HL Select Global Growth Shares - Q3 2023 Review

Gareth Campbell - Fund Manager

16 October 2023

Market Review

Flat market returns over the quarter hid some quite intra-quarter changes in leadership as inflation, interest rates and economic growth continue their battle to be the dominant driver of market returns.

A spike in US interest rates near the end of the quarter likely had the most important impact on quarterly returns, with technology, growth stocks and interest rate sensitive sectors all struggling during this period.

Strong employment data combined with a pickup in inflation in August kicked off a period of higher interest rates. This increased expectations that the US federal reserve will have to increase rates at least one more time to slow economic growth and deliver the “soft landing” the market has been hoping for.

Throughout 2023 inflation has proved harder to tame than central banks expected and a period of higher for longer interest rates looks more likely with the US central bank suggesting rates need to remain higher into 2024.

The US narrowly avoided it’s second debt-ceiling crisis of the year, but with increasing division within the Republican party it looks unlikely that this risk has been averted permanently. The World Bank cut 2023 global growth forecasts by more than half to 0.8% and cuts have already been made to expectations of China’s 2024 economic growth, as high debt levels and ageing demographics weigh on its post-pandemic recovery.

Despite strong market returns in 2023 so far and broad support for a “soft landing”, we remain sceptical as that confidence in a “soft landing” has preceded almost all previous recessions. Although our recession fears have not yet been realised, and we have been at best too early in our predictions, we have stayed consistent in focusing on high-quality businesses that we believe can deliver attractive returns through the cycle.

Performance Review

The HL Select Global Growth fund returned -1.48%* during the quarter 30 June to 30 September compared to the FTSE World Index return of 0.56%. The US was our largest positive contributor, driven by Information Technology, Communication Services and Consumer Discretionary sector. Healthcare, Financials and Consumer Staples were our main negative contributors to performance. Since launch the fund has delivered a total return of 46.13% compared to the FTSE World Index of 51.31%.

Positive and Negative Contributors

Our negative relative performance was primarily driven by stock selection within Financials, Healthcare and Consumer Staples. The most common theme amongst these being GLP-1s, a new type of pharmaceutical drug, which are discussed in more detail below.

Having no exposure to the Energy sector hurt performance as a rally in oil prices led to the Energy sector being the best performing sector in Q3. Despite the challenge of applying a quality growth framework to the Energy sector, we have completed some analysis on potential ideas, but risk from slowing global growth outweighed the potential value we saw in the businesses.

Our lack of exposure to Real Estate and Utilities continued to benefit the fund as a spike in interest rates caused both to underperform.

The Technology sector underperformed the wider market, but positive stock selection meant that overall, it was a strong positive contributor to performance. The fund also benefitted from positive stock selection in the Communication Services, Industrial and Consumer Discretionary sectors.

Positive Contributors

Intuit continued its strong performance YTD with growth from its small business segment offsetting weakness in its consumer segment. In September, the company held an investor day highlighting how AI can lead to an acceleration in new product areas.

TriNet reached an all-time high at the end of the quarter as the business continues to execute well despite macro headwinds to employment growth. TriNet’s management’s confidence in the business was highlighted by a tender offer to repurchase 16% of the outstanding shares.

Alphabet reacted positively to Q2 results with strong revenue and profit beating market expectations. We think it had wrongly been punished by being labelled as a laggard in the AI race, as large investments in R&D leave Alphabet well positioned for this technology shift across all areas of its business. Increased scrutiny by regulators around the dominance of the largest US tech platforms remains a concern.

Booking has continued to deliver excellent results and raised guidance. Strong free cash flow generation helped the business repurchase 5% of its shares in the first half of the year. We had previously trimmed our position given concerns around a weakening macro, but Bookings results do lend support to the view that strong consumer spending power can persist.

CarSales accelerated international expansion over the last year by acquiring the remainder of Trader Interactive, the leading US marketplace for RV’s and commercial trucks, and increased its ownership to 70% of WebMotors, the leading CarSales/AutoTrader equivalent in Brazil. Recent results showed the positive momentum within these businesses and increased conviction in managements long-term growth ambitions outside of Australia.

Negative Contributors

GLP-1’s are a class of drugs, most commonly known by the brand names Wegovy and Ozempic. They were initially used to treat diabetes but have shown very positive results around weight loss. Given the prevalence of obesity across developed societies and the negative impact on other health outcomes, this could lead to broader coverage by insurers and national healthcare providers.

