US Equity Growth: investor letter Q3 2024

Your capital is at risk. 

The portfolio is in a good place, and its performance continues to recover. We’ve still got work to do, but given the efforts the companies have made over the last few years to adapt to the new environment (plus a bit of repositioning from us), we believe good performance should continue to kick on over the next five years.

Progress and future potential

The things the portfolio companies can control are going well. Following 2022’s significant sell-off, we wrote that in a less-forgiving environment, resilience and adaptability combined with substantial growth opportunities would be key for future returns. We highlighted four areas that we believed gave the portfolio an advantage over the broader market: access to funding, control over pricing, control over costs, and growth underpinned by structural change.

These attributes appear to be bearing fruit. Portfolio returns have been good over the last 24 months. But unlike the broader market, which has been driven by a handful of companies (see our thoughts on market concentration later), most of the companies are delivering operationally and seeing their share prices rise as a result.

Some recent highlights include online food ordering and delivery company, Doordash, continuing to grow ahead of expectations while improving its take rate and expansion into categories such as groceries; education app Duolingo’s accelerating user and subscription growth, and its clever AI integration enabling it to raise its growth prospects; and autonomous truck company Aurora’s successful capital raise and significant progress with its operating partners as it approaches commercial launch of its self-driving trucks by the end of the year. However, the most notable exception over the last year has been Moderna, primarily due to a lowered financial outlook, driven by declining Covid vaccine sales and increased competition in the respiratory vaccine market. Consequently, it recently announced cost-cutting measures. Concerns about meeting profitability goals have made some in the market question the company's near-term growth prospects. Moderna’s technology is excellent. Its execution needs to improve. But we remain cautiously optimistic about its long-term potential given its deep pipeline.

Overall, growth is strong, profitability continues to improve and the companies in the portfolio continue to reinvest at a rate several times that of the market. These characteristics are strong indicators for good future long-term returns.

Thankfully, the market still underestimates the portfolio’s potential. For example, on a sales-based valuation (Enterprise Value/Sales), the portfolio’s 5.2 times ratio is cheaper than both the Russell 1000 Growth index (6.0 times) and the Russell 3000 Growth index (5.5 times), despite the forward three-year sales estimates predicting the portfolio to grow 10-20 per cent faster. While it’s not cheaper than the broader S&P 500 index on this basis (we wouldn’t expect it to be), it’s just under a 50 per cent premium, below where we were at the end of 2019, yet predicted to grow at more than double the rate of the index over the next three years.

Of course, this is all based on consensus, which historically underestimates the long-term growth rates of exceptional growth companies. Take the example of Block, the fintech company we bought for the portfolio earlier this year. It’s currently growing its gross profit at 20 per cent year-over-year and is operating more efficiently than in the past. CEO Jack Dorsey is improving the organisational structure and has appointed Afterpay founder Nick Molnar as the lead of the new centralised sales function. The changes are intended to increase the focus on technology and design, foster more cross-business unit collaboration, and speed up innovation in the wake of AI. If Block can continue to grow even close to the current rate, it looks extremely good value. On consensus estimates, it’s only trading on c.11 times 2026 earnings. The S&P 500’s 2026 forecast PE is 18.4 times. Similar examples exist across the portfolio, from companies as diverse as Meta, which owns Facebook and Instagram, to Yeti, which makes premium outdoor products.

In sum, we’re excited by the companies' evident strength as they emerge from a formative period in much better shape. They are gathering pace again as they efficiently execute their opportunities, leveraging technological innovations such as AI where appropriate.

Tailwinds, headwinds and market concentration

Shifting to the broader market environment – as ever, the things companies can’t control remain less clear. Tailwinds include a favourable interest rate forecast in the US, marked by a significant Federal Reserve rate cut, and a reduced risk of recession, suggesting a potential "soft landing." Conversely, headwinds include the unpredictability of the US presidential election's impact on the stock market, global stock market volatility generally, and geopolitical tensions in the Middle East and Ukraine, all contributing to market uncertainty. Despite these external factors, the portfolio's resilience and adaptability, characterised by financial strength, effective leadership, and sustainable competitive advantages, assure us that the companies we've selected are well-equipped to navigate both short-term fluctuations and long-term challenges to realise their long-run exceptional growth.

