Global Leaders Strategy - CALENDAR YEAR REVIEW | January 2022 - Brown Advisory
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Global Leaders Strategy CALENDAR YEAR REVIEW | January 2022 Dear fellow investors, colleagues and friends, There is never a dull moment when investing and 2021 served up its fair share of twists and turns. The year started with a sharp value rally which began in early November 2020 after President Biden was elected and continued over most of the first half of 2021. We have often worried that we would struggle to keep up in that market environment so were pleased to keep in touch over the year, finishing with a net of fees absolute return of 17.0% albeit behind the index return of 18.4%. As we moved through 2021 our societies started learning to live with COVID and its variants as vaccine programmes and boosters were rolled out. Whilst we are a long way from the old normal the Global Leaders team enjoyed time together back in the office and once again in person at our annual offsite. We hope that you and your families are staying safe and well during this recent Omicron infections spike and look forward to a healthy and prosperous 2022. Our paramount principle at Brown Advisory is “clients first” and it is the lynchpin of the Global Leaders’ investment strategy too. At its heart the Global Leaders strategy is very simple – invest in companies that serve their customers’ needs and let our investments compound over long periods of time. For all our process rules and valuation discipline the ultimate judge and driver of our investing outcome is our companies’ customer. The customer is the most important person in any business (not the shareholder!), without them you don’t even have a business. Nonetheless there is an ecosystem to nurture and short-changing employees or the environment will catch up with a management team and company eventually. Given our holding period of over seven years – just under half our investments have been with us since day one – these externalities become meaningful internalities in our timeframe. ESG and in particular climate change is now squarely on everyone’s agenda and “greenwashing” is being called out for the chicanery it is. We proactively seek companies with Sustainable Business Advantage drivers and our philosophy means we have 97% capital overlap between Global Leaders and Global Leaders Sustainable – the only difference being the application of a set of negative screens to help capture a broad set of values we have been asked to help clients with. We view these portfolios as one strategy, both are Article 8 under the EU’s SFDR taxonomy, and believe that the near 100% overlap supports our view that Global Leaders in either version is a very sustainable strategy. We often talk about getting our macro views from the companies in which we invest and one message has become very clear throughout 2021: inflation is everywhere. Raw materials, commodities, energy, shipping, logistics, wages and even import duties in post-Brexit Britain are all up meaningfully over the past 12 months. Any company that cannot pass on cost rises into price right now isn’t trying, doesn’t know how or simply has a bad business. This is probably the easiest environment to get price rises through since Mick was a little boy back in the 1970s! We talked about this impact into Global Leaders in our September investment letter (link) as we require pricing power for the protection it brings to cash flows from the eroding effect of inflation. While we do not attempt to predict the macroeconomic environment, our investment philosophy leads us to invest in a portfolio of companies with relative protection in such an environment. We are fast approaching the seventh anniversary of Global Leaders in May 2022 and we would like to thank our readers and co-investors in the strategy. We suspect much turbulence lies immediately ahead and this can often throw up opportunity for the far-sighted investor. We are optimistic about our current investments and hope to add a couple more “beautiful” companies in 2022. We are pleased to share some detail on our individual investments in this review, including companies that helped and hurt our performance, and those that we have bought and sold in 2021. Please do reach out to us with any further questions and once again thank you for your continued interest and support and we wish you a healthy 2022. Mick, Bertie and the Global Leaders Team Past performance is not indicative of future results. Returns greater than one year are annualized. The composite performance shown above reflects the Global Leaders Composite, managed by Brown Advisory Institutional. Brown Advisory Institutional is a GIPS Compliant firm and is a division of Brown Advisory LLC. Please see the Brown Global Leaders composite disclosure for more information. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
Returns for our Investors
The Global Leaders Strategy Composite (net of fees) generated a 17.0% return in 2021 on top of
20.2% in 2020 and 34.2% absolute return in 2019. This compares to the benchmark returns of
18.4%, 16.0% and 26.5% respectively.
Trailing three-year Global Leaders Composite absolute performance (net of fees) is 88.7% vs the
benchmark’s 73.8% return.
Since inception in May 2015, Global Leaders has compounded at 14.3% absolute return per
annum (net of fees) compared to 10.6% for the benchmark, and more than doubled investors’
money over that period (see chart below).
This translates to 375 bps per annum (net of fees) relative outperformance since inception.
Source: FactSet®. Past performance is not indicative of future results and you may not get back the amount invested. The primary benchmark is the FTSE All-World
Net Index. The composite performance shown above reflects the Global Leaders composite, managed by Brown Advisory Institutional. Brown Advisory Institutional
is a GIPS Compliant firm and is a division of Brown Advisory LLC. Please see the Brown Advisory Global Leaders disclosure statement at the end of this presentation
for a GIPS compliant presentation.
We sit down with our coach every year and look at how our capital allocation from sizing played out.
While strategy returns were up 17.0% in absolute terms, slightly behind our benchmark, our 2021 report
card was not at the level of recent years. We have generated alpha from both investment selection and
capital allocation since inception but in 2021 the verdict was more mixed, our top 10 largest holdings
only had 3 of our top 10 percentage winners, that said our top 10 biggest percentage winners all
contributed over 100bps each. Helpfully our 10 bottom performers in percentage terms only included 3
of our largest 10 weights and only 1 of our smallest ten weights was a top percentage returner. We also
look at how our strategy would have performed had we simply equal weighted our investments; in 2021
our sizing was a positive contributor.
BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosuresIn 2021 our stock selection hit rate 1 was for the first time in years a bit of a headwind to performance. We were invested in 33 companies in total throughout 2021 of which only 12 outperformed the benchmark. At our offsite in 4Q 2021 we analysed our hit rate since inception and our talented analyst team are running at a 67% hit rate in absolute terms and measured relative to the benchmark it is just over 55% 2. We believe this is a top decile hit rate over nearly seven years, although 2021 was not a vintage year. It is some small consolation that our 36% hit rate was still better than the 32% seen in the index as the top ten absolute contributors alone (including Tesla, Nvidia, Apple, Microsoft and Alphabet) drove nearly one-third of the benchmark’s 18.4% return. Information Technology continues to perform strongly for the strategy with three of our top five contributors for 2021 in this sector. Our largest relative underperformance for 2021 came from financials, the sector which remains our second-best since inception. We have a differentiated positioning in financials with high exposure to emerging markets and essential financial infrastructure such as stock exchanges. Our emerging market financials have been a relative detractor to performance this year as the market favoured developed market interest rate sensitive financials, where we have limited exposure. We continue to see meaningful potential in these high-quality investments as they continue to increase market share and compound their competitive advantages from a financial and sustainability standpoint. Relative Attribution – Top Five: Microsoft, Marvell, Alphabet, Intuit and Charles Schwab Microsoft Corporation For the third year in a row Microsoft was our top alpha contributor in 2021 adding 444 bps to absolute performance. Microsoft Cloud driven by Azure continues to scale profitably and underpins multiple growth drivers. Last year we noted that Microsoft’s services including Office 365, Teams, OneDrive, Dynamics, Windows OS, Windows Server amongst others have become “staples for the enterprise” but, as evidenced in our own business, small and medium sized companies can benefit too. Many online small businesses rely as much on Microsoft as they do on Shopify for their website or Intuit for their accounting software. Microsoft showed its latent pricing power in 2021 when it lifted price an average of 15% for a range of products including Commercial Office 365 (their cloud-based productivity apps like Excel and Teams). This was the first price increase in 10 years, during a period of immense value generation for clients. Microsoft appears relatively less impacted by gathering regulatory concerns than other large tech peers (so far) having been through the ringer 20 years ago. Over the past five years we have consistently had to upgrade our base case scenario towards our prior bull case range and did so once again in 2021. We continue to see a double-digit internal rate of return (IRR) with moderate downside and a long runway for growth by creating value for customers. Marvell Technology This is the second year running Marvell has been a top five alpha driver. Just six months after first investing in July 2018 we had to do an uncomfortable -20% drawdown review back in December 2018. The decision to buy more is one of that rule’s best outcomes to date. Since then the share price is up 600%! For sure we have had some good luck but no doubt as our coach would point out it was good process too. We spoke with Matt Murphy the CEO of Marvell in mid-December and our discussion focused on his team’s capital allocation over the past five years. Their decision to invest material research and development (R&D) dollars into autos, 5G, data centre storage and 5 nanometre process technology whilst cutting costs in 2017 and 2018 have paid off handsomely through 2021 and should continue to do so over the next couple of years. We wrote about a number of the fundamental underpinnings of Marvell in our 2020 calendar review (link) but the recent upgrade in long-term revenue growth outlook from 12- 16% post-Inphi acquisition to 15-20% at the September 2021 Investor Day is from investments made 1 The hit rate is based on a Global Leaders Representative account and is provided as supplemental information. Please see the end of the presentation for a GIPS compliant presentation. 2 Ibid, footnote 1 BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
