Brown Advisory Ethical Selection USD Q3 2020 commentary

Market overview

Following a strong second quarter, the markets were up once again in the third quarter. The benchmark, the Russell 3000® Net Index, gained 9.1% while the strategy performed virtually in-line with a gain of 8.9% (net of fees) for the quarter.   

Despite the lingering social and economic impact from COVID, the economy is beginning to make a noticeable comeback from March lows; however challenges still remain. Encouragingly, unemployment numbers have turned in the right direction.  However, a significant slack in employment still remains, and a climb back to prior levels seems arduous as large sectors of the economy continue to face challenges as the threat of the virus persists.  For example, Retail and Travel & Entertainment industries, which employ millions, continue to face muted demand as consumers have fewer avenues to spend their money and are avoiding both business and leisure travel.  Similarly, the Oil & Gas industry is over supplied due to the worldwide slump in energy demand.

Following a second quarter that was marked by widespread fiscal stimulus efforts, the third quarter can be characterized by continued accommodative efforts by the Fed, most notably around inflation. In what marks an important policy shift, the Fed is now aiming to average 2% inflation in the future rather than setting 2% as its target rate.  This means the Fed is likely to keep interest rates low for longer and allow inflation to rise above 2% for a time, rather than acting to tighten monetary policy on the prospect of hitting a 2% level. The Fed is committing to low and negative real policy rates for an extended period of time even as the economy accelerates and inflation picks up.  

As some investors question the market’s return to pre-COVID levels, the portfolio management team (the “Team”) notes that there are rational arguments in favor of the recovery. Federal policies have had marked impacts on market activity before, and the Team believes this swift recovery is no exception. Federal stimulus and policy changes around inflation have and will likely continue to contribute to softening the blow to growth that COVID has brought the economy. Furthermore, while near-term cash flows are depressed in many sectors, one must remember that the vast majority of a company’s value is in its terminal value, which investors are most likely assuming is largely unaffected by the pandemic. Lastly, low interest rates generally make equities a more attractive asset class especially relative to bonds and lower discount rates tend to push equity valuations higher. 

For the quarter, the portfolio saw fairly broad-based outperformance in most sectors, including health care, financials, industrials and both consumer discretionary and staples. The decision to underweight the energy sector also contributed to the outperformance this quarter as these markets remain challenged. The offset was relative weakness in information technology, where a few single stock selections that had outperformed handily in the first half of the year underperformed peers in a ‘catch-up’ trade in the third quarter. 

The portfolio selection process aims to generate consistency and low tracking error to the Russell 3000 Index, thus isolating outperformance through fundamental, bottom-up stock selection process. The Team looks to minimize sector and factor variation against the market while seeking to maximize idiosyncratic upside opportunities. 

The Team believes that 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 (~2.3% and ~2.9%, respectively) are matching overweights in sectors with similar risk and macroeconomic factor exposures: industrials and materials (offsetting energy) and real estate (offsetting utilities).

Portfolio performance

Performance is net of all fees

Top 10 portfolio holdings (as of 30/09/2020)
47.1% of total portfolio

Best performing positions

• Amazon.com, Inc. (AMZN) Amazon’s revenue increased 40% year-over-year in the second quarter and the company’s profits were well ahead of expectations.  Amazon is a key beneficiary of the accelerating shift away from physical stores towards ecommerce. Advertising, video and grocery performed particularly well.  Also of note, the company’s international business was profitable in the second quarter.  As previously mentioned, the Team continues to monitor the company’s treatment of workers; and was pleased to hear that Amazon has committed $4bn in costs to keep workers safe, including PPE and in-house COVID testing, higher wages, and enhanced social distancing measures. The Team also continued to be very active during the quarter in engaging directly with the company multiple times on a variety of their most material ESG risks, including additional disclosures on efforts to keep workers safe.
  
