International All Cap: investor letter Q4 2024

Your capital is at risk.

As 2025 approaches, we wanted to write to recognise that investment performance has not met our expectations, but also that the portfolio of companies is in very good shape with higher margins and returns on capital and lower leverage than the index. These metrics, set out in the table below, combined with exposure to powerful long-term trends and attractive starting valuations, give us confidence that the portfolio can compound growth at high rates over many years. Examples of companies in the portfolio that are attractively valued are numerous and prolific – Greggs (UK food outlet), Bunzl (global distribution company) and Intertek (outsourced testing business) are all on around 18-20x headline earnings, and we expect double digit growth from all of these.

Portfolio characteristics

Underlying company fundamentals remain very strong, however, this has not yet been translated into outperformance relative to the benchmark for the overall portfolio. While our clients remain supportive, and understand and believe in our long-term approach, we are quite reasonably being asked in what environment our performance will improve.

We thought it might be helpful to give our perspective on the investment environment of recent years and importantly set out for you where we expect strong performance to resume.

Firstly, we want to make clear that we have learned lessons from the experience of the last 3-4 years. We sent our clients a paper in the first half of the year setting out how we are putting more resource behind risk management and portfolio construction and how this has fed through to modifications in our process.

A blueprint for growth?

One area of the portfolio that has performed very well over the last twelve months has been in the cluster of online platform companies that have demonstrated an ability to monetise their strong market positions; this group includes Autotrader, Shopify, Recruit and Spotify, among others. Just one year ago these were out of favour and had detracted from performance over the medium term. As with all our holdings, we tracked their progress carefully (and indeed we sold out of some online platforms where we felt the businesses had deteriorated) but for those where we had conviction, we held on and in some cases added to the position. We highlight this example because it illustrates the potential latent value that can exist in out-of-favour sectors, and how quickly the market can turn in their favour (Shopify is now up 86 per cent from its bottom less than six months ago).

The companies above provide a blueprint for what we might expect from the broader portfolio. Strong revenue growth, particularly as the cycle improves, should be met by margin expansion as companies benefit from operating leverage. The result, in our estimation, will be much faster earnings growth across the portfolio than the market currently expects.

The tide will turn…

We want to highlight three areas where we have active exposures that have been a headwind in recent years, but which are cyclical rather than structural. We believe that when the cycle turns, as it inevitably will, the impact on portfolio returns will be significant.

Japan

Firstly, the performance of our Japanese holdings has been particularly painful. In part this is related to investment style. In early 2022 with the invasion of Ukraine and resurgent inflation there was a sharp market rotation from ‘growth’ to ‘value’. Material and energy stocks and interest rate sensitive stocks performed well, while longer duration names and quality compounders underperformed. This was a global phenomenon but in the Japanese market this rotation was particularly pronounced and has been much longer lasting, driven by country specific factors including uncertainty around governance improvements and a very weak currency. Our holdings in higher quality growth businesses which benefit relatively less from balance sheet restructuring or the ‘oxygen’ of a weak currency, have been left behind in this environment. However, we believe that once the governance improvements have been digested and when a convergence in interest rates causes the yen to stabilise or even strengthen, quality growth businesses will once again come back into focus, and given weak starting valuations, their share prices should reflect operational performance and growth prospects.

Within the portfolio, there are plenty of examples of the higher quality growth businesses described above. We would highlight Murata, which has a world-leading position in certain components used in communication devices, Sysmex, which develops and supplies diagnostic instruments, and Shimano, which primarily produces very high-quality cycling components, as compelling flag carriers. In addition, the likes of Nippon Paint is delivering double digit EPS growth, taking market share in most markets, but trades on a mid-teens PE ratio – we don’t expect this clear mismatch to continue indefinitely.

Industrial recovery…

Secondly a sustained industrial recovery would benefit several of our industrial equipment companies. While any equipment related to AI has been booming this year, in other areas such as smartphones, computers, and biopharma there have been some false starts but no sustained recovery. Partly this is because of excess inventory stored up during times of COVID related supply chain disruption and partly because higher rates choked off financing for certain areas. We believe that as inventories are digested, and a replacement cycle kicks in for various sectors, industrial equipment and capex exposed areas of the portfolio will perform strongly. This process of recovery has taken longer than we thought it would, but the legacy of COVID lockdowns means this has been an unusual industrial cycle. We are confident that when a recovery comes through, many of the companies we hold will experience not only a recovery in earnings but a reappraisal of their prospects, which will be reflected in higher valuations. Indeed, we have added holdings to our industrial ‘bucket’ where we think that future prospects are not reflected in the valuations.

A good example from this category is Soitec, the performance-engineered semiconductor wafers manufacturer. The company has guided that sales have bottomed out and that the recovery in demand is picking up strongly as its customers restock inventories. Soitec’s end demand is largely in cell phones and, therefore, it stands to reason that it moves with different cycles to some of the other semiconductor-related companies we hold.

The return of the emerging markets consumer

Thirdly a recovery in the emerging market consumer and particularly the Chinese consumer would be positive for performance. It has been painful to continue our hold positions in luxury goods, cosmetics, and certain beverages categories this year, and we have been disappointed that the emerging market consumer has remained so weak. In hindsight we were too optimistic about a resumption in consumer activity after the disruption of lockdowns. However, in the long term, we believe that a growing middle-class consumer is an important global mega trend that will persist beyond the next decade. As bottom-up stock pickers we continue to revisit the investment cases for all our holdings and have exited from consumer holdings where we think brand strength has weakened but we have also taken new holdings in this sector where we see attractive opportunities in the long term.

When the recovery does gather pace, and the Chinese consumer regains ground, the impact on the fortunes of luxury goods companies such as LVMH and Richemont could be incredibly meaningful.

Strong Long-term Foundations

While we believe the case for the portfolio is strong over the medium-term, we think it is even stronger over the long-term. The portfolio contains exposure to powerful secular trends, such as the integration of technology in industrial applications, the growth of AI and semiconductor capex, and the emerging middle class across fast growing economies. As we enter a more benign economic environment, we think the market’s focus will return to the micro over the macro, favouring companies with the ability to generate value over prolonged periods.

Finally…

This letter is not meant as a list of excuses for underperformance. We have made mistakes and are committed to learning from them. The important point for us is that we have specific groups of high-quality, attractively valued businesses across the portfolio, including in the areas that have proven difficult in recent times. We can already see an improvement in the backdrop and in the fundamentals of these businesses, and we believe that portfolio performance will turn accordingly.

The Portfolio Construction Group enters 2025 positive, focused and optimistic about the broad opportunity set available at extremely attractive starting points. An investment trip to Switzerland in the first week of January helps to underline this point.

We thank our clients for their continued support and patience. We genuinely believe that this will be repaid to you via re-establishing a track record of outperformance through careful, thorough and considered stock picking.

This is an International All Cap commentary based on ACWI ex US All Cap. Not all stocks may be held, but themes of this commentary are representative of: EAFE Plus All Cap and Developed EAFE All Cap. 

The International All Cap Strategy comprises three distinct variants. Overall, the variants are broadly similar, with the key difference being the degree of exposure to emerging markets listed holdings. 

Source: Revolution, MSCI. US dollar. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised.

Past performance is not a guide to future returns.

Legal notice: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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