US Equity Growth: investor letter Q2 2024

We invest into uncertainty. We chip away at that uncertainty through detailed company research built on interactions with company leaders, industry experts, and each other.

We focus that research, and our investment strategy, on recurring stock-market traits where we have developed an analytical edge.

• Companies that grow the most deliver the best returns
• Big winners dominate portfolio return profiles

These traits only assert themselves reliably over longer time frames of five years or more. Even after the most diligent analyses, there’s no escaping the uncertainty that remains. Seeking a sure thing in stock markets is an exercise in futility or delusion. Acknowledging that up front is central to how we operate.

We assess every holding against a long-term return hurdle and a confidence level. We compare our confidence in a company clearing that hurdle against the base rate for a “typical” stock.

In most cases, we set the bar at a 2.5x return in five years at a greater than 20 per cent confidence level. This requires us to look for considerable potential upside from today’s starting point. For a stock to have investment appeal, we must believe it has a better than 20 per cent chance of delivering that return.

There are higher return, lower probability hurdles too. We consider the chances of a holding generating a true “outlier” return.

Around 1 in 20 companies typically generate a 5x return in five years. That sets a 5 per cent base rate for a 5x return. If a company looks unusually likely to clear this bar, then this might drive a larger holding size for established businesses. Alternatively, it may motivate us to take a small position in a nascent business where the outlier case is central to our investment conviction.

A market context

Our 2.5x hurdle rate offers a perspective on recent stock market dynamics. S&P 500 companies have been much less likely than usual to deliver a 2.5x return amidst a turbulent corporate backdrop. The base rate has been c. 7 per cent in the five-year periods ending in 2022 and 2023.

2.5x base rates based on price return 

Source: S&P 500. Monthly data from January 2009 to May 2024.

Several of the USA’s largest companies have been in that narrow group, leading to a rise in index concentration and a flurry of market commentary. The “Magnificent Seven” moniker is now giving way to the “Fab Five” as commentators rehash the group to fit the share price rankings.

Our returns have lagged the market in recent years against this backdrop.

The question for us is whether this dynamic reflects a structural change in how stock market returns are likely to be distributed from here. Should we shift our terms of reference when considering the upside available from the ‘typical’ stock?

We don’t think so. We’ve been through a series of events that seem unlikely to be repeated. The wash from Covid distortions and the subsequent waves of interest rate rises rocked lots of boats, most notably those that were pursuing the fastest route to growth with deliberately loss-making business models. In contrast, big businesses with capital at their disposal have been able to steam on with less disruption. In stormy seas, it’s been better to be on an ocean liner than a speedboat.

Carlota Perez’s analysis of technology revolutions through the ages tells us that we should expect to see market narrowness at the earlier stages of a revolution, plus periods of turbulence as technologies are unevenly deployed across industries. Her analysis also indicates that revolutions always broaden to a bigger population of winners over time.

We can’t disentangle market dynamics, but we can observe that the proportion of S&P 500 companies clearing the 2.5x hurdle is rising once again (over 60 from a low of 27). Companies that had to adjust to a new capital environment are now getting back to focusing on growth. We have seen that play out in the portfolio over the past couple of years. Tougher, leaner operations are now emerging. Importantly they are still investing at high rates into their own businesses.

Ultimately, the only perspective that matters to future returns is the potential for value creation. From that angle, there are several growth drivers that should see the population of high-returning companies rise once again. The US remains a hub of innovation and the best place in the world for companies to grow. While the recent limelight has been occupied by large technology companies, that won’t be restricted to the few for long.

Growing to the sky

We still think that solid opportunities for returns will come from companies that can use scale to their advantage to power substantial future growth. We own NVIDIA, Amazon, and Meta.

NVIDIA has been a clear standout. We bought an initial position in 2016 on the attractions of its GPU business. We felt the lead over the (then dwindling) competition was widening and that there was substantial scope for growth in chips for gaming, data centres, and virtual reality headsets. Our notes from meetings with Jensen Huang at the time highlight the scale of his ambition and the drive for rapid innovation that defined the corporate culture. We liked what we heard.