multiple years back as well as smart mergers & acquisitions (M&A) along the way. Marvell’s products typically have long lifecycles and we would not be surprised to see revenue growth in the long-term 15- 20% range even after management forecast growing ~30% in 2022. This underpins a double-digit IRR. Alphabet We have been invested in Alphabet since 2015 and after being one of our worst detractors in 2020 it has been one of the biggest positive contributors both in relative and absolute terms to performance for the strategy in 2021. Since we first invested it has delivered ~27% IRR per annum over the past six years and most certainly not in a straight line. Alphabet’s core Google search business is the definition of a self-reinforcing two-sided network providing value to both sides as the network gets bigger. After a pandemic stimulated Pavlovian pause to spending in the first half of 2020 we have seen digital advertising roar back as societies migrated personal and work practices online. We believe that the customer outcome for both sides of the network is too compelling to go elsewhere with improvements in underlying algorithm increasing both advertisement effectiveness and search relevance. The auction- based clearing of inventory means the market sets prices, not Google. Google Search faces a number of investigations into its business practices and we recently wrote about some of our views on regulation in our latest Global Leaders investment letter (link). We are watching developments closely here and our investigative research team do an admirable job of keeping us in touch with likely regulatory outcomes. Intuit We first invested in Intuit in the depths of the market throes of March 2020 and it has been a strong alpha contributor ever since. Intuit is the industry leader for online tax fling with TurboTax and in small business accounting software via Quickbooks. Over the past two years it has added to its portfolio of services for individuals and small businesses through the acquisitions of Credit Karma and Mailchimp, both of which appear to accelerate growth as their data driven insights bring additional benefits to clients. We believe that a strong sustainable business advantage and relentless focus on solving customer problems underpins its growth. Intuit was a top five alpha contributor for 2021 and top 10 in 2020. Charles Schwab We have been invested in Charles Schwab since the launch of Global Leaders in 2015. In 2019 Charles Schwab was in our bottom 5 detractors and we topped-up twice on -20% drawdown reviews so its pleasing to see it in the top 5 contributors for 2021. Charles Schwab is the leader in the US online retail wealth management industry with a strong and well-respected management team, client focused culture and brand. Schwab has a popular customer outcome with the widest choice of investment options often at the lowest price resulting in it continuing to grow net new assets in the mid-single digits on an almost $8 trillion asset base. Ongoing innovation includes its move to commission free equity trading and allowing “stock slices” or fractional shares so investors can own any of the S&P 500® companies for just $5 rather than needing to buy a full share which may cost thousands. The recent acquisitions of TD Ameritrade and USAA are both synergistic expanding Schwab’s meaningful scale benefits versus competitors. Newer fintech rivals like Robinhood have not materially impacted Charles Schwab, in fact the publicity seems to have been an opportunity with the average age of Charles Schwab clients declining over the past couple of years. Due to clients’ cash on its balance sheet, Charles Schwab has the strongest sensitivity to interest rate rises within our portfolio but carries next to zero credit risk unlike traditional banks. We estimate net interest income on these cash balances drives approximately half of revenues and is a significant additional driver on top of its core, vertically-integrated asset management business and one which we are happy to be exposed to in today’s inflationary environment. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
Relative Attribution - Bottom Five: Tencent, Safran, Visa, AIA, and Electronic Arts Tencent Holdings Tencent has switched from one of our top contributors in 2020 to being in the bottom five over 2021. There was a widespread selloff in Chinese technology companies as the Chinese Government stepped up regulatory oversight of online platforms in 2021 with a slate of new laws on anti-monopoly, personal data privacy, data security and fintechs. The new policies introduced were part of a wider effort to bring the internet sector into existing regulatory frameworks as the sector has grown considerably over the past two decades to where it now plays an important role in China’s economy. Historically local provinces in China had leeway when it came to enforcement of new central policies and latitude to allow “grandfathering” of previously allowed business practices; not so this time and strict implementation is being centrally monitored. To complicate matters more, the geopolitical tension between the U.S. and China in addition to the SEC approving the Holding Foreign Companies Accountable Act further lowers international investor sentiment towards the sector. Tencent operates some of the most successful digital tech platforms in China and is one of the most successful venture capital investors in the country. Tencent alongside a number of its associate investee companies (JD.com, PDD and Meituan) are impacted to varying degrees. We re-calibrated our base case probability and fundamental assumptions based on these announcements yet we continue to see significant risk-adjusted potential for Tencent. The company has a good track record in being regulatory compliant with its business practices and has been conservative when it comes to the monetization of its platform. The Chinese government seeks technology independence from the U.S., particularly in semiconductors and other “hardcore technology”, and it is our view that they want to regulate their internet champions not to destroy them. We conducted a drawdown review on Tencent in late June and added on several occasions during the turbulent July and August period. A drawdown review is designed to help us overcome loss aversion, a classical behavioural investing mistake. We therefore have a rule that when an investment falls -20% from purchase or underperforms by -20% vs. the benchmark over the trailing 12 months, we must buy more or sell completely. Even after lowering our probability for reaching our base case scenario, we believe Tencent has a very attractive double-digit expected IRR on a five-year investment horizon. Safran Safran saw its share price fall 13.2% in in USD terms over 2021 on the back of firstly the Delta variant then Omicron delaying a return to