During the September 2022 quarter, the world continued to experience persistent inflation. This included the zero tolerance COVID-19 policies in China resulting in the sudden and complete shutdowns of some large cities; the ongoing war in Ukraine; and substantial tightening measures by central banks worldwide.
Portfolio performance
The Polen Capital Global Growth Fund declined by 2.43 per cent for the September 2022 quarter, trailing the MSCI ACWI Accumulation Index (in AUD) by 2.09 per cent as overweight allocations to the communication services and information technology sectors, zero weightings to the energy, industrials sectors, and an underweight to the financials sectors hindered performance. The depreciating AUD/ USD exchange rate assisted returns by around 6 per cent for the quarter.
Since the inception of the Polen Capital Global Strategy on 31 December 2014, the Portfolio has, in USD, compounded at an annual rate of 8.50 per cent, net of fees, versus 5.68 per cent for the Index, outperforming the Index by 2.82 per cent net of fees.
Contributors and detractors to performance
At an individual company level, the top three absolute contributors were Amazon, ADP, and Autodesk. The three largest absolute detractors were Adobe, ICON, and Adidas. Polen Capital added L’Oréal to the portfolio during the quarter, taking an initial one per cent position and then adding a further one per cent following its compelling earnings report. Share prices can and certainly do wild things in the short run, and Polen Capital believe that over the long term, investee companies will trade for fair valuations. When combined with the earnings growth we expect, the Portfolio is poised to generate attractive client returns over the next three to five years.
Changes in the geopolitical landscape
What changed in the September 2022 quarter relative to the six months prior is the geopolitical landscape, which appears to be even more uncertain with the Ukraine war intensifying, an emerging energy crisis in Europe, and central banks tightening monetary policy further to tackle inflation. Central bank actions this quarter largely began with the U.S. Federal Reserve, which has engaged in its most aggressive campaign to tighten monetary policy since 1981. It instituted a third consecutive 0.75 percentage point increase in interest rates while signalling further raises in the coming months.
The Bank of England responded with its own raise of rates, and Switzerland followed. Central banks in Indonesia, the Philippines, Taiwan, South Africa, and Norway all reacted with rate raises. What does this mean for Global Growth?
The first-order impact of rate increases—increased debt servicing expenses—does not materially impact the investee companies. Polen Capital’s investment guardrails, which have been in place for over three decades, filter out highly leveraged businesses from their investable universe. Most of our companies have more cash than debt, and many have no debt at all. Their fortress balance sheets remove concerns over increased rates leading to increases in debt-related expenses.
The second-order impact of higher rates tends to be an economic slowdown or even a recession. To be clear, Polen Capital are not attempting to predict a slowdown, but we think it may be helpful to share perspective on how our companies tend to perform during these periods. Polen Capital believes most companies in the Index will experience a degradation in their fundamentals. Our companies, on the other hand, tend to separate themselves from lower-quality businesses contained in any Index because they enjoy competitive advantages and benefit from secular tailwinds, allowing growth through cycles. Polen Capital’s aim of mid-teens earnings growth over the next three to five years remains intact regardless of whether a recession occurs or not. Most companies in any Index will not be able to achieve this, based on our experience. Stock returns stem from price and earnings growth, and at the end of the September quarter, the Portfolio’s aggregate P/E multiple is about 21x – at the low end of its range since inception nearly eight years ago. Prices can and certainly do wild things in the short run, and Polen Capital believe that over the long term, our companies will trade for fair valuations. When combined with the earnings growth we expect, we believe the Portfolio is poised to generate attractive client returns over the next three to five years.
Contributors to performance
ADP continues to deliver a solid business performance, with FY22 revenues increasing 10 per cent and adjusted EPS increasing 16 per cent, both above initial guidance. A tight U.S. labour market bodes well for the business into FY23, alongside its ability to earn a portion of its revenues as floating rate income. Amazon reported better-than-expected earnings during the quarter driven by robust earnings and margins in AWS, its cloud division. The company also posted positive numbers for advertising in the face of a tough environment for the sector. Autodesk’s 98 per cent recurring revenue, subscription-based business continues to prove resilient even in the face of a tough macro environment, with its numbers in line with expectations despite China’s Zero-COVID policies and slowing property sector.
