EPIC Global Equity: Fund Reflections on Market Sentiments and the Triumph of Superstar Firms

EPIC Global Equity Fund
December 2023

Navigating 2023: Reflections on Market Sentiments and the Triumph of Superstar Firms

The approach of year end is an opportune moment to reflect on 2023 and revisit the sentiments that prevailed at the outset.

Many prescient voices warned us that a recession was not just a matter of "if" or "when," but rather a question of depth and duration. Projections painted a grim picture, with a severe impact on consumer spending and further declines in the stock markets anticipated. Scepticism was notably focussed on the giants of the tech industry. Despite a lacklustre performance in 2022, the premium valuations of the tech behemoths endured. The narrative suggested that faced with a higher interest rate environment they would find it harder to outperform.

Prevailing wisdom suggested that due to slowing growth rates and premium valuations, the S&P equal-weighted index would continue to outperform the S&P 500 cap-weighted index. Put another way – performance would trend away from the largest stocks and the market would become less concentrated.

As it turned out, 2023 has seen a strong rebound, largely driven by the now-called "magnificent seven". Given everything we know about these “superstar” firms, why was their outperformance this year so difficult to predict and why has it taken the investment community by surprise?

Superstar firms operate in areas of structural growth, dominate their competition, generate high returns on invested capital, are often growing faster than the market with higher profit margins, and maintain rock-solid balance sheets. Unsurprisingly, such companies are being rewarded by the market!

Furthermore, investors need to be cognisant of the fact that the outperformance in the mega-cap tech stocks this year comes after a brutal 2022 in which from their peak, Meta fell more than 70%, Nvidia dropped more than 60%, and Amazon’s share price halved.

Recent commentary – drawing parallels with the past – seems to indicate that the shying away from the seemingly unstoppable rise of superstar firms is driven by concerns about market concentration.

However, contrary to this view, it is usual for stock market returns to be highly concentrated. Finance professor at the Arizona State University, Hendrik Bessembinder, evaluated lifetime returns for every US common stock traded on the American stock exchanges since 1926.

He found that returns from long-term stock investing are positively skewed, meaning that a small number of very highretuning stocks raise the average, while most stocks post modest or negative returns. Fifty-eight percent of stocks failed to beat Treasury bill returns over their lifetimes. Thirty-eight percent of stocks beat Treasury bill returns by only moderate amounts. A mere four percent of stocks are responsible for ensuring that the market’s overall return beats Treasury bills over the long-term. These 1,092 companies have been responsible for all of the $35 trillion in wealth created by stocks over and above Treasury bill returns between 1926 and 2016. More than half of the $35 trillion came from just 90 companies, or less than one-third of one percent of all companies on the exchanges.

Inevitably, many will argue that the markets failed to play out the way they had predicted in 2023 because of the concentration of returns. However, this is exactly why active management is so hard. Missing out on the few outperforming companies will lead to underperformance. The last 12 months have underscored our belief in the need to remain highly selective and focussed on maintaining exposure to the best companies in the market. This is a core principle of the EPIC Global Equity Fund and it has served us well in 2023.

Results update

As we approach the end of the third quarter earnings season, we are pleased to report that most of the Fund’s holdings have continued to deliver.

Nvidia. The era of generative AI is taking off, as evidenced by Nvidia's third-quarter financial results, which have exceeded market expectations for the third consecutive quarter. The company reported record-breaking revenue of $18.1 billion, marking a 34% increase from the previous quarter and a remarkable 206% growth compared to the same period last year. Notably, Data Centre revenue reached a record $14.5 billion, up 41% from the second quarter and a staggering 279% year-on-year increase. Nvidia's quarterly GAAP earnings per diluted share soared to $3.71, representing a remarkable twelve-fold increase from the previous year and a 50% increase versus the preceding quarter. The company's operating income was three and a half times higher than the amount generated in the entire first nine months of the previous year. Adjusted gross margin of 75% outperformed guidance of 72.5%, while the adjusted operating margin of 64% significantly exceeded the projected 53%.

Nvidia anticipates revenue of $20 billion in the fourth quarter, compared to estimates of $16 billion. This material upgrade comes despite the company's warning that revenue from China is expected to decline significantly due to newly introduced licensing requirements. However, management believes that the decline will be more than offset by strong growth in other regions.

Salesforce rallied as it demonstrated strong performance in its fiscal third quarter, surpassing revenue and profitability expectations. The company provided positive guidance, particularly regarding profitability, and management expressed enthusiasm about growth opportunities in the data cloud. Noteworthy achievements included strong performance in large deals, accelerated growth in its remaining performance obligation (RPO), and a commitment to capital returns through $1.9 billion in share buybacks during the quarter. In the third quarter, Salesforce achieved 11% year-on-year revenue growth to $8.7 billion, which was above expectations. This strength was attributed to MuleSoft, data cloud, and effective execution. Current RPO grew 13% year-on-year in constant currency, indicating acceleration beyond revenue growth. Salesforce’s non-GAAP operating margin of 31.2% was substantially improved from 22.7% a year ago.

