PORTFOLIO AND PERFORMANCE REVIEW
THIRD QUARTER 2017
|FI Concentrated Value Composite (gross of mgmt fees)
|FI Concentrated Value Composite (net of mgmt fees)
| Russell 1000® Value Index (Benchmark)
* Important performance disclosures can be found at the end of this letter.
** Annualized. Inception Date: August 1, 2006.
Our portfolio slightly underperformed its benchmark during the third quarter, entirely due
to our sector weightings. We had no exposure to Energy, the benchmark's best-performing
sector, while roughly 60% of our portfolio was in Health Care, Consumer Staples and Consumer
Discretionary, three of the benchmark's worst-performing sectors. Our Consumer Staples and
Consumer Discretionary stocks outperformed those of the benchmark, helping to offset the
impact of our heavy weighting in these two sectors. We are also significantly underweighted in
Financials, one of the benchmark's better performing sectors. However, the outperformance of
our financial companies more than compensated for our underweighting in this sector.
Our portfolio weightings are consistent with our desire to invest in high-quality
companies (and industries) that exhibit relatively stable growth in revenues, operating income
and cash flows. We generally have found that these financial characteristics are more likely to be
present in companies within the sectors in which we are overweighted, and less so in the sectors
in which are underweighted. Differences in sector weightings often lead to short-term
performance divergence between our portfolio and our benchmark. However, we believe this
short-term divergence will be more than compensated for by the longer-term outperformance that
accrues from holding higher-quality companies.
An important benefit of our portfolio is its lower risk profile that is hidden when looking
solely at absolute performance comparisons. Since August 1, 2006, when Focused Investors
started managing money, our portfolio has generated roughly 20% less risk than its benchmark
as measured by annualized standard deviation of returns (12.2% for our portfolio compared to
15.4% for our benchmark). While risk reduction often receives less attention when equity
markets are marching higher, its importance becomes clearer when they stumble.
As noted above, our consumer stocks performed well relative to those in our benchmark,
with Target as our top performer. Target reported better than expected quarterly earnings driven
by positive growth in both customer traffic and comparable store sales (following four quarters
of negative comp store growth), as well as 32% growth in comparable digital channel sales. On
the basis of this strength, management modestly raised its 2017 earnings guidance. The company
is benefiting from a number of positive business developments including private label brand
strength, increased ecommerce fulfillment capabilities, an improved customer digital shopping
experience and improved working capital management.
We are pleased with the positive trends reflected in Target's recent financial
performance, but we understand the limited importance that should be placed on short-term results.
Target is undergoing a transition as it moves to compete in a world where many retail
customers are equally comfortable shopping online as in stores, and online competitors are
growing increasingly stronger. This transition will take time as Target modifies its stores and
merchandising to attract customers while also building a compelling online experience for
customers who prefer that mode of shopping. We believe Target can successfully navigate this
transition, but we are watching their progress closely and will revise our assessment of the
company's investment merits as needed.
With the exception of Wells Fargo, our financial companies' share prices rose nicely
during the quarter. After years of facing escalating legal and regulatory burdens, large financial
companies such as those in our portfolio, seem poised to benefit from a more benign legal and
regulatory burden under President Trump's Administration.
This reduced burden does not require passage of any legislation but rather just a change
in how existing rules and regulations are interpreted and applied by regulators. For instance, we
believe that the use of more reasonable, less severe assumptions in the Federal Reserve's annual
stress test next year will allow large financial companies to distribute significantly more capital
through dividends and share repurchases. The higher dividends, coupled with additional earnings
growth fueled by share repurchases, and improved returns on equity from less capital retention,
should all lead to higher share prices.
