U.S. Equity 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:
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. Charter Communications delivered positive second-quarter earnings results in July, as adjusted earnings ($3.85 billion vs. $3.78 billion) and free cash flow ($1.14 billion vs. 904.1 million) exceeded analysts’ outlook. Margins expanded 165 basis points as non-programming expenses fell 3.7%. In our view, merger synergies are coming through well, and the company announced a larger-than-anticipated second-quarter buyback equal to 3.7% of shares outstanding. During the reporting period, Charter ended speculation that it may acquire Sprint. Instead, rumors that SoftBank may buy both Charter and Sprint came to the forefront. Another potential bidder entered the mix in August, as it was reported that Altice also had an interest in purchasing Charter. We attended an investor conference held by Charter to address the rampant merger and acquisition speculation. Regardless of this activity, our perception of this company as an attractive standalone investment remains intact, and we maintain our confidence in management’s ability to lead the company to realize value on its own.  

Bottom Performers:
Under Armour’s share price declined in July ahead of releasing its second-quarter results. Investors likely sold shares based on a report issued by investment research firm OTR Global, which stated that a lack of lifestyle selections in the U.S. along with slow growth in China and Western Europe negatively impacted its business in the second quarter. Once delivered, Under Armour’s second-quarter revenues were in line with market forecasts, and the company’s earnings per share loss of $0.03 was less significant than the $0.06 loss that the market expected. However, management projected no revenue increase in its third quarter, which disappointed investors. In addition, management announced a large restructuring program that is focused on implementing a more appropriate and scrutinized cost structure. The initial plan costs include roughly $70 million in cash-related charges, along with about $60 million in non-cash charges. Despite upbeat reports from market analysts for Under Armour, its share price was also volatile in September, likely impacted by Nike’s fiscal first-quarter revenue results that missed market projections. Investors also appear skittish about retailers in general, and market sentiment is currently negative. Even so, owing to Under Armour’s tremendous expansion opportunities in international, footwear and new distribution, we believe the company is well-positioned to outgrow its larger and more mature peers moving forward. We think Under Armour is capable of achieving 9-11% gross sales increases, even if faced with a business slowdown. 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. 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 positions in Bristol-Myers Squibb, National Oilwell Varco and Netflix. We eliminated Cognizant and Tiffany from the portfolio during the period.
 
Past performance is no guarantee of future results.

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