STRATEGY UPDATE

The road to recovery: Part 1

23 July 2020

The coronavirus crisis has led to turbulent market conditions so far in 2020, but the RWC Continental European Equity Fund has delivered a positive relative return to its investors. Fund managers Graham Clapp and Russell Champion discuss their success in unearthing hyper growth winners and why recovery stocks are forming a major part of their portfolio for the first time in more than a decade.

The first half of 2020 was characterised by extraordinarily volatile market conditions, with an over-arching narrative dominated, unsurprisingly, by the Covid-19 crisis. The early stages of the global pandemic triggered an extremely sharp sell-off in equity markets during February and March, which was followed by an impressively rapid recovery in April and May. The shape of the trajectory of Europe’s stock markets so far this year, therefore, has been classically V-shaped, but it remains to be seen whether the economy will follow the same path.

As is typically the case, the nature of the initial market setback was less discriminate than the recovery that followed. Very few stocks were able to escape the sell-off but, from late-March onwards we saw a significant differential open up between the share price performance of companies that have continued to deliver their products and services in lockdown, and those that have not.

Hyper Growth successes

This bifurcated market has been beneficial to our strategy, which delivered a positive return during the period, compared to the MSCI Europe ex UK Index, which remained in negative territory in spite of the second quarter rally.

The outperformance was driven primarily by what we categorise as ‘Hyper Growth’ companies, because they are climbing the steepest part of the S-curve that characterises the growth trajectory of many young, often technology-oriented businesses as they mature. Such businesses have typically moved beyond the initial ‘hype phase’ where expectations can become inflated, but are still young enough to enjoy the full effect of increasing market penetration as their products and services become established. They have not yet reached the size at which their market starts to become saturated, or where the natural impact of compounding (the law of big numbers) reduces the materiality of year-on-year growth.

Typically, Hyper Growth businesses are delivering annualised growth rates in excess of 10%, sometimes much higher. The market has a tendency to underestimate the potency of S-curve growth, and this is where a thorough understanding of a company’s fundamentals can provide diligent investors with a competitive edge. With consensus expectations typically lagging behind the curve, one often sees an enduring cycle of earnings upgrades and share price outperformance, as the market struggles to keep pace with the company’s rapid ascent.

Although the Covid-19 crisis has represented a material, in some cases existential, threat to many businesses and indeed for entire industries, many other companies have benefited from the changes that have been forced upon societies around the world. Many trends that were already in place have been amplified. The portfolio was already well-positioned to benefit from these trends through our stock picks, but the crisis has brought the rewards through to some of these businesses and their share prices more quickly than we had originally anticipated.

HelloFresh

Take HelloFresh, for example, which was the portfolio’s largest position for much of the period. Founded in 2011, HelloFresh is a disruptive German food delivery business which already provides its home-cooked meal kits to millions of customers across 14 different countries. We originally bought the position shortly after its initial public offering (IPO) in 2017, attracted to its clear growth potential and the fact that, unlike most food delivery companies, it had a business model which looked capable of delivering a decent profit margin as growth came through.

Operational progress since then has been very encouraging, with new territory launches and astute marketing driving rapid growth in active customer numbers, good levels of repeat business and a steady increase in average order values. Despite this, the market has until recently, remained sceptical about the company’s ability to deliver a sustainable profit and the share price has been further hindered by one of its original backer’s decision to sell the remainder of its stake. This provided us with the opportunity to add to the holding at a depressed price, as our conviction in the investment case grew.

The second half of 2019, however, saw the business move meaningfully forward towards positive free cash flow generation, and the market has started to take notice. Indeed, as we have moved through the first half of this year, HelloFresh has been a significant beneficiary of the changes in consumer behaviour that we have seen during the pandemic. It has seen meaningfully higher demand as restaurants remained closed and consumers were left working from home and under lockdown. Meanwhile, the company has not needed to promote itself so aggressively to attract new business. Lower spending on marketing has led to significant operating leverage and rapidly growing profits.

The HelloFresh share price increased almost 150% in the first half of 2020 and ended the period more than five times the price it had been a year earlier. Given this strong performance, we continue to re-assess our investment thesis and monitor the position size closely. We have met the company many times over recent years and have a strong understanding of its operational efficiency and capabilities. For example, we believe its fully integrated supply chain has been key in enabling such strong growth during lockdown. It is noteworthy that many other food businesses have commented on strong demand but have been hampered in their ability to fulfil it. The investment case possesses many other positive attributes that the market is only now starting to appreciate. Our analysis continues to point to revenue growth and operating margins above market expectations.

Source: Bloomberg, 17th July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Portfolio holdings are subject to change at any time without notice. This information should not be construed as a recommendation to purchase or sell any security.

Evolution Gaming

Similarly, Evolution Gaming also delivered outsized returns. Evolution Gaming is a provider of live casino solutions, where players bet in real-time through a video link to a croupier in one of the company’s studios. Evolution dominates this nascent part of the gambling industry, which currently accounts for less than 2% of the total market. However, this niche is increasing in size very quickly with, we believe, plenty of future growth potential.

Live casino broadcasts are distributed by established online gambling operators to their customers, and Evolution has been successfully signing new partnerships with the likes of Flutter Entertainment, owner of the Paddy Power and Betfair brands.

