META - NZS Capital Growth Equity Strategy Q4 2023 Investment Commentary

2024-01-20 05:00:00 ET

Summary

• NZS Capital is an investment company focused on adaptable, innovative businesses that work toward maximizing non-zero-sum (NZS, or win-win) outcomes for their investors, customers, employees, society, and the global environment.
• The flagship strategy was up 16% (net) vs. 11% for the Morningstar Global Target Market Exposure (NR) index.
• We remain highly exposed to information technology given our focus on innovation and disruption, but we are increasingly finding opportunities in other sectors.

PERFORMANCE OVERVIEW

The NZS Growth Strategy performed well in the fourth quarter of 2023. The flagship strategy was up 16% ('NET') vs. 11% for the Morningstar Global Target Market Exposure ('NR') index. An emerging consensus of rate cuts in 2024 provided a supportive backdrop for growth stocks. We also saw a broader market rally. After three quarters of extraordinary outperformance relative to the rest of the market, the so-called Magnificent Seven performed in line during the quarter, a boon to the many active managers who chose not to chase these momentum trades.

IT was the strongest GICs sector within the benchmark in the quarter. In the portfolio, the large exposure to the information technology sector had the biggest sector impact, although most sector exposures added value. Within IT, software and services was the strongest sub-sector and our overweight here helped. The consumer discretionary sector lagged the benchmark and our underexposure also contributed to relative performance.

While sectors exposures generally helped, the portfolio seeks to add value through stock selection. In the fourth quarter, stock selection was a larger relative factor in performance than sector allocation. Our strongest individual contributor was Microsoft ( MSFT ), which was also a large holding. ASML and Workday ( WDAY ) also rose sharply and helped performance. No major news drove these moves, but they rallied with a strong market and continued progress in line with our long-term theses. Notably, Adyen ( ADYEY ) was another large contributor. A detractor in the third quarter, the Dutch payment services company rebounded after the company clarified its strategy after presenting a disappointing outlook earlier in the year.

A few stocks dragged down performance. Nextera’s outlook became more challenging as higher rates pressured its return profile. Chart Industries ( GTLS ) fell with a reduced revenue outlook. While Chart maintained its 2024 profitability guidance, the company has yet to regain investor trust following its acquisition of Howden. We sold Nextera but made no changes to our Chart position as we see a high level of asymmetry in the name should it execute its plan.

PORTFOLIO POSITIONING

We had no major shifts in our portfolio positioning, but what changes we made stemmed from stock-specific opportunities. We remain highly exposed to information technology given our focus on innovation and disruption, but we are increasingly finding opportunities in other sectors. For example, we shifted Trane Technologies ( TT ) into our resiliency sleeve. Trane, which we discuss in greater detail below, is a leader in HVAC, an attractive industry aligned with decarbonization. We added to healthcare names as well, including Danaher ( DHR ), Repligen ( RGEN ), Moderna ( MRNA ) and, a new name, Shockwave Medical ( SWAV ). Cameco ( CCJ ), an essential component of a nuclear-powered, zero-carbon economy, remains an optionality holding.

IT remains an important area, however, and we made some adjustments. We sold Amazon ( AMZN ), which had been a large position, to focus on more favorable stocks with similar opportunities. Shopify ( SHOP ) can thrive in e-commerce while Microsoft’s cloud offering is encroaching on Amazon’s opportunity. We sold Autodesk ( ADSK ) to divert capital to other, more attractive software companies, such as ANSYS ( ANSS ). The firm’s simulation software drives product innovation and reduces time to market with virtual modeling rather than slower and more cumbersome prototyping. Our portfolio reflects an interest in innovation beyond the mega platforms. We do not own three of the M7 – META , Amazon and Apple ( AAPL ) – and are underweight to Nvidia ( NVDA ) and Tesla ( TSLA ), where we think smaller positions reflect the wide range of outcomes, including some disappointing scenarios. We also think AMD ’s new product could be a strong competitor to Nvidia’s products.

We sold stocks where the thesis did not work out as we expected. We exited longtime holding BALL Corp. because we felt the long-term range of outcomes for aluminum can demand had widened to the point the business no longer fit in resilience. We wonder if, in addition to short term issues, lower demand for beer cans reflects structural changes from demographic preferences, including a greater focus on health. We sold Nextera due to the company showing much greater interest rate sensitivity than we preferred. We increased our non-US exposure by adding to Dollarama ( DLMAF ), a Canadian retailer and Constellation Software ( CNSWF ), a Canadian acquirer of niche market software. The moves reflected the fundamentals of the companies rather than a macro geographic view.

