Global Equity: The case for Quality

MARKET OVERVIEW

We think that the market is underestimating the fundamental growth and shareholder value that quality growth companies have created over the past decade, and overly attributed the strong share price movements to an accommodative monetary policy. This is probably spurring profit taking among a number of long-term secular winners.

Furthermore, whilst there has been some pull back, we perceive that the market is also overestimating the mean reversion from the “return to normality”. All empirical evidence we have studied concurs that the COVID accelerated trends such as digitisation, online payments, work from home and so forth will persist far more than excepted.

We would argue that the market is also incorrectly assuming that high quality growth cannot thrive in a higher interest rate environment, and if history is of any guide, this view is misguided.

STOCK MARKET RETURNS IN A RISING INTEREST RATE ENVIRONMENT

According to data from Canaccord Genuity’s Quest, the US FED Funds rose 425 bps from 2003 to 2006, yet the Nasdaq and S&P 500 rallied 40% following the initial rate hike. In more recent memory the 225 bps increase from 2016 to 2019 led the S&P500 and Nasdaq to rise 60% and 80% respectively.

THE CASE FOR QUALITY

According to research by GMO, Quality has typically outperformed the S&P500 in inflationary periods.

This makes sense because a company with pricing power generating high returns on its assets is in a far better position and would be less impacted than a company with no pricing power generating a low spread on its assets, if any,  over its cost of capital even before the inflationary pressures. Furthermore, Quality companies typically have stronger balance sheets and are less affected by increasing costs of debt.

Ultimately the Value companies (a misnomer in our view) tend to be lowly rated for a very good reason. They do not tend to generate shareholder value because they typically do not generate returns on their assets above their cost of capital. Therefore, mathematically we cannot see how the “value rally” can persist over time.

OPPORTUNITIES IN HIGH QUALITY

We think this market scenario has created a lot of opportunities within the high-quality growth space. Whilst of course this is not an exact science, according to our fair value estimates, the Fund’s top ten holdings are trading at a discount to fair value of 18%. We will be in a position to provide more up to date information on completion of the earnings season. In the meantime, we reiterate the strong FCF growth figure of 22% and that to the best of our understanding, the downturn is due to the rotation.

Some companies which we believe are materially undervalued by the market include Meta Platforms 25% discount to fair value estimate, Alphabet 28% discount to fair value estimate and Amazon 32% discount to fair value estimate. Many holdings have also been hit hard. Amongst others Adobe, Veeva and PayPal are currently down 26%, 35% and 47% respectively from highs.

ADOBE

Back in December, Adobe reported strong top line growth. Forward indicators such as remaining performance obligations accelerated to a 23% year on year growth rate whilst current deferred revenue accelerated to a 30% year on year growth rate.

The investor day also provided a few key take away points. Management disclosed that it now has 600 million non-creative professional monthly active users and 400 million unique mobile IDs on the creative platform. Management also upgraded its total addressable market estimate to $205 billion in fiscal 2024 from $147 million in fiscal 2023. We think that the shares are 20% undervalued. 

VEEVA

We like Veeva because amongst other things their business model provides high visibility and management is very transparent with regards to their medium-term projections. They have historically under promised and over delivered. Using Management’s own guidance figures the firm is worth $300 a share. It is currently trading at $222 a share. This implies a discount to fair value estimate of 26%.

MSCI

MSCI posted very strong results; the firm’s operating revenue grew 24% (20% organically), beating market expectations. Top line continued to be boosted by the ESG and Climate Change segment which accelerated to 53% like-for-like revenue growth. The index revenue grew 25% whilst recurring subscription revenue accelerated to 14.4% growth from 12.9% in the prior period. 

