatile in March and jumped late in the month on news that the Affordable Care Act would remain unchanged for now, as investors were likely relieved that its patient volumes would not be compromised as a result of program changes. Baxter International’s fourth-quarter revenues grew 2% from last year and reached $2.6 billion, which met market projections, while adjusted earnings per share of $0.57 reflected 33% growth and exceeded estimates by nearly 10%. Baxter’s full-year 2016 revenues advanced by 2% (4% constant currency), and management’s revenue guidance for the current year is consistent with this growth rate. Lastly, the company generated $1.6 billion in operating cash flow and $905 million in free cash flow for the full year, some of which management deployed to increase the shareholder dividend by 13% and repurchase roughly $300 million worth of shares. Charter Communications’ fourth-quarter results were largely in line with our estimates. Revenues grew 7% (to $10.28 billion) and earnings increased nearly 13% (to $3.85 billion) from last year; both exceeded market expectations. In addition, earnings per share of $1.67 were more than three times the $0.48 realized a year ago. Charter added 357,000 internet subscriptions, which was significantly lower than the 495,000 registered a year ago. However, the reduction was due to the intentional elimination of Time Warner Cable’s low value product subscribers post-acquisition. Meanwhile, Charter Communications continues to make rapid progress in resetting its pricing and packaging strategies for Time Warner’s and Bright House Networks’ legacy business operations, which we think will boost results going forward. 

Bottom Performers:
Despite no material changes, CarMax’s share price declined for the quarter. Investors may be concerned that U.S. auto sales have peaked, and an influential investment manager reinforced these concerns by taking a short position in the company’s stock. However, we find that CarMax enjoys a significant competitive edge from its proprietary inventory system, which uses data derived from a history of more than 20 million appraisal offers and more than 5 million vehicles sold to optimize its inventory mix, anticipate future inventory needs at each store, evaluate sales consultant and buyer performance, and refine its vehicle pricing strategy. We also like that CarMax provides a unique customer experience that includes “no-haggle” competitive pricing, breadth of selection (both onsite and online) and vehicle quality assurance (with a money-back guarantee). We believe that CarMax’s experienced management team remains focused on adding shareholder value and that its shares are presently undervalued. While General Electric’s (GE) fourth-quarter earnings per share met market expectations, total revenues fell somewhat short, mainly due to the Industrial segment where sales missed some market analysts’ forecasts. Even so, GE reiterated its 2017 earnings per share guidance of $1.60-$1.70 and its projected range for organic growth of 3%-5%. In addition, activist investment firm Trian Partners stated that GE has failed to meet some key performance targets, and if not corrected, Trian may demand replacing CEO Jeffrey Immelt. In response, GE committed to generating $17.2 billion of Industrial operating income in 2017 and $1 billion of Industrial non-production cost reductions in both 2017 and 2018. GE also changed its executive compensation plan that now includes rewards/consequences dependent on meeting these goals. Our 2017 and 2018 estimates are aligned with management’s stated objectives, and we continue to believe that GE will reward shareholders going forward. Even though American International Group (AIG) issued an early warning that its fourth-quarter earnings would suffer from a material reserve adjustment, the official results included a reserve addition of $5.6 billion, which was nearly $3 billion larger than expected. We spoke with CFO Sid Sankaran and CEO of Commercial Bob Schimek regarding the situation. The executives stated that the reserve adjustment was in response to several trends: (1) an increase in actual claims versus actuarial estimates, (2) an increase in the severity of trends in U.S. auto, (3) worsening conditions within medical malpractice and excess casualty, and (4) an increase in jury amounts awarded. However, management believes these issues are ubiquitous across the industry, and AIG is just being more aggressive in reserving for the losses. Although we still think AIG remains an attractive investment, we are watching the evolution of this situation closely. Lastly, current CEO Peter Hancock announced he is resigning as soon as AIG identifies a replacement. We were not surprised by this decision and are looking forward to meeting Mr. Hancock’s successor.

During the quarter we initiated positions in Adient, Apache, Moody’s and Weatherford. We eliminated Charles Schwab from the portfolio.

Past performance is no guarantee of future results.

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