HL Select Global Growth Shares - Q3 2022 Review

Gareth Campbell - Fund Manager

11 November 2022

Market Review

Unfortunately, Q3 market performance has continued to be negative across most asset classes. This is the first time the US Stock Market has had 3 consecutive negative quarters since the financial crisis. Returns for UK investors have been flattened by a weak pound, offsetting some of the market weakness.

China’s continuation of zero-covid policies and Russia’s escalating conflict in Ukraine has worsened inflation challenges, increasing pressure on central banks to raise interest rates higher and faster. There have been occasions when markets have enjoyed brief rallies on hopes that an end to rising interest rates might be in sight, but these have proved premature.

Higher long-term interest rate and inflation expectations have resulted in further P/E-multiple contraction. Consumer spending is generally holding up, and employment remains positive, but cracks are beginning to appear in global economies. We are increasingly of the view that a recession is likely, with debate more around its depth and length. This means we think the bigger risk over the next 12 months will come from company earnings, versus further multiple compression.

Central banks and large investing firms have a huge amount of intellectual and financial resource to forecast the economy, yet there is little evidence that they can accurately predict the timing or depth of a recession.

As investors can rarely accurately predict recessions, we believe the best way to deliver good long-term performance is to be ready for them by owning high quality businesses, with resilient cashflow and secular growth, so when an inevitable recession occurs, they will be well placed to emerge from it stronger.

Performance Review

The HL Select Global Growth fund returned 2.09% during the quarter compared to the FTSE World Index of 1.82%. The US was our largest positive geographic contributor to performance, with Industrials and Healthcare the largest negative contributors to performance.

Since launch the fund has delivered a total return of 32.06%, compared to the FTSE World Index of 36.09%.

Past performance is not a guide to the future. Source: Lipper IM to 30/09/2022

*N/A – Full year performance data is not available

Positive and Negative Contributors to Performance

Our negative relative performance was primarily driven by stock selection within Industrials and the Healthcare sector, along with a large underweight to the Energy sector.

Having no holdings in the Energy sector continues to be a costly omission. We are reviewing the sector to test our views on business quality as tighter supply with more stable prices could challenge our views on quality within the sector.

Technology is our largest sector, and although it underperformed the wider market, positive stock selection meant that overall, it was a strong positive contributor to performance.

Stock specific issues are discussed in more detail below.

Positive Contributors

Charles Schwab is a larger, US equivalent, of Hargreaves Lansdown. Despite the value of client assets falling alongside the market, higher interest rates are a positive for Charles Schwab’s earnings because they make higher returns on client cash balances. This makes the business a beneficiary of higher interest rates.

Autodesk is a dominant provider of architectural and design software. These are cyclical industries, but a subscription business model means we think the business should be far more resilient than prior cycles. This thesis has so far been supported by recent results.

Fiserv are a vital part of the payment’s ecosystem. Despite over 20 years of double-digit EPS growth, the business had de-rated over concerns around competition. We think these concerns were misplaced as their Clover segment shows how they can use existing infrastructure to accelerate growth of new products. The fall in valuation of early-stage businesses has substantially reduced the amount of capital attempting to disrupt the industry, while Fiserv still generate substantial amounts of free-cash-flow. We think this is not well appreciated by the wider market.

Vulcan Materials is a large supplier of aggregates to the US construction industry. We consider Vulcan Materials to have an exceptional management team focused on improving gross profit per ton through multiple regional oligopolies, which gives us a lot of confidence in its ability to navigate a more challenging economy and higher rates of inflation. Additionally, investments in infrastructure should support increased volume growth in coming years.

GoDaddy is one of the largest holdings in the fund. We have long admired its business model which enables the acquisition of new clients at low cost. Providing these clients with digital services is hugely cash generative. In recent years its performance lagged versus disruptive growth peers such as Shopify. However, over the last year this pattern has reversed and GoDaddy has performed strongly as investors appreciated GoDaddy’s consistent execution and strong FCF generation even in an increasingly uncertain economic environment.

Negative Contributors

CAE announced poor results in August which led to a 17% fall in the share price. The issues were almost all driven by the defense business and can be divided into the revaluation of two contracts and weak core margins.

Conversations with management suggest the weakness from contract revaluations are not structural, but essentially aggressively priced contracts from a recent acquisition, which unlocked outsourcing opportunities within the US armed forces. These contracts were priced too aggressively but have unlocked some very large opportunities, for example one contract if progressed from R&D to commercial stage could generate revenue of almost $1 billion CAD.

Weaker core margins were due to orders slipping, cost pressures in their supply chain and higher labour costs. Management have said to expect a recovery in the second half of the year, but given continued inflationary pressures, this is less likely to be quick fix.

