Sustainable Growth: investor letter Q4 2024

Your capital is at risk. 

Umwelt: (ˈʊmvɛlt) noun biology, psychology

The specific way organisms of a particular species experience the world, depending on what their sensory organs and perceptual systems can detect and interpret.

Perceiving different worlds 

What if the first alien intelligences were already living with us here on planet Earth? In Ray Nayler's sci-fi novel The Mountain in the Sea, a marine biologist travels to a remote archipelago to investigate a newly discovered species of hyperintelligent octopuses that carve shapes and symbols into rocks, documenting their own language and culture. She does so in secret, trying to evade a powerful tech company that is pursuing the animals to further its research into artificial intelligence. Several members of the Sustainable Growth team picked this novel as our best read of the year. We enjoyed it for its commentary on our own species' ecocidal tendencies, as well as its ambitious attempt to combine the fields of biology and technology. We also liked that the book expanded our vocabularies, with all happy to admit that some of the more esoteric terms required a quick look in the dictionary.

One such term was 'umwelt' which Nayler uses to describe how the octopus perceives a vibrant underwater world through what are essentially eight autonomous brains residing in its tentacles. This gives it a very different view of its environment to humans, who might only see shadows. The concept of a differentiated worldview resonated deeply with us as we reflect on a year in which the strength we see in the portfolio holdings has at times been poorly reflected in stock markets. Our umwelt is the operational progress of these companies and the diverse structural growth opportunities in front of them. For large parts of this year, it's felt like others only perceive the share prices or, at best, the bits of a business with AI exposure.

Recent performance can also be viewed from different perspectives. Another healthy return this quarter means we've chalked up double-digit gains for the year in sterling terms. A good result in the context of long-term global equity returns averaging 6-8 per cent per annum. Yet from the perspective of relative performance, we've lagged a highly concentrated index, an unsatisfactory result given our mandate for active management and superior returns. The tale of the quarter largely mirrors the year as a whole, with tech-focussed US businesses leading the way and European industrials lagging. The only slight narrative change was that small companies outperformed larger ones in the US, most likely in anticipation of lower taxes and a bonfire of regulation during Donald Trump's second presidential term.

Through the lens of operational progress, the holdings continue to perform well. In many cases we're seeing firms benefit from tough choices made during a couple of lean years. Swedish streaming service Spotify is a top contributor in the fourth quarter and for the year as a whole. It is benefitting from a couple of years of strict cost control, with little impact on topline growth. Revenues were up 20 per cent year-on-year when the company reported in November. This is having a positive effect on gross margins, which grew by a whopping five percentage points. However, because of the way music labels are paid for streams, this does not translate into similar improvements in operating margins. Newer audiobook and podcast offerings are not constrained in the same way so we expect to see improved profitability as these segments grow in importance. The nascent marketplace business (where the company provides production tools and data analytics for artists) is showing great promise too, now representing around a tenth of total sales.

Nearly namesake Shopify is also benefitting from cost control measures implemented in 2023. Having divested its logistics arm, the firm is now a pure play on ecommerce software and is beginning to earn software-like margins, going from breakeven to 10 per cent at the operating line this year. We expect this to fall somewhat as the firm returns to investing for growth, but management have talked enthusiastically about how they can make their people more productive with AI tools. In a call with management this quarter we were pleased to hear how they've refocussed on the core business, but we'll be watching with interest to see where margins settle in the long run. Like the octopus using different tentacles to explore its environment, we see multiple dimensions of value creation in these companies. However, we've reduced both positions on share price strength at various points in the year.

The year's other strong performers have also been technology businesses. Hiring platform Recruit is executing well despite tight job markets. Programmatic advertising platform The Trade Desk is benefiting from a pick-up in corporate advertising spend and is winning share from the walled gardens of Meta, Google and Amazon. And the largest holding TSMC continues its march towards a $1 trillion market cap, with more than half of revenues now coming from the manufacture of AI chips, where it has close to 100 per cent market share. We've made reductions to all of these strong performers throughout the year, recycling the proceeds into holdings that have not enjoyed the same levels of positive sentiment.

