11 Sep 2018
The LF Blue Whale Growth Fund is celebrating its first anniversary and we are pleased to announce that our 1st year return of 24.6% outperformed our most obvious benchmark, the MSCI World (Net GBP) by 13.1% and the FTSE 100 by 22.3%. The Fund is ranked in the top 1% in the IA Global Sector year-to-date, and the top 2% since inception.
We aim to deliver consistent outperformance of at least 5% per annum to the traditional benchmarks to justify our active strategy and it was pleasing to significantly exceed this objective in year 1 – we aim to continue such outperformance in the years ahead.
Our performance has been achieved against the backdrop of a volatile political and economic climate which has provided both favourable and unfavourable events. Shortly after the Fund launched, Donald Trump delivered his well anticipated corporate tax cut in the US. This has provided a high-level of stimulus in three ways – firstly it naturally boosted earnings growth, secondly it provided a cash flow boost to many corporates who were looking highly levered and vulnerable and thirdly it enabled repatriation of overseas cash hoards which has resulted in accelerated buybacks. This stimulus helped maintain high economic growth, and consumer and business optimism which resulted in a strong performance in equity markets through to the end of January 2018.
However, this euphoria was broken in February, March and April with the return of volatility to financial markets, after a long period of benign conditions. From the 15th January through to the 20th February, the FTSE 100 Index declined more than 6% and the MSCI World Net GBP Index declined by more than 4% whilst the Fund declined less than 1%. We believe the volatility seen in the first half of year was partially driven by technical factors and partially by a small correction in valuations.
We also wrote to our investors early in the year warning of market complacency over the Italian elections. The election of the Lega Nord and Five Star Party came as a shock to financial markets (but not to us) and led to a sharp rise in Italian yields. After much optimism following somewhat improved economic data in the Eurozone in 2017 we believe the region will continue to face severe challenges from the problematic incompatibility of a shared currency between countries with separate fiscal systems.
Donald Trump’s ongoing actions on global trade arrangements have yet to materialise into an adverse market event although trade tensions and the strong dollar have proved painful for emerging markets, particularly Argentina and Turkey.
We continue to believe the main short-term risk to markets is that the US Federal Reserve raises interest rates too quickly – the flattening yield curve should be a signal to policy makers that further rate rises need to be very gradual. We continue to watch this situation closely. We also have one-eye on the US mid-term elections – any situation which presents the Democrats with the opportunity of impeachment may be painful for risk assets but we currently see a Democrat majority in the Senate as unlikely.
We will not typically invest in companies with high levels of direct exposure to interest rates, commodity prices or industrial cycles. As a result our portfolio has largely consisted of technology, consumer and healthcare stocks which have been less impacted by the macroeconomic factors mentioned above and as previously mentioned, helped the Fund to be resilient in volatile periods.
The main contributors to the performance in our first year were technology and healthcare stocks. Technology stocks Alphabet, Intuit, Microsoft, Amazon, Adobe, Salesforce, PayPal and MasterCard and healthcare stocks UnitedHealth, Veeva and Zoetis all delivered strong returns, well in excess of the indices referenced above. This was due to strong earnings growth which exceeded the expectations of market participants together with rising expectations for future performance. We believe the market continues to undervalue companies that can achieve high long-term sustainable growth due to the short-term focus of many market participants and the rise of passive index trackers that indiscriminately allocate capital.
We did exit our investment in technology stock Red Hat during the first half of the year as we felt that valuation had run too far ahead of fundamentals. Subsequent to our sale, Red Hat suffered a one-day decline of more than 20% in June after disappointing earnings results, justifying our decision.
We also exited our holdings of gaming companies Electronic Arts and Activision Blizzard. The overnight success of the free-to-download hit game Fortnite cast some doubt on our long-term thesis on these stocks, which depends on the willingness of gamers to pay to download games. These stocks have generated some excitement with their drive towards a subscription model, but the share prices have fallen heavily in recent weeks and we are content that our risk-reward analysis was correct.
On the negative front, our investment in Facebook has underperformed our expectations. The Cambridge Analytica story initially put pressure on the stock, but at this time we concluded there was no fundamental change to the long-term structural growth story around the monetisation of the Facebook IP for digital advertising. However, we underestimated the impact the political vitriol had on the Facebook management team and subsequently the decisions they have recently made prioritised stakeholders other than their investors. This led to a disappointing earnings outlook in July and a heavy fall in the stock price. We have readjusted our investment process to include broader assessments of political risk including the impact of scrutiny on management’s decision making. As a result of the disappointing outlook and our reassessment of the political impact, we materially reduced our position in Facebook in the Fund although we continue to monitor the situation as we believe the long-term growth drivers remain in place.
We have often been asked about our overweight position in technology stocks and whether we are actually a “tech” fund. We have long felt the sector allocations determined by the Global Industry Classification Standard (“GICS”) is outdated and we welcome the changes which will be made in the next few months. The technology sector currently consists of three distinct buckets of stocks – Software and Services, Semiconductors, and Hardware. We have almost no exposure to Semiconductors and Hardware stocks where product cycles and high levels of capital expenditure are key determinants of performance. However, the software and services segment where recurring revenues are high and strong free cash flow generation is consistent, has provided plentiful opportunities that meet our investment criteria. Many of these companies use technology to operate in traditional areas such as advertising, retail and media. Given nearly every company now uses technology in their operations, the distinction between some stocks classified as technology and others classed as consumer can appear very blurred. We therefore welcome the decision by GICS to move some stocks current classified as technology, including Facebook and Google, into a new sector which includes telecom companies. These reclassifications will cosmetically provide a distinctly different portfolio composition for the LF Blue Whale Growth Fund later this year.
Going forward, we continue to see excellent investment opportunities in “the cloud” space, which is a significant long-term structural growth story. We also see select opportunities in media, medtech, fintech, animal health and consumer brand companies where we are closely monitoring company performance and valuations of a select group of stocks.
In summary, financial markets will continue to present challenges and opportunities and we are determined to continue our strong outperformance from year 1. We would like to thank our investors for their support to date and look forward to updating you on our performance throughout the course of our second year.
The Fund Managers
Stephen Yiu and Robert Lloyd
Please remember that past performance is not a guide to future performance and that your capital is at risk. Please note also that references to portfolio companies do not constitute investment recommendations.