LTGG second quarter 2024: Sugar rush

Capital at risk.

We’ve recently been revisiting and discussing the holding in Dexcom, the Continuous Glucose Monitoring device company. Dexcom is one of the Long Term Global Growth portfolio’s ‘sleeper stocks’ in the sense that it generates outsized returns by compounding quietly and undramatically over extended periods of time.

Over the eight years or so since we purchased Dexcom, the stock has returned over 500 per cent because the company’s platform is indispensable to the two million or so diabetics who rely on it to monitor blood sugar levels. We’re still in the foothills of the opportunity because sadly around 500 million people around the world suffer from diabetes. The underlying driver here is the regrettable and ongoing rise in global sugar consumption.

It’s eye-opening to look back at sugar association’s lobbying in the 1970s, predicated – remarkably – on the notion that sugar was a useful diet aid. Advertisements in respected publications such as Time Magazine, declared that “Sugar can be the willpower you need to undereat” before going on to explain that “sugar is the fastest energy source around - and when your energy’s up, there’s a good chance that you’ll have the willpower to undereat at mealtime”. More recently, food manufacturers have relied on sugar to give a moreish kick to processed foods that would otherwise taste horribly bland.

There are strong parallels with Mr Market here. Sixty years ago, investment managers purporting to have an information advantage proudly cited the fact that they were on a select list of recipients of an eagerly anticipated annual report. A decade later, such reports were widely distributed, so any edge was then predicated on being close enough to the headquarters to receive those reports first.

Now though, all this information is available instantly to all and Mr Market’s diet consists of information mined from the same seams by a homogeneous cohort of investment banks. Recently, there has been no shortage of electoral and economic data for them to refine heavily before sprinkling their own sugary prognostications on top.

In LTGG though, our diet is different – not only in terms of the breadth of our sources, but also the levels of access that we enjoy by dint of being long-term shareholders.

Our recent work in the domain of robotics illustrates this nicely. We were the first investors to tour Tesla’s Optimus humanoid robotic lab, enabling us to see how the robots can be used in a factory setting. This augmented our perspectives from recent Amazon Fulfilment Centre tours, and the insights that we gleaned at the recent International Conference on Robotics and Automation.

We also recently tried out Intuitive Surgical’s newest surgical robot (the da Vinci 5) in Sunnyvale, before heading to Oxford to speak to surgeons about Intuitive’s new lung diagnostic tool (Ion) and single-arm surgery robot (Single Port). Our ongoing discussions with Professor Shannon Vallor, the Baillie Gifford Chair in the Ethics of Data and Artificial Intelligence at the Edinburgh Futures Institute, help us to synthesise these different angles as we seek to better understand how developments in machine learning might accelerate the ability to operate autonomous machines in unstructured environments.

None of these individual sources of input is going to give a “right answer” on the investment cases of the stocks in question. But together, they help us to calibrate the probability adjusted payoffs in a portfolio context.

The early bird

We remain confident that these differentiated and expanding information sources make us very different to Mr Market. His narrow diet has been causing some interesting market dislocations of late - a small number of crowded trades into a narrow clutch of companies. As a result, over 80 per cent of the global index return has been driven by multiple expansion rather underlying operational growth.

We’ve also seen the highest level of index concentration for over four decades, and – inevitably – a catchy epithet. The ‘Magnificent Seven’ grouping is very unhelpful though. The future attractions of the constituent stocks are far from uniform. At the end of the film that underpins this particular piece of nomenclature, four of the protagonists are dead, remember. This means that as stock pickers, we need to evaluate each of the constituents individually.

Microsoft, Alphabet and Meta, with a combined market cap of $6.5tn (remember when we debated whether $1tn was plausible?) collectively plan to spend $130bn on technical infrastructure capex this year. But as in any investment arms race, the spending is motivated as much by defence as offense; none wants to be left behind, for fear of falling victim to disruption. It’s safe to say that these companies’ days of capital light returns are well and truly over, but we’re watching them closely from the sidelines.

The same applies to Apple. We still kick ourselves for selling this holding too early a decade ago, having underestimated the scope for profit margin expansion even as the top line slowed. From here, we acknowledge that Apple is well positioned because data is the name of the game when it comes to AI, and iPhones are full of it. But in order to consider the company as a portfolio holding from here, we’d need a market cap of over $6tn and the associated assumptions are too heroic for us to entertain, particularly as the company seems disproportionately exposed to souring trade relations between the US and China and ever increasing competition. Is it rational that the four stocks mentioned above are collectively worth more than the entire Chinese stock market? Time will tell.

Amazon, NVIDIA and Tesla meanwhile, remain portfolio holdings; more interesting propositions to us – but for very different reasons. In the former case, Amazon Web Services is now a $100bn annual revenue business in its own right. As AWS has expanded from infrastructure into services, operating margins have widened out to the highest level for a decade. A continuation of the current high teens growth over the very long term seems perfectly plausible and applying a market multiple to the associated resulting earnings stream implies 2x upside.

