HL Select Global Growth Shares - Q2 2024 Review

Gareth Campbell - Fund Manager

5 August 2024

Market review

Q2 initially seemed to be the end of the strong market rally from Q1 as higher than expected inflation delayed rate cuts in the US. However, as these concerns began to ease long-term yields fell, and the previous trend of large cap growth and artificial intelligence continued to dominate, delivering overall positive market returns.

Recent market returns have been criticised for their narrowness and Q2 2024 was no exception, the Magnificent 7 cumulatively contributed 3.37%, meaning the remainder of the market detracted 0.6% from returns. Interestingly, being a technology stock alone is no guarantee of success, as despite the NASDAQ (a technology focused index) delivering 8% growth in Q2, an equal weight version delivered negative returns.

We don’t believe the current dominance of these businesses can be dismissed as simply a bubble, as their fundamental performance has been exceptional. It is expected the growth rates of the wider market, and these “winners” will begin to converge, which we think could be a catalyst that enables a broadening of market performance.

Our defensive positioning continued to be painful, although we do think very negative revisions to employment data and some weaker leading indicators suggest there are a growing number of cracks in the US economy. If this proves to be prescient, it is unlikely to make up for being wrong for 18 months, but it is one reason why changes that increase economic risk in the portfolio are made slowly.

We are disappointed with the fund's returns, but equally unsurprised these market conditions are challenging to a fund seeking diverse drivers of long-term growth, with only around 1/3 of our holdings outperforming this quarter.

Our ambition of identifying high quality businesses with secular growth opportunities that can compound at a high rate over the long-term at reasonable valuations remains unchanged, but we do think we can do better. After detailed reviews of the first 5 years of HL Select Global Growth, we have made multiple tweaks to our philosophy and process, and hope to expand upon these over the coming months.

This initial phase resulted in a larger number of trades at the end of the quarter, which haven’t had time to have an impact, but we hope will lead to positive and more balanced outcomes for our investors longer term.

Performance review

The HL Select Global Growth fund returned -0.4%* during Q2, compared to the FTSE World Index return of 2.68%, resulting in 3% underperformance versus the benchmark. The US was our largest positive contributor, with Information Technology and Communication Services our strongest sectors. Healthcare and Financials were our largest negative contributing sectors. Since launch the fund has delivered a total return of 71.45% compared to the FTSE World Index return of 83.6%. Past performance isn’t a guide to future returns.

Positive and negative contributors

Our negative relative performance was led by underperformance primarily in Europe.

Communication Services and consumer discretionary were our main positive drivers of performance. Within the Information Technology sector there were notable differences in performance drivers. The semiconductor sector was again the best performing sector hurting our performance. Fortunately, strong stock selection in software offset most of this headwind and our new position in Taiwan Semiconductor Manufacturing should reduce the impact of this in the future.

Healthcare and Financial sectors were the main drivers of our negative relative performance. Our positioning in these sectors has been painful for multiple quarters as we typically avoid Banks and Pharmaceuticals, which make up the majority of those sectors in favour of financial services, healthcare equipment and life sciences, which historically have been higher growth and higher quality, but are facing unique challenges today. Around half of this underperformance was just three stocks; Cryoport, Adyen and Sartorius Stedim, these are discussed in more detail below.

Not owning Energy or Real Estate businesses added to relative performance.

Positive contributors

Alphabet delivered very strong results which helped increase profit estimates and improved sentiment around AI risks leading to a rerating in the shares. We trimmed the position given strong performance, but it remains our largest holding.

Nvidia continues to determine overall market performance, it alone drove almost half the market return and a large proportion of profit growth.

GoDaddy’s recent performance suggests greater recognition of the improvements in the business. We trimmed our position to manage stock level risks, but with Free Cashflow multiples in-line with average and the opportunity for AI to unlock its enviable position as the main provider of websites to small and medium-sized businesses we see no reason for momentum to slow.

Amphenol is an exceptional business which has consistently grown faster than expectations, currently it is benefitting from increased spending in AI investment themes, adding to profit growth and sentiment.

Tencent has delivered strong results and announced a large buyback. We sold the position as we think the risk of further political interference in the Chinese economy is too great to justify holding the position longer term.

Negative contributors

Cryoport's recent quarter showed continued weakness in its equipment business, triggering a non-cash impairment charge against its MVE acquisition. Its services business missed expectations as fewer clinical trials and slower commercial launches impacted growth.

Despite a challenging start to the year annual guidance was retained, implying a steeper improvement in the second half of the year. Investor scepticism of achieving this clearly grew after the quarter, as the shares continued to underperform despite no negative news flow or fall in estimates.

The majority of the negative impact is driven by external factors, namely the cell and gene therapy industry developing slower than expected and excess equipment post the covid pandemic. We have retained our position as the cell and gene therapy industry is still widely expected to grow 20%+ per annum and Cryoport remains a unique way to invest in these themes without clinical risk.

The magnitude of the share price reaction is alarming, and the only thing limiting the impact to the fund was our decision to reduce our position size in 2023. We recently met with management and although we're still optimistic about operational efficiencies and the launch of a key new product in 2024, we require these positive catalysts to materialise before the end of the year to justify retaining our position.

Sartorius Stedim and West Pharmaceuticals have both suffered from similar challenges of excess inventory post the COVID pandemic. The most important thing is that underlying demand for their products and services continues to grow. We have tried, and failed, to accurately forecast when destocking impact will precisely end, but the fall in valuation means they look attractive longer term and we added to both positions at the end of the quarter.

