HL Select Global Growth Shares - Q2 2022 Review

Gareth Campbell - Fund Manager

1 August 2022

Market Review

The second quarter of 2022 saw global equities enter a bear market for the first time since the start of the pandemic, as inflation continued to move higher, interest rate expectations increased, and concerns grew around the risk of a recession. The weakness was led by small cap, technology, and growth stocks. This has made for a challenging start of the year for the HL Select Global Growth fund.

Inflation has been higher and longer lasting than we expected as the pandemic’s impacts continue to linger. Labour availability, and its cost, is a key flashpoint, whilst many supply chains are still not functioning as efficiently as they should. Whilst these factors prevail, bringing inflation back down will continue to be a challenge. The longer inflation remains high, the greater the risk that wage inflation becomes more persistent. This has forced central banks to act, raising interest rates more quickly than was previously expected.

Many macro-economic indicators are looking weaker, but a resilient consumer, and positive employment, means that economies are currently absorbing these challenges. The big question is whether central banks’ actions will push economies too far, leading to recession.

We have seen nothing to change our view than inflation will moderate as the impact of the pandemic declines and supply chains normalise, even if this is at a slightly higher level than prior cycles. We do think the likelihood of a recession is increasingly high, which would limit further increases in long-term interest rate and inflation expectations.

The market Price / Earnings multiple (P/E) has fallen from above 19X at the start of the year, to 14.5X at the end of Q2. A fall in long-term inflation and interest rate expectations should limit further multiple compression, enabling company fundamentals to be a larger driver of stock performance.

At HL Select we focus on businesses with pricing power to help protect long-term margins from inflation, resilient business models with limited cyclicality and secular growth drivers. This should enable companies to grow faster than the wider economy. We believe this means that over the long term we are well positioned to succeed during uncertain economic times, though as always there are no guarantees.

Performance Review

The HL Select Global Growth fund returned -13.96%* during the quarter compared to the FTSE World index return of -9.07%. The US was our largest negative geographic contributor to performance, with Information Technology, Industrials and Consumer Discretionary sectors the largest negative contributors to performance.

Since launch the fund has delivered a total return of 29.36%, compared to the FTSE World index of 33.66%. Past Performance is not a guide to future returns.

Past performance is not a guide to the future. Source: *Lipper, to 30/06/2022.

N/A means performance data for this time period isn’t available.

Positive and Negative Contributors to Performance

Our negative relative performance was a combination of stock selection within the Healthcare, Industrials, and Financials sectors, and a large allocation to Information Technology, which has continued to be weak. Additionally, there was an underweight position in Energy and Consumer Staples.

We believe a large exposure to technology-related stocks is warranted, given how digital disruption is impacting almost all industries and as technology plays an increasingly important role in all our lives.

The strong performance of consumer staples is unsurprising given historical trends, but we think that many have weaker barriers to entry than prior cycles, which will limit their pricing power, whilst their lower growth potential means they look less attractive, longer term, than many other businesses in our portfolio.

Having no holdings in the Energy sector has been a costly omission year to date, but it is challenging to find businesses that have optionality from higher oil prices and meet our definition of quality. We do recognise that justification for higher oil prices in the future is stronger than in the past, but equally the higher likelihood of a recession could limit more bullish forecasts of an oil supercycle.

Stock-specific issues are discussed in more detail below.

Positive Contributors

Given weak market performance, there were few positive contributions to the fund.

CAE is benefiting from a recovery in global air travel, while its defence business will likely benefit from increasing defence spending after Russia’s invasion of Ukraine.

Phreesia has rallied strongly since May to end the quarter as one of our better performing stocks over the period. We believe this was more down to sentiment reversing from an extreme negative, versus any changes in the underlying business, as fundamentals have been tracking ahead of our expectations.

Compass continues to execute well despite the challenges to the business from greater home working. We trimmed our position in June, after a period of strong performance, to fund new ideas that we believe can deliver a better risk adjusted return.

Negative Contributors

GXO Logistics stock and business performance since November have been vastly different. The business has raised guidance and acquired a competitor at attractive financial terms. The stock during this period has underperformed substantially, we believe this is due to concerns about the European economy, a slowdown in e-commerce, and a low margin business that would leave it at risk from inflation.

Our analysis and conversations with management mean we continue to think the market is mispricing the durability of growth, and that concerns around inflation are misplaced given many contracts allow them to pass-through these costs.

We will be closely monitoring its upcoming earnings to see if recent results deviate from our investment thesis and if risks around inflation have worsened. If not, it looks very attractive given the long-term secular growth opportunity from outsourcing.

Booking.com continues to execute well and is benefiting from a recovery in global travel. There are some concerns around competition, financial health of the consumer and if it is experiencing excess demand post-pandemic that is not sustainable. We will monitor how these risks evolve in the coming months. We trimmed the position early June to fund new ideas.

Charles Schwab shares have had a disappointing 2022, despite interest rate expectations increasing, which should be positive for earnings. It also has less credit risk than a typical bank, limiting downside in a recession. We still like the business longer term but reduced our holding in early June.

