Concentrated Strategy

June 2019

THE MARKET ENVIRONMENT
Despite fears about new tariffs and trade wars that caused mid-quarter market volatility, key U.S. indexes posted gains for the full second quarter of 2019. Notably, the S&P 500 and Nasdaq Composite indexes reached record highs during the period owing to a few developments that investors viewed positively. After some on-again, off-again talks between the U.S. and China, there was strong optimism that the two countries would finally arrive at a trade agreement. It was widely reported that Presidents Donald Trump and Xi Jinping would meet at the G-20 economic summit (after the quarter concluded) to work out trade details, and investors were pleased that progress was being made. Concurrently, in response to Mexico’s increased efforts to mitigate illegal immigration into the U.S., Trump suspended plans to increase tariffs on imports from the country. In addition, the Federal Reserve left key interest rates unchanged at its quarterly meeting and hinted that rates may be cut in the future (if economic conditions warrant), a move that investors appear to favor.
 
Meanwhile, we were pleased to learn that investors directed $14.4 billion into global equity funds during a one-week period in June, which marked the largest inflow over the prior 15 months, according to a report issued by Bank of America. Likewise, U.S. equity funds attracted $17.8 billion, which was the most invested in 14 weeks. We found this news especially encouraging as it looks as if market investors have regained some confidence, at least for now, in equity investing. We hope this trend will continue because we believe that putting capital to work in this way could lead to solid future benefits.
 
As veteran investors, we recognize that future events may erase past gains. There are still significant issues that could affect market sentiment in the immediate term, such as rising tensions between the U.S. and Iran, concerns surrounding the impending presidential election, and even fallout from extreme summer weather events. Of course, consequences of these and other unforeseen events are unknown. However, our approach is to take such incidents in stride while we continue to look for opportunities these circumstances often provide. Our priority is to always put the needs of our investors first and use our expertise to deliver tangible benefits over the long term. 

THE PORTFOLIO
Top Performers:
American International Group (AIG) delivered strong first-quarter earnings results, which worked to boost its share price for the quarter. Total adjusted after-tax income reached $1.4 billion, which reflected an increase of 44% from the prior-year period and adjusted after-tax income per share ($1.58) handily beat consensus expectations ($1.06). Notably, the insurance unit posted an underwriting profit with improved results due to better risk selection and cost actions with expectations for further improvement moving forward. CEO Brian Duperreault also maintained his commitment to earning at least a 10% return on equity on adjusted book value within three years. Although the company did not repurchase any shares in the first quarter, AIG bought back $1.8 billion for full-year 2018 and the board of directors authorized an additional $2.0 billion for repurchases going forward. 

Hilton Worldwide’s share price began to climb early in the quarter as market analysts anticipated the company’s first-quarter results (scheduled for release in early May) would be solid, and investors were not disappointed with the official report. The company’s first-quarter adjusted earnings growth of 12% propelled adjusted earnings to $499 million to beat both management’s guidance and analysts’ estimates. First-quarter earnings per share ($0.80) also exceeded the market outlook ($0.75), while comparable revenue per available room (RevPAR) grew 1.8% (constant currency), which aligned with management’s forecast. Management slightly increased full-year guidance for adjusted earnings and earnings per share while reiterating its plan to achieve 1-3% (constant currency) RevPAR growth and 6.5% net unit growth. In addition, Hilton returned $340 million of capital to shareholders during the quarter and expects a total capital return for the full year in the range of $1.3-1.8 billion. 

Charter Communications’ first-quarter results included total revenue growth of 5.1% and total adjusted earnings growth of 4.2% (driven by cable segment earnings of +7%) from a year earlier. The strong earnings advance was driven by accelerating broadband subscriber net additions and margin expansion of 112 basis points, while capital expenses also declined 27% year-over-year. Management’s commentary called for fast-paced growth throughout 2019 and continued margin expansion stemming from decreasing non-programming costs, despite an increasing subscriber base. Cable companies in the U.S. are benefiting from strong demand for high-speed internet access, and in many markets, Charter currently has the only fiber-rich network capable of providing internet speeds that align with that demand. We believe the company is favorably positioned to grow its business and expand its market presence as new market entrants would need to invest considerable capital to compete. 

Bottom Performers:
LivaNova preannounced first-quarter sales of $250 million, which fell short of analysts’ expectations. The weakness was driven by neuromodulation, growing only 2% compared to market estimates for 12% growth. This shortfall was due to the launch of a new epilepsy drug, which doctors must test on patients prior to moving forward with LivaNova’s Vagus Nerve Stimulation (VNS) device. Importantly, Medtronic’s competing device has had little impact on VNS’s growth and we believe the new epilepsy drug will produce only a temporary headwind for LivaNova. While the company lowered full-year 2019 guidance, positive clinical data on LivaNova’s sutureless surgical aortic valve Perceval® provided a boost for the company in May. Overall, we appreciate the company’s management team and its progress growing the business and pipeline. Coupled with plans for direct-to-consumer advertisements, we believe LivaNova can sustain growth for years to come. 

Regeneron Pharmaceuticals’ share price suffered following news that the U.S. Food and Drug Administration (FDA) granted priority review status to Novartis’ drug brolucizumab for the treatment of wet age-related macular degeneration, which is a direct competitor to EYLEA. Under the terms of priority review, an FDA decision will occur within six months (versus 10 months under standard review), which means that Novartis’ drug can be fully approved by the end of 2019. Market analysts speculate that the threat from Novartis will be significant. However, Regeneron continues to diversify its portfolio beyond EYLEA and is benefiting from increased sales of other products, such as Dupixent. Investors were also disappointed with Regeneron’s first-quarter results as revenue and earnings per share missed market expectations. Even so, revenues advanced 13% from last year and included solid year-over-year growth from EYLEA (+8%) and Dupixent (+185%). However, earnings per share dropped 4%, driven by higher research/development (R&D) and cost of goods sold expenses. CEO Len Schleifer said increased spending reflects the company’s R&D productivity and current spending for R&D will deliver good returns over time. In addition, Regeneron continues to make progress on the R&D pipeline, namely for oncology treatments, as certain drugs are moving into later stage trials and several new drugs will start clinical trials this year. The company announced in June that its REGN3500 treatment for asthma, developed jointly with Sanofi, successfully completed Phase 2 trials. We continue to see Regeneron as a high-quality company that can deliver rewards for long-term shareholders. 

Alphabet’s share price fell mainly in the middle of the quarter upon releasing first-quarter earnings. Results were sound, by our measure, given that total revenue grew 19% (constant currency) to $36.3 billion. While revenue growth decelerated somewhat compared to increases from prior first-quarter periods (e.g., +20%-23% growth in the first quarters of 2016 through 2018), we do not view the lower growth as being outside of the typical range. Furthermore, Google segment revenues advanced nearly 17% from last year (excluding effects from the $1.7 billion European Union fine) and Google paid clicks rose 39%. On a conference call subsequent to the quarterly release, CFO Ruth Porat expressed that some revenue variability is normal due to adjustments from “product innovations and enhancements” as well as comparisons with “strong 2018 results.” Overall, we believe investors overreacted to signs of slowing growth as Alphabet continues to meet our long-term expectations. Later, the company’s share price sank on news that the U.S. Department of Justice would conduct an antitrust investigation on Google. While we continue to monitor the situation, we believe the valuation for Alphabet remains attractive, offering a compelling reason to own.

There were no new purchases during the quarter. We eliminated the shares of Wabtec we received last quarter via a GE spinoff. 

Past performance is no guarantee of future results.

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