|Stephen Yiu is the Chief Investment Officer at Blue Whale Capital and Lead Manager of the Blue Whale Growth Fund.|
Stephen co-founded Blue Whale Capital with Peter Hargreaves, co-founder of Hargreaves Lansdown, in 2016. The Blue Whale Growth Fund was launched in September 2020 and is a long-only global equity fund focusing on developed markets.
Stephen adopts a high conviction, active approach based on
bottom-up, fundamental research.
After two tumultuous years in 2020 and 2021, all those looking forward to 2022 being blissfully uneventful were sorely disappointed.
To start the year, the spectre of Russian aggression in Ukraine became a reality. After months of tensions on the border between the two countries, Russia invaded Ukraine in February 2022. It quickly became apparent that this invasion would not only affect those in the conflict areas, but shockwaves would be felt around the globe as one of the world’s largest energy exporters became persona-non-grata on the global political stage and sanctions were put in place.
Accordingly, the place to be invested at the start of 2022 was in energy stocks. In fact, this was the only sector that saw positive returns in the year.
Putting aside geo-political tensions, as we left 2021 the world was precariously positioned as we cautiously emerged from the end-days of the pandemic. Having spent two years in fluctuations of lockdowns, travel restrictions and general freedoms being limited, global supply chains were strained to the limit. The strain was caused as demand remained surprisingly high (in part due to generous governmental furlough payments and assistance cheques), but supply was harder to come by as large numbers of businesses shut down or ceased to trade entirely during the pandemic. Economics 101 would tell us that as supply falls against demand, prices rise.
The world was faced with two inflationary problems – 1. energy inflation owing to Russian aggression, and 2. a dearth of supply in goods owing to a world forced into lockdown.
As investors faced this new inflationary environment, and the prospect of central banks raising interest rates, long-duration stocks (typically growth orientated businesses with high P/E ratios) were hardest hit. The sell-off resembled that of early 2020 at the outset of the pandemic, in that entire sectors were sold-off indiscriminately. However, what was different was that quality stocks did not bounce back quite as quickly afterwards.
Technology, being the best performing sector over the previous few years, was the hardest hit. Investors looking for liquidity turned to their best performers to take profits or move into “value” propositions that offered perceived security with their lower P/E ratios.
The “rotation to value” had long been predicted. But we would argue that even a broken clock is right twice a day. In 2022 steadfast value investors finally had their day in the sun – or more accurately, were not as put into the shade as growth investors. Either way, lower rates of portfolio decline was thin gruel for those who had suffered a decade of underperformance relative to those holding a growth orientated portfolio.
Much of the gain driven in said value portfolios was off the back of a resurgent energy sector. Nearly all other elements making up the “value” basket saw annual declines, admittedly not to the same extent of their “growth” counterparts.
It is important to note the changes that were made to the portfolio given the economic landscape we saw in front of us. We have always said we are not afraid to make substantial changes to the portfolio in search of the best opportunities of the moment.
At Blue Whale we had foreseen much change in the world following the rebound rallies of 2020 and 2021. Chief of which was the playing-out of the digital transformation narrative of many of our once-favoured stocks. Businesses such as Amazon, PayPal and Meta were all removed from the portfolio either late 2021 or early 2022 in recognition that they no longer offered the upside potential we required to deliver outperformance for our investors. Those decisions were proved correct as these stocks were down over 50%, 55% and 60% respectively from the point at which we sold them, to the end of 2022. Alphabet was another position in which we sold out in 2022 – being the last of the famed FAANG stocks to leave the portfolio.
However, also in the “tech” sector, we remained convinced in the long-term prospects for companies such as Microsoft and Nvidia. Microsoft still represents the highest-quality business we can find in terms of underlying fundamentals, and Nvidia, despite its challenges, we believe will be the next trillion-dollar company off the back of its omnipresent processing chips, powering everything from machine learning to online gaming. That said, sentiment was not on our side with these two stocks.
Microsoft was a particular disappointment in the year, not least because we saw it as a potential beneficiary of the inflationary environment. Due to its high gross margin and its announced price rises on its key products, we believed Microsoft would weather the inflationary storm, and come out the other side in even better shape than it had entered 2022. As for the share price, we were incorrect. The fundamentals of Microsoft did indeed improve over the year, but sentiment played its part in ruining the party with the stock down nearly 30% in 2022. The good news for investors is that you can now buy the best company in the world at a sizeable discount to its previous highs of 2021.
Our steadfast belief in the merits of these two stocks demonstrates one thing that will not change in the management of the portfolio – the requirement for high quality businesses. Chasing short term trends and stock exuberance can leave you in trouble – we would argue investing in low-quality tech such as Tesla and Peloton during their bumper years was as foolhardy as buying into low-quality value prospects whilst their star was shining in 2022. We have been proven correct in our views on Tesla and Peloton, only time will tell whether value’s day in the sun is over (for another decade at least!).
Given the inflation narrative that dominated in 2022, there was a handful of stocks that produced positive returns for the portfolio – nearly all of which were plays on interest rates and inflation. These were payment titans Mastercard and Visa, and US retail stockbroker Charles Schwab.
Further, given the supply chain issues seen around the world, a new structural trend presented itself – deglobalisation and reshoring of key industry. Accordingly, positions in Canadian National Railway and Union Pacific also held up as investors saw their merits in offering key infrastructure for the reshoring of industry to North America.
I will finish this review in much the same way as I finished the last in pointing out our truly active approach to managing the Blue Whale Growth Fund means we can adapt to the world as it changes. Our robust process continues to evolve, but is based on two key elements:
1. We continue to invest in high quality companies: the ability of companies to exhibit fundamental outperformance is constantly in flux and our team of investment professionals will continue to chart these changes.
2. We maintain a strict valuation discipline: the market is a dynamic beast and prices often diverge from what we see in the fundamentals – but we will never invest into low quality companies (or businesses) that may be at the mercy of cyclical economic gravity.
Looking forward, the portfolio is positioned to take advantage of what we see as the key issues of the year to come – select digital transformation, reshoring and deglobalisation, and a resurgent energy sector. We predicted last year that the inflation narrative would be displaced by that of a recession narrative. Whilst inflation remains a key risk factor, we cannot ignore the spectre of recession and have therefore made investments into new sectors, and increased our exposure in geographies which we believe will take a greater share of global GDP over the next 5 years.
Blue Whale Growth Fund is manufactured by Blue Whale Capital LLP and represented in Malta by MeDirect Bank (Malta) plc.
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