Global Alpha: investor letter Q3 2024

Your capital is at risk. 

Not far from New York’s La Guardia airport, looking out over the East River, stands a factory that breathes with the earthy scent of sawdust. The air thrums with the rhythmic hum of hand tools, punctuated by the staccato hammering of wooden dowels and the metallic clang of clamps. This is a symphony of industry. Here, a machine of hammers, levers, and springs takes form – a Steinway concert grand piano. Building a concert grand is a meticulous 11-month journey of shaping, painting, polishing, tuning, and inspecting. However, crafting a Steinway begins many years before on an archipelago just off the northern Pacific coast of Canada known as Haida Gwaii.

This area is home to ancient coastal forests in which grow some of the world’s largest and longest-lived trees. The towering Sitka spruce reaches skyward to heights of up to 100 metres, forming a cathedral-like canopy that intensifies the call of the marbled murrelet and the drumming of woodpeckers. These trees will form one of the most vital components of a Steinway concert grand – the soundboard. The soundboard amplifies the vibrations of the strings, generating the rich, full sound for which grand pianos are renowned. Only a tiny percentage of Sitka spruce trees will yield timber of soundboard quality. So, what does Steinway look for when selecting trees to produce this component? The answer is simple. The best soundboards are crafted from trees with evenly-spaced growth rings – the result of the tree growing consistently year after year.

Growth matters

Like the Sitka spruce, the portfolio contains companies carefully chosen for their exceptional growth characteristics. At the steadier end of the growth spectrum is US health insurer Elevance Health. Held since the strategy’s inception, Elevance is one of the strongest contributors to returns to date. The company is transforming from being a traditional health insurance company to a diversified healthcare services organisation. Through both organic growth and strategic acquisitions, it is making significant progress in its higher-margin Carelon business, which provides a broad range of health services that help people to manage complex chronic health conditions, refill prescriptions, access mental health support services, and much more. Over the last two decades, it has compounded its earnings 12 per cent per annum and, even throughout the volatility of the last five years, its shares have continued their steady upward progress. We have seen similarly strong track records achieved by other holdings, including ratings agency Moody’s, social media company Meta, and global payments technology company Mastercard. What is exciting is that not only do these companies have exceptional track records, but we believe they still have long growth runways ahead.

The growth achieved by these and many other companies supports our fundamental belief that share prices will follow earnings growth over the long term. From the strategy’s inception in May 2005 until the end of 2021, we delivered an average relative return of +2.2 per cent (in USD) per year. Earnings growth underpinned this. Over its lifetime, the Global Alpha strategy has delivered an earnings growth rate of 11.2 per cent, far exceeding the 7.7 per cent achieved by the MSCI All Country World Index. This superior earnings growth translated into outperformance. Even over the last five years – during which time we have experienced periods of much weaker performance – a representative Global Alpha portfolio has delivered earnings growth of 12 per cent per annum, compared to the 7 per cent delivered by the benchmark index.

The portfolio is made up of around 90 high-quality companies from right across the growth spectrum. This diversity of growth opportunities is reflected in our three growth profiles. It is not just the consistent and enduring growth delivered by Compounder holdings such as those cited above that has contributed to this long-term track record. Looking at the holdings that have delivered the highest returns since inception, the top ten is populated by names from across the three profiles. Among the top ten are Disruptor holdings that are redefining entire industries, including ecommerce giant Amazon, electric vehicle manufacturer Tesla (sold in April 2024) and global leader in accelerated computing and artificial intelligence, NVIDIA. Capital Allocator holdings, which tend to be more exposed to economic, industry or product cycles, also feature, including the world’s leading semiconductor foundry TSMC and global engineering group Atlas Copco.

Patience matters

The most essential ingredient for the compounding of investment returns to take place is time. But growth investing demands not just time but patience. As long-term investors, we understand that on the journey to becoming tomorrow's winners, companies will encounter bumps in the road. Our role is to carefully monitor progress against the investment case for each holding but also to provide the space and support companies need to reach their potential. In recent months, numerous examples of this patient approach have been rewarded from right across the portfolio.

Demonstrating patience can be particularly important for earlier-stage growth companies where the range of outcomes is wider but the potential rewards much greater. Alnylam Pharmaceuticals is a biotechnology company specialising in gene-silencing technology called RNA interference (RNAi). RNAi “turns off” faulty genes, treating diseases caused by the harmful proteins these mutated genes produce. When we first invested in 2015, Alnylam was an early-stage biotech with no drugs on the market. Today, it has five approved RNAi drugs. But it hasn’t always been an easy ride. Earlier this year, the company announced changes to a pivotal late-stage trial for a drug used to treat a fatal genetic heart disorder. The market reacted badly, worried that the changes indicated a lack of confidence in the initial trial design, and the share price fell. The market appears to view every potential new drug in Alnylam’s pipeline as a long shot. However, the trial results were not only positive but validated Alnylam’s technology and its potential to treat and prevent a broad range of common diseases with much larger patient populations, such as hypertension and Alzheimer’s. Our insight lies in our confidence in the inherent value of Alnylam's platform and its strategic approach to drug development, which has helped the company to achieve an impressive 60 per cent success rate in bringing drugs to market, compared to an industry average of 10-15 per cent.

