Global All Cap Strategy

September 2019

THE MARKET ENVIRONMENT
Major global markets finished mixed in the third quarter. August served as the most volatile month, bookended by relatively flat performance in July and September. Most recently, trade negotiations between the U.S. and China are providing a positive impact on global markets as the two countries agreed to restart trade negotiations in early October. Ahead of the planned trade talks, the U.S. delayed a planned tariff hike on Chinese goods from October 1 to October 15 in “a gesture of good will.” On the other hand, China exempted soybeans, cancer drugs and pesticides, among others, from tariffs on the U.S.

Despite the tempered situation between the U.S. and China, U.S. President Donald Trump made headlines for another matter late in September as a whistleblower brought to light the leader’s July telephone conversation with Ukrainian President Volodymyr Zelensky. In the call, Trump asked Zelensky to “look into” 2020 U.S. Democratic presidential hopeful Joe Biden and his son, news of which spooked investors. In response, Speaker of the U.S. House of Representatives Nancy Pelosi announced a formal impeachment inquiry on Trump to further delve into the matter. 

Elsewhere, the political crisis in the U.K. carried on as the U.K. Supreme Court ruled Prime Minister Boris Johnson’s suspension of Parliament earlier in the third quarter as unlawful. Once back in session, the body passed a law requiring Johnson to request an extension from the European Union (EU) on the U.K.’s current exit date of October 31, should the country fail to agree on a Brexit deal with the EU prior to the bloc’s summit on October 17-18. These ongoing situations stoked continued uncertainty surrounding global markets. 

Meanwhile, the European Central Bank opted to lower interest rates and ramp up quantitative easing at its September meeting, which prompted the euro to fall to a two-year low. The Federal Reserve also trimmed U.S. interest rates twice in the third quarter, while the Swiss National Bank and the Bank of Japan maintained negative interest rates in September. 

In our estimation, the lingering memory of the Great Recession is causing investors to be much more fearful than they should be at present. We see no signs of excesses in the economy that typically precede a recession. We believe the noise present today will dissipate and trade will ultimately flow more freely in the next several years. In the meantime, we weather the short-term distractions and volatility in pursuit of long-term results.

THE PORTFOLIO
Top Performers:
Alphabet delivered strong second-quarter earnings results as revenue growth accelerated. Total revenue reached $38.94 billion, which bested analysts’ estimates for $38.15 billion in total revenues. Earnings per share ($14.21 vs. $11.10) also exceeded market expectations. Furthermore, the company’s operating margin of 24% was more robust than consensus expectations of 22.5%, and we found this achievement reassuring given CFO Ruth Porat’s recent comments about the possibility for increased sales and marketing expenses in the second quarter. Management also announced a new $25 billion share repurchase program with no expiration date, which added to our confidence in the team’s commitment to building shareholder value. In addition, we attended the company’s annual investor day where members of the executive team gave updates on several initiatives. Alphabet believes cloud computing provides significant growth potential and is on pace to deliver $8 billion in annual revenue. Notably, Thomas Kurian, CEO of Google’s cloud operations, predicts revenues can exceed $10 billion annually. Moreover, management remains confident in the health of the advertising/search business and is pleased that the company has maintained its leadership position in fundamental artificial intelligence. 

Mastercard issued second-quarter earnings results that, in our view, were consistent with its typical pattern of robust growth, outperformance of market expectations and significant reinvestment in the business. Year-over-year total revenue rose 12% (+15% constant currency), net income increased 31% (+35% constant currency) and earnings per share grew 14% (+17% constant currency). Management reiterated full-year guidance that included a constant currency revenue growth rate in the low teens. We think further growth is likely as the progression of the consumer-to-business electronic payment network provides Mastercard with ongoing expansion potential. In addition, the company continues to expand into new payment flows by way of fully integrated acquisitions and partnerships with emerging financial technology companies. One example of this strategy is its planned acquisition of the corporate services unit of Nets (a European payment technology company), including the clearing and payment services businesses, along with e-billings solutions. Lastly, the company spent $1.9 billion to repurchase approximately 7.7 million shares in the second quarter and paid $337 million in dividends. 

