piranka
Investing Environment
Softer-than-expected US employment data led to market volatility in Q3, as recession worries gripped investors for several weeks. However, stock prices rebounded on resilient earnings and the Fed’s half-point rate cut. Small-cap and value stocks surged.
In Europe, a slowdown in hiring hastened the European Central Bank to lower its deposit facility rate from 3.75% to 3.50%. Outside of the euro area, strength in the UK’s services sector contributed to GDP growth. However, core inflation in the UK also ticked up to 3.6% in August, the highest rate in four months.
In Japan, the central bank raised interest rates to 0.25% in July, just before the early August selloff. Japanese equities fell as well. Concerns over the economy and an unwinding of the yen carry trade, a strategy predicated on low Japanese interest rates, further weighed on equity prices. Stock prices then partially recovered, helped by the Bank of Japan’s pause in September and its positive economic outlook. While a weak yen supports exporters, it undermines Japanese consumers, who must import most household goods. Reinvigorating consumer spending is an important focal point for the central bank’s plans for growing the economy.
Portfolio Activity
The portfolio finished lower than its benchmark, the MSCI AC World Index, in Q3. The adverse effects of stock selection overshadowed positive currency and sector allocation effects.
Stock selection in industrials weighed on relative returns, despite favorable currency effects. Aerospace manufacturer Melrose Industries (OTCPK:MLSPF) reported strong first-half profits and reaffirmed its 2024 guidance, but its stock declined due to industry-wide supply chain issues and uncertainty about its cash flows from its maintenance contracts. In accordance with industry accounting standards, the company recognizes most of its profits from long-term maintenance contracts when selling parts to customers. The company maintains that the value of these aftermarket contracts has appreciated, driven by increased demand for servicing existing fleets during the current supply shortage. Essentially, airlines are willing to pay more to extend the lifespan of their planes while waiting for new orders. Although some analysts have questioned these valuations and accrued cash flows, we remain confident in both. We also believe Melrose is well positioned to grow its earnings further, given the aerospace industry’s ongoing supply-demand imbalances.
Wizz Airlines’ (OTCPK:WZZAF) shares fell in July after the company reported a 44% drop in operating profits caused by ongoing defects in Pratt & Whitney engines that power most of its Airbus A320neo fleet. By June, 46 planes were grounded while both companies worked to fix the defects. In addition, the Hungary-based discount carrier faces delays in receiving new Airbus plane orders given an industry-wide parts and labor shortage. However, by mid-September, shares began to recover after Wizz announced that it expects a 15%-20% increase in passengers next year due, in part, to an increase in its fleet. The new planes are anticipated to nearly double the airline’s current capacity, reduce employee costs per mile and lower fuel consumption by 10% compared to its current fleet. We believe the airline will also benefit from secular growth in air travel driven by favorable demographics.
Financials weighed on relative returns this quarter, despite positive currency effects. Shares of Sumitomo Mitsui Financial Group (SMFG), Japan’s second-largest bank, declined in early August along with other bank stocks, underperforming the broader market. Despite this, the bank reported a 25% year-over-year increase in net interest income and a 49% rise in pre-tax income, driven by higher interest rates. We think the bank will continue to gain from the BOJ’s tighter monetary policy. In addition, the company aims to significantly reduce its cross-holdings, which may lead to an increase in share buybacks.
Our consumer discretionary holdings also detracted from relative performance this quarter, with Amazon.com (AMZN) reporting mixed Q2 results. While its cloud computing unit Amazon Web Services (AWS) grew revenues by 19% and improved gross margins, its e-commerce business slowed, with gross merchandise value rising just 10% and missing estimates by 1%. While we trimmed the position, we remain confident in the company’s growth. We also appreciate management’s focus on demand-driven capital investment as the current generative AI arms race accelerates further.
In health care, our holdings delivered strong returns. Shares of genetic testing company Natera (NTRA) rose after its Signatera™ blood test, which detects tiny amounts of residual cancer post-treatment, showed improved survival rates in colorectal cancer patients. We believe this data will make Signatera™ the standard of care, meaning doctors will routinely use it for colorectal cancer diagnosis or risk liability. We see potential near-term catalysts for Signatera™ in other medical areas and believe it represents a $15 billion market opportunity.
