HL Select Global Growth Shares - Q1 2024 Review

Gareth Campbell - Fund Manager

3 May 2024

Market review

Q1 continued the main theme from 2023, as better than expected employment and inflation data increased confidence in avoiding recession, although more recently it has raised concerns around when the federal reserve will start to cut interest rates.

There is almost unanimous optimism by market experts around the US economy, and the strong market reaction has helped drive cyclicals to recent highs, while typically defensive sectors continue to underperform.

Overall, we saw all-time highs in the US, European and Japanese markets and valuation is increasingly highlighted as a risk. We do not see peaking markets alone as a reason for concern, as all periods of positive return are reliant on the market making a new all-time high. Valuation peaking doesn’t cause a market correction: valuation peaks because the market falls.

Excitement around AI led to a large rally in the semiconductor sector, which broadened out to the industrial economy as the scale of capital expenditure and energy demand needed to support the industry became more apparent.

The Magnificent Seven saw dramatically different outcomes in Q1 with Tesla and Apple underperforming, while Nvidia almost doubled in just 3 months. We think this market reaction has been quite rational given the different fundamental factors that drive these businesses. For example, Tesla saw negative delivery in vehicles, yet still is seen as a growth company, while Nvidia’s expected sales increased by almost $30bn.

Narrow market performance, dominated by momentum, coupled with high valuation, means that Q1 continues to be a challenging market for most investors. We have a large exposure to these areas limiting our downside, but also have looked to diversify our exposure across other parts of the market that we think offer better risk adjusted returns over the long term.

We don’t fully agree with the markets’ wider enthusiasm. We have witnessed weaker newsflow from some consumer companies and whilst employment seems strong at first glance, the devil is in the detail. The headline figures disguise a higher proportion of part-time work and that US job creation is increasingly led by government not the private sector.

We therefore remain relatively defensively positioned, while also focused on identifying businesses with secular growth opportunities that should enable them to continue to compound their growth, irrespective of a change in economic conditions.

Performance review

The HL Select Global fund returned 8.03% during Q1, compared to the FTSE World Index return of 9.57%, resulting in 1.54% underperformance versus the benchmark. The US was our largest positive contributor, with Information Technology and Financials our strongest sectors. Consumer Staples and Industrials were our only negative contributing sectors. Since launch the fund has delivered a total return of 72.14% compared to the FTSE World Index return of 78.81%. Past performance isn’t a guide to future returns.

Positive and negative contributors

Our negative relative performance was led by underperformance in North America and Europe. The absolute performance of Europe and Asia still lagged the US.

The Materials, Information Technology and Financials sectors were our main positive drivers of performance. Within the Information Technology sector there were notable differences in performance drivers. The semiconductor sector, where we are underweight, delivered almost 30% outperformance versus the wider market, detracting from our relative performance. Fortunately, our other Information Technology holdings delivered strong enough performance to offset this headwind.

Healthcare, Industrial and Consumer Staples sectors were the main drivers of our negative relative performance. However, we think a more honest assessment is that we had stock-specific challenges across a handful of companies. Some of the share price reactions are justified, whilst others we think present opportunity longer term - these are discussed in more detail below.

The strong performance of the Energy sector was a headwind as the oil price began to recover on strong economy and geo-political concerns. Not owning Utilities or Real Estate businesses added to relative performance.

Selected positive contributors

Nvidia was the most important single stock in Q1, accounting for 17% of the market return. In addition, the theme of accelerated investment in AI spread across other parts of the broader data industry from data centres to industrial equipment.

Fiserv's continued strong execution and the growing importance of its Clover payments unit helped deliver strong outperformance for one of our largest positions. We used this strength to trim our position in early March.

Vulcan Materials' quality is increasingly hard to question, as the business delivered strong improvements in price and profit per ton, despite weak residential demand. Vulcan’s main peer Martin Marietta, expects faster market growth, but we think Vulcan management have shown they take a more conservative approach in setting guidance, which more likely explains the difference in expectations. We trimmed our position back to 3% in early March given the higher valuation.

Alphabet has been poor at showcasing its AI abilities, with technology malfunctions at launch events and then a well-publicised product issue in AI image generation, which caused the shares to underperform. We recognise the risk to search from Microsoft’s Co-Pilot and other AI tools, but also think investors underappreciate the technical capability Alphabet have in AI. Longer term we think its ownership of Android and Google Cloud leaves the business well positioned and used this weakness to add to our position in March, which has so far proven well-timed.

Adyen's strong growth particularly in the US has helped allay the concerns, which emerged last August that price competition would lead to market share losses and lower margins. Poor communication by management meant that despite the attractive valuation we did not have enough conviction in execution to add to our position.

Selected negative contributors

GXO Logistics gave slightly slower guidance as the impact from lower volumes across key end markets negatively impacted revenue. As volumes recover, we expect to see a positive inflection in the business because the main secular drivers of outsourcing and automation continue to be strong.

