Brown Brothers Harriman Quarterly Investment Journal
Does a Chinese Slowdown
Threaten the Global Economy?
Quarter 4 | 2015
Quarter 4 | 2015
Contents
01
03
10
16
18
The Markets: LeAVES AREN’T THE ONLY THING FALLING
G. Scott Clemons
RED SCARE: Does a Chinese Slowdown Threaten the
Global Economy?
G. Scott Clemons
Equities: core select update
Tim Hartch & Michael Keller
BOOK REVIEW: The Outsiders: Eight Unconventional CEOs
and Their Radically Rational Blueprint for Success
Tom Martin
Estate Planning for Your Online Afterlife: Should
Your Online Accounts Die with You, or Should They
Live On into the Digital Beyond?
Karin Prangley
21
Inside BBH: BBH Investor Day Recap
InvestorView
Contributors
G. Scott Clemons
Tim Hartch
Michael Keller
Thomas Martin
Karin Prangley
Executive Editor
G. Scott Clemons
Editors
Jacob Turner
Kaitlin Barbour
Designed by
Creative Services
InvestorView
MARKETS
Leaves Aren’t the Only
Thing Falling
Stock markets throughout the world posted negative returns
in the third quarter of 2015 as rising global uncertainty drove
down equity prices. Renewed fears of a hard landing in China
bore the brunt of the blame, yet in our opinion, the real culprit of
renewed price volatility is simply the fragile state of the market.
As we wrote in our August 24 commentary, “Volatility Is Not
on Vacation,” the combination of waning earnings growth and
full valuations makes the domestic equity market susceptible to
overreact to external developments. We believe that concerns
about China are overdone, as outlined in the feature article of
this issue of InvestorView, but we conclude that price volatility
is likely to linger due to the lack of support from robust profit
growth or attractive valuations.
The benchmark S&P 500 Index lost 6.4% during the period
(including reinvested dividends), and at one point in late August
stood more than 12% below the May peak. That loss of 6.4%
for the quarter was, nevertheless, better than the 10.3% loss
posted by smaller capitalization stocks (as measured by the
Russell 2500 Index) and the 17.8% decline in the dollar value
of emerging market equities. Returns from international equities – both in developed and emerging markets – have been
constrained by the strength of the U.S. dollar, which has rallied
14% against a trade-weighted basket of other currencies over
the past year. Hedge funds, at least in aggregate, provided little
protection against market losses. The HFR Equity Hedge Fund
Index dropped 5.8% in the quarter, thereby capturing 91% of
the broad market downside. The damage in emerging markets
is such that the three- and five-year trailing performance figures
have now slipped into negative territory.
Equity Returns
(Through September 30, 2015)
15%
10%
13.3%
12.4%12.4%
U.S. Large Cap Equity
12.7%
U.S. Small/Mid Cap Equity
Non-U.S. Developed Equity
Emerging Markets Equity
6.3%
4.6%
5%
0%
-3.3%
-5%
-5.3%
-6.4%
-10%
-4.8%
-4.9%
-10.3%-10.2%
-15%
-20%
-6.0%
-15.3%
-17.8%
3Q 2015
Source: Bloomberg, BBH Analysis.
YTD 2015
Trailing 3 Years*
Trailing 5 Years*
*Annualized.
For more details on equity asset classes, see notes at the end of this article.
Past performance does not guarantee future results.
Traditional fixed income classes eked out modest gains in the
quarter. Investment grade bonds added 1.2%, and municipals
rose 1.7%. Economic concerns led to widening credit spreads,
which drove high-yield bonds down 4.9% on a total return
basis. Inflation-indexed bonds dropped a modest 1.2%.
Author
G. Scott Clemons, CFA
Managing Director
Chief Investment Strategist
Brown Brothers Harriman Quarterly Investment Journal 1
Fixed Income Returns
(Through September 30, 2015)
8%
Investment Grade Taxable Bonds
6%
Investment Grade Tax Exempt Bonds
5.9%
High-Yield Bonds
Inflation-Protected Bonds
4.3%
4%
2.9%
2%
1.2%
1.7%
1.7%
3.4%
3.1%
2.6%
1.7%
1.1%
0%
-1.1%
-1.2%
-2%
-1.9%
-2.5%
-4%
-4.9%
Source: Bloomberg, BBH Analysis.
-6%
3Q 2015
YTD 2015
Trailing 3 Years*
Trailing 5 Years*
*Annualized.
For more details on fixed income asset classes, see notes at the end of this article.
Past performance does not guarantee future results.
The best performing asset class in the quarter, broadly defined,
was the U.S. dollar, which rose 4.6% against a trade-weighted
basket of other currencies and is up 8.8% for the first nine
months of the year. This rally has sapped the return of non-dollar assets to U.S.-based investors while complicating the Federal
Reserve’s decision about when to begin the long march toward
a more normal monetary policy. All else being equal, a stronger
currency leads to tighter monetary conditions, which in turn
helped the Fed decide in September to leave the fed funds target
rate at zero for the 54th consecutive meeting of the Federal
Open Market Committee.1 The futures market now assigns a
probability of only 32% that the Fed will raise interest rates
before year-end.
The strong dollar has also weakened the earnings growth of
large American companies – as represented by the S&P 500
Index – which derive around 40% of revenues abroad. Those
revenues and profits don’t translate back into quite as many
dollars when global currencies weaken. The result is lower dollar-based profits in an accounting sense, but to the extent that
expenses and revenues are based abroad, the genuine impact
on the fundamental value of multinational companies is muted. Nevertheless, the strong dollar adds a further headwind
to earnings already suffering from the diminishing returns of
cost-cutting and margin expansion in this seventh year of an
economic cycle.
Having noted that, we continue to monitor the strength of corporate earnings closely, as they are the fuel of equity markets.
In a modest economic expansion, unit volume growth is hard
to come by, and the absence of inflation implies that pricing
power is similarly hard to find. That doesn’t necessarily spell the
end of a market cycle, although it does illustrate the increasing
2 Brown Brothers Harriman Quarterly Investment Journal
difficulty of finding investment opportunities that offer an appealing tradeoff of risk and return. Where most institutional
investors would respond to rising market risk by diversifying,
we prefer to manage that risk by concentrating into those investments that still offer an appealing tradeoff of risk and return and
holding reserves in short-term fixed income instruments awaiting
redeployment into more attractive investment opportunities.
The U.S. economy continues to expand at a moderate pace,
fueled largely by strong personal consumption, which is in turn
supported by improving housing and labor markets. GDP in the
second quarter of 2015 expanded 3.9% at an annual pace, although that is likely to slow to around 2.0% in the third quarter.
Wage growth has yet to accelerate, even though the unemployment rate of 5.1% is at a seven-year low, and unemployment
claims are at a 40-year low. The labor market is in good shape,
and we expect continued job gains to begin to support wage
increases in the near future. That should provide an additional
boost to personal consumption as well as corporate earnings.
Discipline is an important element of any investment strategy, but that importance is magnified when valuations are full
and the support of earnings growth has begun to wane. To
paraphrase Thomas Jefferson, eternal vigilance is the price
of investment liberty and lies at the heart of our investment
approach.
Refer to our September 17, 2015, commentary, “The Fed Punts,” for additional information on the Federal Reserve’s decision to keep interest
rates near zero.
1
Equity Asset Classes:
Large cap U.S.: S&P 500 – index of 500 large cap common stocks actively
traded in the U.S.
Small/mid cap U.S.: Russell 2500 – index of approximately 2,500 small-cap
common stocks actively traded in the U.S.
Non-U.S. developed: MSCI EAFE – index of stocks from 21 countries designed to
measure the investment returns of developed economies outside of North America.
Non-U.S. emerging: MSCI Emerging Markets – index designed to measure the
equity market performance of 26 emerging economies.
Fixed Income Asset Classes:
Investment grade taxable bonds: Barclays Aggregate – benchmark designed to
measure the performance of the U.S. dollar-denominated investment grade,
fixed-rate taxable bond market.
Investment grade tax-exempt bonds: S&P Municipal Bond Index – index that
seeks to measure the performance of the U.S. municipal bond market.
Inflation-protected: Barclays U.S. TIPS – index designed to measure the performance of inflation-protected securities issued by the U.S. Treasury.
High-yield: BofA Merrill Lynch High-Yield (Cash Pay Only) – index of U.S.
dollar-denominated below investment grade corporate debt publicly issued in
the U.S. domestic market.
Source: Bloomberg, BBH Analysis.
Past performance does not guarantee future results.
Index performance is not illustrative of any specific security’s performance.
Indexes are unmanaged, and an investment cannot be made directly in any index.
InvestorView
Does a Chinese Slowdown
Threaten the Global Economy?
The influence of the United States on the global
economy is captured by the old adage that when
America sneezes, the rest of the world catches a
cold. Yet this historical causality appears to have
reversed of late, as a minor devaluation of the
Chinese currency in August sent global financial
markets into a tailspin, and was subsequently cited by Federal Reserve Chairwoman Janet
Yellen as a reason to delay an interest rate hike
in September. Fluctuations in capital markets,
interest rates, currencies and commodities are
routinely credited to (or blamed on) economic
developments in China. Should investors worry
that a slowdown in the Chinese economy will
spell an end to the domestic economic cycle and
pose a threat to stock and bond markets? Is this
21st century version of a Red Scare warranted?