Pernod Ricard - weak organic growth in the US and China and a winding down of the Russian business has led to a sharp fall in earnings. US struggled with excess inventory at distributors, while China is seeing weaker cognac sales and broader economic challenges. The valuation multiple has fallen from a premium to record discounts, which we don’t think is justified given the strength and longevity of brands.

Adyen fell sharply as lower take rates (the fees charged on payments) declined, adding to concerns about the impact of competition.

Medtronic's organic growth has materially improved, and we think the pipeline of new products looks more exciting than it has in years. Earnings per share disappointed in Q1 as weaker margins impacted results, we think these issues are fixable and are confident in its ability to meet full year guidance. We reduced our position to help fund new ideas with a higher expected rate of compounding.

Fiserv's negative impact was more driven by size of the position, than the magnitude of the loss, but we don’t think the underperformance is justified. Its Clover business segment is executing very well and helping deliver consistent positive earnings revisions.

Fundamentally it has a great long-term track record of compounding profits and delivering outperformance to long-term holders, so we think trading at a discount to the market means the shares are attractive today.

TriNet is currently challenged by weaker employment growth and margin headwinds from higher healthcare costs. Our small position size is because of these risks. We continue to hold the position as longer term the PEO industry is a secular growth industry, so TriNet should be able to sustain its high historic rates of compounding.

CAE has several low margin contracts in the defence business that have severely impacted profitability. There is evidence of poor execution as this issue has persisted for over a year and taken too long for management to get control of the situation. Head of defence has since been replaced and a positive announcement on backlog conversion leave us still positive on the long-term opportunity for CAE, but the execution issues led to us reducing our position size.

New positions

TSMC is the world’s leading semiconductor manufacturer, turning the chip designs of its customers such as Apple and Nvidia into reality. The semiconductor manufacturing industry is currently experiencing record demand due to AI, cloud computing, and 5G/IoT and while we already have a position in Nvidia, the GPU designer, we increased our weight to the sector via a ‘picks and shovel’ route at a substantially lower valuation.

In recent years TSMC’s capabilities have increasingly outperformed those of other foundries - making chips with the greatest processing speed and power efficiency, at the highest yields. So much so that great rival Intel has used TSMC to make some of its chip designs rather than using its in-house foundry.

Highly advanced chips now make up most of its revenues and TSMC’s leading technology coupled with manufacturing efficiency and customer relationships have propelled it to market leader with immense scale. This scale creates a virtuous cycle of huge investments in R&D and capital expenditure, while its high return on capital means the business still generates sufficient free cash flow to fund a dividend.

We think TSMC’s position in the value chain is increasingly valuable. Its high return on capital with huge opportunity for further investment and growing shareholder distribution mean it has the necessary attributes to become a high-quality compounder.

LVMH operate a conglomerate of luxury brands across luggage, apparel, jewellery, cosmetics, spirits and champagne.

It was owned at the fund's launch and sold in March 2020 as we thought its outperformance wasn’t justified given the upcoming challenge of navigating the pandemic.

We have always viewed it as a high-quality business, but we either saw more attractive ideas or weren’t comfortable with the valuation. We also underestimated how much pricing the business could take, which has led to very positive earnings revisions and propelled the stock to all-time highs in 2023.

Challenges within the Chinese consumer and luxury space have weighed on the stock, while more recently French election concerns have negatively impacted sentiment. We think these risks are unlikely to impact a group with such breadth of products and irreplaceable brands over the long term. Having now fallen 40% from their peak and trading at a discount to the market, we think there is an attractive entry point for long-term investors.

Sold positions

Our Aptiv thesis was it's a key supplier to auto manufacturers so a low-risk way of investing in growing electrical content and electrification of vehicles. The business has struggled as volumes of these vehicles have disappointed, content per vehicle growth slowed and customers are facing increased competition by Chinese OEM’s.

Our main reason for selling is greater recognition that business quality wasn’t as high as first analysed and that the long-term threat from Chinese OEM’s is too high.

The poor share price return given the limited fall in estimates suggests our initial purchase price was too high, however if the business does manage to execute on its long-term plan, then it’s likely the shares are very undervalued today.

Tencent built one of the most exceptional business models in technology, its “super-app” was the envy of many western peers who hadn’t successfully grown their business across so many different verticals.

Government intervention impacted key video game markets and has increased control of overall profitability of the business. This growing political risk means we no longer think the business is investable, as a company should be operated for the benefit of shareholders, not political party.

Charles Schwab's challenges over the last year came from mismanagement of its liabilities. We accepted the banking risk given the low credit risk, but this mismanagement of the business highlighted the growing complexity and therefore we can no longer justify owning the company.

Simplistically the business was a huge beneficiary of high interest rates, now that has occurred this mismanagement meant the higher interest income couldn’t materialise. In addition, we believe this rate cycle is over and therefore it's more likely rates will fall from here, so it's hard to see fundamental upside optionality.

Portfolio Changes

We added to Vulcan Materials as we think share price weakness due to challenging weather conditions in the US misses the incredible pricing power and continued benefit from reshoring and infrastructure investments in the US.

We added to Amazon as its cloud business should accelerate as companies prepare for AI investments, and margins within retail are improving, helping improve overall returns. It is one of the few large cap tech businesses where its segment with the highest rate of growth is actually higher margin and higher returns than its other segments. Most peers are making large investments in AI that are depressing their margins and returns in the near term and we do not think this simple but important distinction is yet fully appreciated by investors.