Adyen’s shares rallied 38% as the company’s third quarter business update was well-received by the market. The company reported trends consistent with the first half of the year. Processed volume increased by 21% and net revenue rose by 22%, led in particular by the 21% growth in digital volumes.

Despite the material share price movement following the results, we believe that Adyen’s shares remain significantly undervalued.

Coloplast posted a strong set of results but provided a cautious fiscal 2024 outlook, anticipating ongoing cost pressures which are expected to result in operating margin performing below the historical benchmark of 30%. This disappointed the market and led to a 7% decrease in the share price. Coloplast achieved 8% organic revenue growth, led by ostomy’s 9% organic growth, surpassing market expectations despite challenges in China. Revenue in continence care and voice/respiratory segments also demonstrated solid growth. Advanced wound care grew 8% year-on-year as a result of the resolution of back orders in Europe.

We believe that easing inflationary pressures on input costs and labour, the adoption and market penetration of Heylo and Luja, with potential price premiums, along with scaling operations in Costa Rica and Portugal, should allow the company to return to 30%+ operating margins over the next few years. As a result, we believe that the shares are significantly undervalued.

Roper Technologies reported very strong third-quarter results with a 16% revenue increase and a 24% rise in GAAP diluted earnings per share. Adjusted operating cash flow increased by 72% as Roper's network business excelled, improving adjusted EBITDA margins by 185 basis points to 56.4%

During the quarter, the company allocated $2 billion for acquisitions in vertical software. Neil Hunn, the President and CEO, voiced assurance in the robust performance of their market-leading technology businesses, prompting an increase in the company's 2023 guidance. We continue to be impressed by the consistent excellence exhibited by this company.

ASML reported third quarter results in line with expectations, achieving a noteworthy 15% year-on-year increase in sales. Notably, logic sales surpassed memory sales, influenced by a downcycle in the memory chip market.

The growth was primarily fuelled by substantial demand from China, especially for trailing-edge systems, driven by Chinese chipmakers aiming to bolster their chip equipment inventory amid concerns about US export restrictions.

ASML's gross margin for the quarter was 51.9%, exceeding guidance as a result of a higher mix of deep ultraviolet (DUV) equipment. The company expects sales to remain flat in 2024, whilst robust growth is anticipated in 2025. ASML expressed confidence in mitigating the impact of increased US export restrictions on its top line by diversifying shipments to other regions, showcasing a positive long-term outlook for the company.

Danaher's third quarter performance marginally exceeded expectations, with its bioprocessing business displaying signs of stabilising as had been anticipated by management. After the surge brought on by the pandemic, Danaher's third-quarter results included a 12% core basis revenue decline (adjusted for constant currency and organic factors) and a 21% reduction in adjusted EPS. The biotechnology segment, which had thrived during the COVID-19 vaccine production phase, experienced a 21% core basis decline due to factors like inventory destocking and cautious customer purchasing behaviour. Nevertheless, this segment met management's expectations and appears to be approaching a demand stabilisation point. Similarly, the diagnostics segment, which had also benefited from pandemic-related testing, saw a 16% core basis decline, though the Cepheid business exceeded expectations. These revenue declines had implications for margins, contributing to the overall decline in EPS. The boost from the COVID pandemic continues to distort results and is overshadowing the strong structural growth of this company. We see this as an attractive buying opportunity.

Alphabet, Google's parent company, reported solid Q3 results with total revenue reaching $76.7 billion, up 11% yearon-year, primarily driven by growth in advertising and cloud services. Google's advertising business exhibited strength, particularly in retail ad spending, boosting revenue for both search and YouTube ads. Google's cloud revenue growth was slower than growth of Microsoft's Azure, which led to a 10% drop in Alphabet's shares. We would urge investors not to read too much into quarter-on-quarter results as these can be skewed by large contracts. However, we would also highlight that Azure’s clients tend to be larger and more established corporations whilst Google’s cloud clients are often smaller companies or startups.

Alphabet remains confident in its advertising business as customer ad spending returns. Management highlighted their commitment to investing in artificial intelligence and increasing efficiency, with a focus on reducing client acquisition costs without compromising growth potential.

Meta Platforms reported a robust third-quarter performance, showcasing strength in user growth, engagement, and monetisation while operating with greater efficiency. As anticipated, Reels, which is now attracting more advertisers, is no longer negatively affecting Meta's advertising revenue, as it did in the past. This performance underscores Meta's success in enhancing its data analytics, campaign planning, and measurement tools through the use of artificial intelligence. Total revenue for the quarter surged by 23% to $34.1 billion.