Lest we be accused of burying the lede, our answer
is no. Economies, like trees, don’t grow to the sky,
and as the Chinese economy matures, the pace of
activity naturally slows. In the commentary that
follows, we discuss the evolving role of China
on the world stage and how the combination of
central planning, a crackdown on corruption, the
exigencies of population growth and the desire
to be a bigger player in global affairs adds up to
a more modest, but more sustainable, pace of
Chinese growth.
The State of the Chinese Economy
China’s importance became overwhelmingly evident during the global financial crisis. Although
gross domestic product (GDP) growth slowed to
6.2% in the first quarter of 2009, that rate stood
out in an environment in which every other major
economy shifted into reverse. The world economy
has improved from those dark days, but economic
growth remains modest, and China’s contribution
to that growth therefore remains meaningful –
hence the rising anxiety about the deceleration of
Chinese activity to 7.0% in the first half of 2015
and a further drop to 6.9% in the third-quarter
report recently released.
Chinese Gross Domestic Product (GDP)
Year-over-Year Change
18%
16%
Author
14%
12%
10%
8%
G. Scott Clemons, CFA
Managing Director
Chief Investment Strategist
6%
4%
2%
0%
1993
1995
1997
1999
2001
2003
2005
2007
Source: National Bureau of Statistics of China, BBH Analysis.
2009
2011
2013
2015
As of 3Q 2015.
Brown Brothers Harriman Quarterly Investment Journal 3
Exacerbating that general concern is the suspicion that Chinese
economic growth is overstated – even at the reduced pace of
6.9%. One need not be a conspiracy theorist to draw this
conclusion. The sheer size and breadth of the population, the
informal nature of much economic activity and the lingering
reliance on agriculture all combine to make accurate statistics
elusive. We therefore analyze a variety of secondary measures
of Chinese activity to arrive at a partially objective, but still
fairly subjective, reality check on the health of the economy.
None of these alternative measures of activity provides a clear
answer to the question of real Chinese growth, but in aggregate
they point to slowing, but not contracting, economic activity.
Comparing current conditions with those experienced in the
global financial crisis is particularly instructive.
The clearest indication of economic deceleration is seen in the
import and export statistics, which, although volatile from
month to month, have both shown year-over-year declines.
Imports have been decreasing for 11 consecutive months, while
exports have fallen for seven of the past nine months. This is
by no means as dire as the 2008 to 2009 period, during which
imports contracted by 54% from peak to trough, but it does
speak to a slowdown in Chinese demand for imported goods
(whether for personal or business use). Yet this could also be a
reflection of the desire on behalf of central planners to reorient
the engine of economic activity away from export markets and
more toward meeting demand domestically. We discuss this
policy shift in further detail as follows, but on the surface, the
trade data indicate a slowdown in economic activity, but not
a contraction.
Data on domestic trade in goods show a similar pattern. Rail
freight loadings, which capture domestic demand more so than
air or sea cargo destined for foreign shores, declined 15.3% year
over year as of the latest data point (August 2015). That figure
is markedly weaker than the drop of almost 10% experienced
during the global financial crisis, but once again, changes in
trade patterns may explain some of this weakness. Highway
freight continues to grow (up 5.7% year over year in August)
even while rail freight shrinks, signaling a shift in preference
away from rail and toward roads. Whereas aggregate rail cargo
was four times the size of road cargo in the mid-1990s, that
relationship reversed by the end of the decade, and trucks now
transport 11 times the amount of freight carried by rail.
Chinese Freight Volumes - Year-over-Year Change
60%
50%
Highway Freight
40%
30%
20%
10%
+5.7%
0%
Railroad Freight
-10%
-15.3%
-20%
-30%
-40%
-50%
1999
2001
2003
2005
2007
Source: National Bureau of Statistics of China, BBH Analysis.
2009
2011
2013
2015
Data as of August 2015.
Chinese Imports and Exports - Year-over-Year Change
That change carries environmental implications, and Western
readers are aware of the air pollution challenges that face
Chinese cities, not to mention the occasional epic traffic jam
that lingers for days. Taken as a whole, these two measures
of domestic transportation argue for more modest economic
growth, but continued growth nonetheless.
100%
80%
Exports
Imports
60%
40%
20%
0%
-3.8%
-20%
-20.4%
-40%
-60%
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: National Bureau of Statistics of China, BBH Analysis.
Data as of September 2015.
4 Brown Brothers Harriman Quarterly Investment Journal
Other measures of economic activity lead to similar conclusions.
Domestic construction has slowed from a torrid annual growth
rate between 30% and 40% in the early days of the recovery
from the financial crisis to an average of 5% so far in 2015.
Local bank loan growth remains quite healthy at 15.7% year
over year, but this too has halved over the past few years. Taken
in aggregate, these secondary measures of economic activity
argue that, whereas the economy is likely still growing, it is
certainly not expanding at the pace of the last few decades.
InvestorView
The ‘Devaluation’ of the Renminbi
Anxiety about the deceleration of Chinese economic activity is
not a new development. The proximate cause of the most recent
spike in concern was the action taken by the People’s Bank of
China (PBOC) on August 11 to devalue the renminbi (RMB)
by about 2%. Exacerbated by typically thin trading days in late
summer, the U.S. equity market dropped 10% over the subsequent fortnight. The market interpreted the devaluation as a
sign of panic at a sharp slowdown in economic activity and an
effort on behalf of the PBOC to boost export competitiveness
through a cheaper currency. Market analysts who see a currency
war around every corner labeled this evidence that the Chinese,
whose exports have been punished by the linkage of the RMB
to a strengthening U.S. dollar, were themselves joining the fray.
We couldn’t disagree more with this analysis.
The RMB is loosely pegged to the U.S. dollar in a managed
float, in which the central bank of China sets a reference rate
each morning, and then allows the currency to trade within a
2% range above and below that target. As the nearby graph
shows, the RMB has been trading near the low end of the 2%
trading band since the beginning of the year. The PBOC move
in August was essentially an acknowledgment of reality and
an adjustment of the reference rate so that it better reflected
the spot rate. Since the devaluation, the spot rate has adhered
tightly to the reference rate. Order is restored, and the RMB has
actually strengthened a little bit since the PBOC’s initial action.
Chinese RMB Reference and Spot Rates
5.80
Chinese RMB/U.S. dollar
5.90
Weaker RMB
+2% Band
6.00
RMB Reference Rate
6.10
RMB Spot Rate
6.20
-2% Band
6.30
6.40
6.50
6.60
6.70
Jan
Feb
Mar
Apr
May
Jun
Source: People’s Bank of China, Bloomberg, BBH Analysis.
Jul
Aug
Sep
Oct
Data as of October 15, 2015.
If the intent was to restore competitiveness of Chinese export
markets, a devaluation of 2% isn’t enough to do the trick.
That variation is equivalent to the occasional daily move of
other, more freely traded currencies, and, although it seems
counterintuitive, the export sector is not a large part of the
Chinese economy. As we discuss in greater detail later in this
commentary, investment in infrastructure and capital formation
are the largest part of the economy, accounting for 46% of
GDP, whereas net exports only add 2.7% to the total economy. Gross capital formation does not benefit markedly from a
weaker currency.
We believe that the August currency adjustment is part of an
ongoing effort to enhance China’s profile and influence in the
global economy. A milestone in that effort would be the inclusion of the RMB in the basket of currencies that determines the
Special Drawing Rights (SDRs) managed by the International
Monetary Fund (IMF). SDRs act as a form of global reserve
currency and are based on the four most important currencies
in global export and financial markets. Importantly, these currencies must be “freely usable.” The composition of the basket
is reviewed and adjusted every five years, and since the 2010
review the SDR comprises the U.S. dollar, euro, Japanese yen
and British pound sterling. The RMB is clearly an important
global currency, and the Chinese would like for it to be considered for inclusion in the 2015 review.
In an interview conducted on August 4, 2015, IMF Director
Siddharth Tiwari noted that “[t]he Chinese RMB is the only
currency not currently in the SDR basket that meets the export
criterion. Therefore, a key focus of the current review will be
whether the RMB also meets the freely usable criterion in order
to be included in the SDR basket.” We interpret the adjustment
that took place one week later to be a direct response to this
observation – and a show of good faith, if nothing else – to
Brown Brothers Harriman Quarterly Investment Journal 5
away from Soviet-era planning to a more market-driven socialism) since 1953 to establish economic and social priorities
for the intermediate future. In liberal democracies of the West,
citizens are accustomed to treating economic promises as no
more than that – well-intended aims that often founder when
confronted with political realities. In the centrally planned
economy of China, however, officials have implemented each
and every one of these Five-Year Plans, and their history is the
history of post-World War II China.
enhance the free usability of the RMB. This is, in other words,
continued evidence of China’s desire to integrate more fully into
the global economy, and not the panicked response to economic
weakness that some analysts believed.
