Summary
It's been a fascinating past twelve months with markets rising by approximately 25%. The surge has been largely driven by Artificial Intelligence (AI) and tech companies, which have performed exceptionally well, unlike more defensive stocks that have lagged the index. The Magellan Global Fund has broadly kept pace with markets, and that's despite its inbuilt defensiveness, which will be most valuable when markets inevitably decline and go through a rough patch. The High Conviction Fund has outperformed the broader market, returning 23.2% over the past year to 30 June 2024. This success is attributed to our consistent investment strategy, focusing on quality and valuation without taking big risks, and maintaining full investment.
We started the year focussed on the “Magnificent Seven” stocks, which had rebounded strongly we believe mostly driven by fundamentals. We saw a change in market sentiment and in the last six months, market dynamics shifted, with semiconductor and chip-related companies taking the lead while some companies like Tesla, fell out of favour. This shift was being driven by profit growth, strong revenue growth, strong cash flow, strong buybacks and an outlook which is positive, underpinned by things like the shift to the cloud. However, we do see some speculative elements emerging. The elevated valuations of AI stocks make for an interesting future, reflecting a significant change in investor psychology over the past two years.
Amazon
Over the past year, we have seen a renewed confidence and positive outlook for some of the major tech companies. As an example, Amazon over the past three years has seen their market cap drop from US$2 trillion to US$1 trillion and then rebound to US$2 trillion. This volatility is unusual for a company of Amazon’s quality and unlikely to be representative of changes in its underlying value.
Amazon, has two main businesses: its retail and logistics arm (Amazon.com) and AWS, its cloud computing division.In 2022, the near-term earnings outlook for both segments deteriorated meaningfully. AWS faced optimisation efforts from customers post-COVID and took a cautious approach to cost adjustments, which was wise given its long-term potential. Amazon’s retail business encountered challenges from the reopening of physical stores and increased investments in fulfillment and delivery services, impacting short-term profitability. However, these investments were strategically sound for long-term growth. This presented an opportunity to increase our investment at attractive prices. Similar scenarios unfolded with companies like Alphabet and Netflix.
Chipotle
Last year was challenging for the restaurant industry, however companies like Chipotle emerged as winners. Key factors driving this success include Chipotle’s value-for-money perception held in the mind of consumers and conservative pricing strategies compared to a lot of their peers. While major fast-food brands have seen negative customer traffic in recent results, Chipotle’s customer traffic has increased by a healthy 5% year over year without relying on discounts or promotional activity.
We can also attribute Chipotle’s performance to management execution, not just on product and pricing, but on their efforts to improve labour retention and restaurant operations, which in turn has resulted in another year where Chipotle’s average restaurant sales and restaurant margins have exceeded our expectations and driven earnings upgrades.
A final factor for Chipotle’s success has been their strategic store roll-out in the U.S., which is controlled directly by the company and is not reliant on the financial health of franchisee partners or their access to financing in a higher rate environment. Chipotle’s expansion is primarily focussed on the proven U.S. market, insulating it from the macro and geopolitical challenges that other large restaurant companies have faced in regions like China or the Middle East.
Overall, Chipotle’s strong value proposition, effective management, and high conviction store roll-out opportunity have contributed to its standout performance.
Outlook for markets
Looking ahead, we expect markets to rise, but at a slower pace. Three key drivers we believe will influence this are profit growth, interest rates, and investor sentiment. Profit growth is likely to slow with the economy, making it a modest contributor to returns. Interest rates are expected to be flat or decline, offering neutral to modest support. Sentiment is currently quite high, people are optimistic, and it’s likely to have a neutral impact on markets. Combined, these influences underpin our base case expectation of moderate gains in equity markets.
In recent years, macro factors have driven markets, but as growth slows, individual stock selection will become more important. Defensive stocks, which have underperformed, may present opportunities. Investors should focus on high-quality companies with strong valuations to navigate potential market volatility. While speculative elements are creeping into the market, maintaining a defensive strategy is important to guard against potential downturns. This approach may uncover attractive opportunities in overlooked, high-quality defensive stocks.
Nestle
Nestlé is a high-quality consumer staples company that has traditionally traded at a premium due to its diversified and reliable product portfolio, exposure to attractive categories like pet care, coffee and vitamins & supplements, and a strong track record of innovation. However, recent results have been disappointing, reflecting industry-wide volume challenges and company-specific issues in certain categories, for example some business disruption from a supply chain integration project. . We do not believe these problems are structural andhave confidence that Nestlé will return to being a reliable defensive holding closing its valuation gap to peers over time.
United Healthcare
In the healthcare sector, our analyst Wilson Nghe has focussed extensively on United Health Care, as discussed in the recent Magellan Minutes video series. This US managed care company has seen its valuation pressured by sector rotation away from defensive stocks and company-specific issues like a recent cybersecurity incident,This situation has created an attractive valuation opportunity for United Health Care, which not only offers defensive characteristics but is also well-positioned for the long-term shift towards value-based care in the US healthcare system.
Quick Service Restaurants
One area where we’ve adopted a more cautious approach for the year ahead is our exposure to quick service restaurant companies. These high-quality companies have been strong defensive holdings for Magellan funds for many years. However, due to recent value perception issues resulting from price increases in the fast-food sector, a low income consumer under pressure, and challenges in their international businesses from geopolitical headwinds and a sluggish recovery in China, their earnings have become less predictable and reliable. Additionally, these companies could be impacted by changes in consumer behaviour due to the rising use of GLP-1 obesity drugs, a structural theme we’ve focussed on this year. While we believe these earnings headwinds will be manageable over time, we are managing our exposure to this structural theme at the portfolio level.
SAP
One portfolio company we’re excited about is SAP, the world’s leading Enterprise Resource Planning software company. Our investment thesis hinges on SAP transitioning its customer base to a more modern version of its software S4 HANA Cloud. Our investment analyst Adrian Lu has done extensive work talking to the company, key customers like Nestlé and system integrators to get conviction that customers would stick with SAP and to understand the revenue tailwind to SAP when they make that transition.
SAP was priced as a mature legacy provider, so we didn’t have to pay for the transition tailwind, we just needed to be patient and wait for it to happen. Now, we’re seeing momentum in this shift, with SAP’s revenue growth accelerating towards double digits. This transition is expected to support healthy revenue growth and margin expansion through the end of the decade. SAP is an example of the importance of understanding company fundamentals and opportunities for patient investors to acquire high-quality businesses at attractive prices.
