Brown Advisory Ethical Selection Q2 2023 commentary
|Fundamental analysis focussed on ethical, social and governance (ESG)
|7.70% (net of fees)
During the second quarter of 2023, the strategy modestly underperformed its benchmark, the Russell 3000 Index. For the quarter, strong stock selection within financials and materials was generally offset by the omission of certain perceived generative AI winners within consumer discretionary and IT, along with some stock-specific weakness in the healthcare holdings.
The narrow market leadership that took hold in March following the U.S. regional banking crisis continued into April and May, due to both the euphoria surrounding technology companies that incorporated Artificial Intelligence (AI) and large language models into their narratives.
The March-May “safety trade” primarily benefited the largest technology companies. During this period, Apple, Microsoft, Amazon, Alphabet and Nvidia all rose more than 20% (some much more than that) while the median S&P 500 Index constituent declined in value.
The benchmark broadly recovered in June across sector, style and cap size, as investors weighed the likelihood of the U.S. Fed approaching the end of its hiking cycle, along with both slowing inflation as well as (surprisingly) resilient economic data. At the start of the quarter, a looming mild recession seemed inevitable. By the end of June, investors seemingly had become more optimistic that central bankers could strike a balance on rates so as to avoid recessionary economic conditions.
The topic of generative AI has received outsized attention in recent months, especially following Nvidia’s majorly increased revenue guidance for the rest of the year, dwarfing prior expectations. Enterprises are aggressively experimenting with this technology, partly in fear of being left behind, but with limited knowledge of precisely how it will benefit their customers. Many technology companies have seen a meaningful pop in their equity values this year despite limited visibility on the near-term or long-term growth trajectory.
Broadly speaking, the strong first-half market returns have taken many equity market participants by surprise, especially against the backdrop of the regional bank crisis in the U.S., pesky inflation and geopolitical uncertainty. Time will tell whether this is the first leg of a prolonged bull market, although the broadening out of market leadership in June combined with more optimistic economic data is certainly worth noting.
Portfolio performance (net of fees)
|Since inception (March 2019)
Second Quarter Top Five Contributors to Return - 2023
- Marvell Technology (MRVL) traded up on optimism for a cycle recovery, especially data center-related products, as Generative AI is driving incremental demand for Marvell’s data center optics and semi-custom products.
- Microsoft (MSFT) benefited from the excitement around Generative AI and its leading capabilities across Azure, Office 365 and the rest of their product suite. It appears increasingly likely that Microsoft can drive meaningful incremental revenue next year from these products, and it has the potential to take market share given the first-mover advantage it initially established and its relationship with OpenAI.
- Alphabet’s (GOOGL) stock has now recovered most of the losses that followed the launch of ChatGPT, which sparked fears that Google was behind on AI. While Google was a bit slow out of the gate and fumbled some marketing attempts, they are arguably further along with AI technology by some metrics than any other company in the world. The market now reflects a more appropriate valuation.
- Amazon (AMZN) reported better-than-expected results during the quarter. The company continues to show positive results from e-commerce/retail business, despite some slowing within Amazon Web Services.
- First Citizens (FCNCA) responded positively to its whole bank purchase of Silicon Valley Bridge Bank. The deal boasts strong accretion to both tangible book value and earnings per share.
Second Quarter Bottom Five Contributors to Return – 2023
- Nomad Foods (NOMD) continues to be impacted by price gaps between its branded products and private label competition. Nomad is losing market share due to a wider price premium for its products; it raised prices to offset input cost inflation, while private label competitors did not.
- Nike (NKE) reported a slight earnings miss on elevated markdown activity on merchandise, while its margin guidance for the upcoming quarter was considerably lower than consensus expectations.
- Thermo Fisher Scientific (TMO) underperformed as several peers in the life science tools industry cut their growth outlook. While the company saw weakness in its bioprocessing business due to slower customer spending, particularly among emerging biotech customers, it was largely able to offset this with strong performance in its analytical instrumentation and CRO services businesses.
- Bio-Rad Laboratories (BIO) underperformed after the company cut its growth guidance as well its targets in its Q1 results call. It cited more challenges in scaling up its greenfield plant in Singapore, impact from higher-than-expected raw material inflation, and slower spending by its emerging biotech customers.
- Genpact (G) reported healthy results, but some investors feared business process outsourcers might be losers in an AI-powered future due to their people-based pricing models. We believe Genpact has positioned itself well for an AI future, and that it can demonstrate to investors in the coming quarters how it can deliver continued value for customers.
Changes to the portfolio throughout the quarter
- Fortive (0IRE) is a diversified multi-industrial company that spun out of Danaher. It has executed well since, growing more quickly, earning higher margins, and shifting business mix toward recurring revenue streams. Management's execution on the company’s transformation has proceeded even better than perceived, and further, its current business mix is less cyclical than in the past. Fortive focuses on instrumentation, transportation and automation technologies. Its solutions offer strong customer value by enabling adherence to changing environmental regulations, improving energy efficiency and connectivity of devices, and meeting increasing safety and security requirements.
- Merck (MRK) is a leading biopharmaceutical manufacturer with leading positions across oncology, vaccines, cardiovascular health and animal health. It is also a leader in the emerging fields of immuno-oncology and vaccine technologies (across HPV, pneumococcal, etc), with a series of emerging assets from recent M&A, bringing pipeline-in-an-asset via acquiring mechanisms and emerging pathways that may pave the way for internal indication/therapy application opportunities.
- Intuit (0RCT) offers widely used and recognized market-leading software products for small businesses and consumers. Weaker IRS tax returns weighed on overall growth of its consumer tax segment, creating a buying opportunity. Intuit continues to grow its small business segment revenue at a healthy pace, and has delivered close to 40% operating margins this year, despite the choppy macroeconomic environment in the U.S. The company is uniquely positioned to help improve the financial wellbeing and advance the financial capabilities of households, small businesses and the self-employed through its software services; it has goals to double the household savings rate and improve small business resiliency, which are well aligned with the company’s broader business goals.
- Roper Technologies Inc (ROP), Charles River Laboratories Intl (CRL) and Canadian National Railway (CNI) were eliminated to allocate to more attractive opportunities.