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EAT OUR OWN COOKING

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PORTFOLIO AND PERFORMANCE REVIEW
THIRD QUARTER 2017


Performance*
Third
Quarter
Year-
To-Date
Since    
Inception**
FI Concentrated Value Composite (gross of mgmt fees) 2.2% 12.4% 10.4%
FI Concentrated Value Composite (net of mgmt fees) 2.1% 11.9% 9.6%
Russell 1000® Value Index (Benchmark) 3.1% 7.9% 6.9%

*   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 business.

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 higher.

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 position.

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 portfolio.

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. VeacoNugroho (Dédé) Soeharto
Partner and
Portfolio Manager
Partner and
Portfolio Manager

 

 

Performance Disclosures

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 independent verifiers.

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) $100 $200 $300 $400 $500
Effective Annual Fee (bps) 56 51 47 45 43

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 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006
% of Non-Fee Paying Accounts 2.6 2.3 2.1 1.9 2.1 2.5 3.9 8.8 35.0 53.2 77.5

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:

  September 30, December 31,
  2017 2016 2015 2014 2013 2012 2011
Composite 9.0% 9.6% 9.7% 8.4% 9.7% 10.8% 15.5%
Benchmark 10.3% 10.9% 10.8% 9.3% 12.9% 15.7% 21.0%

Forward-Looking Statements

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.

Form ADV

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.






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