NVIDIA’s technical lead and the growth of a developer community around its CUDA software have provided an even stronger platform than we had imagined possible. Given the vast unmet demand for processing at the leading edge of accelerated computing, we think the upside potential remains attractive. NVIDIA is your portfolio’s largest position based on its chances of delivering another 2.5x from here.

Meta might be the only social media business with enough engineering heft to return the visibility to digital advertisers lost to Apple’s privacy controls. Its AI tools are contributing to better user engagement and should allow it to monetise its widely used Messenger and WhatsApp applications. Meta will continue to invest in Reality Labs, but its renewed focus on costs is driving a more disciplined form of spending. We think the prospects for sustained profit growth are far stronger than the current valuation gives credit for. We have continued to add to the holding.

Amazon’s retail business is growing into the capacity it spent the earlier part of the decade building. Margins are rising, and Amazon is unlocking new advertising revenue streams as it grows. Its formidable distribution business could grow well beyond the retail business as the traditional delivery companies cede ground. Amazon Web Services is becoming enterprise infrastructure and AI already provides multi-billion dollar revenues. The AI strategy across training, third-party models and applications is becoming clearer and will continue to adapt as enterprises evolve how they manage their data. Amazon is a $2tn business with plenty of opportunities to more than double.

Growing out of the shadows

Outstanding company growth can come from anywhere. The biggest rise in market concentration has not come from the biggest companies getting bigger. It came from NVIDIA’s arrival at that stage. At the end of 2021, NVIDIA’s market cap was one-tenth of what it is now. The stellar returns from NVIDIA have been matched in your portfolio, this year at least, by a salad restaurant.

Sweetgreen’s healthy meals with local sourcing have tapped successfully into cultural trends that are taking root: well-being and conscious consumption among them. The company’s pilot automated restaurants are performing well (delivering restaurant margins approaching 30 per cent), and there are plans to accelerate the rollout of this “Infinite Kitchen” concept as it expands. With only c. 220 Sweetgreen restaurants in the network, there is an open-ended opportunity for Sweetgreen to roll out across the USA for years. There are almost 1,200 McDonald’s in Texas alone. We don’t think that other existing restaurant chains will be able to mimic Sweetgreen with enough authenticity to threaten their mission-driven approach.

The financial services business Block has been firmly in the share price shadows, and it looks set to emerge as a much better enterprise. It provides payment processing for merchants via Square, has a rapidly growing consumer business called Cash App, and offers “buy-now-pay-later” lending through Afterpay.

Until recently, Block has operated a highly decentralised model in its pursuit of innovation. The founder, Jack Dorsey, is changing this. Block has reorganised around business functions, which should mean that features are shared more quickly among products. That improves the chances of effective integration. Financial discipline has not historically been one of Block’s strengths, but a cap on employee numbers and greater emphasis on prioritising the highest-return investment opportunities bodes well.

Block may eventually have enough scale to build a closed-loop financial network that challenges the Visa and Mastercard duopoly. Cash App already has 57 million users who can send and receive money person-to-person at no charge. 24 million of those users have also chosen to use Cash App’s debit card.

Block’s capacity for growth looks widely underestimated at the current share price. With one eye on the existing exposure to payment processing, we funded this new position with a reduction to Shopify.

A biotech bust

Plenty of shade has been thrown at the biotechnology sector over the past few years. The S&P biotechnology index has fallen 45 per cent from its peak in early 2021. Some of that might be rational. The funding environment has become more challenging. Biotech bankruptcies are at decade highs.

There is a striking disconnect with the progress being made in innovative healthcare. Half of novel therapies approved by the FDA since 2021 are biotech products. Gene sequencing costs are still falling. A new paradigm is emerging, centred on early and frequent testing to identify effective personalised treatment options.

