Focused on long-term business models


An updated 2020 outlook

As each year ends, we spend time thinking about what events will most likely shape the months and quarters ahead. Coming into 2020, we thought another minicycle was likely to begin, potentially creating a favorable backdrop for value investors. Quality growth companies had performed well throughout most of 2018 and the first three quarters of 2019, then the narrative changed. The Federal Reserve began lowering the Federal Funds target rate as downside risks in the U.S. economy grew, and more accommodative monetary policy improved investor confidence as stronger economic growth seemed likely. Against that backdrop, the market started to reward cheaper, lower-quality businesses — those that would typically lead in the early stages of an economic recovery as they are most dependent on strong economic growth.

The COVID-19 pandemic has made us re-evaluate our views, and two possible outcomes seem most likely for 2020:

  • This is a short-term supply disruption and a temporary pause in demand. Markets recover as the impact from COVID-19 wanes and economic growth returns in the second half of 2020. Supportive monetary and fiscal policy around the globe suggests yet another mini-cycle of economic growth.
  • Public and private reaction to the pandemic creates a meaningful and sustained drop in consumer demand, thus pressuring businesses to lay off workers and cut wages. Gross domestic product (GDP) growth remains low or negative for multiple quarters as unemployment rises and remains high for an extended period of time.

The broad scenarios we’ve outlined could have substantially different implications for investors, both in absolute and relative terms. In the first, we would expect value-oriented businesses to lead and higher-quality companies to lag, at least in the early stages. The second scenario would likely favor higher quality businesses with less potential for downside revisions. In our view, it’s still too early to know exactly how the situation will unfold. We should start gaining a better understanding of how this pandemic will impact the health of the U.S. economy, our citizens and investors in the weeks and months ahead.

Managing risk amidst uncertainty

We often speak about the risks inherent in large-cap growth investing, namely the possibility of business model failure risk and significant downside risk. Many large-cap growth companies have attractive characteristics — high margins, growing end markets, and attractive returns on their assets and capital, to name a few. These characteristics invite competition and disruption, as others want a piece of the pie. At the same time, investors historically pay a premium for these businesses in the form of higher price multiples. These lofty growth expectations are often unmet, leading to multiple compression and meaningful losses in investor capital. In other words, significant downside risk is always a concern. These risks represent an opportunity for the Fund’s fundamental, long-term approach.

Our goal is to own enduring, competitively advantaged business models that we believe are capable of withstanding disruption. We think owning these businesses helps give the Fund the best opportunity to outperform over the long term.

This philosophy also allows us to remain invested during short-term market disruptions. Owning high-quality businesses is an outcome of our fundamental research, and these companies should typically outperform in challenging environments. It’s important to note that this should not come at the expense of participating in the eventual recovery, whenever that occurs. We need to be exposed to risk in order to deliver performance, all the while being measured in our approach and believing that we’re appropriately compensated for accepting those risks over a long investment horizon.

We approach risk in a few ways, and environments like this where volatility and uncertainty seem higher than normal present an opportunity to revisit these principles:

  • Competition for capital: Regardless of the macro environment, we continually evaluate each of the companies within the portfolio and those we’re considering for new investment. We want to be adequately compensated for the risks we take, and this exercise helps us tilt the portfolio toward companies with better expected upside potential and lower expected downside potential as the environment changes, sometimes rapidly.
  • Sources of risk: We intend to let stock selection drive risk, not industry or factor exposure. We entered this environment, even before the COVID-19 outbreak, with a more balanced approach to risk, not wanting individual factors like momentum, beta, value, etc. to drive portfolio positioning and overwhelm our fundamental research. We continue to monitor these exposures regularly, being intentional with where those exposures lie.
  • Focus on business models: Our expertise lies in deep, ongoing fundamental research on individual businesses. We don’t have an edge on market timing, so we remain invested and don’t typically adjust sector weights in order to express a macro view.

Late summer of 2019 is a recent example of the first two principles listed above — competition for capital and active risk management. Our portfolio performed well from the beginning of 2018 through August 2019, returning nearly 30% compared to 21.4% for the Russell 1000 Growth Index, the Fund’s benchmark. Valuations for some of our holdings were becoming stretched and, in our view, no longer offered adequate long-term return potential, and the portfolio was becoming tilted toward momentum. Stocks with positive momentum are those that have performed well relative to their peers in the recent past, and higher-quality businesses had certainly been in favor. We took that opportunity to rebalance away from some of the more expensive businesses and recent outperformers in favor of companies with better potential future returns.