Beyond the value inherent in AWS, Amazon’s advertising ecosystem is now a highly profitable torchbearer for the rapidly growing retail media industry and Amazon has captured a mid-teens percentage share of the US digital ads market. This marks a rapid closure of the gap between Google and Meta and the first real threat to their dominance in a decade. With Amazon embracing video and streaming opportunities within the TV market, we suspect that this shift of momentum has considerable legs.

NVIDIA meanwhile, has added a cool $2.8tn or so of market capitalisation over the last 18 months. Year on year revenue growth of over 260 per cent bears testament to the fact that most artificial intelligence roads lead back to its CUDA operating system. The likes of Microsoft, Alphabet and Meta feature among NVIDIA’s largest customers and in this regard, the company is directly benefitting from the capex of other monoliths, with astonishing margins as a result.

Is it ridiculous to suggest that NVIDIA could grow at 30 per cent per annum for the next six or seven years? We don't think so, but at the same time we know that this is a cyclical industry and with technical factors at play. The exit multiple needed for significant upside is starting to look stretched. We’ve therefore continued to recycle money out of NVIDIA in recent months, despite it remaining a high conviction position.

Tesla represents more of a conundrum for us. A decade into our holding of the company, we’re perturbed by its ageing product range, brutal competition within the EV industry and assorted examples of cultural clumsiness.

Offsetting these concerns, Tesla’s vertical integration still underpins structurally higher margins than competitors. If the price wars prevail, industry consolidation seems inevitable and Tesla could be one of the last standing EV players. Meanwhile, there are signs of the energy storage business finally sparking into life – a $6bn revenue business now, and Tesla’s highest margin division in a triple digit growth sector. After many years of unfulfilled promises, the Full Self Driving (FSD) software is now improving rapidly too – currently ingesting around 15 million miles of data per day and probably closer to commercialisation than the market is prepared to countenance.

Our colleague Michael Pye recently used version 12 for a few days with minimal manual interventions. A scenario whereby Tesla licenses this software to 10 per cent of global car fleet at a subscription rate of, say, $100 per month implies a revenue stream approaching $200bn per annum.

We continue to debate the probability that we should ascribe to this scenario playing out with Tesla earning Apple-like margins on the associated revenue stream. Tesla is a much smaller holding than was once the case – a reflection of the varied views on its prospects within the team.

Stepping back from the specifics, the numbers below show that the market is rather late to the party on all of these stocks. The early bird of LTGG caught most of these worms a long time ago, enjoying chunky returns from six of them, despite the inevitable hairy gyrations along the way.

As you can see, over the last decade we’ve recycled a net 50 per cent of the portfolio out of the stocks in the table above into a much broader range of younger holdings. While not all of our holdings are Amazons and NVIDIAs, overall, it’s been a regenerative approach to portfolio construction.

Compelling disconnects

As a result of the market’s current Magnificent Seven blinkers, several groups of portfolio holdings have been left behind in share price terms, despite their captivating growth prospects.

Surfing on the infrastructure laid by others

One such cohort relates to some of the companies that are building business models on top of the infrastructure that is being laid by others. This is interesting because in many previous infrastructure booms – from rail tracks to telecoms cables to road networks – the greatest profits have accrued to those who have established offerings on top of the foundations rather than the breakthrough technologies themselves.

• Symbotic is a good case in point. This company’s AI enabled warehouse robotics technology taps into ever-improving machine learning capabilities, enabling pallets to be moved through warehouses around twenty times more cheaply than would traditionally have been the case. This recent holding’s top line has grown by around sixty per cent over the last year and Symbotic’s products are in such demand that its order backlog represents ten years of current revenues. For now though, this stellar progress is going unnoticed in share price terms.
• Solar inverter company Enphase enjoys similarly attractive dynamics. Its business model sits on top of rapidly expanding solar and battery infrastructure. Enphase remains the partner of choice for the fragmented solar installation industry in the US and we envisage them playing a key role in the intelligent matching of domestic energy supply and demand. With the market’s focus on temporary short-term headwinds, there’s a mismatch between this holding’s price and its prospects and we’ve been adding to the position because we believe that this disconnect will ultimately resolve itself.

Offering superior value

Another group of holdings stands to benefit from their ability to offer better value in their respective fields. In an economically challenging environment, this is clearly a very useful attribute, but again underappreciated by the market at present.

• Chinese online services platform Meituan, for example, is seeing strong revenue growth partly because many consumers in China are feeling the pinch at the moment. Online meal delivery represents a more economical choice than a trip to the supermarket and the platform is enjoying an additional kicker from the skew towards lower-end accommodation within its travel offering. Despite a bit of a recent bounce, Meituan’s market cap remains at a quarter of the level three years ago. As with other Chinese holdings, we’re being asked to pay very low multiples for a very solid growth opportunity. The increased upside seems like ample compensation for the increased China risks.
• Cancer drug developer BeiGene is another case in point – a company whose business model is predicated on providing better value than large pharmaceutical incumbents. BeiGene’s costs are around thirty percent lower than peers because of their superior operational flexibility which allows dynamic flexing between locations according to relative costs. Revenues are growing at a good clip and BeiGene’s competitive cost advantage is set to grow from here as the company ramps its own biologic capacity. Despite the attractions, the market remains allergic to uncertainty, and because BeiGene is one of the small handful of portfolio holdings yet to reach cashflow breakeven, the attractions have yet to be reflected in the share price.

