Brown Advisory Ethical Selection Q4 2021 commentary

Market overview

Taking 2021 in retrospective, it was no doubt an eventful year. Increasing optimism around the manageability of COVID-19 drove markets up quickly in the start of the year, along with the US 10-year Treasury Note which leapt from under 1% in January to nearly 1.8% by March. Over the coming months, however, markets became a little more hesitant, as increasing concerns around COVID-19 variants (Delta, Omicron) were also met with inflation concerns and supply chain issues—all of which led to increased suggestions from the U.S. Federal Reserve around raising interest rates in 2022. 

Turning to the portfolio’s quarterly results, strength in Financials and Communication Services was offset by modest weakness in Consumer Discretionary, Consumer Staples, Industrials and Information Technology. For the full year, positive performance was fairly broad-based, with the largest detractor being the Consumer Discretionary sector. 

The ESG nature of this portfolio gives it a natural tilt away from hydrocarbon-producing and-consuming companies, typically in the energy and utilities sectors. Offsetting those underweights, are matching overweights in sectors with similar risk and macroeconomic factor exposures, such as industrials, materials, and real estate.

Portfolio performance (net of fees)

Best-performing positions Q4 2021 (note performance shown for the quarter reflects the performance of the security during the part of the quarter it was owned by Brown Advisory, not necessarily the performance of the security itself for the full quarter)

• Marvell reported a strong October quarter and January quarter guide on demand strength across end markets that was well ahead of expectations. The positive growth-rate inflection is the result of a major portfolio transformation that started five year ago.  CEO Matt Murphy has successfully turned Marvell into a fast-growing, cutting-edge networking/data center infrastructure supplier from a slower-growing, storage-centric semiconductor company.  
  
  
• KKR also performed well in 4Q21 with strong asset growth and strong investment performance exceeding expectations, demonstrating continued momentum in the business. We were also pleased to see the company continue to accelerate its focus on ESG investing by tripling the size of its ESG team in 2021 and establishing a new Sustainability Expert Advisory Council during the quarter.  
  
  
• Despite being plagued with shortages in raw materials leading to flat sales growth, demand for Sherwin Williams products remains quite healthy.  As such, investors are looking past near-term headwinds and looking to Sherwin Williams’ historic pricing power due to the company’s product innovation, brand value and direct business model.
  
  
• Microsoft exceeded expectations in the most recent quarter and raised guidance for the year.  Digital transformation demand remains robust and the breadth of Microsoft’s portfolio enabled the company to gain wallet share across business processes, infrastructure and security.  Increased profitability within Cloud is another bright spot as Azure’s gross margins increased. 
  
  
• The companion animal segment drove a strong quarter for Zoetis. The company’s unique portfolio of animal medications are a significant competitive advantage which has translated to exceptional growth.

Best performing positions – 2021  (note performance shown reflects the performance of the security during the part of the year it was owned by Brown Advisory, not necessarily the performance of the security itself for the full year)

• Alphabet exceeded consensus estimates throughout the year, led by its Search and Cloud businesses.  In the most recent quarter, the company benefitted from broad-based strength in advertising, and YouTube surpassed 50 million Music and Premium subscribers.  Alphabet leveraged strong revenue growth into impressive bottom line growth during the year.  In its 2021 environmental report, Alphabet disclosed that it is the first major company to be carbon neutral for its entire operating history. 
  
  
• KKR had an extremely active year. The business, on a fundamental basis, performed well in 2021 with strong asset growth and strong investment performance. In addition, the company acquired a majority share of Global Atlantic, an insurance company, and updated medium-term EPS guidance by a factor of 2x. During the year, KKR refreshed it’s governance with the retirement of Henry Kravis and George Roberts, and introduced a shareholder friendly single class share structure. The company also continues to minimize its exposure to traditional energy with the recent Contango spinoff. 
  
  
• Marvell reported very strong demand from customers in the data center, auto and communications infrastructure end-markets.  Over the last five years, management has built Marvell into a “one-stop shop” for data infrastructure via acquisition and internal development.  Marvell has expertise in a wide variety of end markets including storage/networking, compute/security, custom networking, high-speed connectivity and high-performance cloud switching. 
  
  
• Microsoft’s cloud-computing business, Azure, performed extremely well in 2021.  Moreover, Microsoft’s Windows franchise has the dominant position in enterprise productivity software and is the de facto standard for business users.  Over the last few years, management has also added value via successful acquisitions (i.e. LinkedIn and GitHub) and by dramatically improving operating margins.  The company continued to accelerate its sustainability efforts during the year, particularly within its data centers by focusing on reducing energy and water consumption, and renewable energy procurement—a meaningful step towards achieving the company’s goal to be powered by 100% zero-carbon electricity by 2030. 
  
  
• Charles Schwab continues to report high net interest revenue, high client engagement, high organic growth figures, and high pre-tax margins. The primary business revenue stream (net interest revenue) remains levered to short- and long-term interest rates, which is exciting given the economic and monetary policy backdrop.

Worst-performing positions Q4 2021 (note performance shown for the quarter reflects the performance of the security during the part of the quarter it was owned by Brown Advisory, not necessarily the performance of the security itself for the full quarter)

• Despite reporting a strong quarter, Veeva’s initial FY23 guidance on subscription growth fell below expectations. At the company’s investor day held during the quarter, Veeva reiterated it’s status as the first public benefit corporation, which the company says has aided in attracting top talent and is viewed positively by customers.  
  
  
• Lower organic sales growth in the quarter caused weakness in Nomad’s stock, though the company reiterated guidance given strong cost controls. 
  
  
• Charles River reported results that fell below expectations and guidance was revised downward, though mostly driven by announced divestitures. 
  
  
• WEX reported a quarter where yields in a particular segment—travel and corporate—fell well below estimates, sparking fears that the ultimate recovery in top-line growth due to travel resumption may be less than anticipated. 
  
  
• Dynatrace posted very strong revenue and profit growth in the third quarter but the stock declined on the announcement that the CEO, John Van Siclen, will retire at the end of the year.  We are not surprised by the announcement given Mr. Van Siclen is 65 years old. As customers face increasing observability and application security pressures, we believe Dynatrace is set up for long-term success. 

Worst performing positions – 2021 (note performance shown reflects the performance of the security during the part of the year it was owned by Brown Advisory, not necessarily the performance of the security itself for the full year)

• Visa underperformed in the year given a lack of rebound in cross-border travel, which is very profitable for the company.
  
  
• Disney underperformed throughout the year given uncertainty around the length and severity of the ongoing COVID-19 variants.  
  
  
• Teleflex's performance was stymied by the relentless fits-and-starts the pandemic created for the elective medical procedure landscape over the last 18 months. The company’s stock returns depend entirely on the performance of the company's Urolift product - a novel, non-invasive yet highly deferrable treatment for benign prostatic hyperplasia. Urolift was proving to be a transformational product when the pandemic struck, and as with many medical device companies, 2021 proved to be a lost year in terms of further market gains.
  
  
• WEX underperformed throughout the year given increased pressure on companies that are viewed as 'legacy payment’ players, as well as a late year earnings release that fell below expectations.
  
  
• Bright Horizons shares have been impacted as the COVID-19 pandemic has continued to delay workplace re-openings and teacher’s return to the workforce. Childcare centers have made steady progress in return to normalization, which should continue into 2022.