With US technology firms performing so strongly, what we don't own was again a drag on performance this quarter, with index-heavyweights NVIDIA and Tesla two of the largest detractors from relative returns. While we have owned both companies in the recent past, our decision to sell reflects clear concerns: we see both as richly valued, especially when viewed in the context of increasing competition. Rich valuations are a feature of the US market more broadly, with the S&P 500 valuation multiple expanding by a quarter in the last year alone to a lofty 28 times price-to-earnings. US companies now make up more than two-thirds of global indices, despite generating just over half of global profits. Given this disparity, we remain comfortable with our underweight position in US equities, even though this has dampened returns over the past year. It's also worth noting that, while we appear underweight when looking at company headquarters, the actual exposure to US economic activity - measured by companies' revenue sources - is roughly in line with the global average.

The valuation gap between the US and the rest of the world is at a 20-year high. Just as an octopus might perceive vibrant patterns invisible to human eyes, we're detecting value in European markets that many investors, focused solely on US tech narratives, might be missing. European companies have lagged their US counterparts by more than 20 percentage points this year. A less developed tech sector is part of the explanation, but so is a more diversified stock market, with no company representing more than a half percent of global indices. We should be clear that underperformance is not all about regional weightings and enthusiasm for tech stocks though. The biggest detractor in the portfolio over the year was cosmetics giant L'Oreal, which has delivered low single-digit growth owing largely to its exposure to the Chinese market. While the firm is taking share from rivals like Estee Lauder, we're also aware younger customers are experimenting with newer brands so we would like to see evidence of improved innovation from the French company in future results.

Though not a large detractor from relative performance due to its small position in the portfolio, Moderna has perhaps been the holding we’ve been most disappointed with this year. While we've seen some of the scientific validation of the mRNA platform that we'd hoped for, commercial success has proven more elusive. Vaccination levels for the now endemic Covid-19 are well below those of much less lethal influenza, presumably due to society's general fatigue with the disease they spent two years thinking about. Despite promising trial results for RNA-based flu and RSV vaccines, and the promise of combining these with the covid jab for a single-shot respiratory vaccine, the firm has not seen a significant contribution from these franchises and remains unprofitable. Moderna is still a resilient company due to the cash pile it amassed during the pandemic, and it appears to be addressing the issue of commercialisation with a new board appointment announced this quarter. These are positive signals to us so we've added to the position after the shares more than halved in the first three quarters of the year.

We've seen things differently from the broader market since we established a dedicated research desk for Sustainable Growth at the beginning of 2023. The artificial intelligence theme has dominated global markets, driving large US tech companies ever higher. Out clients have benefited from this via our investments in NVIDIA, Alphabet and Amazon, but our consistent response to outsized returns has been to take money out of these big winners and recycle it into better value stocks exposed to more diverse growth themes elsewhere. This means we end year two with very healthy absolute returns - the portfolio is up around a third in sterling terms - but shy of an exceptionally strong index. Our clients employ us to beat the index in the long run, and we continue to think that positioning the portfolio for a broader range of growth drivers will give us the best chance of doing so.

Evolving our investment ecosystem 

When we made enhancements to philosophy and process at the start of 2023 we set ourselves four goals. We wanted to bolster the portfolio's resilience, to improve its diversification and to elevate its standard of sustainability. Ambitiously, we aimed to achieve these things without compromising on the earnings growth potential that we know drives long-term outperformance. So, what progress have we made?

Through both active trading and the portfolio companies' taking greater control of their own destiny, we've seen meaningful progress on portfolio resilience in the past two years. There is only one company left in the portfolio with negative earnings and cashflow—Moderna—and even there, resilience is high given the presence of a $12bn cash pile. This is an output of stock selection, but we've also brought new portfolio construction tools to bear that help us consider what a new position adds to overall portfolio resilience and how this compares to return potential, taking larger positions where the balance between the two is favourable.