Wells Fargo's share price was basically flat for the quarter as the company continues to
deal with fallout from the unauthorized account problem initially disclosed to investors in late
2016. During the most recent quarter, management announced that a sizable number of
additional potentially unauthorized accounts had been uncovered by the company as it continued
its investigation. The company also found problems in other areas of its consumer banking
Wells Fargo received very little benefit from the various unethical practices that it has
disclosed, but it is facing significant costs as a result of them. These costs include increased
compliance and legal fees, regulatory fines and sanctions, and reputational risk leading to lost
business. We reduced our estimate of Wells Fargo's intrinsic value last year after the company's
initial disclosure of its unauthorized account problem. Based on the recently disclosed increase in
potential unauthorized accounts, as well as the other consumer banking-related problems
disclosed by management during the past few months, we are reviewing our valuation
assumptions yet again. Once our review is complete, we will revise our valuation model as
needed and adjust our position size accordingly.
Zimmer Biomet was our worst performer during the quarter. For the past year, the
company has been working to resolve manufacturing delays at one of the plants acquired in its
purchase of Biomet in 2015. These delays were originally attributed to integration issues related
to the acquisition. However, management subsequently disclosed that some of the manufacturing
delays were the direct result of deficiencies identified during a FDA audit of the Biomet facility.
In order to address these deficiencies, the company embarked on an expensive and time-consuming
remediation program which significantly slowed production of certain key products.
The disclosure of the FDA audit findings called into question whether management had
been sufficiently forthright in its earlier explanation of manufacturing delays and product
shortages, and further damaged the investment communities' leadership assessment of Zimmer
Biomet's long-time CEO, David Dvorak. In early July 2017, Zimmer Biomet announced that
production levels were returning more slowly than anticipated at the Biomet plant. In addition,
the company disclosed that customers (surgeons) that had been adversely affected by lack of
product in previous quarters were not resuming use of Zimmer Biomet products as quickly as
expected. Both of these factors led the company to report preliminary sales results for second
quarter 2017 that were slightly weaker than expected. The same day, the company announced
that Mr. Dvorak was resigning as CEO. Interestingly, these disclosures coincided with rumors
(subsequently confirmed) that an activist investor had taken a position in Zimmer Biomet. The
CEO departure combined with rumors of activist involvement pushed the company's share price
Roughly two weeks after these announcements, Zimmer Biomet's management reported
quarterly results consistent with the preliminary guidance, but also reduced revenue and earnings
guidance for the remainder of 2017 reflecting a continuation of the problems discussed above.
The magnitude of the guidance cut surprised investors, and the enthusiasm from two weeks prior
quickly evaporated, pushing Zimmer Biomet's share price down significantly.
Despite these recent setbacks, we feel comfortable with our Zimmer Biomet position. The
problems affecting Zimmer Biomet are all "fixable", and a new CEO will hopefully bring a
greater sense of urgency, and possibly a more appropriate skill set, to address them. Equally
important, long-term industry fundamentals are very attractive given the aging demographics that
drive demand for orthopedic surgery. Advances in surgical techniques and improved
functionality of orthopedic devices have expanded the age groups for which surgery is
appropriate. Zimmer Biomet's current valuation is significantly depressed providing a sizeable
margin of safety as the company works through its current issues. Given our already sizable
portfolio weighting, we decided not to add to our position.
CBS, one of our newer holdings, was the second largest detractor from our performance.
CBS's recent stock weakness seems to reflect several concerns, some old and some more recent.
The old concerns include continued cord-cutting (cancelling cable television subscriptions) and
the potential for traditional media companies like CBS to face escalating content costs as more
players (e.g., Amazon and Netflix) bid for creative talent and programming.
More recently (i.e., last month), the concern has been the declining viewership of NFL
broadcasts, heightened by the controversy involving NFL player protests during the national
anthem. Sports broadcasting in general, and broadcasting NFL games in particular, is an
important source of revenue for CBS. This revenue arises both through the retransmission fees
CBS collects from cable operators that carry CBS programming, and the fees CBS charges
advertisers during sports broadcasts.
There is no question that consumers, especially millennials and younger, are increasingly
consuming content distributed by providers other than traditional cable television operators.
