Walter Scott Global Equity (MAQ0410AU) Report & Performance

• The Fund returned -0.69%, net of fees, in July 2023, compared with a return for the Benchmark of 2.09%, with investors increasingly taking the view that the monetary policy tightening cycle is near an end following further signs of receding inflation.

• The Energy, Communication Services and Financials sectors saw the largest gains in a positive month for all sectors in the index. For the Fund, the largest relative sector detractors included holdings in Health Care, led by Edwards Lifesciences and Stryker Corporation, and in Financials, such as AIA Group and Prudential; these were partially offset by holdings in Industrials, including ODFL, Automatic Data Processing and Paychex. There were no initial purchases or final sales within the portfolio during the month.

• Walter Scott’s focus remains on businesses capable of delivering long-term growth, notwithstanding challenges they may have to face in the near-term. Edwards Lifesciences, a market leader in the treatment of Aortic Stenosis (AS), a serious heart condition that afflicts millions worldwide, has had to work its way through pandemic-related hurdles such as staff shortages. The first quarter of this year saw transcatheter aortic valve replacement (TAVR) procedures return to a double-digit growth rate, thanks to improved hospital staffing levels and a catch up in procedure volumes. However, in the second quarter, TAVR sales growth did not match the market’s elevated expectations. Overall sales are now expected to grow in the range of 10-13% thanks to improving hospital staffing levels and the launch of a new TAVR valve. Edwards remains well placed to tackle a dangerous, highly prevalent and under-diagnosed condition. Ageing demographics, enhanced awareness, improving diagnosis and new treatment indications will expand the company’s TAVR addressable market, while opportunities in the adjoining transcatheter mitral and triscupid therapy are only just starting to be explored.

• Despite some of the economic challenges, many leading businesses have been continuing to display resilience and growth, judging by recent earnings results. Although not all have been immune from macro headwinds, by virtue of their financial strength, market leadership, pricing power and excellent management, they remain well placed to take advantage of the long-term trends that will drive their earnings over the coming years.

• The Fund returned 3.06%, net of fees, in June 2023, compared with a return for the Benchmark of 3.12%, with the ongoing resilience of the American consumer and better-than-expected US export growth driving a higher revision of US Q1 GDP data and supporting equity markets.

• Nearly all market sectors rose in June, with Consumer Discretionary and IT representing the largest contributors to index returns. For the Fund, the largest relative sector contributors included holdings in Health Care, such as Edwards Lifesciences and West Pharmaceutical Services, partially offset by holdings in IT, namely Keyence. During the month, Walter Scott completed the final sale of Jardine Matheson, to raise funds for other portfolio companies with more compelling fundamental characteristics.

• Having just reported excellent first-quarter results (sales up 15% and gross margins at an all-time high for the same period) it was little wonder that representatives from Inditex were in a buoyant mood when members of the Walter Scott Research team met with the company in June. Management spoke of the consistency of the business and strong strategy execution that was reflected in broad-based growth across physical stores and online, concepts and geographies. The current strength of Inditex and its Zara brand is in many ways the culmination of a decade-long strategy that pivoted the business towards a pure sales growth model. Central to this was a ‘store optimisation’ program that involved fewer but larger stores supported by an online business utilising the very same logistics infrastructure. Today, Inditex is completely agnostic as to the channel through which consumers choose to shop.

• Investor sentiment arguably reflects a nascent ‘goldilocks’ scenario, founded on hopes of peaking interest rates, and economic growth proving more resilient than expected. The latter has certainly been the case, considering the dire forecasts for global economies of early last year. However, inflation has not been entirely conquered and its lag effect on consumer behaviour may yet to be fully felt, while there is a danger that central banks go too far in their attempts to rein in inflation. Quality companies have shown resilience and indeed growth in the face of this mixed macroeconomic climate, as these businesses benefit from market leadership, financial strength, good management and their adaptability in challenging times. These are attributes that are evident in the portfolio’s companies and give Walter Scott confidence in their ability to deliver strong returns over time.

