Dare to Be Different

Outlook

“Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.” David Swenson, quoted in ‘Dare to Be Great’ by Howard Marks (September 2006).[1]

At the end of November, the current strategy passed its 3-year anniversary.[2] Performance over this period would place it in the top quartile within the UK’s IA Global sector, despite its returns having been soundly beaten by the global index over the past 2 years during a period in which the S&P 500 recorded consecutive gains of over 20% for the first time in two and a half decades. Be under no illusions that the last couple of years have made us painfully aware of the concept of an ‘uncomfortably idiosyncratic portfolio’, to use David Swenson’s phrase.

Outperformance over 3 years despite painful underperformance over 2 leads us to two conclusions about active management in a world more dominated than ever by passives. First, that the truly active manager should get (even more) used to uneven payoffs. Second, that the returns of high active share managers must therefore be judged over a long-term horizon, most likely 5 or more years.

This takes us to the outlook for the next couple of years. We have witnessed a period of ‘US exceptionalism’ that has led many to believe that it is almost pointless to bet against its continuation. However, investors backing this argument do so from valuation levels that history suggests are likely to lead to subdued returns for investors in market-cap weighted US indices, or indeed US-dominated global equity indices. We recently read a note by a UK allocator which neatly captured our own thoughts:

“Another behavioural oddity [with] the current situation of the US equity market is a fascination with minor relative positions over very large absolute positions. In simple terms – an investor with 68% of their portfolio invested in US equities will often seem to worry more about being 2% underweight than the 68% absolute allocation they hold in one market.” Joe Wiggins, ‘The Trouble with US Equity Exceptionalism’[3]

It begs the question of how one defines risk. To our minds, equity investors taking the approach described by Wiggins seem to prefer to closely match the benchmark, even if it might fall 20% in absolute terms as in 2022, for the fear of missing out on another year of 20%-plus upside.

With this in mind, among the many eye-catching charts we have seen in recent months, the chart below of the ‘relative value trinity’ particularly stood out. It shows relative value indicators for small caps vs large caps, value vs growth, and global vs US stocks (presented as a z-score). All 3 have reached extremely cheap levels and collectively are at the lowest point since the dot-com bubble.

The central premise of Howard Marks’s Dare to Be Great memo quoted above (subsequently followed up with Dare to Be Great II in 2014 and I Beg to Differ in 2022), is that “you can’t take the same actions as everyone else and expect to outperform.” Our positioning is certainly different, focused in the areas of greatest inefficiency which would benefit from any or all 3 of the relative value trinity mean reverting. Of course, to be different and wrong is just dumb contrarianism, yet the paradox is, as Marks says, “in trying to be right, are you willing to bear the inescapable risk of being wrong?”

We take confidence in our prospects for outperformance from 3 primary sources. We are using a consistent investment approach based on principles which have worked over many cycles. We have a proven ability in the area we have our largest differentiated bet – our outsized allocation to smaller companies – having delivered over 5% stock selection alpha from small caps[4] in each of the last 3 years since the strategy’s inception. And the fundamentals of our investments are very strong: now with 23% return on capital and double-digit sustainable earnings growth, yet still with valuations offering ~7% FCF yield at today’s prices.

We look forward to updating you in more detail about the current portfolio in our quarterly investment letter, which will be available shortly.

Strategy Update

Activity

We bought one new holding and exited two existing holdings in December.

Avantor is a leading provider of mission-critical lab products and services with high consumables mix (85% of revenues are recurring) and sticky customer relationships driven partly by regulation, with content “spec’d in” to customers’ products or processes by regulators. Its long-term growth is underpinned by cell and gene therapy growth, and it operates in an attractive industry with high barriers to entry, which allow Avantor to earn 35-40% returns on invested capital via high profit margins and low capital intensity. The share price had declined from a peak of $44 to our entry price of $21, allowing us to build our position at a 7%-plus normalised free cash flow yield.

We previously owned the shares in 2022 but sold due to concerns around inventory in the channel (and the resulting impact on organic growth), reduction in high margin Covid sales, and acquisitions at elevated valuations which increased leverage at the wrong time. These have come to pass, depressing the share price, but are ultimately temporary and likely to shift to a more positive course over 2025. As destocking runs its course and demand returns to trend, we anticipate operating leverage on higher volumes, further enhanced by a $300m cost savings programme, will drive margin gains ahead of current market expectations. Beyond the near-term recovery, high single-digit revenue growth with 50-100bps of annual margin expansion can deliver double-digit long-term compound earnings growth.

We sold State Street after the share price converged with our assessment of fair value. Its latest results implied some pricing pressure and competitive threats to parts of its business at the margin, and we believe we have built exposure to the more attractive parts of State Street’s business at an attractive valuation through our holding in SS&C Technologies. Our investment case for Smith & Nephew was no longer valid, so we exited our position.

Performance

The Fund returned -2.7% in November. In comparison, the MSCI ACWI index returned -0.9% and the MSCI ACWI Value -3.8% (all in GBP).[5]

Our largest negative contributors predominantly comprised of US smaller companies which had delivered strong share price upside in November, following the re-election of President Trump. John Wiley & Sons (-14% in GBP) fell after a Q2 update in line with our investment case. Margins are already recovering but we have increased confidence this will accelerate in the coming years following reinvestment in the research publication platform. TopBuild (-19%) responded negatively to higher bond yields alongside other housing-related companies. Higher interest rates may also have played a role in Henry Schein’s fall (-9%), which came despite its nearest competitor (Patterson) receiving a bid at an attractive premium. Owning no Broadcom, Apple, Tesla, or Amazon shares cost -1.4% in relative performance.

Sony (+9%) was the Fund’s strongest contributor. A meeting between the sell-side and the co-CEOs of Sony’s Games business demonstrated confidence around an improving outlook, with visibility around strong growth and improving profit margins. This is likely to be a key share price driver over the intermediate term.

 

[1] https://www.oaktreecapital.com/docs/default-source/memos/2006-09-07-dare-to-be-great.pdf?sfvrsn=b3bc0f65_2.

[2] The current investment strategy began as a segregated mandate. The RGI Global Alpha Fund moved to this strategy during 2024.

[3] https://behaviouralinvestment.com/2024/12/17/the-trouble-with-us-equity-exceptionalism/. We also liked the following comment: “Whenever investors talk and behave as if the future is both obvious and unavoidable it is sensible to be wary – this time is no different.”

[4] Source: Bloomberg, River Global Investors. Data to 30 November 2024. Small Cap defined as $500m - $10bn market cap.

[5] Fund: B share class (GBP), midday to midday pricing. Benchmark: close-of-business to close-of-business pricing.

 

KEY RISKS

The value of investments and any income generated may go down as well as up in response to general market conditions and the performance of the assets held, and is not guaranteed. An investor may not get back the amount originally invested.

Past performance is not a reliable guide to future results.

Changes in exchange rates may have an adverse effect on the value, price or income of investments.

There is no guarantee that the Fund will meet its stated objectives.

The movements of exchange rates may lead to further changes in the value of investments and the income from them.

There is a risk that any company providing services such as safe keeping of assets or acting as counterparty to derivatives may become insolvent, which may cause losses to the Fund.

 

For professional investors only.

Capital at risk.

 

For more information about the fund and how the fund is positioned, please visit our fund centre below: