Concentrated Strategy

December 2018

THE MARKET ENVIRONMENT
The fourth quarter of 2018 was marked by significant market turbulence. Investor pessimism came from an array of issues, including unresolved trade wars, tariffs and interest rate increases. Compounding these fears, investors who were accustomed to a growing U.S. economy became concerned over an impending recession given that economists predicted slowing growth ahead. Anxiety intensified further from erratic energy prices, as supply/demand imbalances and other market factors caused key energy benchmarks to fall 40% by year-end from nearly four-year high levels reached in October. The quarter culminated in a government shutdown owing to an impasse over border security and immigration policy. These events, along with weak fourth-quarter asset manager performance across the industry, sparked portfolio redemptions and other de-risking actions and led to forced selling of equities in U.S. and global markets, which sent some major benchmark indexes into bear market territory.

Amid this gloomy backdrop, some positive news emerged. Third-quarter gross domestic product grew a robust 3.5% and generated the fastest annual corporate profit increase since 2012. The unemployment rate fell to 3.7%, the lowest level in nearly 50 years, and has remained constant since September. The tight labor market caused upward pressure on weekly wages that rose 3.3% in the third quarter and outpaced inflation. Holiday retail sales, a metric the market watches closely, rose by 5.1% from last year to more than $850 billion, which was the strongest improvement in six years. Online holiday sales advanced 19.1%, while sales at physical department stores declined 1.3%. Even so, holiday online department store sales increased 10.2%, and this acceleration of online sales is expected to continue as businesses adapt to an evolving retail environment.

As seasoned investors, we have witnessed similar times of uncertainty. Investors now appear to generally lack an appetite for risk and have gotten more defensive, moving from equity investments to cash and other seemingly safe haven instruments, as illustrated by large equity mutual fund outflows that occurred late in the fourth quarter. Investors may presently believe the best market gains are behind them and have lowered expectations moving into 2019. We adopt the opposite view. Market declines offer ripe opportunities for us to identify extraordinary investment candidates that we expect will reward shareholders going forward.

THE PORTFOLIO
Top Performers:
General Motors (GM) delivered strong third-quarter results, as revenue ($35.8 billion vs. $35.34 billion) and earnings per share ($1.87 vs. $1.25) bested analysts’ estimates. Despite higher tariff-induced costs and a weak auto market in China, revenues rose 6.4%, adjusted earnings increased 25% and adjusted earnings per share advanced nearly 42% from the prior year period. Moreover, management reiterated full-year guidance and believes there is potential for further upside. The company is still on track for the initial commercialization of Cruise by the end of 2019 and announced a $750 million investment from Honda in the brand, which we believe provides a nice validation to its place in the autonomous market. In November, CEO Mary Barra announced the closure of seven plants worldwide and a 15% reduction of its North American workforce in an effort to realize about $6 billion of cost savings as a hedge against trade wars and a possible economic downturn. While the decision drew the ire of President Trump, investors viewed the move positively. GM is now optimizing its product portfolio, emphasizing newer, highly efficient vehicle architectures (especially trucks, crossovers and SUVs) along with doubling its resource allocation to electric and autonomous vehicle programs over the next two years.

Netflix reported third-quarter revenue that matched market expectations, while earnings per share were 30% higher than projections. Importantly, net subscriber additions for both domestic and international streaming handily outpaced market estimates along with management’s forecasts. The company’s global growth continues unabated, as trailing 12-month paying subscriber net additions reached a record 26.4 million. While management’s fourth-quarter revenue and earnings per share guidance were lower than market expectations, Netflix predicts fourth-quarter net subscriber additions for domestic (1.80 million) and international (7.60 million) streaming that are far in excess of what the market anticipates. We believe the company is poised to benefit further from the transition to internet-provided TV, which we expect will prove advantageous for shareholders.

Bottom Performers:
Centennial Resource Development’s third-quarter earnings result fell slightly shy of market estimates on light volumes. On the other hand, adjusted earnings of $178 million exceeded analysts’ expectations of $172 million and capital expenditure and production guidance for the full-year period was unchanged. Later, negative analyst notes downgrading Centennial pressured the company’s share price. In addition, Centennial announced the reduction of its 2019 production targets and the elimination of its 2020 production goal due to the current weak oil market. That being said, the company has already managed to optimize its North American wells beyond what previous operators were able to achieve. We believe that as Centennial pinpoints new target zones and fine-tunes well designs for its acres, the company will build upon its early successes. We believe Centennial is a solid investment that should reward shareholders into the future.

Prior to issuing its third-quarter earnings report, American International Group (AIG) announced a pretax catastrophe loss estimated at $1.5-$1.7 billion due to numerous hurricanes and typhoons in the period, including $1 billion worth of losses from several weather events in Asia. The company also expects that losses from Hurricane Michael will approximate $300 million to $500 million, which AIG will book in its fourth quarter. Consistent with the company’s warning, third-quarter results were quite weak as AIG reported a $0.34 per share operating income loss. However, investors viewed management’s accompanying commentary positively. Statements by Chief Actuary Mark Lyons regarding the soundness of the company’s actuarial processes and underwriting culture and CEO Brian Duperreault’s remarks that AIG is on track to deliver a catastrophe-normalized underwriting profit as soon as the first quarter of 2019 were especially reassuring. We acknowledge that recent weather conditions have proven extraordinarily challenging to the company. We are optimistic that its relatively new general insurance management team can achieve a return on equity of at least 10%. Currently, AIG’s balance sheet is solid, in our assessment, and the company remains a compelling investment.

Citigroup’s third-quarter results issued in October were solid, in our view, and generally aligned with our estimates. Earnings per share rose to $1.73, which reflects an increase of roughly 22% from a year earlier. We were especially pleased that expenses were well controlled, which helped improve the company’s efficiency ratio to 57.3%. In addition, Citigroup returned $6.4 billion to shareholders by way of share repurchases and dividend payments in the third quarter. However, at an analysts’ conference in December, CFO John Gerspach stated expectations that fourth-quarter revenue will be slightly lower than what the company had achieved in the year-ago quarter. Lower revenues could jeopardize Citigroup’s ability to meet its efficiency targets within the desired timeframe. Gerspach indicated that while the equity business continues to perform well, a drop in fixed-income market revenue prompted the reduced outlook. We did not find Gerspach’s announcement overly concerning, as we expect some degree of revenue fluctuation in the current macroeconomic environment. Overall, we remain satisfied with Citigroup’s fundamental performance. 

During the quarter, we initiated positions in Charles Schwab and Netflix. We eliminated CarMax from the portfolio.

Past performance is no guarantee of future results.

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