And then there’s the concentration of the US stock market, which deserves some attention. The market's recent dynamics, heavily influenced by a few mega-cap tech stocks like NVIDIA, echo past instances of market concentration, which have come and gone again over the decades.

Here’s some useful context: since 1957, the 10 largest stocks in the S&P 500 have underperformed an equal-weighted index of the remaining 490 stocks by 2.4 per cent per year. But the last decade has seen a notable departure from that trend, with the largest 10 outperforming by a massive 4.9 per cent per year on average. The danger in this environment is that investors head to the benchmark, for safety. We’re wary of this approach. We think the best opportunities are likely to lie away from the most analysed stocks.

Not about mean reversion 

This isn’t an argument for mean reversion. Rather, the evolving landscape of the S&P 500's top echelons over the years showcases a fascinating evolution driven by change and technological advancements. Initially dominated by companies with modest growth, today's leaders—ushered in by revolutions in computing, internet, and mobile technologies—boast significantly higher growth rates. This technological evolution has seen the rise of giants from AT&T's era of fixed-line communications to the current dominion of AI, exemplified by NVIDIA's meteoric rise from a modest c.$25 billion midcap when we first invested in 2016, to a near $3 trillion titan today.

Market concentration comes and goes. The real value then lies in identifying the next wave of mega caps over the coming decade, a task that demands a forward-looking analysis of how structural change will reshape the market's hierarchy.

What we've been doing

We’ve taken profits from the best-performing holding NVIDIA three times this year, most recently selling roughly 40 per cent of the position several weeks before its earnings announcements in August. It remains a top ten position as we are still enthusiastic about its prospects of being at the leading edge of accelerated computing chip design. Our optimism is tempered by emerging competition at less intensive performance points and by the particularly strong profit margins that NVIDIA is currently earning. We are also mindful of the cyclicality of the semiconductor industry.

We have put this money to work in several new positions offering the potential for exceptional growth in underappreciated areas of the market. Lineage Logistics, the temperature-controlled logistics specialist, is one example. Its strategic acquisitions, expanding network and enhanced efficiency position it as a valuable supply chain partner. It offers services that are increasingly difficult for competitors to replicate. Demand is expected to grow significantly, driven by the increasing complexity and fragility of global supply chains, as well as the growing demand for cold storage to ensure the integrity of temperature-sensitive products during transit.

Another is The Ensign Group, a healthcare services company poised for growth through strategic acquisitions and operational improvements in the fragmented skilled nursing sector. Its strong, decentralised culture fosters leadership and best practices. The ageing population of people in the US, projected to rise from about 60 million today, to over 80 million by 2050 is also a significant tailwind.

Our experience owning heating, ventilation and air conditioning (HVAC) company Watsco over the last 12-plus years and counting, which has returned over 500 per cent in share price terms since initial purchase, reminds us of the value such enduring high-growth companies can deliver in the portfolio. We also added to Block and made small additions to self-driving truck company Aurora and EV maker Rivian, where notable milestones have been achieved.

Outlook

The inherent strengths of the portfolio companies have begun driving a robust recovery and promising growth trajectory. Despite facing a complex market environment marked by both tailwinds, such as favourable interest rates, and headwinds, including geopolitical tensions, the portfolio has demonstrated resilience and adaptability. On top of this, most of the companies are beginning to thrive as shown by the operational excellence across the portfolio. Looking ahead, we remain cautiously optimistic, buoyed by the portfolio's potential to outperform, as evidenced by its valuation metrics and growth prospects compared to the concentrated market indices. Our focus remains on identifying and leveraging exceptional growth opportunities, navigating market volatility with a forward-looking approach, and maintaining our commitment to driving long-term value for our clients. We thank our clients for their ongoing support.

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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