normalised air travel. It has now appeared in our bottom five detractors for the past two years. So a reasonable question might be “why are we still invested?” Safran’s serviceable fleet skews to short-haul narrow-body aircraft which are predominantly driven by domestic and leisure travel that we expect to recover earlier than either business or long-haul travel. Last year we noted that Safran has a near monopoly in narrow-body engines and a young fleet with little retirement risk. So far this has proven to be true and was reinforced by management at the company’s Capital Markets Day in December 2021. Our base case remains on-track for a recovery in air traffic to 2019 levels in 2023 and this is in line with Safran’s management. Once an engine is on-wing there is a very long-term (up to 25 years) predictable cashflow profile. Our investment is about the next ten years of cashflow harvesting, not the past two COVID interrupted ones, as the CFM56 generation of engines and the new LEAP engines come in for their overhauls. We expect peak shop visits for the CFM56 engine in the 2026 timeframe, outside the typical investor’s time horizon, and this should drive the FCF generation for our double-digit IRR. We have added more to our investment in Safran during 2021. Visa and MasterCard Visa and MasterCard have both been in the portfolio essentially from inception and combined have generated absolute IRRs of over 20% and nearly 24% per annum respectively, however, 2021 was not a The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
banner year for either investment. Investor concerns increased in 2021 due to: (i) platform e-retailers
such as Amazon seeking to renegotiate fees in a very public fashion, (ii) the growth in new forms of
money transfer such as Account-to-Account (A2A), Buy Now Pay Later (BNPL), cryptocurrencies and
the Federal Reserve’s fast payment service FedNow all of which may divert transactions off the
traditional rails, (iii) the success of digital wallets and semi-closed loop payment platforms such as
ApplePay, PayPal and Square’s Cash App due to the acceleration in consumer e-comm during the
pandemic, (iv) regulatory threats such as the DOJ Civil Investigative Demand focused on Visa’s alleged
limitation of merchants’ ability to route debit card transactions over regional PIN debit networks, (v)
growing rebates and incentives to issuer clients rising as a percentage of both gross and net revenues,
and (vi) a slow resumption of cross border travel. All these fears combined to see both shares
underperform materially in 2021.
Without digging into every issue, we believe that a number of these concerns are misunderstood and
others temporary. A couple of our thoughts include:
What might be the impact of the FED’s launch of FedNow same day payments in the U.S.?
Equivalent real-time payments services in the U.K., Europe and Australia mostly replaced
cheques and peer-to-peer cash payments (N.B. for ex-U.S. readers, cheque remains a dominant
form of payment for U.S. small businesses). Offsetting some of this tap-to-pay or contactless
payment only really got going in the U.S. under COVID.
Will BNPL – which is essentially an alternate method of extending short-term credit – undermine
the payment rails? BNPL is misunderstood as negative when in fact it is positive for transaction
volumes. Today 90% of BNPL loan repayments are four debit card transactions – the net
economics of one credit card transaction lost and four debit card transactions gained is a
tailwind to Visa and Mastercard, but if these repayments switched off card to direct bank account
debits it would slow growth. We believe most people will use their debit card rather than give their
bank account details to retailers.
Cross border travel and net revenue yield compression are in part connected issues, a cross
border transaction is significantly more profitable for the networks due to added costs including
fraud protection. Thus far when borders have reopened, consumer travel has immediately
rebounded and the vast majority of both networks’ cross border travel revenue is from
consumers not business travel. The most important driver of yield (due to mix) and revenue
growth over the next couple of years is expected to be the resumption of cross border travel.
However, if travel rebounds yet rebates and incentives paid back to issuers go up or mix doesn’t
improve the realised net yield then this will raise legitimate questions about the power of the
networks and ultimately raise the question “are their moats narrowing?” We will be watching
closely for evidence either way.
We have over 10% of the portfolio invested into these two payment networks and the crux of all these
issues comes down to “will we care in 4- or 5-years’ time?” It is not our belief that individually any of
these concerns will materially impact volume growth or fee rates over that period, however, the concern
is if collectively they will dent revenue growth. It is our belief that a number of the aforementioned
concerns are misunderstood and others temporary. The companies will do what they have historically
done and leverage the breadth of the “network” to play a role in all forms of new payment flows,
maintaining or increasing their strong market positions. We added to both investments during 2021.
AIA Group
AIA Group is another investment which has been with us since launch nearly seven years ago. AIA traces
its roots back to Shanghai in 1919 and returned to Mainland China in 1992 following the government’s
economic reforms and the opening up of the financial sector. It was the first foreign company with a
wholly-owned life insurance subsidiary in Mainland China. AIA China enjoys advantages over rivals as it
has always had full control owning 100% of its operations in China. AIA has significantly increased its
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of
action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not
be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective
basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients.
BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosurescompetitive position within China over the past three years as it has gained approval for operations in seven out of 31 provinces, up from four when we first invested. Over the next five years we believe that AIA could get approval to start business in one or two new provinces each year. They currently don’t even operate in the third, fourth or fifth biggest provinces by gross domestic product, nor the fourth or fifth by gross domestic product per capita. When we first invested, AIA China was the fifth biggest operation in the group behind Thailand, Hong Kong, and even Singapore – it is now the largest with what we believe is a huge runway still ahead. Importantly, AIA China are not even fully penetrated in the provinces in which they do operate today. In Guangdong they are present in 14 out of 20 prefecture level cities and only seven out of 13 in Jiangsu. China, which is only 60% urbanised, has 50 urban areas with over two million people out of 260 built-up urban areas globally; the U.S. has 26 urban areas over 2 million but is 82% urbanised (see: http://www.demographia.com/db-worldua.pdf). It takes time to scale in these new areas as AIA runs a high-quality tied agent strategy so it typically takes roughly two years to start generating positive value of new business. We are in no rush; we think we will get paid to wait and let management do the compounding for us. We increased our investment in AIA during 2021. Electronic Arts We have been invested in Electronic Arts since Nov 2017 and whilst it has gone up in absolute terms 23% this is only a 5% IRR over the past four years. It has underperformed our benchmark and been a drag on strategy performance on a relative basis. This is a little frustrating for an investment that was a clear beneficiary of lockdowns and quarantines under COVID-19 and currently benefits from a games console cycle with new PlayStation and Xbox hardware which historically drives EA game sales. The main attractions of our original EA investment thesis remain in place. The company currently enjoys a unique position in sports video games with exclusive rights across football (a.k.a. soccer for Australians and Americans), Formula 1, ice hockey, American football and other sports through its annual FIFA, F1, NHL and Madden NFL titles. We estimate that total sports content generates >60% of EA’s free cash flow from either annual updates such as FIFA 22 alongside regular fantasy league style Ultimate Team add-ons each season. Ultimate Team, of which FIFA Ultimate Team is the largest part, represented 29% of 2021 revenue but considerably more of profits due to its strong margin profile. This is more akin to an annuity business not the hit driven model seen at rival games publishers. However, content licenses and royalty payments bring periodic renegotiation risk and despite a web of over 300 individual licensed partners giving access to over 17,000 athletes across 700+ teams, in 100 stadiums and over 30 leagues around the world FIFA announced in October that they are looking to expand partners in their gaming portfolio and in e-sports. We recently saw a potentially analogous scenario when Disney partnered with a second studio removing EA’s exclusivity for Star Wars games but continues to release Battlefront, Squadrons and Jedi Fallen Order with EA. It is not yet clear what FIFA’s game plan is. Additionally, despite standout success with battle-royal format Apex Legends which is on track to generate over $1bn since release, recent acquisitions of Glu Mobile, Metalhead and Playdemic mean future cashflows incrementally rely on mobile gaming – a difficult market in which EA have struggled in the past. If EA management gets mobile right we think the shares show a five-year 13% IRR but future mobile gaming cashflow is undeniably lower probability and probably shorter duration than the core sports content. Name turnover in the portfolio continued at a low level with three entries and three exits in the year. Over the past five years average annual name turnover has been 12% 3 implying a holding period of over eight years. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. 3 Ibid, footnote 1 BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
New investments initiated: Adobe and B3 Adobe Adobe is the leader in digital content creation, management and delivery, a massive and growing opportunity. The Creative Cloud division home to Photoshop and Illustrator now has the most comprehensive portfolio of tools for developing online content and is offered on a subscription basis as a complete solution suite. We believe that both number of subscribers and like-for-like revenue per user growth can continue. The Document Cloud division which contains the company’s first and most widely known product, Acrobat, is also transitioning to a subscription business model. Adobe was founded in 1982 to solve then rampant WYSIWYG (“what you see is what you get”) printing problem, of accurately translating text and images from screen to printed page. We believe that the ease of use of the PDF file format across any device and operating system alongside digitalisation of paper processes such as signing legal documents makes this standard format invented by Adobe’s founders nearly 40 years ago more relevant than ever. The Digital Experience division enabling customers to manage and deliver relevant content for personalized customer journeys has long-term opportunity but the most competition too. Adobe provides essential solutions to businesses as they migrate online; there are plenty of businesses globally either not online properly, not creating engaging online content yet or not fully converted paper to online processes. Adobe is one of the highest quality franchises in global software, with a premier Sustainable Business Advantage driver. It was not until March 2021 that its valuation became attractive to us. We estimate a 75% probability of getting our base case five-year double-digit IRR. We reallocated capital from Aspen to Adobe based on higher return on invested capital (RoIC), growth and IRR. B3 – Brasil, Bolsa, Balcao We initiated a new position in the Brazilian exchange B3, our first investment in Latin America, during the 3rd quarter of 2021. We believe that B3 is a unique piece of financial infrastructure. The company was established through the merger of the Sao Paulo Stock Exchange and the Brazilian Mercantile and Futures exchange in 2008 and subsequently the acquisition of Cetip, Latin Americas largest central depository in 2017. B3 is Brazil’s leading exchange that operates vertically integrated pre- and post- trading businesses in trading of cash equities, fixed income and listed derivatives. As an exchange B3 has some attractive features