Adobe sentiment has bounced between being an AI winner and loser over the last 18 months and unfortunately is now seen as the latter. Its recent customer growth was a bit weaker than expected and management exacerbated concerns with confusing messaging around guidance. Guidance has since been confirmed and we think the market underestimates longer term litigation risk from competitor models that have been trained with unlicensed data, which will help Adobe retain a larger marker share than currently implied by the share price.

Teleflex has struggled since reporting earnings in February. Its margin guidance is admittedly disappointing, but the path to improvement seems achievable and revenue growth has accelerated, yet the multiple remains near lows. We don’t think this recent weakness is justified.

Pernod Ricard results showed continued weakness in US and China, but margins and growth should improve later in the year. We think the fall in valuation relative to other consumer goods is unjustified given the longevity of the Group’s brands.

Aptiv struggled as the expected pace of electric vehicle penetration slowed and Chinese suppliers took share in developed markets. The share price doesn’t reflect the strong secular opportunity for Aptiv, but the risk from competition has increased, which is why the position remains under review.

CAE attempted to ring-fence some lossmaking contracts in its defence segment, but poorly managed disclosures left investors struggling to fully understand the situation. Bearish sentiment was also increased by weaker quarterly margins in its larger civil aviation division, although full year guidance was maintained. As the global leader across its main business units, we are confident that current issues are temporary and with the shares trading at their lowest relative valuation in a year we added to the position in March. While the Defence business may take up to two years to improve, we think there is currently limited value assigned to it. The Civil aviation sector remains very strong, so we think CAE’s civil segment should be able to deliver positive results, presenting an immediate catalyst to the share price.

New positions

We added two new positions to the fund: Tetra Tech and Elevance.

Tetra Tech is a global leader in environmental consulting. Environmental challenges are becoming more prevalent and the need to manage them more widely recognised, presenting a long-term tailwind to industry demand. We think management’s conservative approach to reporting its backlog of work is leading investors to underestimate the long-term growth opportunity from recent contract wins.

The business generates a lot of free cash flow, so acquisitions can be used to accelerate the rate of compound growth, with the most recent acquisition, RPS, performing better than expected. In addition, they have increased the dividend per share and consistently reduced the share count, positive signals supporting our view of it being a long-term compounder.

Elevance is one of the largest health insurance providers in the US. We think expanding additional services can help reduce the gap in revenue per member with United Health, the market leader. Despite the large valuation gap between the two, both companies have been exceptional value creators for shareholders over the long term.

Political risks remain in the US healthcare sector, but broad coverage is more widely accepted in the US today than in prior cycles, limiting downside. Longer term we think there will be greater recognition that insurers are the main tool governments can use to lower the overall cost of care.

Sold positions

Elekta is the smaller part of the global duopoly in radiotherapy, alongside Varian (now owned by Siemens Healthineers).

We invested into Elekta in June 2020 and initially the stock performed well. Business performance declined in August 2021 as pandemic driven cost inflation and supply chain challenges had a severe impact on its ability to install equipment at client locations, impacting the company’s margins.

Elekta’s Unity device is an MRI combined with a radiotherapy Linear Accelerator and is the most advanced piece of technology in the market. We still think the long-term benefits for patients will be proven in clinical studies, which could lead to greater adoption and an acceleration in revenue growth.

As part of a duopoly, in an unfortunately ever-growing market of cancer treatment, we saw Elekta as an inevitable beneficiary of long-term growth, with margin upside from client’s adoption of software and services in addition to the radiotherapy machinery.

Our mistake was not recognising that the long sales cycle for equipment, combined with limited recurring revenue, made the business particularly susceptible to margin headwinds from supply chain disruption and cost inflation.

This lesson reiterated the importance of the business model, even in secular growth industries, and although we are still optimistic about its Unity device, we no longer see the risk reward from the higher business volatility as justifiable versus our other available investments.

We sold Elekta for an average return of -12%, and a negative contribution of -0.53% over our holding period.

Experian is one of the 3 largest credit bureaus in the world and is listed in the UK.

It was held in our UK Select funds, and we thought it suitable for inclusion as a global leader with strong secular drivers from data, which had derated due to cyclical concerns and a slowing of revenue growth expectations.

Our sale wasn’t driven by a substantially negative view on expectations or fundamentals, more that valuation had improved. We used the funds to help buy Tetra Tech which we see as a business with similar revenue growth, but lower capital intensity, so we think is capable of compounding at a higher rate longer term.

Since our initial purchase in June 2022, we have added to the position on a few occasions and then trimmed at the end of 2023. Overall, it has delivered a return of 36.85%, positively contributing 0.84% to overall fund performance.

Portfolio Changes

We trimmed our position in Charles Schwab as we wish to reduce our exposure to interest rate sensitive businesses. We also reduced our position in Intuit given strong performance and used this capital to help fund our addition to Alphabet. We increased Compass Group, as we think it is a high-quality business with limited cyclicality relative to the market, characteristics currently under appreciated.