The Future of the Chinese Economy
China is an old country, and any consideration of the future
must rely on the past. Events taking place now are just the
latest steps in an ongoing effort to reorient the composition of
the Chinese economy and enhance China’s role on the global
stage. In 2007, just before the onset of the global financial crisis,
then-premier Wen Jiabao characterized the country’s economy
as “unsustainable, unbalanced, uncoordinated and unstable,”
a remarkably candid assessment from a Chinese premier. He
found rising income equality to be socially unstable, while the
variation in growth between urban and rural areas led to unbalanced economic progress. An emphasis on the export sector and
capital investment in industry was uncoordinated with the desire
to make personal consumption more of an economic activity
driver. Proof of this overreliance on exports and industry would
come shortly as China suffered from the collapse of economies
elsewhere during the global financial crisis. Finally, the focus on
economic growth at the cost of environment degradation was
unsustainable, and evident in the pollution of air and waterways
throughout China.
The 12th Five-Year Guideline was enacted by the National
People’s Congress in March 2011 and, among other goals,
committed to address the Four Uns identified by Premier Wen
several years earlier. In particular, the guideline called for a rebalancing of economic activity away from capital formation and
more toward personal consumption. As noted earlier, China’s
reliance on personal consumption has declined steadily over
the past 50 years as investment in infrastructure, industry and
manufacturing took the lead. Personal consumption accounts
for only 38% of Chinese GDP, vs. 68% in the United States.
Gross capital formation, on the other hand, is 46% of Chinese
GDP, vs. 17% in the United States. This leads to an overreliance
on foreign demand, booms and busts as capital is not always
allocated efficiently, vast disparities in wealth and income, and
environmental degradation as growth takes priority over air
and water quality – hence the desire to re-establish domestic
demand as a more robust engine of economic activity.
Chinese Gross Domestic Product (GDP) Sector Breakdown
80%
70%
60%
Household Consumption
50%
40%
46.0%
Gross Capital Formation
30%
20%
Government Spending
The Chinese government has used a series of Five-Year Plans
(re-christened “guidelines” in 2006 to better reflect a transition
6 Brown Brothers Harriman Quarterly Investment Journal
13.5%
10%
Net Exports
2.7%
0%
-10%
Source: National Bureau of Statistics of China, BBH Analysis.
Premier Wen concluded that all of these challenges could be
addressed by an economy more reliant on domestic personal
consumption than capital spending and exports. The solution
to these “Four Uns” took the form of a Five-Year Guideline for
economic development.
37.7%
As of 2014.
Part of this plan already seems to be working, as Chinese
household consumption doubled between 2009 and 2014.
After decades of growing at mid-single-digit rates, consumption
during the period of the current Five-Year Guideline has accelerated to an annual pace of almost 14%. This doesn’t address
the challenges of income inequality or environmental pollution,
but it is evidence that a pivot toward a more domestic source of
InvestorView
Chinese household consumption doubled between 2009 and 2014. After decades
of growing at mid-single-digit rates, consumption during the period of the current
Five-Year Guideline has accelerated to an annual pace of almost 14%.”
economic growth is succeeding. The overall economy has fallen
slightly short of a targeted growth rate of 8%, but the dynamism
of personal consumption argues that the transition toward a
more sustainable source of economic activity is taking place.
Chinese Household Consumption Annualized Growth Rates by Decade
16%
14%
12%
10%
8%
6%
4%
Upon his election as General Secretary of the Communist Party
in November 2012, Xi Jinping promised to crack down on
“tigers and flies” – that is, senior leaders as well as lower-level
officials. The record since then is impressive. In the past few
years, high-profile members of the party such as General Xu
Caihou (former member of the Politburo and Vice Chairman
of the Central Military Commission) and Zhou Yongkang (former Politburo member and national security chief) have been
expelled from the party. Xu died before trial, and Zhou was sentenced to life in prison. Most recently, Guo Boxiong, former Vice
Chairman of the Central Military Commission and Politburo
member, was arrested on July 31 for taking bribes in exchange
for officer promotion. He is in jail, awaiting court martial. In
all, over a hundred senior party officials, a dozen senior military
officers and several senior executives of state-owned companies
have been indicted and convicted of corruption crimes, usually
involving some form of bribery.
2%
0%
1950s
1960s
1970s
1980s
Source: National Bureau of Statistics of China, BBH Analysis.
1990s
2000s
2010s
As of 2014.
The Role of Corruption
An aspect of the 11th Five-Year Guideline that was carried over
into the 12th was a desire to create a more transparent society
by cracking down on the corruption that naturally proliferates
in a planned economy. Transparency International issues an
annual Corruption Perceptions Index, surveying the perceived
amount of corruption in every country worldwide. In the 2014
survey, China ranked 100th out of 174 countries, behind Hong
Kong (17), South Korea (43), Brazil (69) and India (85), but
ahead of Russia (136).
Improving that ranking involves a tradeoff, as routine corruption in an economy usually evolves as a way of getting things
done. Deals done in smoky back rooms, bribes and tacit guarantees all grease the gears of economic activity in the short run
but make it harder to compete on a global and level playing field
in the longer run. That is as much a statement about human
nature as it is about Chinese society. Anti-corruption campaigns
have been waged before in China, but the current iteration has
reached the highest echelons of government and business, and
signals that this time is different.
The audience for this crackdown on corruption is not just the
global community, which should welcome a cleaner and more
transparent Chinese economy and government. The rank-andfile members of the party, as well as the man and woman on
the street, have likewise cheered a move away from a system
characterized by patronage, entitlement, conflicts of interest,
bribery and inefficiency. This popular approval strengthens Xi’s
hand in carrying on with the campaign, while burnishing the
credibility of the Communist Party in the eyes of the masses. For
a government still informed by the events of Tiananmen Square
in 1989, anything that fosters social tranquility is desirable.
Chinese history is rife with political purges disguised as a crackdown on corruption, and it is possible that this latest round is
no different. Arrests have clearly broken down factions within the party and diluted a system of client-patron privileges
that drove political and business success within the provinces.
However, when understood in the context of China’s desire to
have more influence in global affairs, the political implications
of these actions become a convenient collateral benefit of an
effort otherwise intended to enhance the country’s standing in
the world community.
This marks, however, a literal change in “business as usual.”
The Chinese word guanxi is often used to describe the Chinese
way of doing business, in which the exchange of favors and the
development of personal relationships are regarded as more
Brown Brothers Harriman Quarterly Investment Journal 7
important than laws, regulations and written agreements. But
when does an innocent exchange of gifts during the holiday season become a bribe? When does the effort to build relationships
with party officials or business leaders become unwarranted
patronage? Activities that were not considered illegal or even
problematic a few years ago are now being called into question,
and that has a naturally depressing effect on economic activity.
It is easy to identify outright bribes as criminal offenses, but as
an economy tries to figure out where the line of acceptability
falls, uncertainty reigns.
Developments in gerontology and the application of those advances in China means that the population will age dramatically
as the percentage of the 65-and-older population balloons from
9.6% in 2015 to 33.8% in 2100. The combination of decelerating population growth and lengthening life spans will act
as a scissors effect, dramatically increasing the portion of the
population that is not in the labor force but reliant on external
support for food, shelter and clothing. To put that into context,
China will become an older society than the United States by
the year 2040.
Demographics Is Destiny
% of Population Aged 65 or Older
China has been able to generate such impressive economic performance over the past several decades because of the rapid
growth and rising productivity of its population. Ironically, it
is precisely because of the size and growth of the population
that China needs to grow so quickly. A growing labor force is a
powerful input to economic activity, but as populations age, the
labor force at some point begins to decline. An aging population
is a call on economic vitality, not a contributor to it.
40%
35%
30%
China
United States
25%
20%
15%
Although we usually associate the challenges of stagnant and
aging populations with Western (and particularly European)
countries, China faces these same challenges in the near future,
largely as a result of its policy to manage population growth by
allowing families to have just one child. (At the end of October,
the Communist Party decided to end the decades-long policy,
boosting the limit to two.) According to the United Nations
Population Division, China’s population will rise from the current level of 1.376 billion to peak at 1.415 billion in 2030. That
seems like a long time from now, but 15 years is not that much
time in demographic terms. From that high, the population is
likely to shrink, ending the 21st century at just over 1 billion
people. Economic growth is hard to maintain when populations
and labor forces are in retreat.
Chinese Population
1,600,000
(thousands)
10%
5%
0%
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100
Source: United Nations Population Division, BBH Analysis.
Data as of October 19, 2015.
These demographic trends pose several challenges. Unlike the
developed economies of the West, China does not have the social infrastructure to handle an aging population. There is no
Chinese version of Social Security, Medicare or Medicaid. As is
common in Asian societies, family ties play the support role that
government programs often play in the West, but those ties are
fraying as younger generations move farther away from home.
Furthermore, the ripple effect of the one-child policy implies that
younger couples will increasingly be called upon to support as
many as four aging parents. This does not bode well for a party
intent on maintaining control and social stability.
1,400,000
The solution to this seemingly existential challenge is to generate
enough economic growth to build a social safety net before these
demographic trends pose the threats outlined. This is the real
reason that China needs to sustain economic growth, enhance
its role on the global stage and complete the transition from
emerging to emerged economy. China needs to get rich before
it gets old, and, as the prior graph illustrates, it has about one
generation to do so.
1,200,000
1,000,000
800,000
600,000
400,000
200,000
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100
Source: United Nations Population Division, BBH Analysis.
Data as of October 19, 2015.