such as high barriers to entry in the form of powerful network effects, combined with high switching costs. These are combined with scale benefits which help drive strong cash flow generation and high incremental RoIC. B3 benefits from a number of secular growth trends including deepening local capital markets and increased domestic investor participation in existing and new products such as OTC instruments and data analytics. Despite B3’s prominence in equity trading, the majority of revenues are derived from more stable and recurring post-trading activities which is similar to our investment in Deutsche Boerse. We had been watching B3 for a long time and after a significant share price correction we believe we could finally see a double-digit IRR even when using a 15% weighted average cost of capital (WACC) to allow for country and currency depreciation risk in the Brazilian market. Investments Exited: Brown-Forman and Aspen Technologies Aspen Technologies Aspen Technologies was a successful albeit short-lived investment in Global Leaders. Having only been a holding since April 2020 the share price had reached our long-term target much faster than expected and we decided to allocate the capital to Adobe and what we believe to be a higher IRR opportunity. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
Aspen’s share price had appreciated by approximately 75% from when we invested last April, however, we had not materially changed the fundamental assumptions in our base case. Our base case IRR had fallen to low-to-mid-single digits on a five-year view. When comparing Aspen to Adobe from a franchise quality perspective, we felt the probability of getting our base case (67% at Aspen but 75% at Adobe) was higher, and favoured Adobe on valuation with double-digit base case IRR in March 2021. Typically, when we have decided to swap capital from one investment into a higher IRR idea we have more often than not sold too early but mostly these swaps have worked out well as the buys have outperformed the sells. Aspen is back on our Ready-to-Buy list at a better price. Brown-Forman In August we exited Brown-Forman, a portfolio holding since 2015. We continue to believe that Brown- Forman has a strong franchise with Jack Daniels, excellent distribution capabilities and a high-quality management team. Nevertheless, even assuming ongoing growth and margin improvement back to near peak profitability levels, we still only saw a low-to-mid-single digit 5-year IRR as European tariffs and input cost inflation have eaten into gross profits. Therefore, we decided to allocate the capital into the initial investment into B3. There is nothing broken at Brown-Forman and it has gone back on to our Ready to Buy list as we would like to invest again at a more attractive valuation level. Investments bought and sold: Fair Isaac We invested in Fair Isaac (FICO) during March. Thirty years ago, FICO began aggregating information from credit bureaus into a single published score for consumer creditworthiness – the eponymous FICO Score. Fair Isaac now holds a quasi-monopolistic position in credit decisioning, monitoring and marketing in North America, in part due to its regulatory mandated use in securitised mortgages. We believe that Fair Isaac has an amazing customer outcome for the financial companies which rely on its scores to reduce default and delinquency risk within their lending portfolios. Consumers can also benefit as improving one’s FICO Score materially improves both access to credit and better credit terms. The score helps both sides of the network make better decisions. Approximately 90% of consumer loans across all categories in the U.S. use a FICO score. Our key investment thesis rested on GDP like, mid- single digit volume growth and more importantly double-digit pricing growth as price continued to catch up with years of investment. The FICO Score is embedded in decision workflows and there is little incentive to switch given mandated use in mortgages, the price (approx. $2-3 per mortgage for a housing loan costing thousands) and lack of a more accurate alternative. The biggest risks to our investments are most commonly the durability of the customer outcome and regulatory risk. Fundamental, ESG and investigative research analysts conduct meaningful amounts of ongoing primary research in an effort to understand the unfolding opportunities and risks for each investment. Our biggest risk for the Fair Isaac investment case was regulatory changes leading to increased supply-side competition for FICO around the U.S. Federal Housing Finance Agency’s (FHFA) review process to potentially open up FICO’s current monopoly in mortgage credit scores to more competition. Supply-side risk is one we are always wary of – most especially for a regulatory monopoly – and we must calibrate any risk in our base case accurately. Our base case probability deteriorated on (1) VantageScore passing an accuracy test by the FHFA although not (yet) approved for use, (2) our investigative work showing that switching costs between scores are lower than we understood for smaller lenders via automated underwriting systems at Fannie Mae (DU) and Freddie Mac (LPA), and (3) historical data may not be as important as we had believed. Coincidently we saw a mortgage score standards change in September to FICO score averaging easily adopted by the industry. If the FHFA approves VantageScore in any form then other agencies may follow suit so that personal, credit card, and auto loans start to accept VantageScore as a reasonable alternative benchmark over time. This would impair Fair Isaac’s pricing power as VantageScore becomes a credible and cheaper alternative to lenders. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
We believe that most of our 20+% RoIC compounders just need business to chug along and nothing to go wrong for our investment to work out fine. In this case the probabilities had worsened after VantageScore was approved as an accurate score by the FHFA and we needed something to go right (FICO9 approval by FHFA – very highly likely) and something to not go wrong (price pressure on FICO scores from wider acceptance of VantageScore after its approval by FHFA). It is the re-calibrating of the probabilities which made this investment difficult. Our conclusion after significant primary research to help understand the potential outcomes of FHFA’s decision was that our base case still had a double- digit IRR but the probability had materially deteriorated and was no longer reflecting a skew of outcomes that we are normally comfortable with. Consequently, we exited Fair Isaac in November. Bertie Thomson, CFA Mick Dillon, CFA Portfolio Manager Portfolio Manager The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