However, many of these new distributors such as Hulu and YouTube TV include CBS
programming as part of their core service, and pay CBS as much, if not more, as do traditional
cable television operators. CBS is also actively growing CBS All Access which is the company's
direct-to-consumer service. The current viewership base for CBS All Access is small compared
to CBS's traditional cable television viewership base, but growing rapidly. On a per viewer
basis, the economics of CBS All Access are actually better for the company than those of
traditional cable television.
Rising content costs are a valid concern as well, but to date CBS has managed them well,
and we believe it will continue to do so. The company's operating margins have been fairly
steady for the past few years with no sign of margin compression. Just as we closely watch the
company's operating margins, we will monitor NFL viewership and its impact on CBS's
retransmission fee renewals with cable operators and the company's advertising rates. If any of
these measures show deterioration, we will adjust our valuation model accordingly.
Despite the market's concerns, we view CBS positively. We see a company generating
substantial free cash flow which management is investing prudently to address changes in the
competitive landscape while also engaging in meaningful share repurchases. In the past year
alone, diluted shares outstanding were reduced by 10%. Management continues to streamline the
business and should soon complete the disposal of the CBS radio business, freeing up additional
capital for share repurchases. We also believe that as additional deep-pocketed players enter the
media business, providers of quality content such as CBS become increasingly valuable merger
partners. CBS is currently selling at less than 12X forward EPS, providing a substantial margin
of safety. We took advantage of the company's recent share price weakness and added to our
United Technologies Corporation's (UTX) stock declined slightly after announcing plans
to acquire Rockwell Collins in a cash and equity deal. Our reaction to the transaction was similar
to the market's reaction – mixed and slightly negative. Rockwell is a well-respected, leading
aerospace company that will provide UTX with additional scale and leverage when dealing with
Boeing and Airbus, the two leading commercial jetliner manufacturers. UTX believes that
shorter-term, the integration of Rockwell with UTX will generate sizable cost savings, leading to
earnings accretion after the first full year of ownership. Longer-term, UTX believes it can
combine Rockwell's software capabilities with UTX's aerospace systems to create more-digital,
next-generation integrated systems and service offerings.
While we can see some benefits from the acquisition, we always tend to view large
acquisitions with a healthy dose of skepticism. We would have preferred that UTX management
focus 100% of its efforts on addressing some of the company's current operational challenges,
while devoting its excess cash flow to dividends and share repurchases. Given the size of the
acquisition, UTX will suspend share repurchases for the next few years as it pays down debt
issued to purchase Rockwell. We will monitor this acquisition closely to determine if any
adjustments to our estimate of intrinsic value are warranted, but for now, we are comfortable
with our position.
Other than adding to our CBS position, there was no other significant activity in our
As always, our commitment to our clients is unchanged: we will remain rational,
disciplined investors as we search for opportunities to preserve and compound the capital
entrusted to us. We also will maintain a significant portion of our own net worth invested
alongside our clients, thereby "eating our own cooking".
Thank you for your continued interest in Focused Investors.
|Bruce G. Veaco||Nugroho (Dédé) Soeharto|
Founded in 2006, Focused Investors LLC ("FI") is an independent investment management firm registered as
an investment adviser with the U.S. Securities and Exchange Commission. Registration with the U.S.
Securities and Exchange Commission does not imply a certain level of skill or training. FI is a value driven
investment manager specializing in a concentrated portfolio strategy.
The FI Concentrated Value Composite was created on August 1, 2006, and contains all fully discretionary, feepaying
accounts that are managed according to FI's concentrated value strategy. FI's concentrated value
strategy seeks to invest client assets primarily in common stocks of companies that are trading at prices
significantly below FI's estimate of their intrinsic values at the time of initial purchase. Accounts that
participate in the composite can be separately managed institutional accounts or pooled investment vehicles.
The FI Concentrated Value Composite is the firm's only composite at this time. A complete description of the
composite and additional information regarding policies for valuing portfolios, calculating performance, and
preparing the compliant presentation is available upon request.
