HL Select Global Growth Shares - Q2 2023 Review

Gareth Campbell - Fund Manager

15 August 2023

Market Review

Investors began Q2 with heightened concerns of a recession and expecting US interest rates to be cut by year end, but the economy has remained more resilient than expected, inflation stickier and interest rates look likely to be higher for longer.

Some industry experts have called the bear market over, are assuming a higher probability of a “soft-landing,” and that stocks are right to rally into more positive economic data. The reality of this market rally is that it continues to be driven by a relatively narrow set of large cap technology stocks and excitement around artificial intelligence.

Apple, Microsoft, Amazon, Alphabet, Nvidia, Meta and Tesla have collectively delivered over 70% of the market returns in Q2. This is rare, and we agree that the narrowness of market performance is something to be concerned about.

High inflation has taken much longer than predicted to control, but in the US, we are increasingly confident that it will finally prove to be transitory. Truflation, an inflation data aggregator, calculate current US CPI at just 2.2%. Strong labour markets remain a challenge for policymakers, but given the lagged impact of housing costs, we think it’s likely headline inflation will continue to fall.

Our longer-term concerns around the lagged impact of higher interest rates on employment and the wider economy remain. Given potentially challenging conditions, the fund remains focused on identifying businesses we think will show resilient growth through the cycle, as well as businesses that haven’t benefitted from the recent rally, but still have long-term secular growth drivers.

Performance Review

The HL Select Global Growth fund returned 4.54% during the quarter 31 March to 30 June compared to the FTSE World Index return of 3.89%. The US was our largest positive contributor, driven by Technology, Industrial and Financial sectors. Since launch the fund has delivered a total return of 48.32%*, compared to the FTSE World Index return of 51.65%.

Positive and Negative Contributors

Our positive relative performance was driven primarily by stock selection within the Industrials, Financial and Materials sectors.

Energy, Utilities and Real Estate all continued to underperform, benefitting the fund as it has no exposure to these sectors.

Our large allocation to Information Technology was a positive contributor to performance, but as our holdings struggled to keep up with the exceptional returns of the sector, it had a negative impact on relative performance.

The Healthcare sector lagged the index and our stock selection within the sector negatively impacted relative performance. This was largely driven by our most notable negative stock this quarter Cryoport, which gave up all its Q1 gains. Cryoport and other stock specific issues are discussed in more detail below.

Positive Contributors

Vulcan Materials put through price increases, while volumes held up despite continued macro concerns. This resulted in a cash gross profit per ton 23% higher than last year. This is a good example of how a business with strong pricing power can better manage during a period of high inflation.

Recent results supported our opinions from last quarter, that Vulcan’s weaker revenue guidance compared to its peers was more down to management conservatism than any difference in execution. This helped catalyse the share price and it more than recovered from its weakness in Q1, leaving the shares 23% higher YTD.

Microsoft delivered strong results with all divisions beating expectations. We think excitement around AI has also likely been a key driver of stock performance. We trimmed the position in June as it had grown above our target size.

Nvidia’s results in Q2 will be regarded as one of the most impressive beats of expectations in recent history. After a more than 200% increase from our initial purchase price we reduced our position size, as we see better risk-adjusted returns in other holdings.

GXO Logistics continued its strong performance from Q1 as positive results reduced investor concerns around the business’ cyclicality, leading to a rerating of the business.

We still think GXO looks very attractive as the pace of outsourcing remains high and we see GXO’s market share increasing as customers look for help implementing automation. For example, in the recent quarter GXO won its largest ever contract as Sainsbury’s decided to outsource its fresh and frozen supply chain.

Adobe has had a volatile 2023, with investor consensus shifting from AI being a potential threat toward it becoming a long-term opportunity for the business.

The overhang of the proposed Figma acquisition combined with the threat from AI means the shares continue to trade at what looks like a very attractive multiple. However the position remains under review as these concerns cannot be easily dismissed and for the first time there are concerns about Adobe’s long-term competitive position.

Alphabet’s recent results gave us higher conviction in the commitment to improve margins, while more successful product demonstrations helped improve sentiment around AI disruption risk. We increased our position in April given we thought concerns around AI capabilities were misplaced.

Negative Contributors

Cryoport: Following the strong gains made in Q1, this quarter’s fall means the stock is now down 5% since the start of the year.

The business itself is executing in-line with expectations. We think the weakness is driven by negative sentiment around early-stage biotech financing and its key end market, cell and gene therapy.

The biologics industry and supply chain are undeniably going through some challenges. Higher interest rates and reduced capacity for risk has caused a sharp fall in early-stage financing, while the bio-processing industry is suffering from excess inventory and some clinical failures in cell and gene therapies negatively impacted sentiment.

We think these issues are temporary and the industry will return to growth, as the investments made over the last decade all but guarantee the continued shift to biologics. Cell and gene therapy is a very nascent industry and growth won’t be a straight line, but there has been no change in experts’ opinion that these therapies are the future of medicine.

Cryoport’s exposure to hundreds of trials does help mitigate clinical risk, but until a larger proportion of revenue is from commercial therapies the business is at greater risk from negative catalysts and a change in investor sentiment.

The key risk is now execution. Management must deliver their goals for Cryoport to mature into a high EPS growth business for investor sentiment to improve.

Sartorius Stedim Biotech is a new position in the fund. It reduced guidance more than investors expected at the end of the quarter, which caused the shares to underperform. We see recent weakness as a very attractive opportunity for investors with a longer-term horizon.

Sartorius Stedim Biotech is one of the global leaders in supplying equipment and consumables used in the development and manufacturing of biologic therapies.

The main concern is that excess customer inventory has led to a fall in new orders, negatively impacting EPS. The valuation multiple has also fallen given this change in sentiment.

We have analysed existing inventory levels and how quickly they will fall in different demand environments. Simplistically all inventory has a shelf-life of typically 12-24 months, so with industry volumes peaking in 2021 to early 2022, we think the excess inventory issue will be resolved by Q4 2023 or early 2024 at the latest.

This is a short-term issue with no negative implications on the long-term value of the business, but the shares are now -60% from their highs in 2021 and only 50% above pre-pandemic levels despite a business that is twice the size it was at the end of the full year 2019.

The biologics industry is expected to grow 7%+ per annum for the next decade, and we believe Sartorius’ leading technologies and singular focus on this area will help them continue to take market share.

Capital allocation and a recovery in margins could help deliver consistent EPS growth approaching 15%, which would drive a valuation rerating and help the business regain its title as one of the highest quality investment opportunities in Europe.

Tencent had positive results but we think more general China-specific and macro-economic concerns have weighed on the stock.

New Positions

Adyen is a global payments platform based in the Netherlands. Its single technology platform simplifies the typically complex and outdated infrastructure that underpins many existing payment solutions. This has multiple advantages from lowering costs, speeding up settlement times and improving analytics to enhanced authorisation rates.

A single platform lowers operating costs and enables Adyen to have a faster pace of innovation than peers, adding new capabilities to its services and expanding its addressable market. 80% of revenue growth is from the existing customers base, as merchants grow their business or use additional services.

Despite it being an early stage business with huge potential, Adyen is also highly profitable. This has enabled it to fund its growth with no additional equity or debt, which is very different to the majority of high growth businesses.

Payments is an industry driven by economies of scale and high operating leverage. Adyen have some of the best technology and the opportunity for revenue to be 10x its current size at maturity, which is why we think Adyen is an attractive investment opportunity for long-term investors.

Motorola Solutions are the global leader in radio communications and are expanding into software for emergency centres.

Radio may be an old analogue technology, but for reliability it is unmatched. As these incidences can often be a matter of life or death, when emergency services need to contact each other, they are reliant on radio infrastructure and not mobile or Wi-Fi networks.

We see Motorola as uniquely positioned as competitors are typically part of defence companies or industrial conglomerates, while Motorola have specialised in this industry for a decade. It has been the source of almost all innovation and it vastly outmatches peers’ investments in R&D.

Virtually all of Motorola's customers use its products and services as a mission-critical component of their operation, with many funded by government spending. This makes for an economically resilient business.

We think investors underappreciate the business model change at Motorola. An increasing proportion of recurring revenue through command centre software and services are reshaping its business. We believe that these factors will accelerate revenue growth and margin expansion.

Sold Positions

Moody’s is an exceptional business, but after a period of strong performance driven purely by investors' enthusiasm for the stock, rather than any fundamental improvement in the business we thought there were more attractively valued businesses that would be more defensive in a weakening economy.

Diversey - sold the remainder of our holding as the discount to the acquisition price narrowed.

Portfolio Changes

Focus has been on reallocating capital from businesses that we think are either at risk from a weaker economy or have delivered better performance pushing their ratings to elevated levels. These funds have been directed to areas where we see a more attractive risk/reward, such as Heineken, Medtronic and Intuit.

West Pharmaceuticals was trimmed after a period of excellent performance that diverged from other companies in the biologics supply chain industry, which we think should normalise over the long term.

Our new positions and adds were funded by trims to more economically sensitive ideas such as CAE, Aptiv and TriNet, or businesses such as LSE and Compass that look less attractive after a period of good performance.

We added to Phreesia, CAE and Zebra at the end of the quarter, as we think recent share price weakness doesn’t reflect the long-term growth opportunities of the business.