Aligned Investors: 2016 year-end review
It is safe to say the year of 2016 will not be soon forgotten. However, when people do eventually look back at the year, they might reasonably assume that the markets, at least, were fairly predictable. The S&P 500 Index finished the year up by nearly 12% including dividends; its closing level of 2251 was not far from consensus estimates at the beginning of the year. Similarly, interest rates ended the year higher than they started. The 10-year Treasury yield finished at close to 2.5%, within the range many expected a year ago. This type of prescience in market forecasting is rare, and, as we know from our experience during 2016, doesn’t really paint an accurate picture. The market plunge that started the year already seems like a distant memory, but with the S&P 500
down more than 10% in the first six weeks those beginning-of-year forecasts were quickly rewritten. By the time the 10-year Treasury yield dipped below 1.4% in early July, it was hard to find anyone predicting a year-end yield above 2%.
Forecasting is hard. Few predicted the Brexit result in late June or the Trump victory in November, and fewer still predicted the market response to those outcomes. It was another tough year to be consistently right about the direction of any macroeconomic variable. We expect 2017 will be similarly difficult. We admit that we do not even attempt to be experts in the forecasting arena. At last year’s Berkshire Hathaway shareholder meeting, Charlie Munger answered a question in typically straightforward fashion: “Microeconomics is what we do, macroeconomics is what we put up with.” We agree.
We spent our time in 2016 the same way we always have: trying to better understand the microeconomics of companies. All of our efforts are directed at building our knowledge about individual businesses. The ways they are able to attract and provide value to their customers. The services they can offer that competitors can’t replicate. The amount of reinvestment they require and how much of their earnings are truly available to owners. Their history and the way that has shaped their culture. The people in charge and their motivations – whether they love the business or love the money, as Buffett puts it. These are areas where we can gain useful insights and they are often overlooked by the broader market as they focus on the next quarter. We remain committed to owning companies that we believe have sustainable competitive advantages and owner-operator management teams, while constantly keeping our eye on valuations and reducing the risk of permanent capital loss. The companies that meet those criteria aren’t always in favor, but we trust they’ll perform better over time as they have in the past. Below we’ll describe how they performed in 2016 and where we found opportunities as we head into 2017.
Our MidCap portfolios finished the year with positive returns but trailed the Russell Midcap Index (please see a Factsheet or client report for details specific to your investment). Most of the underperformance came between Election Day and the end of the year. This was not due to any sort of pre-election positioning that went wrong. We hold companies for much longer (and for much different reasons) and, if anything, we try to use volatility around such events to our advantage. The weeks following the election were similar to other stretches in our portfolio’s track record where the market is driven by expectations for new stimulus – this time in the form of business-friendly policies from the new administration. When the market expects a faster growing economy, the companies that tend to perform best are those that need a strong economy to do well. These are generally weaker companies that are given some relief or cyclical companies that are positioned to ride highest on any coming wave. We don’t own many companies that fit those categories, so our portfolios tend to lag during these stretches.
The sector that benefited most in the recent rally was financials; within the mid-cap universe this group was up almost 18% in the fourth quarter. The potential combination of higher interest rates and asset levels, as well as lower taxes and looser regulations, would likely give a boost to many traditional types of financial companies. Mid-cap banks, for example, rallied 34% in the fourth quarter. Many insurers, brokers, and asset managers rose in similar fashion. While we do own many financial companies in our MidCap portfolios, as a group they are much less levered to equity markets and interest rates. We only own one bank and we don’t own any brokerages. Several of our companies in this sector have fee-for-service business models in contrast to the “spread” business model that is often associated with financials (lending at a higher rate than they borrow, creating the spread). For example, our holdings Moody’s and S&P Global earn a fee for rating debt. Our holding MSCI earns a fee for licensing its indexes. Aon and Brown & Brown earn fees when they broker insurance transactions. Onex earns a fee for managing private equity funds. While these are generally better, less cyclical business models, they also benefit less from a rising rate environment. We underperformed in the financials sector as a result.
Another area that did very well after the election was industrials, particularly those with most to gain from infrastructure spending and a faster-growing economy. Construction and engineering firms were up 19% in the post-election period. Industrial distributors also rose 19%. We don’t own any airlines, but that group finished the fourth quarter with a gain of 32%. We do own several industrial firms. Some of them, like HD Supply and Fastenal, benefited from this tailwind. But overall our industrial companies did not perform as well as the broader group.
Our turnover in MidCap portfolios during 2016 was 15%, which is just slightly lower than our normal amount of trading. Over the course of the year we did establish a few new positions, the largest weights being Sherwin Williams and IHS Markit. Sherwin is dominant in home paint, selling its high quality product from more than 4,000 conveniently located stores. They have four times the number of stores as their nearest competitor. Sherwin agreed to purchase more industrial-focused Valspar in 2016. The two businesses complement each other well. IHS Markit is also the product of a recent merger. Both IHS and Markit are information businesses, with IHS focused on resources (e.g. drilling rights) and transportation (they own the maker of Carfax reports) while Markit works in the financial sphere, delivering pricing and return info and providing valuation services and trade processing. Lance Uggla founded Markit and will eventually lead the combined company. The business is positioned well, the valuation has been attractive, and the owner-operator leadership from Uggla should provide benefits as they improve operations and consider bolt-on acquisitions.