8 Brown Brothers Harriman Quarterly Investment Journal
InvestorView
Conclusions
China is an economy in transition, and the prospect of an
aging population implies that the country needs to accelerate
that progress to a mature economy characterized by robust
and domestic sources of economic activity, a transparent business and political environment, and enough wealth to sustain a
population that will increasingly call on government support.
Other economies have made similar transitions throughout
history, but not at the scale and under the time pressure that
China faces. That poses risks, and as China plays a bigger
and bigger role on the world stage, those risks redound not
just to China alone.
Of course, many of our investments in
domestic and international multinational companies depend on Chinese
demand to drive their bottom line, so
our indirect investments in China carry
a diluted version of some of these risks.”
when those policies collide? How will the government establish
a truly independent banking system, which today exists largely
as a policy arm of the government? How will the central bank
fully float the RMB, and is it willing to cede control to the
market, as a full float implies? Only time will tell if these (and
other) dynamics evolve smoothly, but it is clear that the Chinese
government wishes to play a more influential role on the world
stage and appreciates that this objective requires it to embrace
these developments.
A chief risk is the tricky shift from true communism to some
hybrid form of market socialism. This transition has been underway since Deng Xiaoping in 1978 first introduced the concept of
private land ownership, allowed for more free market pricing of
goods and created special economic zones to encourage exports.
Top-down management by the state was replaced by bottom-up
initiative and even entrepreneurialism, which helped to drive per
capita GDP from $195 in 1978 to $3,866 today. The economy
remains centrally guided, if not strictly planned, but the ability
to enact central control over the economy can be fragile when
the population sees the benefits (and, admittedly, the detriments)
of capitalism in their own lives. The Tiananmen Square protests
of 1989 stand as an example of what could happen if economic
growth slows too much or the party tries to rein in social and
economic freedoms too tightly. That transition is tricky, and
there is no guarantee that the party will get it right, although
the historical record since reforms were first introduced in 1978
is generally encouraging.
There are multiple challenges to economic development that
fall outside the scope of this article but that China will need to
address if the economy is to successfully transition to a developed model. How will the country and the ruling party balance
market liberation with social control, and how will they respond
The rapid transitions outlined in this article make China a particularly tricky place to invest. In addition to the fundamental
and valuation risks that normally accompany any investment,
Chinese equities require investors to assume added political,
regulatory and economic risk, the analysis of which can be
daunting. Our direct investments in China are therefore limited
at present, largely as a function of this opacity. We anticipate
that as the evolution of the Chinese economy proceeds, it will
become easier to identify true company value and invest with
greater conviction. Of course, many of our investments in domestic and international multinational companies depend on
Chinese demand to drive their bottom line, so our indirect investments in China carry a diluted version of some of these
risks. In those cases, we rely on the insight of corporate and
local management to assess and manage the extraordinary risks
discussed in these pages.
None of the forgoing is intended to diminish the risks that
China poses to the global economy, but simply to place those
risks into the context of an economy in transition. We believe
that China will continue to be an engine of global economic
activity, but that the dynamic growth of the past will give way
to more modest, but durable, growth in the future. This is the
natural maturation of an economy seeking to become a more
prominent player on the global stage while creating enough economic wealth to build out the social infrastructure that an aging
population will increasingly need. We’re watching an emerging
market emerge in real time, and at an accelerated pace, and we
conclude that, whereas that certainly poses risks to the global
economy, those risks are outweighed by the opportunities.
Brown Brothers Harriman Quarterly Investment Journal 9
Investing
Equities:
Core Select Update
Large cap equities experienced a
substantial pullback during the
third quarter of 2015 amid a global de-risking of portfolios. While
rising concerns of spillover effects
from economic slowdowns in the
developing world were arguably
the primary catalyst for worsening sentiment, we also believe that
investors have been weighing other factors such as generally high
equity valuations, lukewarm macroeconomic conditions, rising debt
levels, geopolitical challenges and
questions about the efficacy of extended monetary accommodation
by central banks.
The S&P 500 Index declined by
6.4% during the quarter, while the
BBH Core Select Representative
Account2 (Core Select) declined by
4.8%. Year to date, the S&P 500
is down by 5.3%, and Core Select
is down by 5.9%. Over the last
five years, Core Select has compounded at an annualized rate of
12.7% per annum vs. 13.3% for
the S&P 500 Index. Measured
from the prior market peak
reached in October 2007, Core
Select has compounded at 8.6%
per annum, which compares to
5.2% for the S&P 500.
1
Authors
Tim Hartch
Partner
Co-Manager of Core Select
Michael Keller
Partner
Co-Manager of Core Select
The equity market pullback in
the quarter neither surprised nor
disappointed us, given our observations over the last few quarters
regarding stretched valuations,
narrowing market leadership
10 Brown Brothers Harriman Quarterly Investment Journal
and evidence of increasingly indiscriminate buying on the part
of exchange-traded funds (ETFs)
and index strategies as well as
short-term-focused investors who
had been chasing the markets
higher. As we have noted in our
prior investor updates, our cautious posture and adherence to
high standards for business quality and valuation had resulted in
our building up a higher level of
un-deployed cash in Core Select
than has been typical in the past.
Cash is not an intrinsically attractive asset, but it can be a valuable
buffer in bullish market environments with rapidly accumulating
price risks. As such, our cash position contributed to our downside
protection as markets came under
pressure in the third quarter.
The market decline in August and
continued volatility in September
gave us several opportunities to
deploy capital at attractive discounts to our estimates of intrinsic
value.3 Nevertheless, it would still
be difficult for us to make the case
that all signals are clear for the equity markets generally – the global
economy remains in a somewhat
tenuous state, corporate earnings
growth has moderated, financial
leverage has continued to build,
and the U.S. Federal Reserve appears unsure of how to engineer
a needed policy normalization
without creating additional risks
of market tumult and foreign exchange imbalances. We believe
these factors present potential
risks for our businesses and equity valuations overall, and as such,
we have been relatively measured
in the pace of our incremental investments. Moreover, we have
favored adding to companies in
which our level of confidence
and visibility is highest, rather
than simply putting cash into the
stocks with the largest discounts
to our intrinsic value estimates.
This approach is consistent with
how we have invested over time in
both rising and declining markets.
Examining our third-quarter
performance, the strongest contributor was Chubb, which had
a total return of 29%. Chubb’s
shares rose following the company’s announcement that it had
agreed to be acquired by Ace
Ltd., a large, globally diversified
property and casualty insurer
headquartered in Switzerland.
The proposed acquisition price
of $125 per share, which includes both a stock and cash
component, was in line with our
estimate of Chubb’s intrinsic value. Since we initiated our position
in 2007, Chubb’s focused and
long-term-oriented management
InvestorView
team has meaningfully grown shareholder
value through strong operational execution and intelligent capital allocation. We
believe that Chubb presented an attractive
acquisition target given its strong market position, good brand reputation and
well-capitalized balance sheet. As it is not
our intention to roll our Chubb position
into shares of Ace, we began to reduce
our position in Chubb in July.
Our second best contributor in the quarter was Google, whose Class C shares
rose by 16%. Google is among our top
five holdings and has been a meaningful
positive contributor to Core Select’s performance over the last three years. The
shares advanced sharply in July after the
company reported strong quarterly results
led by growth in mobile search, YouTube
and programmatic campaigns. Despite
pressures from adverse currency translation and the continued mix shift toward
distribution platforms that have a lower
“cost per click,” Google’s core revenues
(excluding pass-through payments to online publishers) grew at a robust 13%.
Equally important was the deceleration
of growth in the company’s operating
costs in the quarter, which along with
lower-than-expected capital spending
helped to drive strong free cash flow
conversion. Google’s recently appointed
CFO Ruth Porat affirmed the company’s
intention to sharpen its focus on cost
and capital optimization in the interest
of driving improved long-term shareholder value. We view this as an appropriate
pivot for Google at this stage in its lifecycle, and we do not believe it undermines
Google’s ability to innovate and grow.
The company’s commitment to this strategic evolution was also apparent in its
August announcement of a new operating
structure that will create a public holding company called Alphabet. Within this
new structure, Google’s core internet businesses will be reported as one segment,
and its nascent endeavors in areas such as
life sciences, broadband connectivity and
home automation will be reported separately. As part of this transition, Sundar
Pichai, formerly the Senior VP of Products
at Google, recently took over as the CEO
of the core Google business. Following
the reorganization, Alphabet will become
the publicly listed entity and the current
Class A (ticker GOOGL), and Class C
(GOOG) common shares will represent
the same number of corresponding shares
in the resulting Alphabet equity capital
with the same shareholder rights. We
view this reorganization and the increased
transparency it will provide as a positive,
given that it will enable investors to evaluate the growth and profitability of the
core online advertising operations apart
from the non-core, early-stage investment
businesses. Google continues to trade at
a meaningful discount to our estimate of
intrinsic value per share.
Other solid performers in the quarter included Progressive Corp., Nestlé
and Baxter International. Shares of
Progressive gained 10% as investor sentiment toward the auto insurance sector
began to improve with reports of rate
increases beginning to take hold industrywide. In the last few years, the rate
environment in property and casualty
insurance has been generally weak due
to low inflation in claims costs and the
pass-through impact of lower reinsurance
pricing. Spurred by a recent uptick in accident frequency and severity, the auto
insurance market has achieved some
firming of rates, which has improved the
earnings outlook for well-positioned companies like Progressive and GEICO (part
of Berkshire Hathaway).
