HL Select Global Growth Shares - Q4 2022 Review

Gareth Campbell - Fund Manager

3 February 2023

Market Review

2022 was an extremely challenging year for investors, with negative performance across almost all asset classes. Q4 saw better performance for global stock markets, but a stronger pound negatively impacted UK returns.

We think inflation has peaked, but the debate rages on about its path and if central banks can engineer a fall in inflation without significant damage to employment and the global economy – a “soft-landing”.

Central banks couldn’t be clearer that they see persistent high inflation as a greater threat than an increase in unemployment, as those unfortunate to lose their jobs will have an opportunity to be re-employed in the eventual recovery, however, the reduction in spending power that inflation causes is permanent. Despite this the market still expects interest rate cuts in the US in late 2023. This “fed-pivot” has been the source of multiple rallies in the second half of 2022.

We continue to believe a recession in the US and Europe is the most likely outcome, but we can’t predict the timing or depth of its impact. We have been increasing our portfolio’s resilience and optimising our holdings to help shelter from further downside, while minimising the impact on our long-term expected returns.

The last two years have been very challenging for HL Select Global Growth as macro-economic issues have dominated stock performance. We have also made mistakes in analysis, as our growth expectations for some stocks were too optimistic, not justifying the record high multiples and increasing vulnerability to an increase in interest rates.

What hasn’t changed is multiple long-term secular trends, such as digital disruption, which are the drivers behind many of our investments. As valuation multiples have contracted to more normal levels, we believe these businesses are better positioned, particularly in a world where growth is increasingly scarce.

Performance Review

The HL Select Global Growth fund returned -0.42% during the quarter compared to the FTSE World Index of 2.34% (Source: Lipper IM to 31/12/2022). North America was our largest positive geographic contributor to performance, driven by Industrial and Financial sectors.

Since launch the fund has delivered a total return of 31.50%, compared to the FTSE World Index of 39.28%.

Past performance is not a guide to future returns. Source: Morningstar Direct to 31/12/2022

N/A – Full year performance data is not available

Positive and Negative Contributors to Performance

Our negative relative performance was primarily driven by our European businesses and stock selection within Healthcare and Materials, as well as a large underweight to a strong Energy sector.

Our highest contributions came from strong stock selection in Consumer Discretionary and Communication Services, combined with an overweight position and good stock selection in the Technology sector.

The negative trend in growth stocks finally corrected during the quarter, which along with the energy sector giving up some of its very strong returns helped overall portfolio performance. Stock specific issues are discussed in more detail below:

Positive Contributors

Past performance is not a guide to the future. Source: Bloomberg to 29/12/2022

CAE partly recovered the negative reaction to the previous quarters’ earnings. The civil aviation business continues to perform well, while no further issues have emerged in the defence business giving investors increased confidence.

Teleflex rebounded after a period of negative performance. Staffing issues at hospitals impacted the number of medical procedures, particularly those using UroLift, a key driver of Teleflex’s business. We increased our position size during the quarter to take advantage of its more attractive valuation, as we see Teleflex as a higher quality business than many of its peers, but with more optionality.

Charles Schwab is a beneficiary of higher interest rates. It performed better than banks, because of its limited exposure to credit risk. We see this combination of characteristics as quite unique, justifying a higher valuation.

Visa is a beneficiary of increased travel, given the high margin it makes on cross border payments. Overall, it continues to deliver good and consistent results. We think investors underappreciate the lower risk of disruption, as higher interest rates have reduced the value and funding available for high-growth, loss-making businesses.

Booking finished the year strongly after a period of weaker performance. We reduced our position size given the sensitivity to weaker consumer spending as we enter a more challenging macroeconomic period. Although there is no sign of this impacting the business so far.

Phreesia had a challenging start to the year as the valuation of high growth, unprofitable stocks fell substantially. The business outperformed expectations, with 31% revenue growth and faster improvement in profitability than expected, driven by better operating leverage. We reduced our position size after a period of strong performance since the share price low in May.

GXO continues to execute well but this has only recently and partially been recognised by the wider market.

GXO earns the majority of its revenue in the UK and Europe, at relatively low margins, which resulted in a sharp fall in sentiment for most of the year. However, the business has beaten expectations with new customer growth, helping to offset economic and FX headwinds.