Alnylam Pharmaceuticals, a portfolio holding since 2016, uses RNA interference to ‘silence’ genes and stop the production of disease-causing proteins. This revolutionary technology could treat a wide range of diseases. Alnylam’s platform technology has delivered a 60 per cent success rate in taking candidate drugs from investigational status to late-stage trial success. That compares to a traditional industry rate of 10 per cent. The recent positive share price reaction to Alnylam’s heart disease trial success suggests that stock markets do not yet view Alnylam as a business with a high chance of addressing many more diseases in the future. We see it differently.

Our new holding in Tempus AI, taken at IPO, further broadens our exposure to this exciting space. Tempus provides genomic testing and data insights to care providers and pharmaceutical businesses. Biopsies are not yet routinely sequenced, but Tempus is helping to change that. Tempus tests help doctors make faster and better decisions for their patients by providing data-informed recommendations with results built on the company’s proprietary genomic dataset. The data set will grow as it processes more tests, and recommendations will become more accurate.

While testing represents most of the current revenues, the data services that Tempus provides could be an even more significant opportunity. Customers can pay to interrogate Tempus’ library using AI tools, unlocking new insights. Other test providers could eventually license Tempus’ data to provide insight into their results. This could produce both a broad benefit to the healthcare system and a highly efficient growth engine for Tempus. This is a nascent industry, and our investment case for Tempus is based on the relatively small (but attractive) probability of large upside potential should Tempus establish a leading position.

A wide enough lens

At the other end of the growth spectrum, we are pushing ourselves to consider companies where the durability of their growth is their key differentiator. A five-year time horizon may not be sufficient to capture the exceptionalism of some businesses. This might be particularly valuable work when so much market attention is devoted to a few businesses with exposure to one theme.

When we extend to a 10-year time horizon, a top 20 per cent business delivers a 4x return or better on average. A steadily growing company might not meet our five-year hurdles, but it can compound its way into the top returns given time.

We already own this sort of business in the portfolio. The portfolio’s longest-standing holding is Watsco, an HVAC distribution business that has delivered 19 per cent p.a. returns to its shareholders for over 30 years. The HVAC market remains fragmented even after 30 years of growth. We think Watsco will continue to consolidate the market for years, and its lead will stretch further as it leverages technology spending over a far larger revenue base than anyone else in the industry.

We have recently made a more concerted effort to test this part of our opportunity set via a focused set of analyses of potential holdings. Every team member has written on at least one 4x candidate this year, and we are currently working through our findings.

Conclusion

The US will keep producing outstanding companies that benefit from all manner of growth drivers. There’s no other corporate landscape like it; we don’t see that changing. We will keep seeking out varied and under-recognised growth businesses like Sweetgreen, Block, and Watsco for your portfolio. Some will have the potential to rise to the very top of the market cap rankings, just like our purchase of NVIDIA in 2016, based on the scale of the opportunity they pursue. Block could be one of those businesses. Others will never come close, but it won’t matter if they can deliver several times their starting share price to holders.

The portfolio’s current holdings have come through a demanding spell and have emerged tougher and more profit-focused. The greater spread of maturities and growth drivers in the portfolio provides a solid foundation to generate returns from. Our opportunity set may never have been bigger than it is right now. So much so that we’re taking active steps to ensure we are looking widely enough for stocks that meet our definition of exceptional opportunity.

The emerging artificial intelligence phenomenon will reset the competitive dynamics in many industries. The unstable stock market enthusiasm for these opportunities may be an understandable reaction to the pace of change that this could bring, but the narrow view being expressed now will broaden. Edge and exposure are very different things. We prefer to search out emerging sources of edge rather than simply backing obvious examples of exposure. The greatest return opportunities may lie outside of the current crowd. You just have to be brave enough to look.

Source: Revolution and S&P 500. USD. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite.

Past performance is not a guide to future returns.

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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in July 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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