Sustainable Growth: investor letter Q1 2025

Your capital is at risk.

• We’ve enhanced risk and portfolio construction processes, improving resilience and adaptability in an unpredictable market environment.
• Stock-specific drivers, rather than broad themes, dominate performance this quarter, with the portfolio underperforming a falling index.
• Taking advantage of more favourable valuations amongst high-growth names in the US, we’ve added Sweetgreen, Cadence and Synopsis to the portfolio.

"Don't think of them as stuck up there, they consider us to be stuck down here in our 2D world" Chris Hadfield, Retired Canadian Astronaut

Last summer, 58-year-old Suni Williams and 60-year-old Butch Wilmore blasted off on a mission to the International Space Station (ISS). However, the capsule they arrived on suffered technical difficulties, leaving them unable to return eight days later as planned. This March, a full nine months later, the pair splashed down off the coast of Florida. While they found themselves with fewer changes of clothes than they might have liked for their extended stay, their more essential needs were well catered for. That’s because the ISS always carries plenty more food than it requires, one of many contingencies it considers in extensive scenario planning that means it's always prepared for unexpected events.

In the past three months we've had a taste of a new world order set to last at least four years. One where geopolitics, global trade and, by association, stock markets, can change markedly day-by-day if not hour-by-hour. This increasing unpredictability makes the adaptability and resilience of the companies we hold on behalf of our clients, all the more important. It also makes it crucial that we manage the overall portfolio in such a way that it is set up to cope with unexpected events. It’s against this backdrop that we've been considering enhancements to our risk management and portfolio construction processes, so this quarter we'll update you on our progress on those fronts, alongside the usual summary of performance and positioning.

Risk Management and Portfolio Construction

In the past two years we've made the portfolio significantly more resilient and better diversified. However, our risk guidelines have remained the same throughout this transition. This means that we now find ourselves in a position where the guardrails we place around portfolio construction are no longer aligned with how we think about the concentrations and correlations of risk present within the portfolio.

We've long defined true risk as the permanent loss of capital. However, we also recognise that excessive volatility is both unexpected and undesirable for our clients. Our job is to maximise expected returns while maintaining moderate risk levels. As portfolio managers, we take full accountability for risk management - it's our core responsibility, not something we outsource to mission control at our central risk team.

For a truly active manager, stock selection should drive both risk and return. As such, our risk process focuses on two pillars: fundamental risk (where we aim to reduce the likelihood of poor stock selection) and portfolio risk (where we look to minimise the impact of any such selection errors).

Fundamental Risk

We've been making enhancements throughout our risk management process, from idea generation to portfolio construction and ongoing monitoring. For example, our quarterly risk reviews now include correlation analysis to help us identify blind spots in sectors, countries, and themes. This structured approach helps us explore our entire opportunity set and avoid unintended bets, with priority given to names that bring diversity to the portfolio.

Within our research framework, we explicitly focus on resilience - how much control a company has over its own success - alongside growth and valuation considerations. We now also express our conviction levels and scenario analysis in the form of a probability distribution. This has been hugely helpful for capturing and communicating the range and skew of possible outcomes, as well as identifying milestones and warning signs for ongoing monitoring.

We consider ESG risk as an integral component of fundamental risk, recognising that flawed sustainability analysis can result in material controversies or behaviours that are inconsistent with our investment thesis, thus derailing a company's journey to improved profitability.

Portfolio Risk

While volatility isn't synonymous with risk, we consider it in portfolio construction for two reasons: it provides an external perspective on company risk, and it impacts client outcomes and their ability to manage their wider portfolios. Our position sizing explicitly considers both correlation with the broader portfolio and stock-specific volatility, along with return potential and resilience.

To reflect these process enhancements, we've streamlined our portfolio guidelines as follows. These new guidelines will be effective from year-end 2025.

We've changed our stock size limit to relative rather than absolute, giving us more flexibility to express our conviction against an increasingly concentrated and top-heavy index. This allows us to take meaningful active positions in companies like Microsoft, for example, which is nearly 4% of the benchmark. As such, our previous rules would have constrained our active position to less than a per cent.

While the formal guidelines are fewer and simpler, that should not be mistaken for a loosening of risk controls. Back testing reveals that these controls are indeed more stringent, and would have triggered during the periods of extreme volatility we saw in 2020 and 2022.

We are supplementing these guidelines with a list of indicators that we will monitor on an ongoing basis (‘nudges’). These are a mixture of portfolio characteristics (for example valuation and growth metrics) and outcome metrics (such as tracking error) where we have identified an expected range consistent with our investment approach. This empowers our colleagues in Investment Risk to provide specific challenge and hold us accountable if the portfolio appears to be diverging from our own expectations or those of our clients.  

