Rotation, rotation, rotation

Outlook

"What is the greater risk— underperforming a benchmark or taking excess risk to keep up with a benchmark concentrated in a group of investments that you don’t necessarily find attractive?” This semi-rhetorical question was recently put to clients by a US-based investment team for whom we have deep respect. Regular readers of our notes will know where we stand on this topic. The past few weeks have demonstrated how much capital has been chasing the same trades. Smaller cap outperformance last month is encouraging given our heavy weighting in this segment of the market. We have been vocal that we believed such outperformance was a matter of time given the relative valuation disparity, however we are equally conscious that even a stopped clock tells the correct time twice a day.

For smaller company outperformance to be maintained, the earnings performance from this cohort will need to improve relative to large caps. On this front, we are encouraged by our own portfolio companies’ performance. Our sub-$10 billion holdings have, on average, had earnings forecasts upgraded by 5% over the past 3 months. This highlights another point – we are not buying the small cap universe, but rather own 21 carefully selected companies comprising ~44% of the Fund’s capital at the time of writing. In this sense, we accept some of the analysis that the overall quality of the small cap universe may have declined at the margin (with 40% of the Russell 2000 loss-making, for example), but view this as a reason to use active management rather than to avoid the opportunity completely.

We remain highly enthused by the opportunities within the Global Sustainable Opportunities portfolio and by its characteristics. It offers a yield of roughly 8% on our estimate of sustainable earning power for each company and several of our portfolio companies also intend to return 10-20% of their current market cap to shareholders over the next one to two years.

The portfolio contains a breadth of end markets, earnings drivers, and stock specific catalysts which help offer investors a well-balanced, attractively valued fund compared to highly concentrated, momentum-driven benchmark indices.

Market Overview

Global equity markets continued their ascent in July (MSCI ACWI +1.6% total return in USD[1]). However, this does not tell the full story. Beneath the headline figure was a significant rotation away from the major year-to-date winners, best symbolised by MSCI ACWI Momentum -1.4%. Even this was flattered by a +3% rally on the final day of the month. MSCI ACWI Value (+4.4%) materially beat MSCI ACWI Growth (-0.9%), while smaller companies outperformed large caps (MSCI ACWI Equal Weighted +2.8%). The US 10-year bond yield fell meaningfully from 4.4% to 4.0% and real yields from 2.1% to 1.8%. Recent weaker economic lead indicators have been joined by soft outlooks from several more economically sensitive companies in the latest round of earnings reports. This is particularly notable in certain pockets, such as the US low-income consumer. It is therefore increasingly likely that the Fed will start cutting interest rates in September. Debate has also started to intensify around the return that will be generated on the very significant levels of capital being invested in AI.

 

Strategy Update

Performance

The fund returned +2.9% in June. In comparison, the MSCI ACWI index was flat (all in GBP). Since inception, the fund has returned +33.4%, compared to the global benchmark’s +30.9%.[1]

John Wiley & Sons (+16% in GBP) continued the prior month’s strong performance following a positive set of results, which were ahead of guidance and flagged the potential to monetise its content for AI model training. Henry Schein (+10%) rose from heavily oversold levels. Early reporting from the dental supply chain confirms a cautious near-term outlook, but this is largely factored into Henry Schein’s guidance. Baker Hughes (+8%) delivered an excellent set of results, particularly relating to order intake and margin progression in its Gas Technology business. This is a differentiated asset with an attractive growth outlook.

JEOL (-12%) was the largest detractor within the portfolio. We expect this was predominantly linked to share price weakness in the semiconductor sector, alongside concern about ASML’s extreme ultraviolet (EUV) machine order outlook. We believe JEOL’s growth prospects are underappreciated and have used recent weakness to build our position.

 

Activity

We added one new position in July.

Ferroglobe is a leading global producer of silicon metal and its alloys. Silicon metal is a critical input for hundreds of industrial and consumer products, such as EV batteries, electronics, solar photovoltaics (PV), and semiconductors. The demand growth outlook, particularly in solar and EV batteries over the long-term, should be strong, but we are most interested by supply-side constraints. Silicon metal is on the critical materials list in the EU and the US, where there are limited number of suppliers (of which Ferroglobe is the largest). In addition, China is the largest global silicon metal producer but the fact that a high proportion of Chinese production occurs in Xinjiang province, where there are severe issues relating to Uyghur forced labour, means this production is effectively shut out of the US market due to product tracing requirements (we anticipate the EU will follow). Consequently, Chinese PV producers have started using Ferroglobe’s supply from Europe and South Africa for solar panels which will be sold in the West. Tariffs have been placed on silicon metal and ferrosilicon imports into the US from a broader range of countries, including Russia, which accounted for ~30% of US ferrosilicon imports in 2023. Ferroglobe has been through a remarkable transformation under the current CEO: it has moved from over $450m of net debt to a net cash position, recently reintroducing a dividend and buybacks, and has materially reduced its fixed cost base, driving down its breakeven commodity price level. In 2023, it delivered positive free cash flow despite weak end markets and once all structural cost savings are complete, we expect it can deliver ~$400m in a mid-cycle year. The current market cap is ~$1 billion. We also see strong strategic value in the asset base underpinning the investment case. Based on the current cost of greenfield capacity, the silicon metal capacity alone (less than 30% of overall production but the most valuable part) is potentially worth $2.4bn.

 

[1] All index and stock performance data are sourced from Bloomberg Finance LP.

[2] Inception: 7 July 2022. Fund: F1 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.

MSCI

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

 

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