The third quarter was a challenging one for equity investors. The stock market, as measured by the S&P 500 (including dividends), fell 6.4%. Both the Dow Jones Industrials and NASDAQ Comp Index dropped 7.0%. The pain was shared with investors around the globe, as many key markets outside the US fell even more. In Europe, the German DAX and British FTSE 100 declined 11.7% and 6.1%, respectively. In Asia, the Hong Kong Hang Seng lost 19.8% and the Shanghai Composite skidded 27.9%. Further compounding the pain for investors who have ventured into overseas markets, the US dollar strengthened against most foreign currencies as governments provided fiscal stimulus, or responded to China’s devaluation of the yuan with their own devaluations. Bonds performed as they should by providing a buffer against equity market volatility. The Barclay’s Aggregate Bond Index finished the quarter up 1.1%, driven by declining interest rates.

The silver lining in an otherwise difficult market is that some intrinsically nice businesses whose prices we previously judged as being out of reach are now trading at very reasonable valuations. We outline several such purchases below.

China Thoughts

The main source of investor concern in the third quarter was China, and rightly so. Unlike Greece, in economic terms China matters. It is the world’s second largest economy, accounting for over 13% of global economic output (in contrast, Greece accounts for about 0.3%). Economic statistics coming out of China have been pointing to weakening results, and the unexpected devaluation of the yuan versus the U.S. dollar in August underscored the concern that China’s rapid rate of expansion is a thing of the past, and that the country’s competitiveness in world trade is flagging. Other worrisome signals included the speculative bubble that formed and spectacularly burst in China’s domestic stock markets, the rumors of capital flight from the country, a drop in key commodity prices, and speculation of the extent of problem bank loans in the Chinese banking system. It is a lot to process. As we said several quarters ago when the headlines were dominated by the troubles in Greece, given the complexity of global capital markets and short-term nature of many of its participants, we are relieved that we can look through each of our holdings and evaluate them for their specific exposure and risk to the Chinese economy. We could not obtain this comfort if we used equity sector ETFs, third-party managers or other products, as so many do today.

Some perspective may be useful, however. The United States was once an emerging market too, and its development into the world’s preeminent economy was messy. Prior to the Great Depression, the United States experienced painful financial panics in 1797, 1807, 1815, 1837, 1857, 1893, 1907 and 1920 in the aftermath of periods of land, railroad and commodity speculation, failed trade and economic policies and war. In 1837, 40% of banks failed. In 1893, 15,000 businesses closed and unemployment exceeded 10% for roughly five years. Even after the Great Depression, when production dropped 50% and unemployment topped 25%, our country experienced painful recessions, particularly in the 1970s, early 1980s and following the financial crisis of 2008. So in comparison to our country’s industrialization and modernization, China’s leaders are engineering a masterful transition to a modern, industrial state, but it is not without flaws. We have no doubt that as China works to raise the standard of living of its people from 113th in the world in terms of per capita income to first-world status, there will be policy mistakes, financial crises and recessions. But we have no doubt that over time, China will grow substantially and wealth will be created for those who participate, directly or indirectly, in its economy. Because of the country’s large size and the interconnectedness of its economy with others around the world, there will certainly be ripple effects that reach the businesses whose stocks we own (positive and negative), whether or not they are operating directly in China. The first requirement is to invest for the long term. The second is to do the work and know the businesses you own and understand their risks as well as their opportunities. The rewards will come to those who do.