Nestlé shares returned 4% in the third
quarter, as the company’s strong product portfolio and good execution have
continued to offset unsteady economic
conditions, particularly in developing
markets. Nestlé is distinguished by its
participation in generally higher-growth
categories and geographic markets, which
has enabled the company to balance
weaker performances with outperformers. Nestlé’s focus on nutrition, health
and wellness has positioned it well to
capitalize on important consumer trends
and changing demographics. In addition,
the company’s forward-looking stance on
innovation – along with its strong gross
margins that fund this innovation – has
enabled it to engage with consumers
with appealing products at both the high
and low ends of the value spectrum. The
strength of Nestlé’s brands and its innovation capabilities drive pricing power,
which, combined with internal efficiency
programs, should enable the company to
improve margins even if it experiences input cost inflation. We believe that Nestlé’s
consistent formula of mid-single-digit organic growth with improving margins and
strong cash conversion should continue to
drive long-term value creation for shareholders. While emerging market pressures
and foreign exchange impacts may affect
reported results in the near term, the fundamentals of the company remain strong.
At the beginning of July, Baxter
International completed the spin-off of
its biosciences business into a new, publicly traded entity called Baxalta, which
we will discuss later. Baxter now comprises the medical products and renal
care businesses of the former combined
entity. Shortly after the spin-off, Baxter’s
shares rose sharply at the end of July and
into early August, initially driven by the
company’s disclosure that its board of
directors had started a search for a new
CEO to replace Bob Parkinson, then
Brown Brothers Harriman Quarterly Investment Journal 11
later by the announcement of a large
stock position accumulated by an activist investor who was seeking seats on the
board. Spurred by these catalysts, the
stock quickly traded toward our intrinsic value estimate, leading us to exit our
position for Core Select.
Our weakest performers in the third quarter were Southwestern Energy, Zoetis and
EOG Resources. Southwestern shares fell
44% in the quarter and are down by 54%
thus far in 2015. While all four of our
energy industry holdings have been hit
hard by continued weakness in the underlying commodity prices, Southwestern
has been particularly pressured
as investors have been skeptical
about the company’s ability to
generate sufficient cash flows
to fund growth in its newly
acquired low-cost acreage in
the southwest Marcellus and
Utica shales while at the same
time running a smaller drilling
program in the Fayetteville
shale, which has generally
higher total costs. In addition,
Southwestern and its peers
operating in the Marcellus
have continued to experience
wide differentials between
their price realizations and
broadly traded benchmark
natural gas prices due to constraints on pipeline capacity in
the region. We agree with the
company’s assessment that these differentials are likely to narrow over time, but
in the short term, they will likely continue to pressure production revenues.
Southwestern’s operating skills and low
costs of drilling and completion combined
with incremental reductions in external
well service costs are key factors that
we believe will allow the company to
ride out the current sustained period of
headwinds. Southwestern’s balance sheet
swelled with last year’s acquisition of the
additional Marcellus and Utica acreage,
but we believe the term structure of the
supporting debt is appropriate and that
the company’s reliance on variable capital
sources such as credit facilities is relatively
small.
Also within the energy sector, EOG
Resources was down by 17% in the third
quarter as crude oil prices retreated from
a midyear bounce. Despite the continued
price-related headwinds in the oil and gas
markets, we have been quite pleased with
the operating performance at EOG, as the
company has carefully managed its capital deployment and delivered material
cost reductions to offset sharp revenue
pressures. Notably, EOG’s management
team has asserted that production in its
given the aggressive stance of OPEC and
continued broad pressures on commodity
price sentiment in the context of slowing
global GDP growth. The oil and gas price
assumptions we use in our base case valuation models in the energy sector assume
only a gradual movement back toward
marginal costs of production several years
in the future. While there is certainly no
guarantee that commodity prices will hew
to those marginal cost levels over time,
our extensive work on the supply and demand economics of the industry and the
growing budgetary pressures within major oil exporting countries help to de-risk
a constructive stance, in our view. EOG
remains our largest position in
the energy industry.
Zoetis shares declined by 14%
during the quarter, with much
of the downside occurring in
late September alongside the
healthcare industry broadly as
sentiment was affected by a political backlash against prescription
drug price escalation in the U.S.
Fundamentally, Zoetis continues
to perform well and operates in
areas that are shielded from government-driven price pressures.
The company appears to be
executing well on its major operational restructuring that was
announced in May to streamline operations and emphasize
key product lines and regions.
Zoetis estimates that operating margins
could expand from 25% in 2014 to an
estimated 34% in 2017, reflecting a shift
to higher-margin products and regions as
well as expense reduction initiatives. We
also expect that working capital levels
could ease over the next few quarters,
potentially driving stronger growth in free
cash flow. These financial improvements
are a key part of our investment thesis
on Zoetis, but we also remain very positive on the company’s consistent top-line
growth, particularly in the U.S. market
and in the companion animal market, despite currency headwinds. We believe the
We agree with [Southwestern’s]
assessment that these differentials
are likely to narrow over time, but
in the short term, they will likely
continue to pressure production
revenues.”
core domestic shale plays (Eagle Ford,
Bakken and Delaware Basin) can earn
after-tax rates of return in excess of 30%
at $50 crude oil prices. Returns at those
levels are enabled by the company’s attractive assets, low operating costs and
incremental technology advances in well
targeting and spacing. These characteristics, along with a well-managed balance
sheet, inform our view that EOG can
deliver long-term value creation despite
its often-volatile industry setting. We do
not make near-term predictions on the
trading price of crude oil, but in the current context, we acknowledge that prices
may remain depressed for some time
12 Brown Brothers Harriman Quarterly Investment Journal
InvestorView
underlying fundamentals of the company,
and its leadership position in the attractive animal health market, remain strong.
The third quarter was an active period
for us in terms of portfolio changes. In
August, we initiated a new position in
Discovery Communications, a world
leader in nonfiction and science-based
TV programming. Discovery reaches
nearly 3 billion cumulative viewers across
220 countries with a broad assortment
of unique, high-quality video content
through well-known branded networks
such as Discovery Channel, TLC, Animal
Planet and Science. In our view,
Discovery’s key strengths include its strong positioning in
desirable content categories,
its appeal to engaged affinity groups that are valuable to
advertisers and its expansive
international business, where
pay TV penetration is growing.
The share prices of Discovery
and its peer companies in the
media content business have
come under substantial pressure
over the last year mainly due to
mounting concerns that changes
in viewership habits and shifts
to “over-the-top” digital content distribution will upend the
current industry structure in the
critical U.S. market, in which
cable distributors pay affiliate
fees to content providers on a per-subscriber, per-month basis, then construct
bundled channel offerings for which
consumers pay a bundled rate. The common argument against this longstanding
industry structure is that newer platforms
such as Netflix, Amazon and Hulu will
compel consumers to abandon bundled
cable subscriptions in ever-larger numbers, which will put increased pressure
on affiliate fee revenues for the networks.
We agree that digital distribution will become more prevalent over time and that
at the margin, there could be unbundling
or downsizing of channel packages.
However, we believe that Discovery has
defensive and offensive attributes that will
allow it to thrive in the changing landscape, specifically:
• The company’s continued growth in
international markets should act as
a meaningful offset to subscriber declines in the U.S.
• Discovery’s programming and its
content library appeal to a large audience with attractive demographics.
As the company engages with alternate distribution platforms over time
(or potentially creates its own), the
growth in related royalties will be an
important offset to any erosion of the
traditional affiliate fee model. Even as
distribution models change, high-qual-
Declines in advertising revenue have been
another recent headwind for the cable
networks. These pressures have largely
resulted from ratings declines that have
occurred as consumers spend more time
on alternative video platforms such as
Netflix and YouTube. We expect these
headwinds to persist in the intermediate term, but as noted, we believe that
Discovery’s pricing power and the likelihood of greater engagement
and monetization of digital
platforms over time will act as
key offsets to declines in traditional linear TV advertising
revenues.
ity content remains the scarce asset in
the media ecosystem, and we strongly
believe that customers will continue
to pay for it.
• Even with modest subscriber declines
for the industry within the U.S., we expect Discovery’s affiliate fee revenue to
achieve steady positive growth driven
by pricing power. Our view is that cable distributors will not risk alienating
subscribers by removing Discovery’s
content, especially given its relatively
low cost compared to other networks
and the audience share it delivers.
Our baseline financial assumptions for Discovery incorporate
continued mid-single-digit
growth in revenues, reasonable
margin leverage as content is
spread across the geographic
footprint at little extra cost, a
mix shift toward international
profits that are taxed at lower
rates and continued modest
capital requirements. The resulting free cash flow growth
opportunity is attractive in
our view, and the company’s
shareholder-friendly capital
return policy should drive additional value over the long term. After our initial
Discovery purchase in August, we added
to the position several times at prices that
represented a substantial discount to our
estimate of intrinsic value per share.
