Equities have generally benefited from disinflation and a pause of the rate hike by the U.S. Federal Reserve (“Fed Pause”) in Q2 2023. Inflation is falling and the economy is moderating. This has had a positive impact on equities, with valuations expanding. Growth sectors have been particularly strong, likely due to a combination of discounted cash-flow valuations that are more sensitive to changes in inflation and the bursting of generative artificial intelligence (AI) onto the global scene.
Holdings that contributed to absolute performance:
NVIDIA Corporation (NVIDIA)
At the end of May, Nvidia reported a quarter that announced that the AI moment had arrived.The company guided to a blowout Q2 with revenues that were 60% ahead of expectations.Revenues are expected to increase 65% year-over-year and 53% on a quarter-over-quarter basis.Enthusiasm for Large Language Models is propelling Nvidia’s data centre business.The company also commented that the data centre business in the second half of the year would be meaningfully higher than the first half which is a sign of confidence that the July guidance is actually a production constrained forecast.
Eli Lilly and Company (Eli Lilly)
An impressive string of events for Eli Lilly vaulted it past Johnson & Johnson (JNJ) in terms of market capitalization during the quarter.Towards the end of April, the company reported impressive quarterly results where its key drug, Mounjaro, beat street estimates by over $100M allowing the company to raise their 2023 outlook.Simultaneously, the company released impressive top line data for the Mounjaro Surmout-2 Phase 3 obesity trial which enables Eli Lilly to file for an expanded indication for the drug.Then, in May, Eli Lilly showed promising Phase 3 results in Alzheimer patients and Alz readouts opening up another $20B market opportunity. Finally, towards quarter end, Eli Lilly’s obesity pill demonstrated low teens percentage weight loss at 36 weeks and had not yet plateaued, which suggests the possibility of additional weight loss with longer treatment.
Holdings that detracted from absolute performance:
Progressive Corporation. (Progressive)
Progressive shares came under pressure following its March monthly report which showed its second worst monthly loss ratio in 23 years.Most notably, the personal auto segment reported a combined ratio of 104.5% including an 84.2% reported loss ratio – well in excess of estimates of around 92% and 73% respectively.Our belief is that this was a one-time aberration that was driven by new Florida tort reform.The reform, which took effect towards the end of March aims to address concerns over the litigious nature of the state.Among the changes was the lowering of the statute of limitations to two years from four.This resulted in a flurry of lawsuits/claims being filed in the week leading up to the reform taking place.
Estee Lauder Inc. (EL)
In early May, Estee Lauder reported a very disappointing quarter resulting in them cutting their full year guidance.EPS was cut 45% below its initial guidance.The culprit appears to have been EL’s significant reliance on Asian travel retail where inventories were excessively high.EL massively overestimated near-term growth prospects in Hainan.Through most of the pandemic, Chinese consumers couldn’t leave the country but Hainan was accessible and a frequent shopping destination.This meant longer visits for Chinese consumers and higher transactions for EL in a jurisdiction where EL had outsized market share.The company therefore ended up wrong footed when travel restrictions loosened and the Chinese started migrating travel patterns to Japan, a country where EL under-indexes.
Small Cap Spotlight
We would like to highlight our position in Kneat.com (KSI) – Kneat.com offers a software platform that is used for electronic validation processes primarily in the life sciences sector. The company boasts 8 of the top 10 global pharmaceutical companies as customers which positions it as the global leader in its niche vertical. Growth within its current customer base (expanding use across more global locations + adding more processes), new logo customer growth, as well as customer wins in new verticals (consumer packaged goods companies) leaves Kneat with a long runway of growth. In addition, having displayed the benefits of their core data validation software platform, Kneat has been expanding its total addressable market (TAM) by adding new quality assurance processes which adds another leg of long-term growth to the company. They have had strong momentum recently in new customer wins as well as progress in being deployed across existing customers, which has led to Annual Recurring Revenue (ARR) growth of ~85% in the most recent quarter. Given their very strong competitive positioning, high quality customer base and high growth profile we believe there is an attractive risk/reward.
Outlook and Opportunities
Overall, we believe we continue to remain within the eye of the hurricane at a macroeconomic level but have received an albeit short-term boost from the clearing of the US debt ceiling this quarter.
We also recognize that AI related momentum and a broader “fear of missing out” for those who moved into cash instruments may continue to elevate the current market run in the short-term.
On the more medium term we remain concerned on the growing probability of a hard landing given where the ISM Services PMI and other factors are trending.
With respect to positioning we continue to be selective in our positioning – adding to names that exhibit structural growth and who trade at reasonable valuations.
Our belief is that those who can provide growth will be rewarded in the next cycle.
Thematically, we are positive and long term bullish on housing (i.e. homebuilders, building material distributors, and property managers) as a whole given the extreme supply/demand imbalance on both sides of the border.
Furthermore, we also remain positive in the long-run on commodities (i.e. copper) and materials but have a more muted to neutral position at the moment given where we are in the current cycle.