Disclosures Past performance may not be a reliable guide to future performance and investors may not get back the amount invested. All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned. The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client. ESG considerations that are material will vary by investment style, sector/industry, market trends and client objectives. The strategy seeks to identify companies that it believes may have desirable ESG outcomes, but investors may differ in their views of what constitutes positive or negative ESG outcomes. As a result, the strategy may invest in companies that do not reflect the beliefs and values of any particular investor. The strategy may also invest in companies that would otherwise be screened out of other ESG oriented funds. Security selection will be impacted by the combined focus on ESG assessments and forecasts of return and risk. The strategy intends to invest in companies with measurable ESG outcomes, as determined by Brown Advisory, and seeks to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client. ©2020 MSCI ESG Research LLC. Reproduced by permission; no further redistribution. Although Brown Advisory’s information providers, including without limitation, MSCI ESG Research LLC and its affiliates (the “ESG Parties”), obtain information from sources they consider reliable, none of the ESG Parties warrants or guarantees the originality, accuracy and/or completeness of any data herein. None of the ESG Parties makes any express or implied warranties of any kind, and the ESG Parties hereby expressly disclaim all warranties of merchantability and fitness for a particular purpose, with respect to any data herein. None of the ESG Parties shall have any liability for any errors or omissions in connection with any data herein. Further, without limiting any of the foregoing, in no event shall any of the ESG Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) arising from use of any of the data herein even if notified of the possibility of such damages. Factset® is a registered trademark of Factset Research Systems, Inc. FTSE Russell® calculates a series of net-of-tax total return indexes where withholding tax is deducted at either the maximum rate (the rate that applies if a non-resident investor is unable to take advantage of any double taxation treaties), or the rates that apply in the presence of applicable double taxation treaties. The latter depend on the type of investors as well as on their tax residence. FTSE Russell® currently calculates standard net- of-tax indexes for two such investor types: a US Regulated Investment Company (RIC) and a UK pension fund. The FTSE All-World Developed Index is a market-capitalization weighted index representing the performance of large and mid cap companies in Developed markets. The index is derived from the FTSE Global Equity Index Series (GEIS), which covers 98% of the world’s investable market capitalization. FTSE® is a trade mark of LSEG and is used by FTSE under licence. The MSCI World Index captures large and mid cap representation across 23 Developed Markets (DM) countries. With 1,632 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. All MSCI indexes and products are trademarks and service marks of MSCI or its subsidiaries. The benchmark is the S&P 500® Index. The S&P 500 Index is a capitalization-weighted index of 500 stocks that is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Index returns assume reinvestment of dividends and do not reflect any fees or expenses. An investor cannot invest directly into an index. Benchmark returns are not covered by the report of the independent verifiers. Standard & Poor’s, S&P ®, and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc. ROIC is a measure of determining a company’s financial performance. It is calculated as NOPAT/IC; where NOPAT (net operating profit after tax) is (EBIT + Operating Leases Due 1-Yr)*(1-Cash Tax Rate) and IC (invested capital) is Total Debt + Total Equity + Total Unfunded Pension + (Operating Leases Due 1-Yr * 8) –Excess Cash. ROIC calculations presented use LFY (last fiscal year) and exclude financial services. ROIIC is calculated by dividing a company’s constant rate incremental operating income (plus depreciation and amortization) by the constant rate- weighted average-adjusted investment capital. The ratio is expressed as a percentage. The internal rate of return (IRR) is a measure of an investment’s rate of return. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. It is also called the discounted cash flow rate of return. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
FCF yield is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF yield calculations presented use LFY and exclude financial services. Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital. Enterprise Value to Free Cash Flow (FCF/EV) compares the total valuation of the company with its ability to generate cash flow. It is the inverse of the Free Cash Flow Yield. Earnings before interest and taxes (EBIT) is an indicator of a company's profitability. EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes. EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company's overall financial performance and is used as an alternative to net income in some circumstances. Compound annual growth rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment's lifespan. The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management. BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosures
Global Leaders Composite
Composite
3-Yr Benchmark 3- Composite GIPS Firm
Composite Composite Annualized Yr Annualized Portfolios in Composite Assets Assets
Total Gross Total Net Benchmark Standard Standard Composite at Dispersion ($USD ($USD
Year Returns (%) Returns (%) Returns (%) Deviation (%) Deviation (%) End of Year (%) Millions) * Millions) *
2020 21.0 20.2 16.0 16.9 18.1 Five or fewer N/A 2,428 59,683
2019 35.1 34.2 26.5 11.6 11.2 Five or fewer N/A 731 42,426
2018 -2.2 -2.8 -9.6 11.0 10.5 Five or fewer N/A 303 30,529
2017 35.1 34.0 24.0 N/A N/A Five or fewer N/A 77 33,155
2016 -0.6 -1.4 8.0 N/A N/A Five or fewer N/A 38 30,417
2015** 1.2 0.7 -4.4 N/A N/A Five or fewer N/A 24 43,746
**Return is for period May 1, 2015 through December 31, 2015
Brown Advisory Institutional claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this
report in compliance with the GIPS standards. Brown Advisory Institutional has been independently verified for the periods from January 1, 1993
through December 31, 2020. The Verification reports are available upon request. A firm that claims compliance with the GIPS standards must
establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on
whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and
distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis.