  
• Bright Horizons Family Solutions (BFAM) Bright Horizons has continued to make the case that while its child care centers have been greatly impacted in the short run due to COVID-19, a choppy recovery is likely to take hold and their services are likely to be deemed potentially even more “essential” on the back side of this pandemic-induced lockdown as they were going into it. Its balance sheet remains well capitalized.  
  
  
• Canadian National Railway (CNI) Canadian National outperformed in the quarter as volumes recovered dramatically from the depths of the second quarter trough and pricing has become a tailwind with a tight trucking market. 
  
  
• Sherwin-Williams Co. (SHW) Sales trends for Sherwin-Williams meaningfully improved as the quarter progressed as economic activity gradually resumed and DIY demand took a step up. However, earnings came in much stronger than expected due to extraordinary gross margin expansion largely due to favorable product and customer mix (DIY sold one-gallon at-a-time vs. five-gallons for pros), lower raw material costs and pricing. The crown jewel paint store saw sequential improvement as residential new and repaint recovered, particularly in exterior projects as the outdoor painting season went into full swing.
  
  
• Zoetis Inc. (ZTS) Zoetis reported strong results that beat Street estimates on revenues, margins and EPS. Organic growth was an impressive +4%, and reported revenue was ~15% ahead of Street estimates. It does not expect competitive launches for its key franchises in dermatology and in combo tick/fleas/heartworm in the U.S. in the next 6-12 months, a positive and key driver of earnings. Growth was driven by its companion animal segment, with livestock seeing a sharp decline in the U.S. due to COVID-19 related customer disruptions and channel shifts. Further, the company is amongst a select few that had not removed FY20 guidance earlier in the year, showing business resiliency.

Worst performing positions

• American Tower Corp. (AMT) The portfolio’s one holding in the real estate sector is American Tower, whose weakness reflects concern over negotiations on a large 15 year lease deal.  The Team believes the deal adds tremendous visibility to cash flow and removes uncertainty surrounding decommissioning from a key client.
  
  
• Cisco Systems Inc. (CSCO) Cisco's July quarter came in modestly ahead of expectations, but October guidance missed low expectations with forecast for -10% y/y growth at the midpoint (versus consensus of -7%). It is no surprise that Cisco is slower to pull out of COVID-19 than most: the majority of its revenue is tied to business CapEx, and it is a very tough environment for on premise IT CapEx spend.
   
• Jack Henry & Associates, Inc. (JKHY): Shares of Jack Henry fell on guidance for lower-than-expected growth in 2021. The near-term outlook was hurt by lower bank M&A activity and some COVID-related implementation delays, but importantly the Team believes Jack Henry’s competitive position remains intact.
  
  
• Washington Federal Inc. (WAFD) Washington Federal was a detractor in the quarter as the credit outlook under continued COVID-19 uncertainty and lower interest rates continued to weigh on bank stocks.
  
  
• WEX Inc. (WEX) Diminished travel spend continues to hurt ~20% of WEX’s business, and it continues to weigh heavily on investor sentiment.

Changes to the portfolio 

• The Team made one addition—Genpact (G)—to the portfolio during the third quarter. Genpact is a leading provider of Business Process Outsourcing (BPO) services to the Fortune 500. The company helps customers build resilient business models, drive efficiencies, and enhance operational risk management (including sustainability and climate-related risk). The Team believes Global Client BPO can continue to grow low/mid-teens for years as Genpact expands existing relationships and adds new clients. GE, Genpact’s largest customer, should remain essentially flat, and has become less relevant overtime. The Team expects operating leverage from G&A efficiencies in the near-term and gross margin mix shift longer-term. Capital return is consistent and not overshadowed by M&A. 
  
  
• There were no deletions to the portfolio this quarter.

Outlook 

In conclusion, the portfolio management team was pleased with the performance of the portfolio in a very challenging market, and continues to believe in the process, which has driven outperformance over the long term. The Team believes that the rigorous bottom-up security analysis, ESG alignment of the investments and thoughtful portfolio construction should lead to meaningful outperformance in the long run.