Concentrated Strategy

September 2017

THE MARKET ENVIRONMENT
The third quarter saw some new records set in the United States. Hurricanes surpassed historic levels for rainfall (Harvey), duration (Irma) and landfall intensity (Maria). The recovery costs and lost productivity from Harvey and Irma are estimated to be between $150-$200 billion, according to Moody’s Analytics. Moody’s also estimates that Maria could cost Puerto Rico up to $95 billion, which is nearly an entire year of economic output for the island. 
 
The total impact of these storms on economic growth may not be evident for some time. Surprisingly, investors barely took notice. Key indexes surpassed record high levels, and the third quarter marked eight consecutive quarters of market advances. In 2017 alone, the Dow Jones Industrial Average Index reached 41 record high levels, and the S&P 500 (39 records), the Nasdaq Composite (50) and the Russell 2000 (21) followed suit.
 
Meanwhile, the Federal Reserve elected to leave interest rates unchanged for now. However, Chair Janet Yellen stated that, owing to positive economic momentum, the central bank would end its extensive quantitative easing program and reduce its $4.5 trillion worth of bond holdings by $10 billion each month. Shortly thereafter, the Commerce Department revised gross domestic product growth for the second quarter to 3.1% (from 2.6% initially), as inventory spending and orders of durable goods rose. The increase reflects an improvement from the first quarter that generated growth of 1.2% and points to building economic strength.
 
We think that current market conditions are favorable for investors. However, we know that at any moment, a good news story can become a bad one. Geopolitical issues, such as tensions with North Korea, may threaten our progress. As always, our intent is to capitalize on any opportunities that the market provides. With all of the recent stock price advancements, some may wonder if there are still quality bargains to be had. Our answer is yes. We use our focus on underlying business fundamentals and our disciplined approach to uncover new opportunities that we believe will prove advantageous to our investors in the long term.

THE PORTFOLIO
Top Performers:
Blue Buffalo Pet Products continued to benefit throughout the third quarter following a positive second-quarter earnings report released in August, as earnings per share, revenue and adjusted earnings were all largely in line with market expectations. Importantly, we appreciated that base profitability exceeded consensus estimates, with stronger gross margins more than offsetting higher advertising and marketing spend. The company also announced the authorization of a $50 million share repurchase program. Blue Buffalo opted to launch a subset of its BLUE Life Protection Formula product line (its lowest, entry-level product) to select mass and grocery retailers. The company benefited further from positive analysts’ notes in September that either upgraded or reaffirmed conviction in Blue Buffalo. In our view, Blue Buffalo is a high-quality business that has been over-penalized by the market due to last year’s pet superstore downturn. The company’s meaningful margin opportunity, significant free cash flow and potential for a merger and/or acquisition offer adds to our confidence in the investment and provides a compelling reason to own. General Motors’ second-quarter earnings results were strong, in our view, driven by the company’s evolution of its business model via exiting unprofitable international operations. In addition, August unadjusted auto sales for General Motors (GM) (+7.5%) bested consensus estimates (+3.7%) for the period. We met with GM Financial’s management team in September, which provided us with additional insight on the company’s strategy. We believe the biggest takeaway was that GM Financial is autonomous and freestanding from GM, with its own leadership team, risk management and funding platforms. We find that while GM Financial wants to help GM sell cars, the former’s focus is on earning returns. Overall, the meeting gave us confidence in the team enacting the plan, and we continue to believe the investment is undervalued at present. CarMax delivered a positive second-quarter earnings report in September. Both earnings per share ($0.98 vs. $0.95) and revenue ($4.39 billion vs. $4.26 billion) exceeded analysts’ expectations. In addition, the company executed $156.5 million worth of share repurchases in the second quarter. The current share repurchase program allows for an additional $1.25 billion in repurchases, further solidifying our belief that the management team is intent on building shareholder value. 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.

Bottom Performers:
General Electric issued second-quarter earnings that were in line with expectations. However, the vague and downbeat nature of management’s earnings call concerned investors and caused share price weakness. We have since met with the new CEO John Flannery and are confident that he will generate improved results over time. Management plans to drive cost-cutting efforts and improve efficiencies with an emphasis on boosting the return on invested capital (ROIC). We applaud the focus on ROIC and believe the investment remains quite undervalued. Although CommScope indicated its second quarter would be weak, the magnitude was greater than investors anticipated. The slowdown in spending by service providers is now expected to extend for the next few quarters. Management cited industry consolidation, competitive dynamics and the timing of certain large projects as reasons for expected weakness in revenues. That being said, we find that management is doing a good job of controlling costs tightly, while also being careful not to cut too deep. In addition, after speaking with others in the industry, our view that CommScope is taking the right steps overall to endure the challenging operating environment was confirmed. As a whole, we continue to believe CommScope is undervalued relative to its normalized earnings power. Investors were disappointed with the results from HCA Healthcare’s second-quarter earnings report, as earnings and earnings per share figures fell short of consensus estimates. Much of the shortfall stemmed from unexpected weakness in the London market. However, management reaffirmed its guidance for the full-year period. Amid the uncertainty surrounding health care changes in the U.S., we appreciated management’s increase in share repurchases to $542 million, compared with $424 million in the first quarter. We like this investment because we think HCA Healthcare is not only the largest operator of for-profit hospitals and related health care services in the U.S., but also the best company in the industry, and its size provides economies of scale as well as leverage over commercial health care providers in local markets.

During the quarter, we initiated a position in Under Armour Cl C. We eliminated Aon and BlackRock from the portfolio.

Past performance is no guarantee of future results.

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