In early July, we received shares of PayPal
Holdings after it was spun off from eBay
as an independent company. We are enthusiastic about the long-term prospects
for PayPal as it pursues continued growth
in the attractive global market for online
and mobile payments. We believe that
the company’s vast two-sided network of
Brown Brothers Harriman Quarterly Investment Journal 13
We believe that [PayPal’s] vast two-sided
network of users and merchants and its scalable,
secure global infrastructure represent a strong
competitive position and multiple avenues
for growth.”
users and merchants and its scalable,
secure global infrastructure represent
a strong competitive position and
multiple avenues for growth. PayPal
has 169 million active users who collectively transacted more than $250
billion in payment volume in the year
ended June 30, 2015. With an open and
flexible platform approach, PayPal adds
value for the parties on both sides of
a transaction. PayPal’s online and appbased interfaces enable consumers to be
in control of the purchase flow while
limiting the amount of personal information they share. Merchants benefit
from competitive pricing, value-added site tools and guaranteed payment.
Alongside its core online payments business, we believe that PayPal has several
compelling parallel opportunities in areas such as next-generation point-of-sale
solutions, multichannel payment integration, cross-border remittances, small
business credit, transactional consumer
credit, social payment technologies and
merchant loyalty solutions. Given these
opportunities and the solidity of the core
business, we believe that PayPal’s shares
are attractive at current levels. In August,
we approximately doubled our position
size at prices in the low $30s.
As noted earlier, Baxter International split
off its biosciences business into a new
public company called Baxalta in early
July. With $6 billion in sales, Baxalta
is a global leader in the development,
manufacturing and commercialization
of therapies that address unmet medical
needs in various disease areas including hemophilia and immunology. The
company is also investing in complementary areas including oncology, gene
therapy and biosimilars. Baxalta’s core
strategy is to improve diagnosis, treatment and standards of care across a wide
range of bleeding disorders and other rare
chronic and acute medical conditions by
developing and leveraging a differentiated product portfolio, ensuring the
sustainability and safety of supply to
meet growing demand for therapies and
accelerating innovation in new treatment
areas by leveraging internal expertise as
well as acquisitions and collaborations.
We believe that Baxalta has a very strong
leadership team and a solid portfolio of
new and differentiated products. The
company has invested in its market-facing activities to sharpen its commercial
execution in sales and the product launch
process. Importantly, the company has
also reinvigorated its research and development (R&D) organization by
14 Brown Brothers Harriman Quarterly Investment Journal
moving away from a focus on product
lifecycle management and instead pursing cutting-edge innovation with an
expanded team of world-class scientists
at a newly created facility in Cambridge,
Massachusetts. Over the last two years,
Baxalta has received seven key approvals
and advanced five programs into regulatory review. We believe that the company
can grow its revenues at attractive high
single-digit rates for several years while
also achieving margin and cash flow
improvements as separation costs and
capital spending are reduced. We added
to our position shortly after the spin-off
based on our view that the public market
valuation did not appropriately reflect the
quality of the business and the free cash
flow strength that we foresee over the
next few years.
We were surprised to learn in early August
that the Irish pharmaceuticals company
Shire PLC had approached Baxalta with
an all-stock merger proposal at a substantial premium. Baxalta’s management team
and board declined the initial offer given
their view that the strategic rationale was
somewhat lacking and the valuation was
too low. For our part, we see some merit
to a potential combination on the basis
of cost consolidation and tax savings,
and we believe it is possible that the two
companies will continue a dialogue over
the next few months. Since the initial announcement, the proposed value of the
deal has slipped as Shire’s share price has
fallen.
With the large market decline in mid-August and subsequent volatility throughout
the remainder of the quarter, we were able
to make several small additions to other
positions in Core Select at attractive discounts to our intrinsic value estimates. We
added to our position in Oracle at three
different points as the shares’ valuation
continued to imply low growth expectations and muted investor sentiment in
spite of what we believe to be solid underlying business performance. We also
added to Qualcomm, as we believe the
InvestorView
currently low valuation reflects an overreaction to certain cyclical and competitive
challenges.
We added modestly to our existing
holdings in Diageo and Wal-Mart, two
consumer-oriented companies in which
investor sentiment and expectations
have trended negatively over the last few
quarters. Both are facing headwinds in
their markets, but we are pleased with
the strategic course the management
teams are pursuing. Finally, we added to
our positions in U.S. Bancorp and Wells
Fargo after the share prices dropped
sharply, driven by concerns that equity market volatility would compel the
Federal Reserve to further delay raising
short-term interest rates.
At the end of the third quarter, we had
positions in 31 companies, with 46% of
our assets held in the 10 largest holdings.
Core Select ended the quarter trading at
76% of our underlying intrinsic value
estimates on a weighted average basis,
compared to 83% at the end of the
second quarter and 86% at the end of
2014. As detailed, we took advantage
of the market’s weakness and bought
or added to our holdings in several
companies, ultimately investing nearly
7 percentage points of portfolio value
on a gross basis. Offsetting these additions were our reductions in Chubb and
Baxter International. While the valuation
environment overall is clearly more favorable than it was even a few months
ago, we still see certain high-level risks
that could affect our companies’ earnings or market sentiment generally. In
addition, absolute valuation levels still
remain fairly high for many companies
in Core Select and our investment “wish
list.” As such, we will remain patient in
our deployment of capital and will continue to favor high-conviction businesses
where we have better visibility regarding
the range of potential outcomes. We ended the third quarter with a cash position
of 12%.
Our investment team is pleased to announce the milestone of our 10-year
anniversary managing Core Select. We
are proud of the long-term track record
that we have achieved through the consistent application of our highly selective,
value-oriented “buy-and-own” approach.
As we have said in the past, we strongly
believe that the ultimate driver of differentiated performance over the long run is
a differentiated approach that is delivered
in a consistent way by a dedicated and
talented team. Our fellow Core Select
investors can be assured that our adherence to this philosophy remains every
bit as tight as it did when we set out in
2005. Our commitment for the future is
straightforward: we will consistently apply our demanding qualitative investment
criteria, we will exhaustively research our
companies and our industries, we will invest with a margin of safety,4 and we will
maintain a long-term, ownership-based
approach. We will not bind ourselves to
short-term thinking or benchmark sensitivity, but instead will aspire to deliver
attractive compounding over full market
cycles by participating in rising markets
and protecting capital during challenging
periods.
We greatly appreciate the interest and
support you have shown us over the
last 10 years. We feel very fortunate to
have an outstanding group of clients and
partners that have entrusted us with their
capital. Here’s looking ahead to another
great decade!
The holdings identified do not represent all of the
securities purchased, sold or recommended for clients. Performance data quoted represents past performance, which is no guarantee of future results;
investor principal is not guaranteed, and there is a
possibility of loss on all investments. Further information on the calculation methodology and a list
showing every holding’s contribution to the overall
account’s performance during the quarter is available upon request.
BBH prepares proprietary financial models for each
Core Select company in order to determine an estimate of intrinsic value. Discounted cash flow analysis is the primary quantitative model used in our research process. We supplement our discounted cash
flow work with other quantitative analyses, such as
economic profit models, internal rate of return models and free cash flow multiples.
A number of the comments in this document are
based on current expectations and are considered
“forward-looking statements.” Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection
of BBH’s best judgment at the time this document
was compiled, and any obligation to update or alter
forward-looking statements as a result of new information, future events or otherwise is disclaimed.
Furthermore, these views are not intended to predict
or guarantee the future performance of any individual security, asset class or markets generally, nor are
they intended to predict the future performance of
any BBH account, portfolio or fund.
There is no assurance that any securities discussed
herein will remain in an account’s portfolio at the
time you receive this report or that securities sold
have not been repurchased. The securities discussed
do not represent an account’s entire portfolio and in
the aggregate may represent only a small percentage
of an account’s portfolio holdings. It should not be
assumed that the recommendations made in the future will be profitable or will equal the performance
of the securities mentioned within the article. A
complete list of portfolio recommendations for the
past year is available upon request.
The information provided in this article should not
be considered a recommendation to purchase or sell
any particular security.
1 S &P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designed to
measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The index is not available for direct investment.
2 The representative account is the largest account
managed with the same investment objective and
employing substantially the same investment philosophy as the Core Select strategy. Performance
figures for the representative account are reported
net of a 1% investment advisory fee. Performance
of different types of investment vehicles employing
this strategy may differ as a result of the different
fees, expenses, charges, number of securities and
restrictions applicable to the vehicles.
3 Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and
distribute to shareholders over its remaining life.
4M
argin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of
its intrinsic value.
Brown Brothers Harriman Quarterly Investment Journal 15
Book Review:
The Outsiders:
Eight Unconventional CEOs and Their Radically
Rational Blueprint for Success
In his 2012 letter to Berkshire Hathaway shareholders, Warren Buffett casually recommended a book,
The Outsiders: Eight Unconventional CEOs and
Their Radically Rational Blueprint for Success, by
William N. Thorndike, Jr., calling it “an outstanding
book about CEOs who excelled at capital allocation.” In 2013, the book quickly became a hit and
won public praise from a range of CEOs and star
investors. In a Forbes interview, Thorndike himself
said: “The reaction to the book has dramatically
exceeded any expectations I had … .” While the book
has generated discussion in many areas, possibly the
most important contribution is that Thorndike, as
well as many of “the outsiders,” are collectively responsible for putting the previously obscure term
“capital allocation” into the business lexicon. So
what was so special about this book?
The book, which began as a research project that
wound up spanning eight years, starts with the
premise that a CEO’s performance should be judged
objectively by the long-term returns he or she earns
for shareholders relative to the broad market.