While GLP-1 drugs are unlikely to be the only driver of negative contribution in healthcare and consumer stocks, we think increased debate and concern around their long-term impact has negatively impacted many of our holdings.

The direct impact on diabetes and reduced secondary implications from obesity has negatively impacted the medical devices industry, which the fund has historically seen as a very attractive sector. Teleflex recently acquired a gastric band product, but slower regulatory approval combined with this negative sentiment led to weakness after results, while Medtronic’s positive fundamental momentum in diabetes and the wider business has been hurt by a decline in sentiment and multiples across the sector.

Alongside weight loss from reduced consumption there have been very convincing anecdotal reports around better overall impulse control. This has negatively impacted large parts of the Consumer sector such as beverages, tobacco, restaurants and snacking. Despite seeing attractive returns in some of these areas we are increasingly concerned of the implications across the economy. It is likely many of these businesses are primarily driven by a small cohort of “super-consumers”, which if we see a substantial behavioural change could lead to greater negative outcomes than current expectations.

Heineken and Pernod Ricard both had disappointing results as Vietnam and the US respectively disappointed versus expectations. Over the quarter, the multiple contraction has magnified the impact of these small negative revisions to long term fundamental expectations.

Adyen’s recent results were poor and caused a violent negative reaction to the share price.

The main investor concern is a closing in the technology gap between Adyen and rivals, which has been a large part of their barriers to entry and premium pricing. This combined with management’s continued investment to support long-term growth, which is pressuring margins, and poor communication or explanation around investor concerns, created a perfect storm for the shares.

Although we recognise the long-term growth opportunity, and positive incremental margins from scale in a payments business, we share enough of the concerns that downside risks have also increased, limiting our ability to add to the position.

The only minor positive from this experience is we had a small position size, limiting the negative contribution to the portfolio. After speaking to the company, it was made clear they were surprised by the magnitude of the reaction and said they would announce an event to help investors get clarity over the issues. Management have since announced an analyst day in early November, we will wait until seeing this event before deciding if Adyen still qualifies as an HL Select investment.

Phreesia’s fundamental execution has been far better than its share price performance YTD. Its share price has lagged software and growth peers, despite delivering 25%+ revenue growth and beating investor expectations.

This is likely due to concerns around the need for revenue growth to accelerate for the company to meet 2025 revenue guidance. For a business at this stage of its development we think longer-term growth expectations matter far more than an arbitrary year’s guidance and in that regard the business looks to be performing well. Speaking to management it was made clear they have a singular focus on reaching cashflow breakeven as early as possible as in a world of higher rates the cost of financing growth is too great.

We do still have questions around why average revenue per customer hasn’t been growing at the same pace, despite continued investments in R&D, but do accept some of management’s explanation around comparability of customer segments and that this is coming but the focus has been around on-boarding new customers.

Zebra had weaker than expected results leading to a large negative reaction to the shares. End customers have been absorbing excess capacity built during the pandemic and distributors have reduced inventory levels. This has led to weaker sales and a negative margin impact from lower volumes.

Similar trends at peer Honeywell suggest this is more of an industry issue than company specific, which combined with its limited impact on the long-term need for Zebra products and services, means we think this weaker period will have limited impact on longer-term investment opportunity.

Cryoport is a unique business operating in the high growth and revolutionary industry of cell and gene therapy. It announced a substantial cut to annual guidance, despite raising guidance earlier in the year. Its weak results were a combination of weaker biotech funding environment and other industry headwinds, combined with poor execution by the business.

Believers see them as having improved their position for a strong recovery in end market, while sceptics rightly point to a management credibility issue. Even after retracting back longer-term guidance, management continued to talk positively about upside optionality from new growth opportunities.

The main weakness was in its MVE segment, a manufacturer of freezers and equipment used to transport cell material. Its sales in China fell 67% and accounted for 700bp of the cut to company revenue growth. Despite these weak sales, this segment remained margin and free cash flow positive.

Cryoport Systems is the core business focused on logistics of cell material. It still grew the number of clinical trials it supports, which is a positive indicator for the long-term growth opportunity. Alongside a recovery and maturing in the cell and gene therapy industry, Integricell and other new opportunities should begin to generate revenue in 2024, which we think could have a positive impact on investor perceptions.

Our main error had been not recognising the slower growth in new approvals versus expectations and that approved therapies had very low treatment volumes, which increased volatility of results in the core business and reduced downside protection.

We reduced our position immediately after results, as despite an attractive long-term opportunity, we felt management credibility limited out ability to own a larger position size.