THE MARKET ENVIRONMENT
Major global markets moved higher in the first quarter, despite contending with a barrage of geopolitical pressures. Following the second rejection of her Brexit deal, Prime Minister Theresa May secured a two-week extension on the U.K.’s departure from the European Union (EU) with the exit date now set at April 12. The EU also offered a later exit date of May 22 should the prime minister ultimately receive approval from British Parliament on her version of Brexit before the end of March. In the meantime, members of parliament brought eight alternative plans to the floor, none of which achieved a majority. A subsequent third vote on May’s deal late in March also failed to pass, leaving Brexit very much in limbo.
Meanwhile, trade disputes proved challenging for the Chinese economy as February exports dropped over 20% from the year-ago period. The country’s industrial output growth also experienced its slowest pace of expansion in more than 15 years. In the U.S., even though manufacturing sector job growth at the end of 2018 was the highest it had been in the last 30 years, factory production during the first quarter reached the lowest level since 2017. Contrary to market analysts’ forecasts of gains, manufacturing output fell in January and February due to pressures of trade disputes and slower global growth. Monthly building permits also fell in excess of market projections. In Europe, the IHS Markit’s Purchasing Managers’ Index’s (PMI) March reading decreased to 51.3 from 51.9 the month prior, while the Flash Eurozone Manufacturing PMI sank to a near six-year low.
The European Central Bank announced increased stimulus, a decreased economic growth forecast for 2019 and a hiatus on interest rate increases until 2020. The Federal Reserve left key interest rates in the U.S. unchanged and noted it does not foresee raising rates in 2019, stating intent to employ patience and consider market concerns before taking action. Despite this, the reigniting of trade negotiations between the U.S. and China in the final days of March provided a late boost for global markets.
That being said, we use these periods of uncertainty in the market as opportunities to invest in temporarily undervalued companies by looking beyond readily available statistics to uncover hidden value. Our differentiated perspective comes from our unusually long time horizon, an unwavering focus on identifying quality businesses and a deep level of engagement with management teams.
Lloyds Banking Group’s underlying fiscal-year 2018 results were largely in line with our expectations as lower credit costs offset slightly higher operating expenditures. That being said, the market appreciated the company’s announcement of a new share repurchase program for 2019 worth up to GBP 1.75 billion, up from GBP 1 billion in 2018 and higher than our expectations. Lloyds also guided for 14-15% return on tangible equity and further operating expenditure reductions in 2019. In addition, the company announced plans to switch its computer systems to a new platform, pending regulatory approval. Management expects the change will result in technology cost savings amounting to hundreds of millions of pounds annually. We continue to view Lloyds as a best-in-class financial institution.
H&M’s share price soared upon the release of its fiscal first-quarter earnings results. Earnings per share (SEK 0.49 vs. SEK 0.31) and earnings (SEK 1.01 billion vs. SEK 650.6 million) bested consensus estimates. Sales increased 4% in local currency, despite the replacement of the online platform in Germany that pressured sales in the country. However, March sales through the 27th of the month were up 7% in local currency, with signs of improvement in Germany. Sales in China grew quite strongly in the first quarter at 18%, while sales in Sweden increased 11%, implying strong like-for-like performance. Moreover, H&M reported an increase to the gross margin year-over-year to 50% compared to the market’s expectation for a decline in the gross margin. Company leadership has been diligently working to improve the business and has made significant investments to strengthen H&M brand management, logistics, purchasing and technology in an effort to better control costs, boost efficiency and reduce product lead times. We find that the underlying performance of the company is improving, adding to our confidence in the investment.
In January, Olympus unveiled a corporate transformation plan with the goals to become a truly global medical technology company and greatly improve efficiency. To achieve these goals, the following changes will occur: 1) Hiroyuki Sasa will be replaced as president by the current CFO Yasuo Takeuchi, 2) three ValueAct directors will be appointed to the board, 3) operating expenditures will be frozen in an effort to improve margins, 4) the therapeutic business headquarters will be moved from Japan to the U.S. to help source better talent, be closer to customers and be closer on the ground to competitors, and 5) the company will organize staff with clear lines of accountability and a move to a merit-based compensation scheme. Later, Olympus announced the appointment of two new board members (one internal and one external), both of whom we find to be sensible choices who will hopefully lead to stronger governance and accountability at the company. We met with management in February and perceived soon-to-be President Yasuo Takeuchi’s openness to recommendations from ValueAct positively. Overall, we believe he is the right person to lead Olympus through this period of transition. While we are still evaluating the changes, we believe that this plan should lead to the probability of higher profitability at the company.
