Looming behind the wild market swings that closed out the year was a growing sense that the economy may be reaching the late stages of expansion. While selling pressure was widespread, energy, housing and auto stocks took much of the pain. Performance in those areas suggests investors believe companies will struggle to meet the lofty earnings expectations that, as shown, are just beginning to adjust from near-peak highs.
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Past performance does not guarantee future results.
In addition, concerns of an escalating trade war, the effects of rising interest rates, and higher input costs all contributed to the more sober outlook. In response to the new tone, investors sought out traditional safe-havens such as Utilities and Consumer Staples.
The cautious mindset also took a toll on mega-cap Technology companies and growth areas that had enjoyed positive momentum during the first half of the year.
Security selection was strong with holdings in Financials and Industrials boosting relative results and the Strategy beat its benchmark, the Russell 3000® Value Index, for both the quarter and full year. Our holdings in Utilities outperformed the broader market during the quarter. Oil prices continued to fall and Energy stocks suffered as a result; an overweight to and stock selection in the group detracted from results.
A Financial advantage.
The portfolio’s Financials holdings were down but outperformed those in the benchmark during the period. Shares of Berkshire Hathaway Inc. (BRK.B), a multi-business holding company run by legendary investor Warren Buffett, were off modestly during the period as earnings from the company’s manufacturing and rail businesses continued to improve, and as its insurance units recovered from hurricane-related losses incurred during 2017.
Shares have benefited from a change announced mid-year to the company’s share buyback policy. Under the new guidelines, management has greater flexibility to initiate stock repurchases. Given Berkshire’s significant cash reserves, the move has been well received. Leadership has capitalized on recent volatility and began repurchasing shares.
Despite appreciating for the full year, Berkshire continues to trade at a nearly 30% discount to the broader market and 20% below peers, based on our analysis. We find the valuations particularly compelling given the company’s $80 billion in cash and reserves, which will allow it to make strategic acquisitions if competitors stumble, or provide a cushion in the face of economic uncertainty.
No longer the “it” sector?
After spending most of the past two years as a top performing sector, Information Technology (IT) was weak and the group sank with the broader market. The strategy’s holdings in the space also lagged, but we continue to hold what we believe are high quality businesses.
For example, Cisco Systems, Inc. (CSCO), the world’s leading computer networking provider, was down moderately for the period but remained a top contributor for the year. The company’s focus on recurring-revenue businesses has gained traction and robust sales have produced strong free cash flow.
We believe the positive results in the current sales cycle should continue. Despite a strong run, shares are trading at a reasonable 16x earnings.
Good long-term prognosis?
The portfolio’s Health Care names outpaced those in the benchmark; however, the group contained a key detractor. Long-time holding Quest Diagnostics, Inc. (DGX), a diagnostic testing and services company trading at 14x estimated 2018 earnings, was down after issuing lower-than-expected guidance for the fourth quarter. Management sought to temper expectations after seeing a jump in the number of billing claims rejected by insurers. The company believes the contested charges are an isolated incident and is working to recoup at least a portion of the outstanding balances owed.
The poor recent results have, in our view, temporarily masked what is a great long-term story. Quest should benefit from regaining its status as an “in-network provider” with UnitedHealth Group (UNH). The designation should help Quest as it seeks to capture business from United’s large book of insured population.
Quest should also benefit by growing its hospital outreach business as hospitals either outsource lab operations or look to team with a third-party to help them run the business. The company is a low-cost provider of diagnostic testing services—with competitors often 2x to 5x more expensive—which we believe provides a competitive advantage over peers.
The stock remains attractively valued in our view, and we believe that growth and cost-reduction initiatives are now accelerating.
Economic data suggests that the economic expansion remains intact, yet energy markets and the yield curve highlight a sense of caution for 2019 and beyond. The gathering headwinds are just beginning to show up in downward revisions of earning estimates and, as shown below, tepid expectations for broad market performance over the next few years.
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