An example of the first and third principles is Estee Lauder. We invested in Estee Lauder during a period when it was underperforming in the fourth quarter of 2018. The company performed extremely well through the first half of 2019. At that point, we determined upside, both near and long term, appeared limited. So, we dramatically reduced the position size despite still believing the company’s business model was very attractive. The fundamentals remained strong, but expectations had risen to a point where valuations were stretched. Potential for meaningful downside grew, and the upside seemed minimal, but we didn’t know what the trigger would be. Going through this exercise helps us minimize potentially negative consequences and we’re comfortable waiting for a more attractive time to make incremental investments.

ESTEE LAUDER COMPANIES INC. CLASS A — Total Return Relative to Russell 1000 Growth Index (%)

Source: Factset -- Data 06/29/2018 to 03/31/2020. Past performance is no guarantee of future results.

Looking beyond the noise

When the market is focused on the very short term, we try to take the opposite approach by looking for opportunities to re-position the portfolio into companies where we have high conviction in the long-term ability of these holdings to execute and withstand market disruptions.

We continue to focus on underlying business models, not emotions or the news of the day. Some of the highest quality businesses in the Fund’s portfolio are being priced in a way that would have a person believe the next six months are all that matters, when that’s clearly not the case. While we think there will be disruption in the short term, our focus will be on executing the Fund’s investment process of emphasizing fundamental research and multi-year time horizons to help us remain focused on the most important issues for our long-term shareholders.

We believe COVID-19 will impact the global consumer over the next quarter. However, will this event really change the amount of discretionary dollars flowing into the retail footwear and athletic wear industry over the next three to four years? Is this pause in activity going to significantly impair long-term contact lens consumption and growth? Is the near-term disruption going to derail multi-year upgrades and replacements to public safety communication and surveillance networks? We hold a view that with this nearterm pause, in terms of consumption and economic growth around the coronavirus, is not going to change the long-term value of companies like Nike, Inc., Cooper Companies or Motorola Solutions. If the market starts discounting these types of companies over the long term, we are more than willing to increase our positions in order to realize those expected potential compounded annual returns.

Travel and tourism will be impacted, without question. Some airlines and cruise lines have seen their stock prices fall between 50–80% since the beginning of the year. While these companies typically lack the traits we look for in more durable businesses, there may be opportunities in related areas. Booking Holdings is likely to be materially impacted by the stall in travel demand. However, we believe this shortterm disruption is going to solidify the value the company can bring both to consumers, through convenient trip planning, and to the travel industry, by allowing hotels and rental cars fleets to gain access to high conversion consumer demand in one location. As investors react to significant near-term negative revisions, we will watch patiently and work diligently to make sure Booking Holdings is managing its business in a manner that drives an even stronger competitive moat looking out past the rubble.

In a market drawdown, we look for opportunities to reallocate to stocks where we have higher conviction. We also look at stocks within the Fund’s portfolio that have held up well in the downturn and reallocate to holdings that appear to offer better upside potential. We tend to be more thoughtful and patient in drawdowns and try to avoid being reactive. We choose to stay focused on business models with strong three- to four-year prospects, rather than worry about short-term estimate revisions. If we’re seeing that the market is discounting a business model to a point where we’re getting very attractive long-term compounded annual returns, then we’ll consider stepping into that short-term risk. It may not be the right answer for the next quarter ahead, but we believe it will be the right thing to do for our shareholders over the long term.

Fund Performance
Top 10 Equity Holdings

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Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through April 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in companies involved primarily in a single asset class (large cap) may be more risky and volatile than an investment with greater diversification. The Fund typically holds a limited number of stocks (generally 40 to 60), and the Fund’s portfolio manager also tends to invest a significant portion of the Fund’s total assets in a limited number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s NAV than it would if the Fund invested in a larger number of securities or if the Fund’s portfolio manager invested a greater portion of the Fund’s total assets in a larger number of stocks. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It is not possible to invest directly in an index.

Class I shares are only available to certain types of investors.