The Fund returned 0.83%, net of fees, in May 2023, compared with a return for the Benchmark of 1.18%, with equity markets remaining volatile in the face of data which continues to paint a mixed picture of global economic health.

The IT sector was the main driver of positive index returns in May, with most other sectors, led by Energy, Consumer Staples and Financials, detracting. The largest relative sector detractors for the Fund included holdings in Consumer Discretionary, including NIKE and LVMH, partially offset by a lack of exposure to the Energy sector and holdings in Materials, namely Shin-Etsu Chemical. There were no initial purchases or final sales within the portfolio during the month.

Amidst the swirl of global macroeconomic and political currents, it remains the case that across the world many leading companies are getting on with business. The results season has shown how many have adapted and thrived, with leading companies able to tap into growth despite the broader economic environment. The pressure on consumer wallets does not seem to have crimped the appetite for travel, for example. Judging by Booking Holdings’ strong set of quarterly results, demand remains robust, with few signs of a slowdown on the horizon. And despite the significant rise in hotel room rates relative to 2019, there is nothing to suggest that customers are trading down to lower-star hotels. The booking ‘window’ – the time between the date of booking and the date of travel – lengthened more than expected and is now longer than it was pre-pandemic. This meant overall room nights booked came in ahead of expectations at 38% year-on-year. Compared with the first quarter of pre-pandemic 2019, room nights grew 26%. The only slight cloud was a lower margin relative to 2019 (due to higher payment processing) although this should start to trend up from here.

Predictions of a mild global economic slowdown have been baked into the equity market psyche, but there remains scope for volatility. The pace of inflation is slowing, but it remains high. It continues to chip away at incomes and for now central banks are sticking to their tightening mantra. A weaker demand environment and higher interest rates will continue to expose vulnerable, highly geared business models, and emphasises the importance of financial strength and market leadership.

Performance summary

• The Fund returned 2.47%, net of fees, in April 2023, compared with a return for the Benchmark of 3.16%; the gains in global equities occurred against a backdrop of renewed unease over the durability of growth, with the economic outlook for the US in particular under the spotlight.

• All market sectors advanced in April, with Health Care, Financials and Consumer Staples making the largest contributions. For the Fund, holdings in IT, led by TSMC, Texas Instruments and Keyence, were the largest relative sector detractors, partially offset by holdings in Health Care, such as Intuitive Surgical and Roche, and in Consumer Discretionary, including LVMH and Compass Group. Walter Scott also completed the initial purchase of ODFL, a leading less-than-truckload carrier in the US, whose key competitive advantage is its strong pay-for-performance culture, superb real-estate network and laser focus on service excellence.

• A key attribute of the companies Walter Scott holds is their ability to position for the future. They are leading brands with strong balance sheets, healthy cash flows, and experienced management teams that can seize opportunities. This month, the market responded positively to L’Oréal’s purchase of the luxury personal hygiene brand Aesop. At US$2.5 billion, the acquisition is the cosmetic group’s largest and gives it access to an area of the market where it has only limited exposure at present. Whilst Aesop is more exposed to physical retailing than most of L’Oréal’s portfolio, management has experience of this format through the Kiehl’s brand. L’Oréal has a good track record of acquiring solid brands and scaling them globally. L’Oréal saw solid 13% like-for-like growth in the first quarter, with all areas growing strongly with the exception of China.

• So far this year, markets have maintained a positive tone in the belief that a severe economic downturn can be avoided and that an end to monetary tightening might be in sight. A more marked deterioration of growth and/or high-for-longer interest rates would clearly dampen that sanguine outlook. Walter Scott’s focus remains on how portfolio companies are meeting current challenges and positioning themselves for future growth.