Another company in the portfolio where patience has mattered is the online pet supplies company Chewy. Throughout 2022 and 2023, weaker consumer spending acted as a headwind for the company and it experienced a slowdown in its new customer acquisition rate. Fast forward to this year, and our patience is paying off. The company is reporting increased sales for its Autoship subscription service and higher net sales per active customer. It has also introduced a sponsored advertising programme that allows brands to showcase their products on Chewy.com, supporting gross margin expansion and driving its share price upwards. Chewy is rapidly becoming a one-stop shop for pet owners. We are excited by its potential to leverage strong customer relationships by cross-selling into new (and higher-margin) areas, including pet insurance and vet clinics.

Elsewhere in the portfolio, companies are achieving impressive operational progress that is yet to be reflected in share prices and we are optimistic that our patient approach will soon be rewarded. A prime example is Royalty Pharma, which provides capital to biopharmaceutical companies in exchange for a share of the revenue generated by the drugs they produce. In a higher interest rate environment, Royalty Pharma’s role as a provider of capital is increasingly important. In this environment, we have seen the number and value of Royalty Pharma’s royalty deals accelerating. However, its seven times price-to-earnings ratio belies the company's robust fundamentals and ongoing revenue generation from its diversified drug portfolio. We are reminded that when market conditions are unusual, the unique opportunities it offers may be overlooked by the market. Our conviction in Royalty Pharma’s growth potential remains high and we have added to the holding twice since first purchase in 2022.

Diversification matters

A core tenet of our investment philosophy is that growth comes in many forms and from diverse sectors. We also know that a high level of diversification within the portfolio has played a significant role in generating outperformance over the long term. Since we first introduced the growth profile methodology in 2010, the portfolio in aggregate has outperformed over individual months more frequently than any of the individual profiles in isolation. However, diversification has posed challenges in recent months due to unusually high levels of market concentration. Since the recovery in global stock markets that began towards the end of 2022, the portfolio has delivered respectable absolute returns but performance has trailed that of the benchmark index. The narrowness of index gains – dominated by the ‘Magnificent Seven’ – is well-documented and has been one of the drivers of relative underperformance. Although we are enthusiastic about AI's potential to change how we live and work, we remain open-minded about which companies stand to gain from this profound shift.

With the market so narrowly focused, it is an ideal time to be reward-seeking. We search widely for unrecognised growth and are finding it in an eclectic range of companies. Within the broader AI value chain, we have purchased the French materials science company Soitec. Soitec has an essential role in addressing the challenges of digitalisation, electrification and AI across end markets including smartphones and data centres. It supplies the semiconductor industry with engineered substrate wafers, which enhance chips and ensure more reliable connectivity, lower power consumption and better performance for the devices that contain them. The company’s proprietary technology lends it a strong position in a fast-growing niche. This, and its attractive valuation in light of expected future returns, form a compelling investment case.

Builders FirstSource operates in a different sphere from the high-tech world of AI, yet its potential for growth is no less transformative. This new holding is the largest supplier and manufacturer of building materials, components, and services for professional homebuilders in the US. It is a leader in one of the world’s largest residential property markets, which is facing a shortage of affordable housing. Builders FirstSource is helping to address this challenge, as its products make constructing new homes faster and more efficient. With low penetration in a vast addressable market, we have conviction in the company’s potential for significant expansion through both organic growth and strategic acquisitions.

From chips to construction to coffee, we have also invested in the US drive-through coffee chain Dutch Bros. The market does not appear to appreciate the scale of the store roll-out opportunity over the next decade or the enduring nature of the shift towards the newer and different caffeinated drinks it offers its customers. Also within the Disruptors profile, we have added to several names where conviction in their outlier potential is increasing. These include The Trade Desk (advertising technology), Adyen (payments technology provider), and DoorDash (food delivery). Despite the uncertain macroeconomic environment, all three are growing healthily and executing strongly.

Outlook

While construction methods have been honed over decades, the process of building a Steinway has remained essentially unchanged since the first concert grands of the 1890s. Similarly, Global Alpha’s core philosophy of identifying and investing in a broad range of exceptional growth companies has remained constant since the strategy's inception in 2005. At the same time, however, we remain committed to strengthening and fine-tuning our process, incorporating lessons learned over what has been a challenging few years. This fine-tuning has resulted in a diverse portfolio populated by an eclectic mix of growth businesses that have proven to be immensely adaptable in the face of change and uncertainty. We have great faith in the strength of the portfolio’s foundations. For a representative portfolio, the vast majority of holdings (around 98%) are profitable or free cashflow positive and the portfolio overall is much less reliant on debt funding than the broader market, with net debt-to-equity at around 20% compared to 50% for the index.

Meanwhile, the portfolio is exposed to an even wider range of powerful, long-term trends that will support future growth. These underpinnings – alongside our patient approach to investing and focus on business fundamentals – position the Global Alpha portfolio well to deliver long-term outperformance. The three-year earnings growth forecast for the portfolio in aggregate remains ahead of that of the index and, looking ahead, we see encouraging signs of a broadening market environment. We believe the benefits of a diversified portfolio will become even more apparent as a wider range of high-quality growth companies are likely to be recognised and rewarded by the market. The portfolio is in tune. The stage is set.

This is a Global Alpha commentary. Not all stocks may be held, but themes of this commentary are also representative of: Responsible Global Alpha, Global Alpha Paris Aligned and Responsible Global Alpha Paris Aligned.

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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