We think the combination of guidelines and nudges will deliver the risk-return outcomes we know our clients desire, balancing adequate diversification with appropriate flexibility. However, ultimately, we expect the enhancements to our risk management and portfolio construction processes to really make the difference. It's about having a better pilot controlling trajectory rather than thicker heat shields on the shuttle.

Performance

One output of the enhancements made to our risk process is that performance is increasingly driven not by broad themes but by stock specifics. In the first three months of this year over- or underweights in particular countries or sectors have not been the dominant driver of relative returns, instead it has been the companies within those categories. We've seen this rebalancing play out over the course of the past two years. At one point the portfolio's tracking error (a measure of benchmark-relative volatility) showed thematic risk contributing more than 80%. Today it's closer to 50%.

Of course, one big theme that's been at play in those two years has been the dominance of a handful of mega-cap US technology companies. We've been unwilling to own these 'magnificent seven' stocks in the size they feature in our comparative index because of concentration risk, stretched valuations and opportunity cost. That discipline has begun to pay off this quarter, with three of the top five contributors being 'Mag 7' stocks we don't own performing poorly (Apple, Tesla and NVIDIA).

More broadly, US companies have underperformed this quarter as the market digests the events of Trump’s first 100-odd days in office. While he was initially seen as good for business, there are now concerns about the impact of policy uncertainty on growth and investment, as well as the potential inflationary impact of trade restrictions. This was compounded by the emergence of China's low-cost AI model Deepseek in January, which challenged the narrative of US technological dominance. Our largest detractors this quarter were indeed US companies, though stock-specific factors played a significant role as the portfolio underperformed a falling index.

When it reported results in February, The Trade Desk detailed impressive year-on-year growth of 22%. However, this was short of guidance by 2% and the shares fell by a third in US dollar terms. This was the first time the company had missed estimates in 33 quarters as a public company, with the extreme reaction reflecting something of a ‘fall from grace’.  Founder/CEO Jeff Green admitted to execution missteps rather than any structural change to the company's competitive position. Half of its sales and engineering roles were reorganised in December, and the new advertising platform with AI forecasting capability ('Kokai') experienced teething problems. While disappointed by the unforced error, we are reassured that the company is prioritising long-term client satisfaction over short-term profitability. The opportunity for The Trade Desk remains vast, with gross spend on its platform of ~$12 billion just a small fraction of the ~$1 trillion advertising market.

After a difficult couple of years, Illumina shares were by no means priced for perfection but still experienced a punishing drawdown. This was in part due to policy gyrations: academic research comprises about a third of revenues for the firm, so scrutiny of US federal budgets casts some doubt over demand from public sector customers. Now the firm finds itself caught up in the trade war, with its machines placed on China's 'unreliable entities' list, putting up to 7% of revenues in jeopardy. Our enthusiasm for Illumina lies in the clinical market where it is extremely dominant and where the opportunity is much larger than academic settings. One biotech we spoke with recently told us their new Novaseq X machine replaced 16 older sequencers. It cost four times as much but its improvements in throughput added several percentage points to gross margins. These advantages give Illumina an edge even in an increasingly competitive market. With the shares trading on a low multiple of depressed earnings, the odds are tilted in favour of good returns from here.

Illustrating the swings in market sentiment over the past six months, this quarter's top contributor to relative returns was our bottom contributor last quarter. Operationally, ecommerce and fintech platform MercadoLibre continues on an impressive trajectory, with marketplace revenues growing around a third year-on-year last quarter and the credit portfolio expanding by 75%.

Spotify has been a more consistent performer in share price terms, making it a top contributor over the past quarter, past year, and since the inception of Sustainable Growth back in 2023. Again, operational performance continues to impress, with good revenue growth (+18% last quarter) and even stronger profit growth (gross profit was up more than a third while operating expenditures fell by a fifth).

Over the longer term, while absolute performance has been good, the portfolio continues to lag an index dominated by a handful of mega-cap US technology stocks - a concentration we continue to avoid due to the inherent risks and lack of diversification such extreme top-heaviness entails.

Positioning

We've been turning a more volatile trading environment for high-growth US stocks to our advantage this quarter, using favourable valuations for opportunistic purchases of a handful of companies we've been following for some time. In particular, we're mindful of our relatively modest exposure to semiconductors (we currently have only two direct holdings in this increasingly important industry - TSMC and Texas Instruments). We've complemented these with new positions in two firms that sit further up the semiconductor value chain, Cadence and Synopsis. These additions give us exposure to AI research and development, as opposed to capital expenditure, so they ought to be more resilient to market cycles. Owning both gives us diversified exposure to different skill sets within what is a world-leading duopoly.