As we expected, thyssenkrupp reported weak first-quarter results due to reduced demand from the auto industry, raw material pressures and operational issues. Earnings were flat to down in all divisions, but management maintained guidance that calls for a meaningful increase year-over-year. As reported last year, the board recommended splitting the company in two: thyssenkrupp industrials and thyssenkrupp materials. During the quarter, the company announced further details on the split, which will target improved efficiency and simplification. The new companies will give full profit and loss responsibility to the business and consolidate central functions. The goal is to reduce selling, general and administrative costs by roughly EUR 80 million. We view this incremental detail positively. Although the most recent quarter’s results were disappointing, we have confidence that management has a solid plan to improve operations and simplify the business. In addition, we believe the company is trading at a significant discount to our estimate of intrinsic value.
Bayer issued fourth-quarter results in February that included revenue, adjusted earnings and earnings per share that were ahead of market forecasts by roughly 4%, 5% and 34%, respectively. Furthermore, management confirmed fiscal-year 2019 revenue growth guidance of about 4% and reiterated Bayer’s overall 2022 targets. While we found these results to be acceptable, the company’s share price fell in March after a jury ruled in favor of a litigant and found that Bayer’s Roundup product (produced by Monsanto) was responsible for causing cancer. The jury later issued an award of slightly more than $80 million. Although this was the second time Bayer was found liable, management vowed to keep defending the safety of the herbicide glyphosate. Furthermore, we expect several more cases will emerge because of the outcomes of the initial two. Even though the juries’ conclusions were disappointing, we have factored potential future costs from litigation into our valuation metrics. We recently spoke with CEO Werner Baumann and discussed various possible scenarios specific to Roundup. Baumann believes an outright ban for Roundup in the U.S. is an extremely low probability because of the support for this product by regulatory bodies and how disruptive it would be to the industry since he estimates it would take about five years to build capacity for alternative herbicides. Baumann also expressed that the integration of Monsanto is progressing well. While we continue to monitor this situation closely, our investment thesis for Bayer remains intact.
BMW reported total vehicle sales of 2.49 million units for full-year 2018 (+1.1% over 2017), led by BMW brand sales that rose 1.8%. The company’s Rolls-Royce subsidiary saw record high sales that reached 4,107 units in 2018, which reflects a 22% increase from a year ago. Furthermore, BMW delivered 140,000 electric vehicles in 2018 and electric vehicle sales rose 38.4% over 2017. Later, the company reported full-year earnings per share (EUR 10.82 vs. EUR 10.60), revenue (EUR 97.48 billion vs. EUR 97.34 billion) and earnings (EUR 9.12 billion vs. EUR 9.01 billion) that all exceeded analysts’ estimates. However, BMW’s share price was negatively impacted by guidance for 2019 pretax profit that was “well below” the year-ago period. Incremental headwinds for the year will include Brexit contingency costs, negative currency effects and raw materials pressures. In addition, the ramp up of the new plant in Mexico will also weigh on profits. That being said, we believe the guidance figure looks worse than it actually is in reality on a cash basis, which is reinforced by expectations for free cash flow to be similar year-over-year, despite slightly higher capital expenditures to sales than in 2018. While we believe the communication around the guidance could have been better and the operating environment remains challenging, our investment thesis for BMW remains intact. Although the company faces some headwinds at present, we continue to believe BMW is a quality investment that is trading at a significantly undervalued share price.
During the quarter, we initiated a position in Rolls-Royce Holdings and received shares of MultiChoice Group through a spinoff (Naspers). We subsequently sold MultiChoice Group and also eliminated Ctrip.com International and Pernod Ricard from the portfolio.
Past performance is no guarantee of future results.