The Fund returned 6.83%, net of fees, in March 2023, compared with a return for the Benchmark of 3.88%, with the demise of Silicon Valley Bank (SVB) spreading fears of contagion in the banking sector and resulting in a volatile month for global equity markets.

Financials were the sole noteworthy sector detractor from market returns in March, with particularly positive returns for IT, Communication Services, Health Care and Consumer Discretionary. For the Fund, an underweight to Financials and holdings in the sector, namely Mastercard (recently re-classified from the GICS IT sector), as well as holdings in Health Care, led by Novo Nordisk and Intuitive Surgical, were the largest relative sector contributors. These were partially offset by an underweight to Communication Services. During the month, Walter Scott completed the initial purchase of Costco Wholesale, the global leader in membership-only warehouse clubs with a recurring and highly predictable earnings profile, as well as the final sale of SGS, to provide a source of funds for new investment ideas.

With the benefit of a long-term investment horizon, Walter Scott gets to know how businesses work and how they are steered by management as they go through various cycles or execute strategies. This month, the investment team had an update from Kevin Lobo, CEO of medical device maker Stryker Corporation for the past 10 years. During his tenure, the company has pursued the acceleration of organic revenue growth while building a leadership position in several markets through M&A. The company is now well placed, having a strong portfolio of products with no more competitive gaps to fill. ‘‘I do not have to buy anything’’, he declared. The market environment is favourable given the backlog of procedures created by Covid and a reduction of bottlenecks in the form of nursing and component shortages. As a result, Stryker is expected to maintain its impressive revenue growth which will be tilted towards organic revenues with only modest contribution from bolt-on M&A. This, in Walter Scott’s view, should result in lower financial gearing and improving returns and margins.

The events of March have provided a cautionary tale of the unintended consequences of monetary tightening. It remains to be seen if there is any further spill-over from the SVB saga, but higher interest rates will continue to expose frail business models that have binged on debt. The macroeconomic backdrop remains challenging with inflation still squeezing incomes, although so far, consumer expenditure is proving resilient. Whatever the market direction, Walter Scott’s investment focus remains on investing in marketleading companies with strong balance sheets and long, resilient growth runways.

Performance summary

• The Fund returned 2.87%, net of fees, in January 2023, compared with a return for the Benchmark of 2.97%, with equity markets recording a positive start to the year despite simmering inflation and rate hike concerns.
• On a sector basis, the largest contributions to the positive market return included IT, Consumer Discretionary, and Financials, while Health Care notably struggled. For the Fund, holdings in IT, led by Automatic Data Processing and Paychex, and an overweight to Health Care were the largest relative sector detractors, while holdings in Consumer Staples, namely L’Oréal, and a lack of exposure to the Energy and Utilities sectors were the largest relative contributors. There were no initial purchases or final sales within the portfolio during the month.
• Keyence, one of the Fund’s top individual contributors in January, is the world’s leading supplier of sensors and measuring instruments mainly used in factory automation. Shares in the Japanese company have performed strongly over the last ten years, but last year reflected the worldwide valuation compression in growth stocks from which Japan was not immune. The company had a better-than-expected first half in its current fiscal year, with 25% organic sales growth and 15% organic operating profit growth, as China rebounded from a lockdown-related lull in the first quarter. While management noted a more uncertain macro environment and some weakness in smartphone customers, they reported that overall, the business was showing resilience. Keyence has an impressive track record at growing its revenues, with a compound annual growth rate of 14% over the last 30 years. Walter Scott believes there is significant opportunity for further penetration of automation solutions both in Japan and overseas markets. This opportunity, coupled with Keyence’s outstanding profitability metrics, should result in exceptional levels of internal wealth creation.
• Walter Scott’s positive view on the Japanese companies held in the portfolio, including Keyence as well as SMC Corporation and Shin-Etsu Chemical, derives more from a high level of conviction based on bottom-up fundamentals than from hopes about economic transformation in the country. They are financially strong businesses that compete and thrive on a global stage, with long track records of delivering strong returns over time.