These firms operate in the field of Electronic Design Automation (EDA), which Cadence’s CFO describes as "the paintbrush of the silicon renaissance". EDA software is where engineers transform the concept of a new chip into a blueprint ready to manufacture. This is getting ever more complicated: today, designers must configure 100 billion transistors for each bleeding-edge chip. By 2034, they’ll need a trillion. EDA enables them to optimise this with otherwise impossible speed and accuracy. Other Cadence and Synopsis products test if these designs work and meet specifications, meaning the design is unlikely to fail at the foundry. Without EDA, innovation in semiconductor design is virtually impossible.

A key reason customers pay for EDA is to reduce the power consumption of the chips they are designing. These firms are, therefore, critical enablers of sustainability targets for their customers. These include hyperscalers whose unquenchable thirst for energy means they are investing heavily in renewables to offset their use of fossil fuels. EDA helps reduce the power consumption of almost anything with a chip in it, a benefit that is material on a planetary scale.

At first glance our other new purchase this quarter, US salad chain Sweetgreen, may seem less technologically sophisticated. However, its Infinite Kitchen concept is revolutionising fast casual dining with a robotic assembly line that can easily satisfy the busy lunchtime rush, serving up a salad bowl every three minutes. The US faces a nutritional crisis, with 95% of Americans getting inadequate fibre in their diets, a deficiency linked to heart disease, diabetes and cancer. Sweetgreen's farm-to-table approach offers an alternative to fast food for a demographic that is increasingly concerned with what they eat and where it comes from (>80% of customers are Millennials or Gen Z). The company has just 240 locations in 18 states at present, but its ambitious plans to get to 1,000 stores by 2030 imply rapid growth in the years ahead.

These purchases were funded by the sales of three lower conviction positions in Exact Sciences (cancer diagnostics), Staar Surgical (implantable lenses for vision correction) and Kubota (agricultural machinery). We also completed our annual exercise of testing the remaining upside in our largest, best-performing companies. This led us to trim positions in Spotify and Workday, and contributed to our decision to sell our holding in Amazon.

Our engagement with Amazon over the past decade has focused primarily on two key areas: working conditions and climate change. On working conditions, we've seen some progress, including improved transparency through its first Safety, Health and Well-being Report in 2022, declining injury rates, and technological solutions to reduce physically demanding tasks. However, our climate change engagement has been less successful. We were surprised by Amazon's 2023 decision to step back from the Science Based Targets initiative and were concerned about their narrow Scope 3 emissions boundary, which represents only about 1-2% of platform sales.

Despite our efforts to influence Amazon on both issues through direct conversations and formal letters, we’ve found their responses to be consistently reactive rather than proactive. While we have been influential on some issues, for every battle that was won another emerged. Our concern is that these issues may become financially material over time, so we decided to take advantage of a substantial share price increase over the past two years and sell the position. This allowed us to reallocate capital to companies where we maintain stronger conviction in the long-term viability of the business model and in the management team's approach to sustainability challenges.

We may well be at the point of maximum pessimism for sustainable investing, with company efforts to hire equitably being blamed for plane crashes and European defence firms benefitting from squabbles in the Oval Office. The pessimism hanging over the green technology sector stands in contrast to the structural growth in these technologies as they become cost-competitive. We've had little exposure to these themes, preferring instead to hold less obvious sustainable growth companies like the New York Times (which has benefitted as onlookers search for reliable sources of news), but now we are actively exploring opportunities in this space. Why? Because we continue to believe the firms that create enduring value for society will be the growth firms of the future, and because we know growing firms deliver the best share price returns.

Return to Earth

When interviewed aboard the ISS, Butch Wilmore told viewers he was looking forward to the smell of freshly cut grass and walks amongst nature when he was finally back on earth. As their capsule bobbed in the ocean waiting to be pulled ashore, a pod of curious dolphins came close by to inspect them, allowing Butch to get reacquainted with nature almost immediately and in spectacular fashion.

As equity markets splash back down to earth after a year or more in orbit, the first quarter of 2025 has been a difficult one for the portfolio, underperforming due to stock-specific factors. However, the silver lining is that this is an indicator of an improved risk management process, with thematic risks no longer dictating results. We are confident the portfolio's diversification and resilience will come to the fore, and that our enhancements to portfolio construction and risk management will be increasingly valuable in the choppy waters of the four 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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