A Word on ETFs

We think exchange-traded funds (“ETFs”) are legitimate investment vehicles, providing broad diversification, low cost and the ability to trade real-time rather than at the end-of-day, as traditional open-end mutual funds do. We use some bond market ETFs in certain client accounts, and they have served their purpose well. But as owners of ETFs, we are also cognizant of some of their important shortcomings. The inherent problem with the ETF structure became apparent again on August 24th, when some of the most widely-held equity ETFs traded down in excess of 30% in spite of the fact that the stocks that served as the basis of value for the ETFs were down less than 10%. Investors who panicked and sold their ETFs in the midst of the chaos were badly burned. The ones who fared the worst had given their brokers stop-loss orders, thinking that they were protecting themselves against downside, but who managed instead to lock in the day’s worst executions. This mismatch between the ETF’s net asset value (“NAV”) and its price has happened before—notably, the May, 2010 “Flash Crash”—and will certainly happen again. Under duress, these widely-held securities became illiquid and added volatility to portfolios rather than mitigated it. As the dust settled, ETF prices and NAV converged and trading returned to normal. Given these risks, our playbook with ETFs is simple: (1) as with any investment, take a long view; (2) don’t panic, ever; (3) understand what securities underlie the ETFs and focus on their NAV rather than the ETF’s price, as price will converge to NAV when volatility subsides; and (4) never use stop-loss orders.

We prefer not to use ETFs for our equity exposures, except in rare circumstances. We would rather have intimate knowledge of each of our holdings rather than roll the dice with baskets of equities—our experience as security analysts and rigorous approach give us confidence in our decisions that we will generate positive returns and avoid costly mistakes. For bond exposures, ETFs help provide a level of diversification, liquidity and income production that is difficult to achieve with individual securities in smaller client accounts, so we will supplement our individual bond holdings with selected, high-quality, bond ETFs, following the rules outlined above.

Q3 Portfolio Changes

During the quarter we initiated positions in Kraft Heinz (KHC), Procter & Gamble (PG), Schlumberger (SLB), and Halliburton (HAL).  In addition, we exited our position in Coca-Cola (KO).  Please keep in mind, these commentaries should not be construed as a recommendation to buy or sell the securities discussed. Such decisions are made only within the context of the market environment as we perceive it at the time of the decisions and the structure of the diversified portfolio of which the securities are a component

[***]. Brief explanations for these actions are as follows:

Purchases:

Kraft Heinz (KHC)

The recent combination between Kraft Foods and H.J. Heinz created one of the world’s largest food & beverage companies with over 200 brands sold in nearly 200 countries.  Our purchase of KHC was driven, in large part, not only by the business’ inherently favorable characteristics (i.e. brand strength and scale advantages in product innovation, marketing, manufacturing, and distribution), but also by what we consider to be a “Dream Team” Board of Directors and management.  The 11-person Board of Directors consists of three representatives from Berkshire Hathaway (including Warren Buffett) and three representatives from 3G Capital, one of the most successful investment firms in history and subject of the book “Dream Big”.  Together Berkshire Hathaway and 3G own a 51% controlling interest in the company, and 3G Partner Bernardo Hees leads the company as CEO. 

Over the years, we’ve witnessed 3G perform a multitude of value-enhancing transactions including deals that eventually led to the creation of Anheuser-Busch InBev, the world’s largest brewery.  Like Anheuser-Busch InBev, Berkshire and 3G should be able to transform KHC from a stodgy, slow-growth business formerly led by bureaucratic management into a streamlined, high-energy, acquisitive institution led by one of the world’s most shareholder-friendly management teams.  While KHC doesn’t trade in the market as cheaply as some other portfolio holdings, we believe management will create enormous shareholder value over the long term.  Accordingly, we initiated a 2% position in the name in Q3.

Procter & Gamble (PG)

P&G was once a core Golub Group holding that we exited in 2013.  At that time, the stock had appreciated to levels that could not be justified by our valuation models, even utilizing optimistic growth and margin assumptions.  As importantly, the decision to sell was influenced by our belief that management’s strategic initiatives were misguided.  Most notably, the company’s brand portfolio was bloated and, in fact, was so diverse within each individual product line that the consumer was actually becoming confused when viewing their products on store shelves.

Over the past couple years we’ve been impressed by management’s strategy to re-focus the business.  They’ve: (1) reduced the portfolio of brands by over 100; (2) decreased non-manufacturing headcount by 22%, with further cuts to come; (3) sold non-core, lower-margin businesses including Ace, Wella, Duracell, and pet food; and (4) transformed the supply chain by moving to lower cost plants, localizing manufacturing, and streamlining inventory.  What we’re left with is a much healthier company focused on 65 premium brands.