Verification does not provide assurance on the accuracy of any specific performance report. GIPS® is a registered trademark of CFA Institute. CFA
Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
1. *For the purpose of complying with the GIPS standards, the firm is defined as Brown Advisory Institutional, the Institutional and Balanced
Institutional asset management divisions of Brown Advisory. As of July 1, 2016, the firm was redefined to exclude the Brown Advisory Private
Client division, due to an evolution of the three distinct business lines.
2. The Global Leaders Composite (the Composite) aims to achieve capital appreciation by investing primarily in global equities. The strategy will
invest in equity securities of companies that the portfolio manager believes are leaders within their industry or country, as demonstrated by an
ability to deliver high relative return on invested capital over time. The minimum account market value required for Composite inclusion is $1.5
million.
3. The Composite creation date is August 26, 2015. The Composite inception date is May 1, 2015.
4. The benchmark is the FTSE All-World Net Index. This index is a free float market cap weighted index representing the performance of the
large & mid cap stocks from the FTSE Global Equity Index Series. The Index covers Developed & Emerging Markets. Base Value 100 as at
December 31, 1986. “FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to
the FTSE or Russell indexes are trademarks of the London Stock Exchange Group companies. An investor cannot invest directly into an
index. Benchmark returns are not covered by the report of the independent verifiers.
5. As of January 1, 2019, the Composite benchmark was changed from Russell Global Large-Cap Net Index to the FTSE All-World Net Index.
The change was applied retroactively from the Composite inception date. The Russell Global Large-Cap Net Index was decommissioned as
of December 31, 2018 and is no longer published.
6. Composite dispersion is an equal-weighted standard deviation of portfolio gross returns calculated for the accounts in the Composite for the
entire calendar year period. The composite dispersion is not applicable (N/A) for periods where there were five or fewer accounts in the
Composite for the entire period.
7. Gross-of-fees performance returns are presented before management fees but after all trading commissions, and gross of foreign withholding
taxes (if applicable). Net-of-fee performance returns reflect the deduction of actual management fees and all trading commissions. Other
expenses can reduce returns to investors. The standard management fee schedule is as follows: 0.80% on the first $50 million; 0.55% on the
next $50 million; 0.45% on the next $50 million; and 0.40% on the balance over $150 million. Further information regarding investment
advisory fees is described in Part II A of the firm’s form ADV. Actual fees paid by accounts in the Composite may differ from the current fee
schedule.
8. The investment management fee for the Investor Shares of the Brown Advisory Global Leaders Fund (the Fund), which is included in the
Composite, is 0.65%, and represents the highest fee charged excluding Advisor Shares. The total expense ratio for the Investor Shares of the
Fund as of the most recent fiscal year end (June 30, 2020) was 0.90%. Further information regarding investment management fees and
expenses is described in the fund prospectus and annual report.
9. The investment management fee for the Sterling Class B Acc Shares of the Brown Advisory Global Leaders Fund (the UCITS), which is
included in the composite, is 0.75%. The total expense ratio for the Sterling Class B Acc Shares of the UCITS as of the most recent fiscal year
end (October 31, 2020) was 0.92%. Further information regarding investment management fees and expenses is described in the fund
prospectus and annual report.
10. 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 December 31. The 3-year annualized standard deviation is not presented as of December 31, 2015, December
31, 2016 and December 31, 2017 because 36 month returns for the Composite were not available (N/A) and the Composite did not exist.
11. Valuations and performance returns are computed and stated in U.S. Dollars. All returns reflect the reinvestment of income and other
earnings.
12. A complete list of composite descriptions and broad distribution and limited distribution pooled funds is available upon request.
13. Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request.
14. Past performance is not indicative of future results.
15. This piece is provided for informational purposes only and should not be construed as a research report, a recommendation or suggestion to
engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy,
including whether or not to buy, sell or hold any of the securities mentioned, including any mutual fund managed by Brown Advisory.
BROWN ADVISORY GLOBAL LEADERS REVIEW Please see the end of this letter for important disclosuresYou can also read