Beneficiaries of deglobalisation

A third set of companies stands to benefit from ongoing geopolitical friction in a way that is not currently being recognised by the market.

• Cloudflare helps companies to defend themselves from the exponential growth in cybersecurity risks. Following a 175 per cent rise in Distributed Denial-of-Service (DDoS) attacks over the last year, an increasing number of companies are coming to rely on their services. Revenues are growing at over thirty percent per annum and Cloudflare now fends off up to 140 billion attacks every day. Leaders Michelle Zatlyn and Matthew Prince are building this company on the basis that revenues can grow tenfold from the current $1bn, but the shares have broadly gone sideways for a couple of years and our recent addition to the holding is based on a view that the market is missing this compelling growth opportunity.
• Meanwhile, geopolitical tensions are ushering in a range of protectionist measures. Five years ago, few US auto manufacturers would have worried about being knocked off their perches by a Chinese phone company. But Xiaomi means business and Joe Biden has responded by quadrupling the import tariffs on Chinese EV cars and Rivian may well be one beneficiary of the resulting brand nationalism. The aspirational story here is founded upon the rugged outdoors. Recent discussions with the management team have increased our confidence that there’s a path to substantially better margins than other manufacturers. Rivian’s potential to emerge as a winner in a substantially consolidated industry has been boosted by a $5bn investment from Volkswagen but remains a long way from being reflected in the current share price.

What else is on our minds?

While the examples above illustrate the underpinnings of our growing confidence and enthusiasm in the vast majority of the portfolio, we are scratching our collective pates (some more hirsute than others) on a few other holdings.

Moderna is a bit of a conundrum. Our conviction in the underlying potential of its computational biology platform remains strong and recent share price strength reflects decent progress in the respiratory franchise beyond Covid. To really move the outlier dial though, we need to see further progress from the cancer vaccines. Recent data on this front is incrementally promising but the value is reliant on oncology projects with long-dated and uncertain paybacks. In the round then, the current holding size feels about right.

Meanwhile, in the case of enterprise software company Atlassian (a 7.5x returner since 2016), we’re musing on whether much of the growth runway is in the past rather than the future. In the case of content platforms Spotify and Roblox, we’re asking ourselves whether there is as much intrinsic operational leverage as we might have hoped and expected. We’ve also moved on from a couple of small and relatively short-lived holdings. The first of these is synthetic biology company Ginkgo Bioworks, whose royalty based business model has struggled to gain traction. The second is Buy Now Pay Later Company Affirm, whose competitive advantage has been eroded in an increasingly crowded market.

Meanwhile, our ideas geyser is gushing nicely. In the last three months, we have used recent sales and reductions to recycle capital into three new holdings for the portfolio.

Cosmetics company e.l.f. combines an outsourced, heavily vetted and low-cost manufacturing base, with a digitally focussed approach to offer quality cosmetics to mass market consumers twice as fast as incumbent players and at considerably lower prices. Its fantastic growth has been catalysed by a remarkable online marketing strategy involving the “e.l.f. Beauty Squad” – four million loyal advocates who post real user reviews and drive a formidable feedback loop. The brand’s messaging around authenticity and cruelty-free products resonates deeply with the target audience for whom the product is as much about entertainment as the underlying product.

Meanwhile, Titan’s entry to the portfolio follows our work on a lengthy list of Indian stock ideas. This company owns a number of brands in the Indian jewellery market which is not only massive (more than 2.5 times larger than the US on a GDP adjusted basis) but also growing strongly, thanks to the enduring cultural enthusiasm for both Diwali and wedding celebrations.

The free “Karat meter” jewellery gold purity testing service offered in Titan’s Tanishq chains reveals over 60 per cent of gold bought from local artisans to be less pure than claimed. The trust that Titan has earned as a result will, we believe, drive continued market share gains for a very long time. Post election market volatility following Mr Modi’s recent travails provided a good entry point for us.

Slow Release Energy

It remains the case that the portfolio’s returns are being driven much more by fundamental progress than overarching multiple expansion. Indeed, LTGG’s five-year returns, while comfortably ahead of the index, have been compromised by multiple compression which has partly offset the underlying growth return. This stands in contrast to the index. With further electoral activity in the months ahead, Mr Market will have plenty more sugary polls and data feeds to tuck into, so his ability to distinguish between short-term price and long-term value may remain compromised for a while.

At some point though, the sugar rush will wear off. When it does, the broad, diversified and muscular growth drivers within the LTGG portfolio should increasingly come to the fore. This is exciting because it points to clear and material latent upside that can be unlocked in the years ahead.

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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.

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