In the most recent quarter this heightened awareness of company resilience led us to exit the position in Denali Therapeutics, the biotech focussed on neurodegeneration. Denali's mission to get a large molecule drug across the blood-brain barrier to treat diseases like Alzheimer's and Parkinson's remains an admirable one. However, progress through medical trials has been slower than we would have hoped and there is little in the development pipeline that gets us excited. In this case, we didn't feel the return potential made up for a fundamental lack of resilience.

In its place we've added a new position in US cold storage logistics business Lineage. The company has been an acquisitive player in a fragmented industry, building up a 30 per cent market share that is twice as large as the nearest competitor. This scale gives it resilience in an industry that is susceptible to market cycles. It also allows it to invest in automation in a way that wouldn't make sense for smaller firms. For example, a strategically located site in Pennsylvania features a crane and rail system for product handling, allowing it to efficiently manage 85,000 pallet positions and serve 60 million people within its 250-mile radius. Globally, around 14 per cent of food is lost between harvest and retail, enough to feed more than a billion people per year. Lack of refrigeration accounts for around a quarter of this, so Lineage's efficiency improvements can have real impact.

Companies like Lineage clearly elevate the portfolio’s sustainability credentials, but our other new purchase this quarter has an even more direct impact on human health. Edwards Lifesciences was founded in 1958 by an engineer who had the ambitious goal of creating the first artificial human heart. The company has pioneered minimally invasive surgical methods for the treatment of structural heart diseases with its transcatheter aortic valve replacement (TAVR) technique. In the US around 5 per cent of over 65s suffer from a form of heart disease that, if left untreated, kills half of those affected within five years. Edwards’ TAVR procedure inserts a replacement valve through a small incision in the leg, a method that is much preferred to open heart surgery. We think there's lots of room for growth as this method is used to treat more moderate forms of heart disease and as the company begins to expand overseas. Recent staffing shortages at hospitals have led to fewer doctors training up on this new method, resulting in a downgrade to management's short-term outlook. With the shares falling around a third we were presented with an attractive entry point for this long-term growth story.

Each of these new names adds something new to a portfolio that now has tentacles in 57 holdings spanning 15 different countries and 29 distinct industries. Establishing a dedicated research desk has allowed us to take a more holistic view of portfolio exposures, and to judge what a new position might bring that we don't already have exposure to. As a result, we've made real progress on our goal of greater diversification.

These new purchases were funded by sales of Chinese ecommerce company JD.com and European sportswear giant adidas. In both cases we had waning conviction in the sustainability case as intensifying competition is likely to be prioritised over missions to improve outcomes for people or planet. Progress on improving our sustainability standards is not just about adding new holdings like Edwards and Lineage then, its about weeding out the weaker cases too. This progress can be tracked in our recently published sustainability report [2024 Sustainability Report], which aims for greater transparency than ever before, including the portfolio's alignment with the UN Sustainable Development Goals and a summary of our sustainability hypothesis for every holding.

We're pleased to have made improvements across these three key criteria, but we're especially proud to have done so while not compromising on our targeted double-digit earnings growth rate. On one measure we're 2/3rds higher than we were two years ago, and also 2/3rds above the current index level. This proves that we've maintained the growth rates that will drive long-term performance as we pursue greater resilience and diversification. We've been able to achieve that by using our sensory apparatus to detect a broader spectrum of opportunities, finding a range of growth companies that add new dimensions to the portfolio.

Interestingly, the index's strong return over the past year has been driven primarily by valuation multiple expansion while earnings growth has been the dominant factor in the portfolio’s return. As we move into 2025, we expect other investors to begin detecting the fundamental strength we perceive in the holdings, leading to improved share price outcomes across a wider spectrum of growth opportunities.

Just as the remarkable octopus perceives its world through multiple independent neural centres, our investment approach maintains various points of contact with diverse growth opportunities across sectors and regions. While the market's current umwelt seems narrowly focused on US tech and AI, our broader perspective reveals a rich landscape of operational progress and emerging opportunities. We believe this multi-dimensional view gives us a more complete picture of the investment environment and positions us well for the years ahead.

*31 December 2022

Source: Revolution, MSCI. US dollars. 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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