OUTLOOK

The performance of the Magnificent Seven was hardly that in the fourth quarter, a promising development for active managers that consider a range of outcomes and avoid momentum trades. For three quarters of 2023, Amazon, Alphabet, Apple, Meta Platforms, NVIDIA Corp, and Tesla accounted for most of the performance of markets. An equal-weighted index of these stocks was up almost 84% in the first nine months of the year compared to a broader indices in the range of 10% to 15%. In the fourth quarter, however, these stocks performed roughly in line with the rest of the market, hardly a retrenchment but some hope of a broader based market in 2024.

A new paradigm would be good for markets and investors. In a period of great economic uncertainty, the growth opportunities of these platforms and the mania of AI attracted buyers. The momentum brought more investors, perhaps seeking shelter amid the herd. Defense has given way to danger, in our view. The excitement over these companies does not fully consider a range of outcomes, including many scenarios where these stocks face significant challenges. These may be interesting companies, but we think the valuations underplay the risks. Remember in the namesake movie, most of the seven heroes end up dead.

We enter 2024 with a balanced portfolio that should benefit from what we expect to be a broader market. Interest rates and economic policy never go away as factors, but we expect that they diminish in 2024. Stock selection and company performance, with reasonable assessments of risk, should determine results. We are also seeing stabilization in some end markets that were impacted by post-COVID hangovers and higher rates. Bottoming cycles in housing, bioprocessing, and some areas of the semiconductor market, such as memory and capital equipment, bolster our confidence in a broader market.

Our M7 concerns notwithstanding, we remain strong believers that AI will have transformational impact on society and the economy. It is drawing our focus outside of IT, including healthcare. In December, the FDA approved the first ever CRISPR/Cas9 gene-edited therapy, CASGEVY from Vertex ( VRTX )/CRISPR Therapeutics ( CRSP ). We are on the precipice of curative therapies for a wide range of diseases. AI is boosting the digital transformation of scientific research, long seen as an analog industry. The market is not pricing in accelerated innovation from AI taking over scientific discovery.

The 2024 presidential election will influence the U.S. market, naturally, but we still like the opportunities for growth and innovation. Unlike many other developed markets, the U.S. has a backdrop for growth, including accelerating population growth and accelerating innovation. Falling populations, waning levels of innovation, and increasing geopolitical tensions burden many other regions. The U.S. market is not pricing in the prospects of economic growth without job growth – and the corresponding expansion in profit margins – driven by AI.

RESILIENCY IN THE BUILDING

Our disciplined approach considers two types of stocks: resilient and optional. In both cases, we consider a broad range of outcomes. Rather than making one prediction and investing behind it, we consider the range of scenarios that provide a favorable return. A stock with a broader range of outcomes, and thus more uncertainty, is considered optional and remains less than 1.5% typically. A company with a narrower range of outcomes gives us more confidence and can fit in the resilient sleeve, which typically includes positions sizes from 2.5% positions to 6% of the portfolio.

In the fourth quarter, we promoted Trane Technologies to resilience. Trane is a leading participant in the HVAC and Transport Refrigeration industries globally. Roughly, 60% of Trane’s business is commercial HVAC, 20% is North American residential HVAC, and 20% is transportation refrigeration units.

A hallmark of resilient companies is the ability to adapt and sustain themselves in changing business conditions. A decentralized approach helps nimbleness. Trane has a robust operating system that is executed day-to-day at a local level. It allows management to maintain a long-term orientation and to focus on capital allocation and cultivate a culture centered on innovation to drive decarbonization.

Another hallmark of resilient companies is broad predictions. For Trane, we are invested in the broad and comfortable prediction that the world continues on the path of decarbonization. Globally 15% of greenhouse gas emissions come from heating and cooling buildings. Reducing the energy intensity of buildings is quite likely to remain a key lever in the world’s decarbonization efforts. For years, growth in the HVAC and transport refrigeration industries has benefited from efforts to decarbonize, driven by increased regulatory standards. The trend remains strong, with additional regulation and incentives and with corporate commitments to cleaner and more efficient buildings. Demand for HVAC would also benefit from Another boon is additional manufacturing infrastructure investment, such as new semiconductor fabs and electric vehicle battery plants. The industry is not without cycles, but the company is well suited to endure them and even emerge in a better competitive position.

Through innovation, Trane is also creating high-NZS, or win-win, outcomes for customers. For example, the energy efficiency of Trane’s HVAC equipment has greatly improved over the years, enabling the company to offer its large customer base attractive returns on replacement projects. New equipment also helps these customers meet their carbon reduction commitments. Utilizing digital connectivity has allowed Trane to remotely monitor the installed base of equipment, creating a better outcome for customers while also winning market share from independent service providers. Trane is a high-NZS business, creating win-win outcomes for all constituents, without a myopic focus on profitability at the expense of customers or society.

Finally, the stock’s valuation is a component of the stock’s place in our resiliency sleeve. We do not need a series of successful predictions to earn our required return; rather, we can rely on our broad predictions and our confidence in the innovation and adaptability of the business.

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