Halozyme Therapeutics’ (HALO) share price rose this quarter following the approval of two partner drugs in the US: OCREVUS ZUNOVO™ for relapsing multiple sclerosis and TECENTRIQ Hybreza™ for various cancers. Both drugs, marketed by Roche, received approval in Europe earlier this year. Halozyme’s ENHANZE® technology allows historically intravenously administered drugs to be delivered subcutaneously, significantly reducing treatment time. For example, OCREVUS can now be administered in minutes with a short needle rather than hours via an IV. Halozyme earns mid-single-digit royalties on product sales. Over the long term, we value the company’s cash generation potential, which supports further share buybacks.
Biotech firm UCB (OTCPK:UCBJF) had another strong quarter. Shares surged after the FDA approved Bimzelx® for psoriatic arthritis, a condition that affects 30% of psoriasis patients. Bimzelx® is already the leading treatment for psoriasis, a $13.4 billion market that is expected to grow to $35 billion by 2032. The biologic has helped UCB more than double its stock price this year.
In communication services, Meta Platforms (META) added to relative returns. The company has created new AI offerings that enhance user engagement and advertising revenue. We value the company’s recent work on building Meta AI, a multilingual intelligent assistant integrated into its family of apps. It helps users create personalized experiences through recommendations and images. In turn, this information helps advertisers create more targeted, engaging and effective ads, improving advertising returns. Combined with Meta’s latest open-source large language model, Llama 3.2, we believe Meta AI can transform the social media landscape as it rolls out globally.
Also, Netflix (NFLX) sustained its momentum from Q1 into Q2, adding 8 million new subscribers, which beat analyst expectations of 5 million. Subscriptions to its lowest ad-supported pricing tier-$6.99 per month in the US-jumped 34% in Q2 and 65% in Q1, driven by new customers and those affected by the password-sharing crackdown. Netflix plans to raise its basic ad-free plan price from $11.99 to $15.49 in the US, aiming to convert the value of ad-free viewing into higher revenue. Additionally, the company is implementing region-based pricing, factoring in local conditions, competition and content costs. These pricing strategies helped Netflix increase average revenue per user by 5% and total revenues by 22% in Q2. We believe Netflix is a structural winner that can continue to gain scale advantages in content production and library acquisition, which should support profitable growth and higher free cash flow. Netflix currently leads the industry in revenue and gross profit per subscriber.
Positioning Activity
We made meaningful changes to the portfolio this quarter, trimming or selling stocks that appear to have limited upside and adding to positions we believe to be undervalued. Financials and health care remain the two largest sectors. Our cash position also increased and is now closer to its long-term average.
In Q3, we exited several holdings in our infrastructure/transportation theme, one in which we invest in structurally advantaged companies with hard-to-replicate assets. We sold aviation leasing leader AerCap Holdings (AER) as it approached our target price. We also sold our position in GE Aerospace due to declining cash flows and reduced plane orders for its largest customer, Boeing (BA). As of August, Boeing had delivered 86 fewer planes than at the same point last year. While high-margin earnings from GE Aerospace’s aftermarket services have driven its share price, we believe the longer-term impacts from Boeing’s struggles will eventually impair these fundamentals. Additionally, we sold our stake in Belgian automotive firm D’Ieteren Group (OTCPK:SIEVF) on a declining outlook for its automotive parts revenues. Lastly, we sold home improvement retailer Lowe’s on slowing sales and reduced guidance.
We scaled back investment in our technology theme by trimming large tech players like Meta Platforms and Microsoft (MSFT). In addition, we sold our Alphabet shares after a federal court ruled against the Internet search giant’s distribution agreements with smartphone companies allowing Google to be the default search engine on their devices. While the case could take years to resolve, we believe the uncertainty surrounding this decision could negatively impact the company’s advertising business, which makes up the majority of the company’s annual revenue. Lastly, we sold Temenos (OTCPK:TMNSF), a Swiss financial services software provider specializing in cloud banking solutions. The company is reorganizing and streamlining its core business to achieve better earnings growth.
