U.S. Equity 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.

We initiated a position in Masco late in the fourth quarter, during which time the company’s share price increased. In our view, Masco’s business mix underwent a dramatic improvement in the last several years as lower quality and non-core business segments and product lines were either spun off or sold. Concurrently, the company’s core markets continued to consolidate, with Masco’s business mix now more heavily skewed toward its highest return, highest margin business segments. Today, the large majority of the company’s earnings are generated from the decorative architecture and plumbing segments, both of which we find to be quality businesses with strong margin profiles and low capital requirements. In our estimation, brands such as Behr (paints) and Delta (faucets) rank as some of the best names in the space and compete in rational and highly consolidated markets. The revenue derived from these businesses also tends to be much less cyclical than other product categories. Furthermore, management believes the plumbing segment has significant room for expansion into logical product agencies or to take additional market share in existing categories. Moreover, Behr’s partnership with Home Depot affords it with unique competitive advantages, in our view, including stronger consumer awareness and omnipresent product accessibility without the need to build out its own retail footprint. A strong balance sheet is enabling management to repurchase stock at attractive prices, in our opinion, which adds to our confidence that management’s objectives are aligned with shareholders.  

Bottom Performers:
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.

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. Despite these solid results, investors focused on management’s fourth-quarter revenue and earnings per share guidance that were lower than market expectations, which pressured the company’s share price. However, 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. Though shares of Netflix are trading at a substantial discount to what we believe is its total worth, we continue to find the company’s fundamental performance impressive.

National Oilwell Varco’s share price came under pressure from recent significant energy price declines. We have found that while commodity prices are intrinsically prone to short-term volatility, the normalized earnings power of individual companies is much more stable. We believe the company’s stock price movement and the related impact on its business reflect purely cyclical factors. Our participation in National Oilwell Varco’s investor day during the quarter reinforced our view that the company has strong competitive positions everywhere it operates. It is also the undisputed leader in drilling technology and is poised to benefit from the adoption of drilling automation and preventative maintenance. Furthermore, the company is uniquely positioned as an independent equipment manufacturer, which allows it to reach a broad customer base of both large and small service companies. In addition, management announced a new share repurchase program of up to $500 million in November. Overall, we believe National Oilwell Varco’s management team is highly focused on returns and an excellent steward of shareholder capital. 

During the quarter, we added Halliburton, Masco and Post Holdings to the portfolio. We eliminated our positions in Medtronic and Weatherford.

 
Past performance is no guarantee of future results.

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