During the third quarter of 2022, the fund underwent significant changes to the line-up of subadvisors. Effective July 29, 2022, the fund removed all but one existing subadvisor and added three subadvisors with expanded flexibility to invest globally. The fund retained Nuance Investments to manage a global mid-cap value sleeve. Two teams from Polen Capital were added to run concentrated sleeves (global large cap growth and global SMID growth). Scharf Investments is the fourth subadvisor and is charged with a global large-cap value mandate. The fund’s new mandate expands the subadvisors’ ability to invest in highest-conviction ideas globally, as well as provides dedicated exposure to small- and mid-cap companies.
To reflect the expanded opportunity set of the subadvisors, the fund’s primary benchmark has been updated from the Russell 3000 Index to the MSCI World Index. From the start of August through end of the quarter, the fund fell 15.91% compared to a 13.09% loss for its index. The Morningstar Global Large-Stock Blend category fell 12.75% over the same two-month period.
Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.imgpfunds.com. The advisor has agreed to waive fees and limit the expenses of the fund through at least April 30, 2023.
Quarterly Portfolio Commentary from Managers
Scott Moore and Chad Baumler, Nuance Investments
Inflation remains top of mind for investors, with the Consumer Price Index (CPI) recently posting year-over-year highs not seen since the 1980s. Financial conditions also continue to tighten in response to higher inflation, with the target federal funds rate now above 3%, the highest level since 2008. These dynamics are not isolated to the U.S. as similar situations are being experienced in many geographies around the globe. In Europe, the war in Ukraine continues with no clear end in sight. Supply chains are strained, and energy costs have soared, introducing an additional level of uncertainty and risk of recession heading into winter.
We believe higher inflation has been a primary source of under-earnings at many of the businesses on our Nuance Approved List, and our view is that input cost inflation has caused transitory margin compression in some of our favorite consumer staples and health care businesses, among others. That opportunity persists, in our opinion, and we thought it prudent to update investors on some of our top inflation-related ideas.
Akzo Nobel is a leading global paints and coatings company with number 1 or 2 market positions in nearly all its business segments, according to our research. The company supplies architectural paint in Europe, the Middle East, and Africa (EMEA), Asia and Latin America and has a global industrial coatings business for a diverse set of end-markets such as automotive, packaging, marine, aerospace, and general industrial. In our opinion, the company has recently experienced modest under-earning due to raw material inflation and transitorily weaker demand in Europe. We believe the company represents a reasonable value today versus the market and justifies a position in the portfolio.
Damon Ficklin and Jeff Mueller, Polen Capital
During the third quarter of 2022 the world continued to experience persistent inflation; zero tolerance COVID-19 policies in China, resulting in the sudden and complete shutdowns of large cities; and the ongoing war in Ukraine. What changed relative to the first two quarters is that the geopolitical landscape 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 rise in interest rates while signaling 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 the Portfolio? The first-order impact of rate increases—increased debt servicing expenses—does not materially impact our companies in our view. Our investment guardrails, which have been in place at Polen Capital for over three decades, filter out highly leveraged businesses from our 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, we 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. In our experience, 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.
We believe that our 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. Prices can and certainly do wild things in the short run, but we 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.
Rob Forker, Polen Capital
The third quarter of 2022 echoed themes that started earlier this year. Our Portfolio companies’ fundamentals remain on track, but high inflation, rising interest rates, and a general “risk-off” mentality have created some difficulty for our investing style. In response to rising inflation, the U.S. Federal Reserve Board (the “Fed”) has ramped up its tightening of interest rates, prioritizing curtailing rising prices over the risk of tipping the economy into a recession. Whether the Fed’s strategy proves successful remains to be seen.
Among other macro developments, the absence of a resolution to the Ukraine-Russia conflict as well as China’s zero-COVID policy contributed to persistent inflation and rising energy prices. Investor sentiment has become increasingly negative as a result, and while broad multiple compression has slowed, companies have started to revise earnings expectations in anticipation of growing recessionary pressures.
