While the market experienced some recovery during the fourth quarter, the speed of the market decline and the aggregate losses as of year-end made 2022 one of the most challenging years for the market in many years.
Portfolio performance
The fourth quarter was notable for being the only one to post positive returns in 2022. Having been buffeted by inflation and sustained interest rate rises throughout the year, a perceived slowdown in the pace of central bank action, particularly by the U.S. Federal Reserve, provided support for global equity markets, especially in October and November. For the quarter, the Polen Capital Global Growth Fund (the Portfolio) returned 1.03 per cent net of fees, versus the MSCI ACWI Index (AUD (the Benchmark) which returned 4.07 per cent.
Market commentary
The backdrop changed swiftly in 2022. Inflation went from non-existent to rampant, rates from the lowest ever to more “normal” with monetary policy shifting from highly stimulative to tightening, all of which has increased the risk to business performance and shifted investor sentiment from ebullient to cautious.
We’ve written extensively about the factors that we believe led to the market declines and created notable pressure on growth company valuations, including the quality growth companies that we own. Persistent and meaningful inflation, which resulted from prior monetary and fiscal stimulus as well as COVID supply chain challenges and the war in Ukraine required a monetary policy response.
We believe higher rates have been the primary driver in the notable change in market sentiment and psychology.
The U.S. Federal Reserve raised rates at one of the fastest paces in recent history, and we’re seeing similar tightening in most major countries around the world. While the pace of rate increases seems to finally be slowing in the final quarter of the year, creating some reprieve, Federal Reserve Chairman Powell has been consistent in his resolve to raise and to maintain higher rates until inflation is brought back down and any heightened inflation expectations are broken.
This has created what seems to be the most widely anticipated recession in memory. While it’s always a bit curious when everyone is anticipating the same outcome, we can’t say that we have a differential view on this. It seems that the Fed and other monetary authorities must get inflation back under control and that higher rates will ultimately have their intended impact. Only time will tell if we enter a recession in 2023 and, if so, how long and deep it will be. But, we are seeing the impact of higher rates starting to affect some markets. We’re also starting to see hiring freezes and layoffs in certain industries. Despite the consensus view that we’re heading into a recession, we are optimistic about the businesses in the Portfolio and their ability to weather the business cycle.
Interestingly, the market decline in 2022 was driven more by the shift in the interest rate environment than by the results on main street.
Some of the best performing sectors or industries for the year— like energy, materials, industrials or leveraged finance—are made up of businesses that tend to exhibit more economic sensitivity and will likely see more downside in a recession, based on our experience. It will be interesting to see how these businesses hold up as higher rates start to impact the real economy. We think our Portfolio will show greater earnings resilience than companies in these industries, very few of which meet our investment guardrails. We feel quite confident that highly differentiated, sustainable growth companies will prove to be better investments over the long term.
Overall, we expect our businesses to be resilient, and we continue to expect mid-teens earnings per share growth in the coming years. While the economic cycle has some impact on most businesses, we believe we own competitively advantaged, secular growth companies with strong ongoing growth prospects. We feel quite confident that these will prove to be solid investments over the long term and through the cycle.
Contributors and detractors to performance
The Portfolio trailed the Index in the fourth quarter. The top three absolute contributors during the fourth quarter were Visa, Adobe, and Mastercard. The leading absolute detractors during the same period were Amazon, Alphabet, and Meta Platforms.
Adobe shares bounced back this quarter after coming under pressure last quarter with the announcement of ~$20 billion proposed Figma acquisition. As we discussed in our 3Q commentary, the price tag was steep. For some, the acquisition created concern that management was acquiring from a defensive position and might have signaled that the core business might be under pressure. The most recently reported results and management’s guidance for fiscal 2023 helped allay fears about the core business. Despite stronger currency headwinds and a deteriorating environment, management maintained their initial fiscal 2023 guidance, provided last quarter. Management expects earnings to continue growing at a solid double-digit pace despite the environment and Adobe’s exposure to consumers and small businesses.
Amazon’s Q3 results were mixed. On the positive side, revenue growth accelerated in the company’s ad business despite much slower revenue growth from other ad competitors. On the negative side, Q3 operating margins were lower than expected and management provided weaker-than-expected revenue and margin guidance for the Q4 holiday quarter. One of the primary culprits here is the international segment, which is being negatively impacted by slower growth and higher costs in many regions, but particularly Europe. AWS also decelerated to 28 per cent growth and is expected to decelerate further into Q4. That said this trend is not all that different from what we saw across competitors, and the AWS backlog looks healthy. It’s taking some time to pull costs out of the business, but management has announced some major expense reductions. We believe the business should also return to a more “normal” revenue growth rate as tough comparisons ease. All this could lead to much better earnings growth in 2023.