The larger civil aviation business, the main reason for owning CAE, is executing very well despite limited profit contribution from Asia (historically almost 50% of operating profit). We think this leaves the business well positioned to reach record margins and profit as China begins to reduce their zero-covid strategy.

With the stock down over 30%, and defense making up 40% of the business, on a sum-of-the-parts basis it implies the defense business is worth less than half what it was before, despite historically stable margins and a huge outsourcing opportunity. For these reasons we think the shares look particularly attractive today.

Cryoport’s performance through the quarter changed dramatically in August, when concerns around inflation and higher interest rates negatively impacted higher growth stocks. Cryoport had outperformed by nearly 30% in August, but by quarter end had underperformed by 17%.

We believe the volatility of the share price doesn’t reflect a business which has large structural growth drivers, limited cyclicality and a management team that has so far executed its long-term strategy very effectively.

Biotech funding has fallen dramatically over the last year, but with over 600 clinical trials using their services and an expectation of over 10 commercial therapies within a year, we think the growth opportunity still looks very robust.

Diversey’s large exposure to Europe and natural gas input costs makes the current macro environment particularly challenging.

Management have put through 6% and 10% price increases year-on-year in Q1 and Q2 respectively, with further increases expected in Q4. This, combined with historical performance of peers means we are confident that the current pressure on margin will not be reflective of the long-term earnings power of the business.

Tencent is one of the largest tech companies in China, the business has suffered from continued lockdowns in China, political risk and weaker results in the gaming segment.

Elekta has had a challenging previous year due to cost inflation, which has a slow pass-through to pricing because of long-term contracts in their tender process. These headwinds continued in recent results, negatively impacting the shares.

Radiotherapy is essentially a global duopoly between Varian and Elekta. Competition is likely to get tougher because of the acquisition of Varian by Siemens Healthineers, who will no doubt put more resources behind Varian. However, Elekta’s Unity device is one of the most advanced piece of radiotherapy equipment ever developed and we think this will show a superior clinical profile longer term, which is underappreciated by investors.

Radiotherapy device are large capital purchases, so orders could be more at risk from a weaker funding environment in a recession. Buyers will also face a higher cost of financing as interest rates rise. We think the asset remains undervalued in comparison to peers but are reviewing the original thesis as management execution during these periods has been worse than we had anticipated.

Adobe announced the acquisition of Figma in the middle of September for $20 billion, immediately reducing their own market cap by $29 billion, as investors balked at both the high price paid and the implication of what that meant to competitive risks for Adobe’s core business.

Figma seems like an excellent product fit and will create interesting cross-selling and bundling opportunities. The share price reaction seems excessive, and the shares look attractive for their high margin growth, but we have been reluctant to add to the position given our perceived risk that the acquisition is blocked by the FTC on anti-competitive grounds.

New Positions

Heineken was our only new position added during the quarter.

Heineken is the world’s second largest brewer of beer with a history spanning over 150 years. In addition to its famous green bottled lager, it owns over 300 other brands and operates in over 190 countries.

We think Heineken has many attributes that make it an attractive investment. Much of its strength is centred on its strong portfolio of brands, which while spanning multiple price points are focused on premium brands. This is an important quality as in recent years drinkers have been happier to pay more for a superior product while moderating their consumption. A burgeoning set of low and no-alcohol beers are also playing to the theme of moderation and are a strong and growing proportion of Heineken’s sales.

Heineken’s significant presence in faster growing emerging markets in Asia, Africa and Latin America also provide strong long-term growth prospects. This growth, complemented with excellent distribution networks, durable brands supported by marketing and scale means growth should prove resilient in what is already a durable consumer category.

We see growing volumes and positive pricing as key drivers of profitability, supported by the company’s ‘Evergreen’ efficiency programme. In addition, a robust balance sheet and Heineken’s family ownership structure means that it is able to make decisions based on optimal long-term outcomes and is insulated to a large extent from short-term pressures.

Heineken has two share classes, an operating and holding company, the rights of both shares are equal, but the holding company has less liquidity. We chose to invest in the holding company, as it increases the dividend yield by over 20% and we believe the liquidity discount is excessive for a business as stable as Heineken which has been in production for almost 160 years. Remember that no dividend is guaranteed and yields are not a reliable indicator of future income.

Sold Positions

No positions were sold outright during the quarter.

Portfolio Changes

During the quarter we trimmed our position in CarSales, Booking and Zebra Technologies. We have increased concerns about consumer spending power which will impact CarSales and Booking. We think Zebra is a key facilitator of industrial automation with structural long-term growth, but there is increased risk of order delays as customers look to cut costs given recession concerns.

We increased out positions in Experian, Heineken, Teleflex and West Pharmaceutical as we think all these businesses will offer more resilient growth in more challenging macro-economic conditions.