US Equity Growth: investor letter Q4 2024

Your capital is at risk. 

The ostrich, the index, and us

They say you shouldn’t put all your eggs in one basket. But what about putting 500 eggs in one basket: seven massive ostrich eggs sitting atop 493 small quail eggs? That’s a lopsided basket. It also seems expensive when you go to pay for it. You must be vigilant on your long walk home if you need these eggs for your retirement omelette. If the ostrich eggs move, your journey could be wobblier than expected.

Market exposure?

Passive index investing has been a pivotal innovation in our industry. It is low-cost and important in helping investors choose how to build a diversified portfolio. It puts pressure on ‘active’ managers who are actually just closet index-huggers. This active manager welcomes passive in many ways. Our high-growth, truly long-term, high-active share approach is a natural pairing with passive.

However, passive index funds are not currently a diversified investment. They are an ostrich egg basket. The so-called Magnificent Seven (Mag 7) companies dominate US equity indices: Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla.

In the S&P 500, the Mag 7 constitute about 35 per cent. In the Russell 1000 Growth and 3000 Growth indices, they make up around 50 per cent. The median market cap for the Russell 3000 Growth is $2bn, while the weighted median is $1.1tn, 550 times larger. In comparison, the ratio in the portfolio is 3.7x, with a median of $14.3bn and a weighted median of $53.2bn. Which has more significant upside potential from here?

Given the strong performance of the US indices, are investors burying their heads in the sand about the lack of diversification?

On volatility

We live and breathe concentrated portfolios, so we won’t thoughtlessly criticise index concentration. Prof Hendrik Bessembinder’s research on the nature of long-run returns shows that markets are naturally skewed. Indeed, we aim to exploit this asymmetry in our approach to growth investing.

The Mag 7 companies are powerful and impressive, generating incredible cash flows and profits. There are four of them in the portfolio (NVIDIA, Amazon, Tesla and Meta). For us, these four are magnificent ostrich eggs with very tough and strong shells – if they do wobble, the journey will be more volatile. But they are unlikely to break and could get even bigger from here.

For us, volatility is not risk but often an opportunity.

Our job is to seek out tomorrow’s winners, select a differentiated group of companies, and ride out inevitable market swings caused by short-term news flow and sentiment shifts. However, despite the potential rewards of this approach and the backing of our clients, we know the volatility in our returns since 2020 was beyond expectations and higher than we would like to deliver in the future.

We continually strive to improve, and there were lessons from this period that we are applying to our investment process while maintaining that outlier philosophy that will drive future returns. In 2024, we implemented some portfolio construction enhancements following a thorough and methodical review to improve how we build and maintain our high-conviction, high-growth portfolio. Three new internal guide rails are now in play, tracking portfolio levels of financial maturity, concentration of sources of demand, and company growth profiles (transformational/dynamic, enduring and early).

Delivered tracking error and portfolio volatility have been trending down this year and are back at pre-pandemic levels.

On opportunity cost

Perhaps the biggest risk for investors in passive US index trackers is opportunity cost.

The Mag 7's market cap of $18tn poses a challenge for investors to express relatively positive views on these mega caps without allocating disproportionate capital. For instance, Apple constitutes over 7 per cent of the S&P 500 and 12 per cent of the Russell 1000 Growth. A modest 2-3 per cent active weight would consume 10-15 per cent of a portfolio. Mutual fund rules often prevent such concentration, and even if allowed, it is challenging to significantly impact relative returns.

Investing large amounts in the Mag 7 may come at the expense of other, potentially more promising opportunities elsewhere. Strikingly, when looking at the Russell 3000 Growth index over the past year, 457 stocks have outperformed the median return of the Mag 7, and 48 stocks surpassed NVIDIA’s remarkable return 1. For those looking for upside, there are ample opportunities to outperform the index and exceed the returns of the Mag 7 and even NVIDIA.

Beyond NVIDIA, the top relative contributors in the portfolio were:

• programmatic advertising platform The Trade Desk
• online food delivery company Doordash
• streaming platform Netflix
• fast-casual salad chain Sweetgreen
• autonomous driving technology company Aurora

These five companies are approximately 22 per cent of the portfolio. The overlap with the S&P 500 is 0.8 per cent, and the ‘broader’ Russell 3000 Growth is 1.6 per cent.

So, an important question for passive index investors to contemplate is: Will this Mag 7 group of companies still be at the top in 10 years’ time? Some might be. Some might not. What matters is that we are actively hunting for the next generation of megacaps.

Valuations: passive’s package deal

Linked to opportunity cost is valuation risk.

Over five years to November 2024, an expanding Price/Sales multiple drove 43-45 per cent of benchmark returns versus just 13 per cent for the portfolio, where fundamental growth contributed 79 per cent.

However, this pattern shifted in 2024, with valuation expansion driving more of the return across both the portfolio (70 per cent) and indices (62-77 per cent) – a trend we’ve been watching closely, particularly since November’s election rally. Unlike a passive index, we monitor this as part of our ongoing processes and, where necessary, adjust the portfolio.

Expectations versus upside?

Research suggests returns follow fundamentals over the long term. The stock market rewards companies that deliver the greatest earnings growth. It also shows that investors can find the greatest returns in companies where the market does not anticipate or appreciate that growth – it pays to think differently.

