U.S. Equity Strategy

March 2019

THE MARKET ENVIRONMENT
Despite episodes of volatility that occurred over the past three months, key U.S. indexes ended higher for the first quarter, extending what most identify as the longest bull market in history. While some have argued that indexes temporarily dipped into bear territory since the financial crisis recovery began in March 2009, no one can dispute that both the Dow Jones Industrial Average and the S&P 500 Indexes have more than quadrupled in value from 10 years ago. 

For several years, it seemed as if financial market and economic growth would continue unabated. However, the positive tide may be turning as some leading economic indicators are showing signs of weakness. 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 addition, the Treasury yield curve recently inverted, which many believe points to an impending recession. Furthermore, according to FactSet, an above-average number of S&P 500 constituent companies that issued first-quarter guidance are expecting negative earnings per share. After assessing current conditions, the Federal Reserve left key interest rates unchanged and stated it does not foresee raising rates through 2019.

While some near-term indicators might appear troubling, other crucial economic measures remain on steady ground. Unemployment is still at historically low levels and in February wages grew 3.1% from a year earlier, the fastest pace since 2009. Concurrently, we continue to see evidence that companies are working to strengthen underlying fundamentals, which may lessen the impacts from some immediate negative trends. Yet we acknowledge that many unresolved issues (e.g., lack of a trade agreement with China, possible increased auto tariffs, fallout from Brexit) could spark a touch of fear in the market. If so, market factors may lead to deeply discounted share prices of fundamentally sound companies and we stand ready to capitalize on the additional investment opportunities this scenario would provide.

THE PORTFOLIO
Top Performers:
Netflix delivered strong full-year earnings results, in our view, as global subscriber additions totaled 28.6 million in 2018 compared with 21.6 million in 2017. Notably, the company produced the best annual U.S. subscriber additions since 2015, despite U.S. subscriptions that are already more than two times the size of rival Hulu and about 50% higher than HBO. We believe the number of subscribers is the most important driver of long-term value at Netflix and, by our measure, the company continues to grow at a remarkably stable rate. In addition, Netflix gained some distinction in February when its film “Roma” won four Academy Awards and was the first film distributed primarily by a streaming service that was nominated in the “Best Picture” category. We remain pleased with the underlying performance at the company.

Although Moody’s fourth-quarter earnings results were shy of market expectations, the company’s outlook for 2019 boosted its share price in February. Moody’s fiscal-year 2019 guidance exceeded consensus estimates due in large part to Moody’s Analytics where margins expanded 180 basis points in 2018 and revenue increased 7% organically, despite a software-as-a-service transition headwind. In addition, the company announced a $500 million accelerated share repurchase program to be completed during the second quarter of 2019 along with a 14% increase to its previous quarterly dividend to $0.50 per share. In March, we met with CEO Ray McDaniel who came across as both logical and focused on preserving the company’s competitive position. We appreciate Moody’s evaluation process for mergers and acquisitions, which includes looking for deals that extend its position toward private market debt issuers and deals that enhance its position in regulatory and accounting compliance software. Our investment thesis for this company is intact as we believe its management team is working to enhance shareholder value.

Charter Communications’ share price soared upon the release of its fourth-quarter earnings report late in January. Year-over-year revenue rose 5.9% and adjusted earnings (excluding mobile revenue and operating expenses) advanced 7.6%, which was the highest rate since the second quarter of 2017. Both metrics outpaced market projections. Broadband net subscription additions accelerated to 289,000 (+9.9% year-over-year). In addition, management provided upbeat commentary about 2019 performance and expressed expectations that capital expenditures will decline from 2018, while margins will continue to expand. Charter’s quarterly results provided evidence of increasing profitability, declining capital intensity and improved free cash flow generation as the business transitions toward broadband.

Bottom Performers:
In February, General Electric (GE) spun off its transportation business (mainly locomotives and associated parts/services) and merged it with Wabtec (Westinghouse Air Brake Technologies), a leading rail equipment supplier. We reviewed Wabtec, including the new exposure to GE’s transportation business, and found that it is a reasonably attractive investment. Concurrent with the merger, Wabtec reported fourth-quarter revenue of $1.12 billion and cash from operations of $277 million, both of which surpassed market forecasts. However, earnings per share of $0.97 fell about 5% short of projections and its share price declined after we acquired our shares.

The share price of American Airlines Group dropped in the quarter after the Boeing 737 Max jet was taken out of service. American Airlines currently has 24 Max 8 planes in its fleet and had been operating approximately 90 flights per day using that aircraft. Management stated that flight cancellations and rescheduling will increase costs in the immediate term, but cannot estimate to what extent financial results will be impacted. In the meantime, American Airlines issued solid fourth-quarter results, by our measure, as operating revenues rose for both the quarter (+3.1%) and the full year (+4.5%) from the respective prior periods. Notably, net income reached $319 million in the fourth quarter (compared with negative results from a year earlier) and rose 10.2% for the full year. Along with the earnings release, management expressed optimism that operational improvements and culture enhancements would continue to drive positive performance. We, too, are hopeful that American Airlines will continue to build strength in 2019 and that Max 8 issues will have only a temporary effect. However, in light of current uncertainty, we adjusted some of our near-term valuation estimates to be lower and will continue to monitor the situation closely. 

During the quarter, we initiated positions in Constellation Brands and received shares of Wabtec through a GE spinoff. We eliminated our position in Baxter International.

 
Past performance is no guarantee of future results.

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