Certain market segments, including consumer discretionary, are under more acute selling pressure given fears about consumer weakness in recessionary periods, however some of these more cyclical areas have also experienced modest bear market bounces. This is also reflected in the fact that small caps outperformed large caps over the quarter. Another notable feature of the investment backdrop has been the outperformance of lower quality cyclical sectors, energy being the best example. With our focus on what we believe to be high-quality compounders over the long term, companies in this space tend not to fit our investment criteria.
As expected, during periods of heightened volatility and a shifting economic environment, we are refining the Portfolio opportunistically. This includes adding to companies that have been unfairly punished and taking profits by trimming companies that have held up well that we believe have lower return expectations going forward.
We continue to stay focused on the long-term value propositions, competitive advantages, ongoing initiatives, growth opportunities, and potential earnings power of our Portfolio companies. In challenging periods like these, we believe the strong get stronger. In other words, we believe businesses with robust balance sheets that can self-fund growth are poised to withstand a potential recession, maintain resilience, and gain market share while their competition retreats. We believe the opportunity for long-term investors like us is more favorable than it has been in years.
Brian Krawez and Gabe Houston, Scharf Investments
Persistent core global inflationary trends have forced the hands of central banks. The 10-year U.S. Treasury rose from 3.27% to 3.83% during September, further inverting the 2-10-year U.S. Treasury spread. The U.K. 10-year Gilt closed August at 2.80% and peaked late September at 4.51% as investors demanded high rates amidst higher U.K. fiscal and inflation risks. Stocks suffered corresponding price multiple compression.
Central bank rate increases are making an economic impact. The U.S. housing market is cooling and wider leading indicators like the Conference Board U.S. Leading Economic Index has declined 2.7% over the last 6 months, a rate only witnessed during the last three recessions in 2001, 2008-2009 and 2020, respectively. The S&P Global Eurozone Composite PMI Output Index was 48.1 in September, its third straight month of contraction. Earnings compression is likely the next shoe to drop as estimates have yet to materially decline.
As concerns about slowing growth accelerate, we are confident in the portfolio’s sustainable earnings profile. We believe investors are not fully discounting the risks of earnings deterioration in second half of 2022 and 2023. S&P 500, an index like the MSCI ACWI still levered to mega cap tech, net margins assumptions for 2022-23 are greater than 12% versus a post millennium average of 7.75%. This presents near-term risk amidst inflationary pressures, operating deleveraging in a slowing economy, rising interest rates, a stronger U.S. dollar and deglobalization.
Discussion of Performance Drivers
It is important to understand that the portfolio is built stock by stock with sector and cash weightings being residuals of the bottom-up, fundamental stock-picking process employed by each of the four sub-advisors. That said, we do report on the relative performance contributions of both sector weights and stock selection to help shareholders understand drivers of recent performance. Attribution comments are limited to two months since the fund reshuffle at the end of July.
It is also important to remember that the performance of a stock over a single quarter tells us nothing about whether it will be a successful position for the fund; that is only known at the point when the stock is sold.
iMGP Equity Fund Region and Sector Allocations as of September 30, 2022
|Health Care & Pharmaceuticals||23.30%|
Sector Attribution for Three Months ended September 30, 2022
- Five positions within the industrials sector underperformed during August and September. MillerKnoll, Knorr-Bremse, 3M, Atlas Copco, Legrand, and Schneider Electric each had declines in excess of the broader sector.
- Health care stock picks were mixed. Health care benchmark names outperformed the MSCI World Index. However, fund positions in Azenta, Dechra Pharmaceuticals, and Align Technology underperformed. On the positive side, Tecan Group and CVS Health had slightly positive gains in the two-month period.
- The fund’s underweight to energy stocks was a drag on returns as energy sector outperformed the broader index. The fund does not have any positions in this sector.
- Positive two-month gains from Reinsurance Group of America, Charles Schwab, and Everest Re contributed to gains within the financial sector.