Five years ago, NVIDIA and Tesla were very different-looking investment propositions – substantially smaller, with evolving addressable markets and uncertain growth and profitability. However, exceptional operational progress has generated returns for NVIDIA (+2,600 per cent) and Tesla (+1,500 per cent), which now place them in the Mag 7 roster. That starkly contrasts with the much larger and more mature names Apple and Microsoft, where multiple expansion has made a meaningful contribution.

Our philosophy focuses on identifying individually unlikely but rewarding opportunities we think are materially undervalued – exceptional growth companies. Part of our analytical framework is building conviction in a company’s addressable opportunity relative to its current size. Through the lens of asymmetry, we are positively disposed to companies earlier in their growth journey, companies with the potential for greater upside.

The opportunity for the greatest relative returns lies where we have sufficiently differentiated insights. That is reflected in our investment decisions and portfolio construction, which lead to a very low overlap with US stock indices.

We’re not burying our heads in the sand (and neither is the ostrich)

Earlier, we did a disservice to the ostrich. Ostriches don’t actually bury their heads in the sand. Instead, they carefully, diligently and regularly rotate eggs in communal nests dug into the ground. They work as a team to ensure the best chance of success.

And if you allow us to stretch this letter’s metaphor to its conclusion, we too haven’t been burying our heads in the sand. We’ve been checking and adjusting the holdings based on their maturity and probability of becoming massive from here.

We’ve harvested gains from NVIDIA several times this year to fund other investments where the growth opportunity is at an earlier stage, asymmetry is more pronounced, or we have growing conviction in the upside prospects. We’ve been monitoring all holdings that have performed well this year to check their upside from here, especially since November. Most recently, we made a notable reduction to the position in Tesla, which saw a significant price increase following President Trump’s victory in the US election.

We reinvested most of the Tesla reduction into a new holding, DraftKings, the online sports betting platform. It is a $20bn company growing revenues at 40 per cent year-on-year. At the time of the trade, Tesla was over $1.1tn in market cap and growing sales at 1 per cent (which is impressive in the context of its industry, nonetheless). DraftKing’s valuation was at a discount to the US growth indices on an enterprise value-to-sales (EV/Sales) basis and lower than Tesla’s.

Inevitably, not all our ideas succeed. We sold Coursera, the online learning platform, this quarter. Education and training remain substantial global markets. However, Coursera’s revenue growth has slowed as its sales and marketing spending has reduced. We believed it would be able to grow on the strength of its learning platform’s attractiveness to learners, education institutions and enterprises – this appears to be wrong. Additionally, Coursera’s degree business has not progressed as quickly as we had hoped, challenging our views about Coursera’s potential for long-term expansion.

Proceeds went into a handful of companies where we believe growth is underappreciated:

• medical instrument pioneer Penumbra
• refrigerated transport and storage leader Lineage Logistics
• edge-computing security software provider Cloudflare
• online home furnishing platform Wayfair
• product and technology design company SharkNinja

The average market cap of these companies is $16bn, and the average growth rate is 16 per cent (20 per cent if you exclude Wayfair, which is facing challenging industry headwinds but still gaining share and should rebound as the outlook improves).

Moderna has been the largest relative detractor this year. We had a recent meeting with management to discuss the company’s plans to turn around its commercial efforts. Successful execution will be key, so we are now keeping it as a smaller position in the portfolio.

The indices and us

Our portfolio characteristics are encouraging relative to the US market. On valuation, we’ve seen the portfolio’s EV/Sales ratio decline slightly from February this year. In contrast, the same ratio in the S&P 500, Russell 1000 Growth and Russell 3000 Growth indices had increased up to the end of November.

On the same basis, the portfolio is at a 46 per cent premium to the S&P 500 (as we would expect and lower than in December 2023), yet forecast to grow 112 per cent faster for the next three years. The portfolio is cheaper than the Russell 1000 and 3000 Growth indices by between 4-11 per cent, yet is forecast to grow 14-16 per cent faster for the next three years.

Furthermore, gross margin is higher in the portfolio, R&D/Sales is 3.1x the S&P 500 and 2x the Russell Growth indices, and net debt/equity is negative (i.e., net cash) versus positive (net debt) for the indices.

Nearly 90 per cent of the portfolio generates net income and/or positive free cash flow. This gives the portfolio the resilience and adaptability to manage whatever challenges and threats may come. Indeed, much of the current focus in the market is on what the Trump 2.0 Presidency will bring. The truth is that no one knows. What matters more is that the companies are financially resilient, address long-term structural demands, and are run by visionary long-term leadership teams.

Conclusion

Passive index funds are here to stay, but it is more important than ever to pair genuinely active managers with passive exposure. The portfolio stands apart from the market. Like the communal nests of ostriches – where careful tending leads to the emergence of extraordinary survivors – we’ve built a distinctive collection of companies at earlier stages of their growth journeys. While only 15 per cent of ostrich eggs successfully hatch in the wild, those that do become some of the fastest creatures on Earth.

The data shows that our odds of success are much higher than those of the ostrich. The portfolio companies, with their strong financials, visionary leadership and exposure to transformational trends, are positioned to become the giants of the future.

The market’s focus is on concentration, valuations and geopolitics. Against this backdrop, our focus remains on identifying and nurturing tomorrow’s exceptional growth stories. As history shows, the greatest returns come not from following the herd into today’s largest companies but from spotting tomorrow’s winners before their potential is fully recognised.

1 Based on analysis of the past 12 months to 29 November 2024, for the Russell 3000 Growth index (a representable investable growth universe).

Source: Revolution, S&P. 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.

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