We also sold completely out of some companies this year, several of which had grown outside the mid-cap range such as Becton Dickinson, Crown Castle, TJX Companies, and PayPal. The majority of our trading, however, was from trims and adds to existing holdings. We sold some of our shares in Brown & Brown and Martin Marietta Materials and Leucadia National, as those companies’ solid performance brought their prices closer to intrinsic value. M&T Bank and Microchip were both in favored areas of the market during 2016, so we lightened our positions as their shares rose. On the other side, our largest additions were to SBA Communications and Moody’s, two high quality businesses that had negative returns in 2016. We also increased the portfolio’s weight in CarMax, CBRE Group, and Dollar Tree during stretches of the year where their shares were weak.
Our Blue Chip portfolios also finished the year with positive returns. They outperformed the Russell 1000 Growth Index, the primary benchmark of the strategy, but underperformed the S&P 500, which is also occasionally used by clients (please see a Factsheet or client report for details specific to your investment). Blue Chip’s relative performance lagged during the post-election period for many of the same reasons outlined above. Some of our higher quality companies that don’t rely as much on the economy’s strength (Alphabet and Visa, for example) did not participate in the recent rally. Our holdings in the industrial and financial sectors did not do as well as benchmark peers. S&P 500 financial companies rose 21% during the fourth quarter. While some relative performance was given back during the last seven weeks, overall Blue Chip had a good year. We had some assistance from the struggle in healthcare stocks. Biotech and pharmaceutical companies were down last year, while our one holding from either industry, the animal health firm Zoetis, turned in solid performance. More broadly, while we faced some headwinds in the market environment, the companies we own did well. In attribution terms, company selection added value in 8 of the 11 GICS sectors.
Our turnover in Blue Chip portfolios was about average at 24%. We established new positions in Charles Schwab and Costco, two companies we know well from our years of owning them in our MidCap portfolios. Both companies have cultures instilled by their founders that focus on constantly finding new and better ways to provide value to customers – and the companies have been rewarded as those satisfied customers continue to grow in number. Schwab’s investments in technology and its online platform have positioned the company to take advantage of changes sweeping the investment industry. Its shares, however, plummeted when interest rates fell in late June following Britain’s vote to leave the European Union. This allowed us to build our position at attractive prices, and its shares have since recovered. Costco was also the victim of some short-term concerns after releasing weaker-than-expected August sales numbers. With its shares more attractively valued, we began buying in mid-September.
During 2016 the most meaningful positions we sold were Walgreens Boots Alliance, BlackRock, and Nestle. We still think highly of these firms and believe they are managed better than peers, but a combination of intensifying competitive pressures and higher valuations led us to believe there were better opportunities elsewhere. As with MidCap, most of our buying and selling involved existing holdings. As valuations came up, we sold some of our shares in Facebook, Starbucks, and Zoetis. We added substantially to American Tower, the largest cell phone tower company, especially during the first and fourth quarters when its shares were under pressure. We also increased the weight of Liberty Global, a cable and broadband provider with assets across Europe and the United Kingdom. Uncertainty related to Brexit and the resulting currency weakness weighed on Liberty Global’s shares during 2016. We bought more Danaher shares during the year. We have long admired the founding Rales brothers (who continue to own 12% of the company) and the way they’ve implemented the Danaher Business System of continuous improvement to produce results at the many businesses they’ve acquired.
In closing, we want to say thank you for the confidence you have placed with us. We love being able to do what we do. We deeply believe that an investment approach that is committed to long-term results and that prioritizes aligned incentives will outperform over time.
Restaurant Brands International
Another company we added to during 2016 was Restaurant Brands International, which was formed when Burger King and Tim Horton’s merged in 2014. The controlling shareholder is 3G Capital, the Brazilian group that has successfully improved operations at firms such as Kraft Heinz and Anheuser-Busch InBev. The top executives of Restaurant Brands are 3G people, and they have quickly established an owner-operator culture at the firm. One display of this culture is the work environment at headquarters. Tim Horton’s previously had two buildings where the floors were filled with a labyrinth of closed-off rooms and offices. The top executives were rarely seen by the lower-level employees. The cold temperatures kept people from even bothering to cross the street from one building to the other (no joke!). This all had the effect of stiffening an already bureaucratic culture. The Burger King (3G) leaders have opened it all up. They believe even top executives should work side-by-side, in close proximity to everyone else, facilitating the sharing of ideas and faster decision making while also underlining their belief in meritocracy. The old bureaucratic agendas have been replaced by transparent goals and tracked results. The better use of space means one of the buildings is no longer even needed. When we visited last year, we were impressed. To the left is a picture we took of the new environment.
Air Products & Chemicals
We also bought more shares of Air Products & Chemicals, an industrial gas company. The industrial gas industry has many appealing characteristics. It is already consolidated, with the top four firms accounting for almost 80% of industry revenues, and it’s becoming more so: two of the large firms, Praxair and Linde, are combining. The gases and related services that Air Products provides are critically important to industrial customers but make up a small portion of their cost structure. Because of this, many customers agree to long-term contracts. About 50% of Air Products revenue comes from 15-20 year contracts. Despite these strengths, Air Products has a history of uneven financial performance and questionable decisions by top leadership. This changed when Seifi Ghasemi took over in 2014. Ghasemi is an industry veteran with a proven track record. He set a goal for becoming the most profitable industrial gas company in the world. To do so, he has focused on the core industrial gas business (selling or spinning off non-core Materials businesses), removed bureaucracy by implementing a decentralized structure with transparent incentive plans, and focused his own efforts on better use of capital and lower overhead costs. He also showed his confidence in this strategy by personally buying Air Products shares in the open market. In just two and a half years, EBITDA margins have improved from 25% to 35%. As Ghasemi puts it, “What counts in the long-term is the increase in per share value of our stock, not size or growth.” This may seem obvious, but we wish more executives felt the same way – and acted accordingly.