Thorndike was looking for CEOs whose stock returns exceeded two performance hurdles. They had
to beat the relative performance (vs. the S&P 500)
that Jack Welch earned during his tenure at GE and
also meaningfully exceed their industry peer group.
At a certain point, he realized the CEOs who met
these criteria had several things in common – among
those were a preference for independent thinking,
a focus on cash flow over reported earnings and,
perhaps most importantly, an understanding of how
astute capital allocation can increase a firm’s per
share business value. In Thorndike’s words: “CEOs
need to do two things well to be successful: run their
operations efficiently and deploy the cash generated
by those operations.” The latter of those two tasks,
capital allocation, is often overlooked by CEOs, yet
is a critical driver of long-term returns. Thorndike
says it best:
Basically, CEOs have five essential choices for
deploying capital – investing in existing operations, acquiring other businesses, issuing
dividends, paying down debt, or repurchasing
stock – and three alternatives for raising it
– tapping internal cash flow, issuing debt, or
raising equity. Think of these options collectively as a tool kit. Over the long term, returns
for shareholders will be determined largely by
the decisions a CEO makes in choosing which
tools to use (and which to avoid) among these
various options. Stated simply, two companies
with identical operating results and different
approaches to allocating capital will derive
two very different long-term outcomes for
shareholders.
Author
Tom Martin
Assistant Vice President
Investment Strategy Analyst
Published by Harvard Business Review Press,
Copyright William N. Thorndike, Jr.
16 Brown Brothers Harriman Quarterly Investment Journal
InvestorView
Henry Singleton, the original outsider, provides an interesting
case study. Singleton earned bachelor’s, master’s and PhD degrees in electrical engineering from MIT, had no formal business
training and was described as somewhat of a recluse. In the
1960s, Singleton’s conglomerate Teledyne refused to pay dividends, a decision that stuck out much more then than it does
now. When there was a bubble in conglomerate stocks during
that decade (which Buffett writes about in his 2014 letter),
Singleton used this overvalued currency – Teledyne stock – to
make 130 acquisitions. In contrast to other conglomerates of
the day, though, Teledyne emphasized a decentralized operating
model, with limited staff at headquarters. Eventually, Singleton
largely removed himself from what little centralized operations
there were in the firm and focused on capital allocation for
the business. In 1969, as the honeymoon with conglomerates came to a crashing end, Singleton stopped acquiring. As
Teledyne stock plunged with the rest of the market, between
1972 and 1984 Singleton tendered for an unprecedented 90%
of Teledyne’s outstanding shares (at a time when repurchases
were “unpopular and controversial”), earning a compound
return of 42% on these purchases. The result was that while
net income increased sevenfold during this period, per share
earnings increased by more than 40 times. The combined results
of paying for quality businesses with overpriced stock and then
repurchasing undervalued shares in the 1970s led to a 20%
compound return over the span of 27 years – more than nine
times that of peers and 12 times that of the S&P 500.
While the CEOs Thorndike profiled in The Outsiders achieved
success in different ways, they also shared a number of remarkably similar traits. All were first-time CEOs, and none gave
Wall Street guidance. Almost all opportunistically used share
buybacks and acquisitions, and all employed a decentralized
operating structure in their firms. On the personal side, the
CEOs were highly analytical and frugal, and they all embraced
independent thinking. Many eschewed most forms of public
communication that are commonplace among CEOs today.
The key metric they sought to maximize in the long term was
the per share business value of their respective firms.
A fitting way to summarize these CEOs is that they brought an
investor’s mindset to the business of management. While investing skill is more prevalent among money managers than CEOs,
it is no less important to shareholder returns than operational
prowess. Though there are many paths that CEOs can take to
achieve success – they can be a visionary like Steve Jobs or a
master in operations like Jeff Bezos – the investor’s mindset that
the eight outsiders brought to the job is commonly overlooked.
“The Outsiders”
Tom Murphy
Capital Cities Broadcasting
Henry Singleton
Teledyne
Bill Anders
General Dynamics
John Malone
TCI
Katharine Graham
The Washington Post Company
Bill Stiritz
Ralston Purina
Dick Smith
General Cinema
Warren Buffett
Berkshire Hathaway
As Thorndike points out, these CEOs were constantly aware of
the full range of opportunities they had for deploying capital.
They were continually aware of both the price and the value of
their own stock, as well as the price of potential acquisitions
and internal reinvestment opportunities.
At BBH, an emphasis on capital allocation has long been a part
of our investment process, as it goes hand in hand with value
investing. Among other things, we look for both management
teams and investment managers who are good stewards of capital. Many company management teams today are incentivized
to grow earnings per share (EPS) at all costs; however, this can
often be in conflict with the principles of good capital allocation.
Good management teams realize that there should be a high bar
for growing a business through acquisitions or reinvestment and
that sometimes the best investment is your own stock. Simply
knowing these facts, however, still doesn’t make the execution
any easier. In fact, the data indicates that most companies have
poor buyback records. Anecdotally, it appears companies do
share buybacks when they have extra cash on hand or as a
short-term EPS management tool, as opposed to when their
stock is cheap.
The Outsiders does a masterful job at bringing the obscure and
misunderstood practice of capital allocation into the foreground.
In addition, it sheds light on the idiosyncratic personalities of
some of the most successful CEOs of all time. The management
techniques espoused in the book are compelling and highly rational, and we think any student of the business world would
benefit from reading it.
Brown Brothers Harriman Quarterly Investment Journal 17
WEALTH PLANNING
Estate Planning for
Your Online Afterlife:
Should Your Online Accounts Die with You,
or Should They Live On into the Digital Beyond?
Have you ever thought about what might happen to
your online accounts such as email, photo sharing,
social media and iTunes after your death? Given
recent developments in the law, the better question
to ask yourself may be: “What do I want to happen
to my online accounts after my death?”
Author
Karin Prangley
Senior Vice President
Wealth Planner
The fate of one’s online afterlife is a topic that
lawyers and technology companies have struggled
to address for the past several years. While both
groups recognized the importance of enacting new
laws that would resolve whether and how various
legal representatives (such as executors, personal
representatives, powers of attorney, guardians and
trustees) can access the online accounts of a deceased
or disabled person, until recently, the two could not
agree on what exactly those laws should say. Most
existing laws addressing a legal representative’s access to the property of a deceased or disabled person
were written long before the age of the internet and
are insufficient to cover online account access. After
all, online accounts aren’t like cash, jewelry and
art; a legal representative can’t simply take physical
18 Brown Brothers Harriman Quarterly Investment Journal
custody of online accounts from the deceased or
disabled person’s home. Moreover, online accounts
are often protected by username and password
information that the legal representative may not
know. In some cases, even with the password and
username, a provider’s terms of service may restrict
or prohibit any access following death or disability. Having the means to access the online account
(i.e., username and password) is not the same as
having the legal right to do so. Federal data privacy
laws prohibit many online account providers from
disclosing account contents without a government
subpoena, and none of the laws expressly authorize
providers to give the password or account contents
to a deceased or disabled person’s legal representative. Understandably, some online account providers
choose to simply prohibit any access following death
or disability rather than risk violation of a federal
data privacy law.
As understandable as a “no access following death or
disability” policy might be from a legal perspective
though, grieving families have struggled to accept it.
InvestorView
Over the past 10 years, many families have taken account providers to court to obtain the email and social media accounts
of deceased loved ones. Certainly, no technology company
enjoys being painted in the press as unsympathetic to grieving families, but the companies remained firm that access by
well-intentioned family members must yield to user privacy.
These landmark legal battles underscored the need for a new
set of laws that would definitively answer the question: do authorized legal representatives have access to the online accounts
of a deceased or disabled person?
The Uniform Law Commission (ULC), a nonprofit organization
comprising lawyers that drafts model state laws on areas of
legal ambiguity, was one of the first to attempt a solution. In
2014, a group of ULC lawyers set forth a model law that would
provide a legal representative with full access to the online accounts of a deceased or disabled person, and any terms of service
that restricted or prohibited such access would be declared null
and void. The lawyers argued that allowing a legal representative to have automatic and full access to the online life of the
deceased or disabled person should not be controversial. After
all, legal representatives will have access to and control of one’s
bank and investment accounts, real estate, physical mail, tax
records and all tangible assets. Why treat online assets differently? ULC’s lawyers also argued that it is not only consistent with
longstanding trusts and estates laws for legal representatives to
have full access to online accounts, but also crucially important
to grant such access. Email is increasingly one’s primary means
of communication; people are encouraged to “go green” and
receive important statements and documents relating to various
components of their financial and nonfinancial lives strictly via
email. If a person is no longer around to access email, it is often
difficult for those left behind to piece together his or her financial
and nonfinancial lives. If no record of a financial asset such as
a bank account or insurance policy exists outside of an email
account, important and financially valuable assets could go
undiscovered following the accountholder’s death or disability.
After all, online accounts aren’t
like cash, jewelry and art; a legal
representative can’t simply take
physical custody of online accounts
from the deceased or disabled
person’s home.”
Although legislatures in 26 U.S. states considered the ULC’s
model law, it has thus far not been successfully enacted anywhere. Large technology companies such as Yahoo!, Facebook,
AOL, Google and their trade/lobbying associations were adamant that the ULC got it wrong and that the majority of people
in the U.S. do not want their electronic communications such
as email and social media messages disclosed following death.