Non-GAAP operating margin increased to over 41% from 22% in the previous year. This margin expansion is attributed to reduced headcount, lower spending on sales and marketing, and a decline in general and administrative expenses, partly due to reduced legal costs. Meta's efficient operations in the third quarter are expected to persist into 2024, which should lead to further margin expansion.

Meta experienced year-on-year increases in monthly and daily average user counts across most regions, reflecting heightened engagement. Furthermore, the outlook for ad pricing improved, with a decrease of only 6% in contrast to the 16% year-on-year decline in the previous quarter, as the drag from Reels subsided.

Meta expects its total revenue for the fourth quarter to grow approximately 19%. The company has also reduced its expense guidance for the full year to between $87 billion and $89 billion, which includes restructuring costs. Additionally, Meta has slightly lowered its capital expenditure plan for the year and anticipates an increase in spending of around 16% to $30 billion to $35 billion next year. These investments will be primarily directed toward artificial intelligence and data centres.

United Rentals saw a strong 18% increase in rental revenue in the quarter to $3.2 billion with used equipment sales growing 102% to deliver the second consecutive quarter of triple digit growth. Used equipment sales are lower gross margins, meaning that the growth led to a gross margin decline of 240 basis points to 41.9% for the quarter. While the stock has experienced some downward volatility over the past month, macroeconomic concerns proved to be unfounded as the demand for rentals remains robust. It is expected that this robust activity will persist into the next year as contractors are increasingly recognising the economic benefits of renting equipment for intermittent use. We believe that the steady rise in rental penetration among contractors will over the coming years.

There is a growing concern about the anticipated weakness in commercial real estate impacting the construction sector. However, this overlooks investments in sectors such as manufacturing, power, and public infrastructure projects which should outweigh spending in the commercial real estate sector. We anticipate that new infrastructure spending in the US will stimulate construction projects over the next decade – with The infrastructure Bill, EV investment, semiconductor onshoring, North American LNG and the Inflation Reduction Act providing an estimated $2 trillion tailwind. We see this as a buying opportunity.

Microsoft reported strong first-quarter results, exceeding expectations in both revenue and profit. The company's performance reflects improved demand in the commercial sector, driven by the strength of Azure, contributions from artificial intelligence (AI), and reduced efforts in cloud optimisation by clients.

Microsoft achieved 13% year-on-year revenue growth, driven by robust performance in its different segments. Commercial bookings rebounded, with 17% year-on-year growth. The productivity and business processes segment, as well as the intelligent cloud segment, outperformed expectations.

Within the productivity and business processes segment, Office and Dynamics delivered strong sales. Dynamics continued to exhibit consistent growth and Office 365 experienced 10% increase in seat growth. In the intelligent cloud segment, Microsoft's cloud revenue increased by 23%, with Azure exhibiting 28% year-on-year growth. Workload optimization trends have shifted towards AI, contributing to growth.

Microsoft's operating margin improved significantly to 47.6%, thanks to cost management (including headcount reduction) and higher-than-expected revenue.

Microsoft's guidance is positive, with Azure expected to remain strong over the course of the year.

Novo Nordisk achieved 33% increase in sales and 37% growth in operating profit for the first nine months of 2023, aligning with their previously announced results in October. Their updated guidance for 2023, with expected top-line growth of 32%-38% and operating profit growth of 40%-46%, slightly exceeds prior expectations. This exceptional performance is largely driven by the strong sales of their GLP-1 therapies, specifically the diabetes drug Ozempic and the obesity drug Wegovy in the US, which have surpassed management's projections.

The company is well-positioned to extend the use of GLP-1 therapies into new medical indications and expand obesity coverage in Medicare in the coming years.

Finally, Novo Nordisk is accumulating positive data from various cardiovascular-related trials for semaglutide, which is expected to contribute further to its success.

Portfolio Update

We have decided to sell out of Masimo, prompted by growing concerns about its business focus. We have reinvested the proceeds into Constellation Software. This company is a leading provider of software and services in both public and private sector markets. Their mission is to acquire, manage, and build market-leading software businesses, specialising in mission-critical software solutions tailored to specific industries. Recognising Constellation Software as a world-class compounder, we believe its inclusion further enhances the underlying quality of the EPIC Global Equity Fund. Stay tuned for more information on Constellation Software in due course.

Performance and Outlook

The EPIC Global Equity Fund has increased 22.2% in the year to 30 November, materially outperforming the market.

In our January 2023 update, we highlighted that "a number of EPIC Global Equity Fund’s portfolio of exceptionally run companies are being mispriced, creating a great opportunity for investors."

Despite the substantial returns achieved this year, the starting point was relatively low and in our view valuations remain attractive overall.

Malcolm Schembri
Fund Manager, EPIC Global Equity Fund