Brown Advisory Ethical Selection Q1 2024 commentary

Performance in USD as of 31/03/2024 and net of all costs including management fees.

Market overview 

During the quarter, the strategy posted absolute returns, but underperformed the Russell 1000® Growth Index benchmark, which was up 11.4% during the first quarter. 

Most of the underperformance was driven by an underweight to NVIDIA, which continued its meteoric rise and finished the quarter up over 82%. A small sell-off that began in late March was taken advantage of to establish a position and reduce underweight exposure to semiconductors more broadly, an underweight that had increased due to rapid growth in NVIDIA coupled with more challenging end-markets for holdings like Marvell. While underweights to other names like Meta contributed to underperformance, there were a few stock-specific factors that also drove underperformance, mainly in healthcare holdings Zoetis and UnitedHealth. Zoetis stock came under pressure following some concerns (largely in some social media groups) on the safety profile of its recently launched pain medicine, Librela. Furthermore, the European commission initiated an antitrust investigation into the company's acquisition of NexVet Biopharma in July 2017. It is believed that the shares are unduly punished here and we like the stock's return profile. UnitedHealth underperformed peers, given its leading position in Medicare Advantage and the uncertainties around both utilisation trend and forward CMS rates within Medicare Advantage. Furthermore, headlines around a cyberattack on its Change subsidiary and news of a DOJ investigation into its proposed acquisition of AMED further weighed on shares. Similar to Zoetis, we find the shares are undervalued here.

On the positive side, results from names like United Rentals (URI) and KKR were pleasing. URI revenue growth has slowed along with non-residential construction activity; however, this has held up well relative to low expectations. Continued strong pricing and profitability have allayed concerns that earnings will decline in FY24. KKR performed well, given strong earnings relative to expectations, along with increased bullishness on their market opportunity. Recent changes to their compensation structure will make for stickier fee-related earnings (which are highly valued by investors) while anticipation for capital markets continuing to open up has fueled expectations for more realisation activity, an earnings stream that has in many ways been in hibernation for multiple quarters now. At their much-anticipated Investor Day, management laid out a clear path to doubling earnings twice over the next 10 years. Confidence remains in our holding.

The first quarter was one of interesting narrative inflection, as the recessionary concerns of 2023 began to calm and investors increasingly shifted to more of a consensus around a soft landing. Despite credit optically deteriorating, banks are painting the move up as a ‘normalisation’, following years of abnormally low losses and excess liquidity. Economic conditions are still quite resilient: the consumer faces low unemployment, climbing home prices and higher stock markets; meanwhile, business EBITDA growth is notable, as inflationary pressures have been offset and managed, and the higher cost of capital is being managed with expectations for rate cuts this year.

Global conditions seem fairly asynchronised. There are pockets of strength and pockets of weakness worldwide. Central banks around the world are closely watching the conditions to help determine policy and while some central banks in emerging markets begin to cut rates, the story in the US is not quite so clear. The market went into 2024 expecting six rate cuts, yet now expects fewer and some are beginning to question whether rate cuts will come in 2024 at all. After all, the economy is not slowing down, supercore inflation is trending higher, the labour market remains tight and financial conditions are easing. The uncertainty over the future of the global economy and whether the cautious optimism is misplaced has markets guessing where corporate profits are likely to go. As always, the aim is to own high-quality companies that are believed to perform well throughout economic cycles. While continuing to acknowledge that there are more unknowns than knowns when attempting to predict macroeconomic outcomes, the multi-year investment horizon and quality business bias remain unchanged while navigating the current backdrop.

Portfolio review

The Brown Advisory Ethical Selection strategy leverages Brown Advisory’s in-house fundamental and sustainable investment research to pursue attractive returns that align with our investors’ values. The twin aims of the portfolio construction process are to exclude companies that have controversial business involvement and poor risk management, and to isolate stock selection as a key driver of performance relative to the market. Fundamental business analysis and sustainable investment research are conducted and combined with objective portfolio analysis. The result is a portfolio that seeks outperformance relative to the benchmark, while staying within the confines of a socially responsible investment universe.

A low tracking error vs. the benchmark is sought, while seeking to drive outperformance through stock selection. As a result, there should not be meaningful divergence between sector weights in the portfolio and those in the benchmark. The mild exceptions to this rule have been the energy and utilities sectors, where tilting away from heavy hydrocarbon producers and consumers has generally occurred. As a consequence, there have been attempts to offset those underweights with specific investments in other sectors (industrials or technology companies, for example) with exposure to energy end markets.

Top five contributors to return – Q1 2024

• United Rentals’ revenue growth has slowed along with non-residential construction activity; however, this has held up well relative to expectations. Continued strong pricing and profitability have allayed concerns that earnings will decline in FY24.

• KKR reported 4Q23 DE/share of $1.00/share, materially above expectations and +14% vs 3Q23 of $0.88/share. The main driver of the beat vs our estimate is higher FRE of $675m (LTM margin 62%). While the biggest delta was FRE, the results were also strong elsewhere, with insurance segment earnings of $231m and realised investment income $147m. Organic AUM growth was strong in 4Q23 at +$31bn, double the levels of the prior quarters (3Q23 $14bn, 2Q23 $13bn, 1Q23 $12bn, 4Q22 $16bn). Overall, AUM/FPAUM ($553bn/$446bn) both grew 5% QoQ and there was a notable increase in perpetual capital, +10% QoQ, driven by organic growth of Global Atlantic. Fund returns for 4Q23 were broadly in line with our assumptions, with marks of Traditional/Core PE +3%/+2%, Real Estate -1%, Infra +5%, Lev Credit +3%, Alt Credit +2%. Overall, we think these results are highly encouraging in many areas, with KKR already benefitting from full ownership of Global Atlantic. Investor Day is upon the horizon.

• Microsoft Corporation continues to execute well, driving sustained revenue growth with improving profit margins. Microsoft has leveraged its relationship with OpenAI to drive market share gains in multiple parts of its cloud portfolio, while also seeing a recovery in some of its legacy transactional businesses.

• Marvell Technology (MRVL) offered a disappointing guide for the April quarter, but investors were willing to look past the miss, as MRVL GenAI-driven data center business continues to generate strong growth.

• Amazon made strong progress on margins across the board, as the company focused on efficiency and leveraging investments. Retail accelerated, reflecting even more share gains--and more importantly, doing so profitably.

Bottom five contributors to return – Q1 2024

• Zoetis stock came under pressure following some concerns (largely in some social media groups) on the safety profile of its recently launched pain medicine, Librela. Furthermore, the European commission initiated an antitrust investigation into the company's acquisition of NexVet Biopharma in July 2017. The company has refuted concerns on the safety profile of Librela (product has been on the market in Europe for three years). We believe the shares are unduly punished here and like the stock's return profile.

• Dynatrace lowered their ARR target for FY24, leading to a significant re-rating in the stock. Sales execution has been extremely lumpy, but we continue to believe this is a symptom of a relatively immature company, as opposed to any competitive pressures.

• American Tower Corporation traded down in Q1 on a slowing carrier 5G spend, as well as a higher-for-longer view on interest rates.

• UnitedHealth Group Incorporated underperformed peers given its leading position in Medicare Advantage and the uncertainties around both utilisation trend and forward CMS rates within Medicare Advantage. Furthermore, headlines around a cyberattack on its Change subsidiary and news of a DOJ investigation into its proposed acquisition of AMED further weighed on shares.

• Apple (AAPL) missed Q1 guide, but more importantly appears to be losing share in China, which is AAPL's biggest non-US market.