We think investors have a poor understanding of the business model and the business will be quite resilient through a recession. Concerns around margins are misplaced, as GXO has a proven ability of managing margins in a declining volume environment. As every year volumes collapse after the peak Christmas period, but margins see limited impact.

Negative Contributors

Past performance is not a guide to future returns. Source: Bloomberg, 29/12/2022

Cryoport's share price fell after it unnerved the market with large cuts to revenue guidance in November, despite seemingly strong secular tailwinds supporting the business.

Taking a closer look at the announcement we see that 80%+ of the cut was driven by MVE business unit. MVE is a capital equipment business focused on the design and build of cryo-shippers and large freezers, with the latter particularly weak.

The biopharma business has lost some share as customers look to reduce risk and dual source suppliers. After a recent site tour and meeting with management, our confidence has increased that the services Cryoport provide are superior to peers and that this is valued by their highly risk averse customer base. We therefore still see Cryoport as a long-term beneficiary of the fast-growing cell and gene therapy industry.

With $500m of cash and positive operating profit we think the business is poised to show an inflection in operating leverage, which should deliver solid earnings. This should help underpin valuation and improve stock performance.

The remaining challenge to the shares is management’s announcement that long term guidance will be reviewed. These were always a stretch target and not in estimates or the share price, but guidance reviews are rarely positive, and this news may negatively impact the share price.

Autodesk saw a reversal from last quarter’s strong performance as recent results suggested a slowing in new business wins and fewer multi-year contracts, which will reduce this year’s cash flow. We still view the business as being more resilient than in prior cycles and a shift to more annual contracts will increase predictability of revenue and business quality longer term.

West Pharmaceuticals has seen a faster deceleration in COVID-19 revenue than expected, which has had an additional impact on margins. COVID-19 related revenues were highly profitable, and the new business won in its place is lower margin. This is pressuring near term earnings but has limited impact on our long-term expectations for the business. We used this weakness as an opportunity to increase our holding.

Alphabet has seen more margin compression than expected as it becomes clear that 2021 profit margins weren’t sustainable. Recent cost cutting measures should help get the business back on track. For example, only recently have the Google Maps and Waze Maps teams been consolidated.

Diversey has faced a continued challenge from a large exposure to Europe and natural gas input costs, negatively impacting margins. Leverage is higher than we would typically like, but an economically resilient business with pricing power, means we see less risk from this. We think shares look attractively valued as natural gas prices stabilise and sentiment around European exposure improves.

New Positions

Nvidia is the global leader in Graphic Processing Units (GPU). GPUs were originally built to quickly render 3D graphics in video games but have now been repurposed to accelerate other applications, such as data centres, artificial intelligence and autonomous driving. This makes it an excellent way to invest in the proliferation of data and analytics.

Nvidia’s datacentre business is now over 50% of sales and is the main driver of growth. We expect this to continue as 60% of possible workloads are still not in the cloud. The addressable market is also expanding as required computing power increases with new applications such as AI, online gaming and the industrial omniverse.

Software and services are a growing percentage of sales, this is not only improving margins, but should also increase the proportion of recurring revenue and make the business more resilient longer term.

Nvidia outsource manufacturing of chips to TSMC and Samsung, which helps limit capital intensity, improving long term return on capital.

Barriers to entry are very high and its closest peers can’t offer a product with the same capabilities. The huge scale of Nvidia also means it can deliver high margins, while still out-investing competition in R&D.

As a global leader benefitting from multiple durable and persistent growth drivers, Nvidia is a business we have followed for a long time. A weak semiconductor cycle and negative share price performance helped us build a position near the stock’s lows in October.

Sold Positions

No positions we sold outright during the quarter.

Portfolio Changes

In October we increased diversification, trimming some of our larger positions that had performed well such as GoDaddy, Fiserv, Aon and Visa. We reduced our position in Amazon to fund a new position in Nvidia, as both investments are driven by growth of the cloud and Nvidia had an attractive entry opportunity after a period of very poor share price performance.

We also reduced our positions in TriNet, Amphenol and Aon to help fund investments in less cyclical businesses like Pernod Ricard, Experian, Teleflex and West Pharmaceuticals.