HL Select Global Growth Shares – Q3 2021 Review

Gareth Campbell - Fund Manager

18 October 2021

Market Review

As interest and inflation rate expectations eased over the quarter, "growth" stocks continued the strong performance they had started in May. However, from September, concerns that the US central bank may soon begin reducing support for the bond market led to an increase in long term interest rates and a reversal of performance for "growth" stocks.

Investor concerns around the Chinese and the US economies increased during the quarter, negatively impacting the overall market return.

In China, the Government passed multiple reforms to centralise power. Energy shortages in many states resulted in manufacturing shutdowns, and the country is still dealing with the potential fallout of the solvency concerns of China's largest property developer, Evergrande.

Chinese political reforms are concerning and something we watch closely given our holding in Tencent. We believe the systemic risk from the Evergrande crisis is low, with the Chinese Government likely to ring-fence or bailout the company. Economic growth may be slower than expected, but it is still one of the fastest-growing consumer economies, creating interesting investment opportunities both directly and indirectly.

In the US, the debt ceiling, a legislative cap on funding government spending with borrowing, was close to being breached, before the senate voted to extend it until 3 December. If the US was to have defaulted on its obligations, this could have led to downgrades of the US credit rating.

Concern about the US debt ceiling is genuine and justified. However, since it is largely a symbolic and political issue, it is likely to be resolved before the US defaults on any payments. In 2011 the Senate raised the debt ceiling two days before the Treasury said it would default. That week was extremely volatile, but since then, the US economy and stock market have performed far better than most of the world.

Germany also completed its first major election without Angela Merkel running for office. Although voters seem to have tired of her party, there so far seems to be a limited mandate for any fundamental change.

Overall, this doesn't seem to have dampened investor sentiment as Q3 saw record M&A and IPO activity of $1.5 trillion. Thus far, 2021 has broken the previous record set in 2007 before even reaching Q4.

We remain aware of the above risks but firmly believe that our focus on identifying high-quality companies with pricing power will help shelter long term performance from inflation and other market uncertainties.

Performance Review

The HL Select Global Growth fund returned 2.01%* during the quarter compared to the FTSE World Index of 2.52%. The US remained our main contributor to performance, with Financials, Industrials and Communication services our best performing sectors at a sector level.

Our performance was driven primarily by stock selection, but in a reversal of trend since launch, Healthcare and Information Technology were our largest negative contributors, primarily due to GoDaddy and Elekta, offsetting positive contributions across other sectors.

Since launch, the fund has delivered a total return of 58.85% compared to the FTSE World Index return of 40.30%. Past performance is not a guide to future returns.

Past performance is not a guide to the future. Source: *Lipper IM to 30/09/2021

N/A = data for this period is not available.

Positive and Negative Contributors to Performance

Despite the outperformance of "growth" stocks over the quarter, the portfolio delivered negative relative performance. This underperformance was attributed mainly to stock selection within Healthcare and Information Technology, discussed in more detail below.

Positive Contributors

CarSales was our largest positive contributor during the quarter. It was one of largest negative contributors in Q1 and underperformed for most of 2021, and so we used this opportunity to increase our position size in June. Despite the Covid-19 lockdowns in Australia, CarSales continues to execute well. It completed a large acquisition in the US and hopes to launch an end-to-end e-commerce automotive platform, which reduces the risk of disruption while expanding its addressable market.

TriNet had a disappointing start in the portfolio. Despite it being in an industry with secular growth and a beneficiary of employment growth at a surprisingly low valuation, it had underperformed. Recent quarterly results changed that, with positive announcements from management leading to an increase in estimates and rerating of its valuation multiple.

In July, Aon terminated their agreement to acquire Willis Towers Watson. Since then, through to the end of Q3, the shares have performed very strongly, this is despite the $1B compensation they must pay as part of the termination agreement. We never supported the merger and believed the additional complexity and regulatory risk explained why the shares lagged other high-quality peers. With this risk removed, the shares could rerate to a more typical multiple.

Booking is benefitting from a reopening of travel as Covid-19 restrictions are reduced across the world.

Negative Contributors

GoDaddy's underperformance is a source of frustration as our investment thesis is largely progressing as hoped. The pace of innovation is increasing, and the launch of new commerce tools could be meaningful to long term growth. As a legacy technology business that has gone through a transformation over the last decade, investors often overlook it. However, its consistent growth and strong free-cash-flow generation, we think, will at some point reward investors, so, despite the recent share price performance, it remains a high conviction holding in the portfolio.

Elekta had a mixed quarter with positive developments with its Unity and Harmony products offset by a significant increase in operating costs tied to logistics and service. This increase in the expenses surprised investors, and it may foreshadow what's to come for peers as their accounting periods slightly differ. We will be monitoring Q3 results to gain any additional insight.

Tencent's negative performance is due to increased concerns about Chinese regulation. The business seems to be managing these risks better than peers, and results have so far been good. Valuation is very attractive, and the market opportunity is vast. However, until these concerns abate, the stock may struggle to outperform.

New Positions

Since our last quarterly update, we have added Diversey to the fund.

Two companies lead the global cleaning and hygiene market, Diversey and Ecolab, and together they represent around a third of the market, with the rest of the market highly fragmented.

There is significant health, financial and reputational risk associated with inadequate cleaning, and therefore customers highly value Diversey's products and services. Diversey's solutions are also essential to customers' abilities to meet health and safety regulations, which means the economic cycle has a limited impact on the business.

Diversey operates a 'razor - razorblade' business model, providing proprietary dispensing machines and equipment upfront that only work with Diversey cleaning products. This creates a recurring revenue stream and long-standing customer relationships.

Over Diversey's nearly 100-year history, it has undergone many ownership structures, being bought by businesses such as Sealed Air Corp, Unilever and SC Johnson. Now the company is a stand-alone entity, is it better positioned to grow revenue and improve margins.

Diversey is growing share in infection prevention, a fast-growing area of the market which has benefitted from increased standards for cleaning and hygiene due to the Covid-19 pandemic. The business is also looking to expand wallet share of 'global strategic accounts', who typically have higher brand risk, value the energy and water savings Diversey can offer and are faster growing than other players.

To improve gross margins, Diversey is focusing on pricing actions, operations savings and supply chain and sourcing savings. For example, they are working to minimise the impact of rising raw material costs and building a new factory in the US to reduce reliance on contract manufacturing.

Sustainability is core to the value proposition provided to customers and Diversey designs solutions that enable customers to meet their efficiency, effectiveness and sustainability goals. Diversey declare that their products are so deeply engrained in customers’ operations that they can help improve in almost all key environmental areas, including reducing water, transportation, energy, greenhouse gas, packing, waste and chemical usage. A simple example is ensuring that the proper chemicals are used with the correct water amount and the optimal equipment.

Sold Positions

No positions were sold in the quarter.

Portfolio Changes

We made only minor changes to the portfolio during the quarter.

At the end of July, we increased our position in Fiserv as the business continued to execute well, yet it traded at a significant discount to payment peers. We reduced our holding in Visa to fund this purchase to limit our overall exposure to the payments sector. We remain high conviction owners of both businesses.

We increased our position in Ubisoft in August following a formal review of the business, given performance since the fund's launch had been poor. Our primary learning outcome was an underappreciation of the risks of investing in a hit-driven business, despite being in a secular growth industry. Nevertheless, the review highlighted that our original investment thesis was intact, and the share price offered excellent risk-reward potential. Our view is that the current valuation implies limited benefit to revenue and margins from secular industry trends and a very low probability of success from Ubisoft's investment in Free-To-Play games.