We added to our environment theme by adding holdings of companies that stand to benefit from a shift to cleaner energy. For example, we added National Grid, a British utility that generates and transmits natural gas and electricity in the UK and the US. It recently launched a renewables group to better integrate clean energy into current infrastructure. This year, National Grid announced a £60 billion investment over five years to upgrade, expand, digitize and decarbonize the electric grid. As an example of its forward-thinking investments, the company uses AI in combination with autonomous drones to predict electrical grid failures before they happen, reducing downtime and maintenance costs. We appreciate National Grid’s unique position in the industry and the essential assets it can leverage to meet the growing demand for power. We also initiated a position in Engie (OTCPK:ENGIY), a global energy company that designs, builds and operates low-carbon power plants. Like National Grid (NGG), it is also a pioneer in using AI to deliver power to customers. It uses large language models to better predict renewable power supply and demand, allowing energy grids to operate more efficiently. We see upside in Engie’s earnings given rising energy prices and a growing demand for renewable energy. Lastly, we reestablished a position in industrial gas leader Air Liquide. Like others in its industry, Air Liquide (OTCPK:AIQUF) is confronting slowing sales volumes by increasing productivity and pricing, leading to expanding margins. By benchmarking to its rival Linde (LIN) in earnings per employee and aligning its pricing strategy with global price movements, management is confident in its ability to deliver recurring net profit growth over the long term. We think the company can achieve its outlook.
Falling inflation and interest rates and resilient labor markets influenced our new purchases in the demographics/consumer trends theme. For example, we added Pernod Ricard back to the portfolio. While many consumer goods companies have experienced slowing sales for more than a year, we think low inventory levels, increased promotions and lower financing rates for US wholesalers could be catalysts for premium spirit sales in the coming months.
Premiumization trends, particularly for Gen Z consumers, still provide a tailwind for many of the company’s top brands. Additionally, we opportunistically purchased shares of 3i Group (OTCPK:TGOPF), a position that provides exposure to Action, a privately held, high-quality discount retailer in Europe that we believe is undervalued. In our analysis, Action represents a significant and mispriced portion of 3i’s overall valuation.
In our financial services theme, we increased our holdings in diversified European banks and insurance brokerage. We added to BFF Bank, an Italian finance and factoring company with a strong balance sheet. We expect BFF Bank to reinstate its dividend in the coming months. The bank’s €720 million dividend guidance and solid financial targets are encouraging. We also added to our position in UniCredit (OTCPK:UNCFF), another Italian bank that generates a significant portion of its revenues from wealth management, asset management and specialty finance-resilient businesses that are less reliant on interest rate spreads than traditional banking. At the same time, we sold Deutsche Bank (DB) after it posted its first loss in four years and suspended a share buyback due to the provisioning of $1.4 billion to fund the ongoing litigation over its 2010 Postbank acquisition. Adding to the stock’s headwinds, Germany’s economy showed further signs of deterioration this quarter. Lastly, we added back Aon, a leading insurance broker we believe is currently trading at a discount. Aon’s high margins, pricing power and defensive business model make it an attractive investment.
Finally, we added to our weighting in the demographics/health care theme by increasing our exposure to biotech winner UCB, both directly and by buying shares in Financiere de Tubize, a holding company that owns UCB stock. According to our research, Financiere de Tubize is currently trading at a large discount to its net asset value, offering us an opportunity to invest in UCB at a below-market price. At the same time, we trimmed our large Novo Nordisk position to lock in gains. The Danish biopharma leader is optimistic that amycretin, its phase 1 obesity treatment, will lead the next generation of weight loss drugs. We remain confident in Novo Nordisk’s pipeline and its ability to continue to ramp up supplies of Wegovy to meet the growing global demand.
Outlook
Declining inflation and interest rates should contribute to a supportive backdrop for growth stocks in the coming months, even as economies slow. Further, a rebound in China could help lift Europe’s manufacturing sector. With continued earnings growth across industries underpinning our investments, we remain optimistic that the final months of the year will offer ample opportunities for us to uncover high-quality companies generating sustainable growth at compelling valuations.