MASTERCARD & VISA

Results from Visa and Mastercard largely mirrored each other, both posting strong results, benefiting from the economic rebound. Mastercard grew top line 28% on a consistent currency basis whilst Visa grew at a 25% rate. Data from both companies suggest that gross domestic dollar volumes have accelerated from pre-pandemic levels as the pandemic has accelerated the transition from Cash. The all-important cross border volumes continue to recover strongly; Mastercard grew 63% year on year to 98% of 2019 levels whilst Visa grew 51% to 101% of 2019 levels. Adjusted margins grew to 54.2% from 49.9% for Mastercard with management suggesting further margin improvement in the coming quarters whilst Visa’s adjusted margins grew to 69.8% from 67.6% a year ago.

MICROSOFT

Microsoft's results have been strong and bode well for a number of the other holdings within the Fund as despite the ongoing weakness in software stocks, the results demonstrate that the digital transformation remains intact. Once again during the earnings release CEO Satya Nadella implied that this is not a one-off strong quarter but more of a long-term secular growth as “tech as a percentage of GDP continues to increase” and “digital technology is the most malleable resource at the world’s disposal to overcome constraints and reimagine everyday work and life”  

The results themselves showed revenue of $51.73 compared to market consensus figures of $50.85 billion as strength was practically across the board with 20% year on year revenue growth. More Personal Computing was particularly strong with revenues $700 million above the top end of guidance. 

Azure, Dynamics 365, LinkedIn all grew strongly with year-on-year growth figures of 46%, 45% and 37% respectively. The strong top line growth figures led operating margins to expand 150 bps to 43% due to improved operating leverage.

Next quarter’s guidance top line figures are circa $600 million above consensus. We would also highlight that the Commercial bookings and remaining performance obligations, both future performance indicators, remain strong.

Following the latest results, we think that Microsoft is worth approximately $355 a share compared to the market price of approximately $300 implying a discount to intrinsic value of over 15%. 

HEALTHCARE

In the healthcare space, the recovery has been slowed down due to the Omicron variant flare up which has once again put hospital resources under pressure.

EDWARDS LIFESCIENCES

Edwards Lifesciences reported 2021 sales growth of 19%, which slowed down to 12% in Q4. Shares have retreated a bit however we think that this is an opportunity.  In a recent investor day, the company materially increased its total addressable market projections due to the product innovation, regulatory approvals and better treatment options. 

INTUITIVE SURGICAL

Intuitive Surgical saw top line revenue growth of 17% in the fourth quarter of 2021.  Crucially the firm also shipped 385 da Vinci Surgical Systems compared to the 326 it shipped out in the corresponding period last year. This is important because each system feeds the high margin consumable revenue which is approximately $600k revenue per system (depending on usage which tends to trend upwards). The company provided conservative procedure growth guidance of 11% to 15% due to uncertainty around hospital capacity. The long-term structural trends remain intact.

ILLUMINA

Illumina disclosed that preliminary 2021 results and guidance for 2022 will be above market consensus. In the fourth quarter of 2021, the shares surged 17% on this update, yet the shares have practically given all this back due to the market malaise.

Illumina generated revenue of $1.2 billion (25% growth). For the full year ended 2021, the firm generated $4.5 billion of revenue (39% growth).

A key takeout was Grail’s revenue guidance for 2022 in the range of $70 million to $90 million. Their liquid biopsy test - Galleri - for early cancer detection in about 50 indications was launched in June 2021.

Grail's technology remains especially compelling, it has a five-year head start in a total addressable market which is expected to reach $150 billion in the next decade.

Illumina also highlighted a number of key new product developments.  For example, its Chemistry X initiative could serve as the platform that crushes sequencing costs to the so far elusive $100 per genome milestone. It is also faster, more accurate, and longer read technology, and with such capabilities should stave off competition. Illumina's Dragen technology also could make analysis of the data derived from genomic sequencing much quicker (40 times faster genome alignment and variant calling) and more accurate (2 times). Additionally, Illumina plans to introduce a long-read technology on its existing platforms called Infinity that could help Illumina compete better with the likes of Pacific Biosciences and Oxford Nanopore Technologies in long-read applications. Whilst consisting of a much smaller part of the market, the long read market is growing at twice the size of short reads.

Malcolm Schembri
Fund Manager - EPIC Global Equity Fund