In the past year or so the company’s “organic” results have been reasonable but the company, with a large percentage of sales overseas, has been heavily impacted by adverse movements in foreign exchange rates.  In addition, Wall Street is in “show me” mode, not yet convinced that P&G’s strategic changes will bear fruit.  We disagree.  In fact, as management continues to retool the company there is no reason P&G’s profit margins cannot be on par with smaller competitors that lack its scale advantages. 

P&G trades below its historical average at a current multiple of 15.7x June 2017 projected earnings and has a 3.9% dividend yield.  This appealing valuation, coupled with the aforementioned positive developments at the company, compelled us to initiate a 3% position in the company this quarter.

Halliburton (HAL) and Schlumberger (SLB)

In Q3 we also initiated a 1.5% position in oil services companies, Halliburton and Schlumberger.  The position size was split evenly between these two names.  The companies provide a wide range of services to oil and gas producers that are utilized in planning and drilling wells and extracting hydrocarbons out of wells.  The recent decline in oil prices has been driven by the proliferation of shale oil production in North America and by OPEC’s decision to maintain their production level despite global over-supply.  Not surprisingly, the oil services stocks have been impacted by this development as the demand for their services has declined. 

We feel the current oil price is unsustainable since many producers are operating at a loss.  Inevitably, either of two events will happen: (1) OPEC countries, suffering from severe budgetary pressures, will curtail supply to raise oil prices; or (2) we’ll experience bankruptcies at North American producers.  Either of these two events will drive oil prices higher, causing an eventual rebound in demand for HAL and SLB’s services.

While we cannot predict short-term movements in oil prices, favorable industry developments for oil services companies may lead to higher stock prices for HAL and SLB even if oil prices remain low for an extended period.  Specifically, industry consolidation continues as evidenced by HAL’s recent bid to purchase Baker Hughes (BHI).  After this transaction is complete HAL and SLB will be, by far, the largest and most dominant oil services providers around the globe and should operate in a rational pricing environment given the newly-formed duopoly industry structure.

Our strategy with the purchase of these two names was to initiate a small position at the outset in the hopes that further oil price declines would allow us the increase our weightings in the names on even more favorable risk-reward terms.  Oil prices have drifted upward since initiating these positions, but we stand ready to add to these names if oil prices reverse.

Sales:

During Q3, we sold our position in Coca-Cola (KO).  Our decision to sell KO was not due to a breakdown in the company’s fundamentals or valuation; rather, we simply believe that P&G is a more compelling opportunity given P&G’s potential for material margin improvement and lower valuation.  Specifically, P&G trades at 15.7x earnings estimates for 2017 while KO trades at 17.3x.  In addition, P&G’s 3.9% dividend yield is superior to KO’s 3.5%.

New Teammate

On October 5th, Robert Gwin III will be joining us as Senior Research Analyst on the Investment Team.  Rob’s investment philosophy gels perfectly with other members of the Golub Group team, and his extensive experience should serve to enhance our investment expertise across all industry sectors.  Rob received his Bachelor of Engineering degree from Vanderbilt University in 1995 and his MBA from UCLA’s Anderson School of Business in 2002.  He has spent 17 years of his career in finance and investments, most recently as Global Equity Analyst and Portfolio Manager for WCM Investment Management in Southern California.  Rob is an avid soccer fan, having competed extensively in college, and now enjoys coaching youth leagues.  He is currently in the process of relocating his wife and kids to join us here in the Bay Area. Please welcome Rob when you see him.

As always, we have included with this commentary your quarterly performance figures, management fee invoice(s), and a copy of your portfolio allocation as of 09/30/15.  You will receive statements from your custodian as well.  We urge you to compare both statements to ensure accurate reporting.  Please let us know if you do not receive a separate statement from your custodian. 

We look forward to speaking with you, and if you would like to come in for a visit, please drop us a note or give us a call.

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Partner

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[***]The securities identified do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.