Alphabet revenues were up 11 per cent constant currency with a 6 per cent FX headwind to reported revenue growth during the most recent quarter. This was a deceleration in growth and Operating Income declined year over year, but this was due to incredibly difficult comparisons from the prior year. On a two-year basis, Total Revenue, Search Revenue, and YouTube Revenue all grew at roughly a ~20 per cent CAGR, as did Operating Income. The Google Cloud Platform continued to grow at a strong pace. Margins expanded significantly last year given the incredibly strong growth and are now falling back to a more normal level as revenue growth moderates on those tough comps. While management did note a small impact from the softening economic environment (ad budgets are easy to adjust down and then back up as we saw during the pandemic), we believe underlying trends in the business remain healthy for the long term.
Changes to the portfolio
Portfolio activity picked up during the fourth quarter of the year. We sold four long-term holdings, Nike, Adidas, Starbucks, and Meta Platforms. We initiated three new positions, Thermo Fisher Scientific, ServiceNow, and Estée Lauder, and made a few adds (Microsoft) and trims (Visa and Mastercard) as well. Each of the exited positions were smaller weights within the Portfolio, reflecting some concerns on our part. We had been waiting patiently to add businesses to the Portfolio this year and felt that the market pullback provided a more compelling entry point. In aggregate, we added what we believe are great businesses and moved on from areas of concern.
Thermo Fisher Scientific is a leader in serving science, serving more than 400,000 customers working in pharmaceutical and biotech companies, hospitals and clinical diagnostic labs, research institutions, and government agencies. We see it as a durable business that is a leader in attractive end markets with a skilled management team who has demonstrated the ability to consistently and wisely allocate capital. It acts as a key provider of products and services to pharma, biotech, and science in general, providing everything a company in these industries needs to operate and drive science forward. They are, by far, the largest global supplier of branded technologies, tools, and solutions to biotech and pharma companies. We believe Thermo will play a strong safety role within the Portfolio. The company is targeting core organic growth, excluding COVID testing, of 7-9 per cent. With expanding margins and what we consider wise capital deployment, we see mid-teens underlying earnings per share growth seems very doable over the next three to five years. We also think the business would be very durable in a downturn. Pharma and biotech customers account for roughly 60 per cent of the company’s sales today and roughly 80 per cent of sales are highly recurring consumables and services. At 21x forward earnings, we think the valuation is attractive for this well- managed and durable business.
ServiceNow is an $80 billion market cap business based in California. Its purpose is to make the world of work, work better for people. Getting a job done in an enterprise (what the company refers to as “workflow”) usually requires different people in various functions of an organization to work together. Often, they rely on different technology systems and inefficient manual processes to complete each step of the job before moving on to the next.
ServiceNow believes the most effective digital transformation initiative utilizes tools that can integrate workflows across siloed systems, departments, processes, and people. The company is solving what is arguably the biggest pain point in the biggest profit pool in the world (enterprises). Consider the explosion in data growth and all the software point solutions emerging constantly. ServiceNow wrangles all this into a fully integrated dashboard on a global scale with global customers in every industry. Nearly 100% of revenues are subscription based with a 99 per cent renewal rate, and the company currently has no direct competition, according to our research. ServiceNow started with IT workflow, and today, ~40 per cent of net new annual contract value is in non-IT workflows. Through constant innovation, the business has continued to expand its total addressable market, and we think it can grow free cash flow (FCF) at a 20 per cent+ annualized rate for the next three to five years. At less than 30x FCF, we thought the valuation was attractive.
Estée Lauder is the leader in prestige beauty, which is the only category it sells in. In fact, one of the only differences between Estée and L’Oréal, which we also own, is that more than a third of L’Oréal’s sales are mass-market products. We view these companies as a global duopoly and a combined position. We originally purchased Estée Lauder for Global Growth in Sept 2020. We then sold it purely due to valuation reasons a year later, trading at over 45x earnings. We were able to purchase it back this quarter at ~28x earnings and believe it is an even stronger business today than when we initially purchased it in 2020. Estée generates most revenues outside the U.S. (>70 per cent) and operates in over 150 countries. The pandemic has enabled the company to accelerate a shift to more direct-to-consumer sales. In 2019 online as a percentage of total sales was 15 per cent and now it is well over double that, bringing with it higher margins, more control over their brands, and greater omnichannel and e-commerce capabilities. Like L’Oréal, Estée has become stronger in the face of changing basis of competition, and we feel that it is an extremely durable company with many years of compounding ahead.
2022 was challenging year in the market, particularly for growth stocks, and now we enter 2023 with the consensus expectation for a recession. With inflation still well above target, the Fed and other monetary authorities will have to stay the course for a while and higher interest rates are likely to have a dampening effect on economic activity. We’ll see how soft of a landing the Fed and other monetary authorities are able to orchestrate.
Despite the likelihood of a recession next year, we are optimistic about the businesses in the Portfolio, their ability to weather the business cycle, and to continue to deliver strong long-term earnings growth.
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Past performance is not an indicator of future performance. Returns are not guaranteed and so the value of an investment may rise or fall.
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