Detractors from performance
On the negative side of the coin, late in the quarter, Adobe announced the intent to acquire Figma for $20 billion, financed with half stock and half cash and debt. The market didn’t take kindly to the announcement, and Adobe’s stock fell around 17 per cent on the day. Polen Capital have been owners of Adobe for a long time, respect CEO Shantanu’s vision and ability to execute, and believe management is looking ahead 3-5+ years, as they should be, and making a strategic move. The deal is expensive but reveals that Adobe thinks Figma’s collaboration platform is the way that design development will evolve and that it is more logical to buy than build. It does imply a competitive weakness in this area, but Adobe has a very strong position in digital media creation, which is still a large and growing market. As a natural outcome of capitalism, an extremely profitable and growing market will attract competitors over time. While there are still some questions to be answered and management has some work to do, we believe Adobe still has strong competitive advantages and is likely to be a good investment from here, with or without Figma. With respect to regulation, we’d be surprised if regulators do not at least examine the deal, given Adobe’s position in digital media creation.
If the deal does go through, Polen Capital believe Adobe would invest heavily in supporting and accelerating Figma, bringing Adobe’s vast strength in the photo, video, and editing space to Figma’s platform of real-time collaboration. We think the analogy between Adobe’s solutions being like Microsoft Word and Figma being like Google docs is a pretty good one. There are still plenty of users and uses for Adobe’s existing products (the business is growing nicely), but Figma’s web-based collaboration capabilities, which are a function of designing its platform more like Google Docs, is where some design development work is going. We believe Adobe wants to combine its capabilities with Figma’s platform to accelerate its own evolution and to create new products together. We see the vision. If the acquisition does not go through, as mentioned, web-based collaboration for design development is a big market, it’s growing, and Adobe enjoys a leading position in content creation tools, particularly for more high-value design. This is in addition to its Digital Experience platform, which we view as also highly advantaged and has ample room to grow as well.
While not reflected in the stock price performance, fundamentals remain solid for ICON this year. The integration with PRA Health is progressing nicely, customer retention remains high (it has had no significant customers leave), and employee attrition continues to improve. Despite continued disruption from COVID, weakness in biotech funding, and the ongoing war in Ukraine, top-line growth remains in line with long-term expectations of mid-to-high-single digits. Additionally, ICON continues to expect to reach $10 billion in sales by 2025. Specifically, sales grew 7.8 per cent and 4.4 per cent, respectively, in the March 2022 quarter and the June 2022 quarter, respectively, on a constant currency basis. And, in the June 2022 quarter, sales grew 16 per cent excluding COVID-related studies. Profitability remains stable to slightly improving with gross margins in the high-20 percentile and operating margins in the mid-to-high-teens percentile. The combined company, which benefits from tremendous scale advantages, continues to win new business, and growth in backlog has accelerated (to $20 billion as of the end of the June 2022 quarter).
Adidas continues to suffer from inventory build-up in China, as up to 60 per cent of its stores are in cities that are in some form of lockdown. Despite the rest of the company performing well, China is a significant portion of Adidas’ revenues, which have declined 35 per cent for two quarters running.
An addition to the portfolio
Despite the noise in the market, Polen Capital’s trade activity was especially low during the September 2022 quarter. The team continue to research what we view as deeply attractive businesses trading at more attractive prices than they were at the beginning of the year and believe we already own most of the best companies on offer today. That said, we added L’Oréal to the portfolio during the quarter, taking an initial one per cent position and then adding a further one per cent following its compelling earnings report.