The composite's benchmark is the Russell 1000® Value Index and is provided to represent the investment
environment existing during the time periods shown. The Russell 1000® Value Index measures the
performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000
companies with lower price-to-book ratios and lower than expected growth values. The Russell 1000® Value
Index is constructed to provide a comprehensive and unbiased barometer for the large-cap value segment. The
Index is completely reconstituted annually to ensure new and growing equities are included and that the
represented companies continue to reflect value characteristics. For comparison purposes, the Russell 1000®
Value Index returns do not reflect transaction costs, management fees, or other expenses that would be
incurred in managing an account. While FI's objective is to outperform its benchmark, this does not imply that
FI's portfolio strategy will share or track the same or similar characteristics as the benchmark. In addition,
there can be no guarantee that FI will achieve its objective. The index returns are not covered by the report of
Performance for the composite and the benchmark is calculated on a total return basis, which includes
reinvestment of all income, plus realized and unrealized gains and/or losses. Individual account performance
will vary depending upon, among other things, timing of transactions and market conditions at the time of
investment. Returns are stated in U.S. dollars.
Because FI's portfolios are relatively concentrated, the performance of each holding will have a greater impact
on an account's total return and may make the return more volatile than a more diversified portfolio. In
addition, while FI believes that the portfolio holdings are value stocks, there can be no assurance that others
will consider them as such. Past performance does not guarantee future results. As with any investment
vehicle, there is always the potential for gain as well as the possibility of loss.
Gross-of-fees performance returns are presented before management and custodial fees but after all trading
expenses. Prior to January 1, 2010, net-of-fees performance returns were calculated by deducting one-twelfth
of the highest management fee borne by any account in the composite (1%) from the monthly gross composite
return. In 2010 and 2011, subsequent net-of-fees performance returns are calculated by applying the standard
management fee schedule for separately managed accounts, including tiers, to all accounts in the composite.
Beginning January 1, 2012, FI began using actual fees to compute net-of-fees performance returns. Actual fees
vary. FI's standard management fee schedule for institutional separately managed accounts is as follows: 90
bps on the first $10 million of assets under management, 70 bps on the next $10 million of assets under
management, 50 bps on the next $80 million of assets under management, 45 bps on the next $100 million of
assets under management, 40 bps on all assets under management in excess of $200 million and 35 bps on all
assets under management in excess of $400 million. Based on this fee schedule, accounts of the following
varying sizes would pay an effective annual fee of:
|Account Size (millions)
|Effective Annual Fee (bps)
FI's management fees are more fully described in Form ADV Part II, which is available upon request.
The composite includes a pooled investment vehicle in which certain participants do not pay a management fee.
|As of December 31
|% of Non-Fee Paying Accounts
No measure of dispersion is presented for periods where there are less than five accounts in the composite for
the full year as it is not considered meaningful. Internal dispersion is calculated using the asset-weighted
standard deviation of annual gross-of-fees returns of those portfolios that were included in the composite for
the entire year.
The three-year annualized ex-post standard deviation measures the variability of the composite (using gross
returns) and the benchmark for the 36-month period ended on the following dates:
As investment managers, one of our responsibilities is to communicate with our investors in an open and direct
manner. Insofar as some of our opinions and comments in our letters are based on current management
expectations, they are considered "forward-looking statements" which may or may not be accurate over the
long-term. While we believe we have a reasonable basis for our comments and we have confidence in our
opinions, actual results may differ materially from those we anticipate. You can identify forward-looking
statements by words such as "believe," "expect," "may," "anticipate," and other similar expressions when
discussing prospects for particular portfolio holdings and/or the markets, generally. We cannot, however,
assure future results and disclaim any obligation to update or alter any forward-looking statements, whether as
a result of new information, future events, or otherwise. Further, information provided in this letter should not
be considered a recommendation to purchase or sell any particular security.
Our most recent Form ADV (Parts I and II) is available at http://www.adviserinfo.sec.gov. If you would like to receive a printed copy of either, please contact us.