Zebra Technologies is a business that enables industrial automation, so has suffered from similar concerns that have impacted GXO Logistics. As it has a high proportion of equipment sales, we think there is greater risk to the business in the short term and have reduced our position size. Long term we still see Zebra as a key supplier to a persistent and durable industry change.

Amazon shocked the market at the end of April as it told investors it had excess capacity, which would limit margins. This increased concerns about any businesses tied to e-commerce.

New Positions

Aptiv is one of the largest component suppliers to most of the world’s car manufacturers. It specialises in two areas: electrical systems and active safety products. The design of cars is going through something of a revolution, and these two areas are both crucial for the industry to transition to electric cars and achieve autonomous driving.

Firstly, consumers and governments are increasingly looking to electric cars rather than petrol- or diesel-powered cars to get them from A to B. As car powertrains shift from fossil fuels to batteries, the amount and robustness of car wiring will likely increase.

Secondly, while safety improvements are nothing new, the race among manufacturers towards ever more automated vehicles in order to achieve this has accelerated. The level of automation on most cars is currently relatively low, many cars have anti-lock brakes and cruise control, but only high end, new cars have even intermediate levels of automation such as active braking and lane control. As computer power has grown, we believe this is set to rapidly evolve over the coming decade.

The auto sector is very cyclical, but new car sales are currently depressed due to the semiconductor shortage impacting the industry. We think this means that volumes will be more resilient than in previous cycles, increasing our comfort in making an investment with strong secular growth, despite the potential for industry headwinds from a recession.

Aptiv has strong and long-standing partnerships with its car-making customers. It has also been collaborating with them for a number of years already on how to approach these challenges. Its scale and accumulated skills and technologies mean it is well positioned to continue to offer its customers the great products they demand. We believe these factors put Aptiv in an ideal position to benefit from the growth we see ahead.

West Pharmaceuticals are a major global manufacturer of elastomer components (the rubber end of an injectable drug vial) and other components used in the packaging and delivery of injectable drugs.

We held West Pharmaceuticals at launch but sold the position in November 2020 after a period of exceptional performance during the pandemic, which at the time we didn’t think was sustainable.

Since then, the role West Pharmaceuticals products play has continued to grow, and the business saw rapid growth in revenue and margins, helping to justifying its very high valuation.

The pandemic will still influence the business, but we think revenue is likely to be more resilient than businesses exposed to testing, as there is a trend from multi-dose to single vial dosing for vaccines. So even if there is a fall in the number of vaccines, this may be offset by an increase in the number of vials produced, a positive for volumes at West Pharmaceuticals.

Since the start of the year the business has sold off with other high growth and high multiple stocks, we thought this created an attractive entry opportunity for a business we have always liked but couldn’t previously justify the valuation.

Experian is a leading global credit bureau and data analytics business, helping banks and other businesses make more informed lending decisions.

We see Experian as one of the highest quality businesses in the UK, with high margins and very high barriers to entry.

Fundamentals have so far been strong but weakness across high multiple and high growth stocks created an attractive buying opportunity.

The reduction in funding from private markets has also likely reduced the threat of new entrants or technologies that could have eroded barriers to entry longer term, we don’t think this is well appreciated by investors.

Sold Positions

Masimo announced the acquisition of Sound United in February, causing a sharp fall in the share price as investors questioned the strategic rationale of the deal.

We still think the base business is excellent, and there is substantial optionality from new products and upcoming litigation with Apple, but we were disappointed that management have delayed detailed information about the acquisition until their investor day in September. We no longer felt we could justify owning the position given the fall in conviction of our investment thesis.

Masimo was owned at the fund’s launch, and despite our sale price being similar to the purchase price, it has been a positive contributor to performance as we trimmed the position after strong outperformance during the pandemic.

Amedisys are one of the largest providers of home health and hospice services in the US. These businesses have strong demographic tailwinds and are favoured by both patients and payers given the lower cost of care.

Margins in the business are low but given Amedisys is reimbursed by the US government including cost escalators, we believed they were sustainable. So, although the business didn’t have pricing power in the traditional sense, sustainable margins meant we viewed the business as high quality.

In June, CMS, the main US Government organisation that sets pricing for healthcare services announced a substantial cut to pricing, despite cost inflation from labour and fuel. We agree with management that the interpretation of the situation by CMS is flawed, and patients are at risk of losing out. However, it highlighted why focusing on companies that have pricing power and are in charge of their own destiny is such a key foundation of our investment philosophy.

We corrected our mistake and sold the position after the announcement. We held the position for less than a year and do not anticipate buying it or any peers in the future. We count our experience as a lesson we hope not to repeat in the future, and thankfully it cost the portfolio less than .50%.

Portfolio Changes

In addition to the above changes, we trimmed our holdings in TriNet, CarSales, Visa, Fiserv, Microsoft and Diversey to fund new ideas in the portfolio.