Toyota Motor reported fiscal first-quarter results that outpaced our estimates and market expectations. Auto volumes increased 3%, net revenue rose 4% and operating income advanced 9% from the prior year. Margins also expanded 40 basis points. Importantly, margins improved by 130 basis points in North America after two years of weakness, which illustrated that management is beginning to achieve its key priority to rejuvenate margins in this critical market. Also, North American net revenues were up 1.5%. Net revenue grew 8% in the core Japan region (which includes exports), primarily led by strong volume growth in both Japan and export markets. In Europe, net revenue and volumes increased 10% and 8%, respectively, while margins improved 110 basis points. Despite these healthy results, management lowered full-year revenue, net income and operating income guidance owing to expected negative currency effects. However, we think management’s forecasts are quite conservative and we have left our estimates unchanged. Lastly, at the end of September, Toyota announced it bought back 43,347,500 shares, which completes its JPY 300 billion share repurchase program. 

Bottom Performers:
Daimler issued two profit warnings before releasing fiscal first-half results that, as predicted, were weak. Revenue of EUR 42.65 billion was slightly better than market expectations, while an earnings loss of EUR 1.56 billion led to negative earnings per share of EUR 1.24. Total revenue growth from industrial operations fell short of our estimates, driven by poor performance in the Mercedes-Benz segment, and margins were weaker than we had projected across the firm. However, revenue growth in the trucks, vans and buses segments all exceeded our forecasts. Subsequently, we met with CFO Harald Wilhelm and discussed the company’s current challenges and planned improvements and solutions. We also met with Arno van der Merwe, president and CEO of Beijing Benz Automotive, which is one of Daimler’s most important joint venture partnerships in China. We discussed several aspects of operations in China where it sells more than 600,000 cars and about 70% of which are manufactured there, which supports margin expansion. In our view, Daimler is a high-quality company with shares that are trading below our estimate of intrinsic value. 

In late July, Continental issued preliminary second-quarter earnings results and a second-half profit warning. While the warning itself was somewhat expected, analysts were surprised by the magnitude of the shortfall. In early August, the company’s official second-quarter results showed weaker revenue and earnings from the year-ago period. Revenues fell across product groups with the exception of tires, where revenue was unchanged year-over-year. Even though CFO Wolfgang Schäfer stated that results were impacted by an ongoing slowdown in global automotive production, management left full-year guidance unchanged. To be better positioned for the shift to electric vehicles, the company will no longer invest in manufacturing injectors and pumps for gas- and diesel-powered engines. CEO Elmar Degenhart sees this “technological upheaval” as a significant growth opportunity for the company. Continental later unveiled a restructuring plan that includes reducing costs by EUR 500 million annually by 2023. We like that management has implemented this proposal as we believe it will benefit shareholders over the long term. 

Under Armour’s share price fell significantly after the company released its second-quarter earnings report. We think the market overreacted as we viewed results as satisfactory. Revenue growth of 1.4% (+3% in constant currency) slightly missed market forecasts. Revenue in North America declined 3.2%, owing to reestablishing the company’s full price premium model after a couple years of using price discounts to clear inventories, and we see this as a temporary situation. Concurrently, international revenue grew 13.3%. We were pleased that Under Armour’s gross profit margin again expanded (+170 basis points) and selling, general and administrative expenses grew modestly (+2%). If these trends continue, we believe the company can return to acceptable profitability in coming quarters. While management left full-year revenue growth guidance unchanged (+3-4%), the composition was updated to include a slight decline in North America compensated for by low- to mid-teens growth in the international markets.

During the quarter, we received shares  of Prosus as a result of a Naspers spin-off. There were no new purchases or final sales during the period.

Past performance is no guarantee of future results.

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