Electronic communications, they argued, were not like physical
letters that a person could expect his or her family to read and
access after he or she dies or becomes disabled. Further, they
said, the nature of communications has dramatically changed,
and the American public now expects email, text and social
media messages to remain private in the afterlife. The tech companies rejected the ULC’s model law in favor of the Privacy
Expectation Afterlife and Choices (PEAC) Act drafted by technology trade association NetChoice, which provides that no
legal representative may access the electronic communications
(i.e., email and social media messages) of a deceased person
unless that representative obtains a court order and demonstrates that the deceased person consented to access by the
representative.
As the 2015 legislative year passed, everyone involved in the
attempt to develop a law to provide or prohibit access to online
accounts following death or disability learned that it would be
nearly impossible to enact the ULC’s model law or the PEAC Act
in multiple states. Lawyers and technology companies fought
to a draw.
In May 2015, representatives from several large technology
companies contacted ULC representatives to negotiate a compromise. The negotiations resulted in the Revised Uniform
Fiduciary Access to Digital Assets Act (RUFADAA), which
makes a distinction between online accounts that do not contain any protected electronic communications (such as domain
names) and online accounts that hold certain types of electronic
communications (such as email accounts) – for which experts
believe there is a greater expectation of privacy. Thus, under
Brown Brothers Harriman Quarterly Investment Journal 19
RUFADAA, an authorized legal representative can only access
protected electronic communications if the deceased or disabled
person consented to such access. The deceased or disabled person can consent to access in estate planning documents such
as a will or power of attorney or through a setting inside the
online account itself that allows the user to designate his or her
wishes in the event of death, incapacity or account inactivity.
The expectation of privacy for online accounts that do not
contain protected electronic communications is much less, and
therefore, the rule for those types of accounts is reversed: unless
the deceased or disabled person restricted access, an authorized
legal representative may access such accounts.
RUFADAA is “hot off the press” – it was finalized on September
11, 2015, and it may be awhile before it is the law in
most states. When it does become the prevalent
law, the express consent of the accountholder is paramount to ensure an authorized
legal representative has access to electronic communications such as email.
Accordingly, proper estate planning to
address online accounts is more important than ever.
If your estate plan does not address
your online accounts, consider
whether you would like your legal
representatives to have access following your death or disability. Are
there any particularly sensitive online
accounts that you would like to remain
private? If making any online account
private will render it more difficult or impossible for your legal representatives to find
and access your financial accounts, develop an
alternative plan to preserve the important financial
information in such accounts. After considering your
wishes for online accounts, contact your BBH Wealth Planner
and/or estate planning attorney to ensure your estate planning
documents include the appropriate language that specifically authorizes or prohibits access to your online accounts. Depending
on your wishes, appointing a special “online executor” to take
responsibility to shut down your accounts or otherwise manage
your online identity may be appropriate.
If you would like your legal representatives to have access to
your online accounts following death or disability, updating
your estate planning documents is just one step. Most online
accounts do not require any paperwork, and therefore, it is
often hard for legal representatives to know where to look to
actually find such accounts; creating a list of online accounts,
usernames and passwords can help with this issue. There are a
20 Brown Brothers Harriman Quarterly Investment Journal
number of ways to create this list. One option is to write out all
online accounts, usernames and passwords on a physical piece
of paper. Although simple and easy, there are obvious security
concerns with this approach. What if the list is stolen or falls
into the wrong hands? What if your legal representatives can’t
find it when they need it? A better approach would be to keep
an updated, encrypted electronic file with a list of all passwords
and to store the password needed to unlock the encrypted file
separately; make sure that your legal representatives know to
look for this list if something happens to you. Online or software-based storage accounts may also help: a service provider
will store digital data regarding online accounts, usernames
and passwords and release it according to the owner’s instructions. In this case, the legal representative would merely
need to know that the deceased or disabled
person is a participant in the service (no
password required). These sites usually offer state-of-the-art security,
and participation fees are usually
modest.
Whether or not you want
your online accounts to
outlive you, it makes sense
to review the terms of service of your online account
providers – or at least those
you use most often – to understand what will happen
to such accounts following
death or disability. For example, Yahoo!’s terms of service
completely restrict access in such
cases. Google’s terms of service, as
one alternative example, do allow
legal representatives to gain access to
a deceased user’s account under certain circumstances. An optional feature within all Google
accounts, the Inactive Account Manager, also lets users plan
in advance for what should be done with their accounts if they
become inactive (as a result of death or otherwise). Whichever
online service providers you use, it is a good idea to become
familiar with what will happen to your account after death or
disability and to terminate accounts with those that cannot
fulfill your objectives.
The BBH Wealth Planning team has been carefully following
the developments regarding estate planning for your online
accounts and would be pleased to discuss this topic with you
and your team of legal advisors in greater detail.
InvestorView
Inside bbh
BBH Investor Day Recap
On September 28, BBH hosted our inaugural Investor Day in New
York City, drawing over 200 attendees.We want to thank attendees for not just listening to the day’s presentations, but for also
actively asking presenters questions. Our investment partners in
attendance – Akre Capital Management, AltaRock Partners, Bares
Capital Management, Burgundy Asset Management, Clarkston
Capital Partners, Dodge & Cox, Oaktree Capital Management,
REMS Group, Select Equity Group and Southeastern Asset
Management – as well as members of BBH’s Core Select and
Municipals investment teams appreciated the quality and depth
of questions asked during the formal presentations and informal
conversations around breakfast and lunch.
After breakfast and introductions, the event kicked off with an
insightful, wide-ranging fireside chat between BBH Partner Jeff
Meskin and Michael Angelakis, former CFO and current Senior
Advisor to the Executive Management Committee of Comcast.
The conversation homed in on the importance of capital allocation
from the perspectives of both a manager of an operating business
and a direct investor. Michael provided a number of examples of
exceptional capital allocators with whom he has had the privilege
of working closely and the decisions these allocators made that
generated outsized long-term value. With Comcast representing
a longstanding BBH Core Select investment (6.1% of holdings
in the Core Select Representative Account1 as of September 30,
2015), there was no shortage of Q&A from Comcast owners
– our clients – sitting in the audience, and Michael covered a
number of questions related to key cable industry trends.
Next up was the U.S. equities discussion, the first of three investment panels. BBH Partner Rick Witmer moderated, and panelists
included Brian Bares, President, Portfolio Manager and Research
Analyst at Bares Capital Management; Staley Cates, President and
CIO of Southeastern Asset Management and Longleaf Partners
Funds; and Michael Keller, Partner and Co-Portfolio Manager of
BBH Core Select. The back-and-forth touched on topics such as
finding and owning “extreme winners,” avoiding “value traps”
and partnering with “owner-operators.”
1
Our international investment panel followed. This discussion – led
by BBH Private Banking Senior Advisor Rian Dartnell, CEO and
CIO of SHL Capital – included Anne-Mette de Place Filippini,
Portfolio Manager at Burgundy Emerging Markets; Chad Clark,
Portfolio Manager of Select Equity Group’s international equity
strategy; and Tim Hartch, Partner and Co-Portfolio Manager of
BBH Core Select and BBH Global Core Select. Key takeaways
included the importance of investing with a margin of safety in
terms of both business quality and valuation, the misconception
of international markets being “riskier” than the U.S., the importance of “on-the-ground qualitative field research,” and as
minority investors, the importance of understanding that who
one partners with is magnified in international markets, with all
panelists saying that the large family-owned or -controlled businesses in such markets are attractive ponds to fish from.
The keynote speaker, Oaktree Capital Co-Chairman Howard
Marks, followed. His thought-provoking presentation, “Advice
for Investors,” touched on a myriad of investment topics – including expectations and goals, creed, process, mental setting
and inescapable truths – and was full of kernels of wisdom and
advice for all investors.
The day ended with a fixed income panel. BBH Chief Investment
Strategist Scott Clemons was joined by Dana Emery, CEO,
President and Director of Fixed Income at Dodge & Cox, and
Greg Steier, Managing Director and Portfolio Manager of BBH
Tax-Exempt Fixed Income. The discussion centered on the three
key roles of fixed income: liquidity, stability and income. With the
income component of fixed income currently impaired due to low
interest rates, Dana and Greg highlighted the importance of credit
work and investing with an adequate margin of safety – no easy
feat given the relative dearth of attractive risk-adjusted investment
opportunities today. Bond market liquidity, a recurring headline
in mainstream publications recently, was also explored in depth
by Dana on the corporate side and Greg on the municipal side.
After a successful event, BBH plans to host our second Investor
Day in September 2016.
he representative account is the largest account managed with the same investment objective and employing substantially the same investment philosophy as
T
the Core Select strategy. Performance figures for the representative account are reported net of a 1% investment advisory fee. Performance of different types
of investment vehicles employing this strategy may differ as a result of the different fees, expenses, charges, number of securities and restrictions applicable to
the vehicles.
Brown Brothers Harriman Quarterly Investment Journal 21
New York Beijing Boston Charlotte Chicago Denver Dublin grand cayman Hong Kong Kraków
London Luxembourg nashville new jersey Philadelphia Tokyo Wilmington ZÜrich www.bbh.com
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the
European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy
securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code
or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does
not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited.
This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority
(FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
1102_15