We have been studying globally dominant cosmetics businesses for years, and at a high level, our research revealed that cosmetics and beauty is an extremely durable business. Cosmetics and beauty have been an ingrained part of humanity for at least 10,000 years. Our research led to the purchase of Estée Lauder in 2020, which we sold last year for valuation-related reasons, and now to the addition of L’Oréal to the Portfolio.
L’Oréal was founded in 1909, is headquartered in Paris, France, and is the market leader in the beauty industry with a leading share (more than 14 per cent) and a market capitalisation of more than €180 billion. The company meets and exceeds all guardrails with approximately 30 per cent ROIC (return on invested capital), stable and improving margins, consistent and durable organic growth, and net cash. With A&P (advertising and promotions) and R&D (research and development) of approximately 30 per cent and 3.5 per cent of sales, respectively, the company executes what we see as a successful business model similar to Nike and Adidas.
For decades L’Oréal has acquired and then nurtured brands to globally dominant levels. Today the company has several brands that drive around 75 per cent of company growth (Armani, Garnier, Kiehl’s, Lancôme (more than €4 billion revenue), La Roche Posay, L’Oréal Paris (more than €6 billion), Maybelline, and Yves Saint Laurent. The shifting basis of competition stemming from internet and social media proliferation combined with e-commerce has, in recent years, led to faster and more profitable growth that we believe will continue. Some examples of the shift benefiting L’Oréal is skincare continuing to grow rapidly, where real science and efficacy are involved, and a channel shift from brick-and-mortar to higher margin e-commerce and travel retail. E-commerce was 29 per cent of 2021 revenues, with an equal split among direct-to-consumer, e-retailers, and online pure players.
The company operates four divisions (Professional Products, Consumer Products, L’Oréal Luxe, and Active Cosmetics). Beneficial to the investment case, the divisions with the highest operating margins are the fastest growing and enjoy the strongest secular tailwinds. Further, L’Oréal, which is run as a large portfolio of products, is not reliant on just one variable to drive returns for our clients. In addition to skincare and China, the company is seeing fast growth in North America for its dermatological skincare (where the doctor becomes the salesperson), fragrances, and premium hair care. As long-term shareholders, we also appreciate that management will reinvest most future margin expansion above approximately 35 basis points per year to ensure continued durability.
Polen Capital continue to see nearer-term growth headwinds primarily from COVID-19 grow-over issues. Uncertainty about the trajectory of interest rates and inflation and input costs still weigh on markets and are contributing to a broader ‘risk-off’ sentiment, which is exacerbated by any negative news at a company level. Our long-term earnings growth expectations, however, remain largely unchanged, and we plan to continue to use volatility to take advantage of pricing anomalies and become more concentrated in our best investment ideas for the next five-plus years.
If you would like to learn more about the Polen Capital Global Growth Fund, please visit the fund’s web page to learn more: Polen Capital Global Growth Fund
Past performance is not an indicator of future performance. Returns are not guaranteed and so the value of an investment may rise or fall.
This report has been prepared for the purpose of providing general information, without taking into account your particular objectives, financial circumstances or needs. The issuer of units in the Polen Capital Global Growth Fund (ARSN: 647 518 723) is the Fund’s responsible entity Fundhost Limited (ABN 69 092 517 087) (AFSL: 233045). The Product Disclosure Statement (PDS) contains all of the details of the offer. Copies of the PDS and Target Market Definition (TMD) are available from Montgomery Investment Management, contactable on (02) 8046 5000 or at www.montinvest.com and at https:// fundhost.com.au/ An investment in the Fund must be through a valid paper or online application form accompanying the PDS. Before making any decision to make or hold any investment in the Fund you should consider the PDS and TMD in full. The information provided is general in nature and does not take into account your investment objectives, financial situation or particular needs. You should consider your own investment objectives, financial situation and particular needs before acting upon this information and consider seeking advice from a licensed financial advisor if necessary.You should not base an investment decision simply on past performance. The investment returns of the Fund are not guaranteed, and so the value of an investment may rise or fall.