Evolution’s pioneering position in a fast-growing market, places it firmly in the Hyper Growth phase of the S-curve. The most recent set of financial results confirmed progress ahead of consensus expectations, leading to earnings upgrades and a progressive re-rating of the shares. Our analysis suggests rapid growth can be maintained, with some near-term benefit coming from the recent lockdowns, as traffic that would normally flow to physical casino venues migrates online. Some of this benefit will likely prove temporary, but it should also be helpful in cementing live online casinos’ reputation as a credible part of the overall industry.

All of these factors combined to broadly double the company’s share price over the first six months of 2020. As you would expect from a company growing this quickly, it trades on a relatively high multiple of earnings. As long as Evolution can continue to deliver hyper growth, we are comfortable with this but will remain mindful of valuation risk.

Other risks include increased regulation. Stakes placed in live casinos are not currently regulated, so we must stay on top of the regulatory agenda as it evolves. Meanwhile, increased competition is another obvious area of incremental risk to the investment case. However, our positive thesis has been built around a belief that Evolution can maintain an advantage over competitors through innovation and the quality of its service. We have spoken to Evolution’s management regularly and have been impressed by the company’s focus on product quality. In February we attended ICE London, the largest business-to-business gaming conference worldwide, which also allowed us to meet with some of its competitors. We came away with the even greater confidence that Evolution’s product line-up and ability to drive innovation forward, remain superior. Indeed, we would argue that Evolution has increased its lead on competitors by focusing purely on this market niche, investing in its studios, and innovating new games to broadcast through them.

Source: Bloomberg, 17th July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Portfolio holdings are subject to change at any time without notice. This information should not be construed as a recommendation to purchase or sell any security.

Ambu

Some of the portfolio’s Covid-19 beneficiaries were positively impacted in a more nuanced way. For example, Ambu is a Danish healthcare business, which makes, among other things, disposable endoscopes for use in surgical procedures. We first met the company back in 2017 and were attracted to the company’s growth potential but felt that, at the time, the shares were too expensive. We kept an on eye on it, hoping for a more appealing entry point, which arrived after a period of share price weakness and the arrival of a new CEO, in 2019.

The business has continued to roll-out new products, which we think have significant potential as the medical standard moves from reusable endoscopes to disposable solutions such as those delivered by Ambu. The Covid-19 crisis has shone a light on the (small, but at a time of great stress for global healthcare systems, significant) infection risk of reusable endoscopes, which is accelerating the pace at which the healthcare industry is embracing Ambu’s disposable solutions. From the outset we have viewed this as a Hyper Growth opportunity. However, the crisis has in effect, steepened the ascent of the S-curve even further, leading to significant share price appreciation.

On the face of it, this is now a relatively expensive share again but, with revenues capable of growing organically at more than 20% per annum and operational leverage driving even higher levels of earnings growth, we continue to see further upside.

Source: Bloomberg, 17th July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Portfolio holdings are subject to change at any time without notice. This information should not be construed as a recommendation to purchase or sell any security.

Inspecting the disappointments

Of course, not everything in the portfolio has performed as well as these examples. The crisis has represented a negative development for the investment theses of some other holdings

CGG

CGG is a French geoscience business which provides seismic data services to the oil exploration industry. The industry has suffered from over-capacity in recent years but, in 2019, with capacity much reduced and a higher oil price, utilisation rates and pricing were improving. Meanwhile, CGG had raised equity to strengthen its balance sheet and had massively reduced its cost base during the lean years, putting it in a relatively solid position to benefit from a more benign industry backdrop.

We invested in CGG for recovery in 2019, and the investment thesis had been developing reasonably well. That is, until the oil industry was hit on the demand-side by Covid-19 and on the supply-side by Saudi Arabia’s decision to flood the market with oil to punish Russia for failing to abide by Opec’s production quotas. The combined impact of these events caused the oil price, and practically all oil exploration activity, to collapse, which has substantially undermined our investment case. We have therefore sold the position and redeployed the capital to higher conviction investments.

Source: Bloomberg, 17th July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Portfolio holdings are subject to change at any time without notice. This information should not be construed as a recommendation to purchase or sell any security.

Applus

Spanish business, Applus, is a worldwide leader in testing, inspection and certification. We live in a world which demands high standards across almost all walks of life. Ultimately, we believe the services that Applus offers will be in high and growing demand. This is a secular growth stock, in our view. It is a good business which delivers attractive returns and has considerable long-term growth potential.

Inevitably, however, every part of this company has been, like so many other businesses and indeed entire industries, negatively impacted by the Covid-19 pandemic. It simply could not operate whilst its core territories of Spain, Ireland and the US, were in part or total lockdown. With a relatively high fixed-cost base, there was little the business could do to prevent it becoming loss-making for a period.

For most of the business, however, this impact is temporary. Its core Automotive division, which delivers MOT-type testing in different countries, is already recovering strongly and we expect the same for IDIADA, its engineering services division. The key exception is its oil and gas business, which has also been negatively affected by the oil price dynamics outlined above and which may take some time fully recover.

The material share price weakness that we have endured from Applus this year is disappointing, but the investment case retains much of its former appeal. Indeed, as the oil and gas division becomes a smaller part of the overall group, we believe the valuation gap that exists between Applus and its testing peers should narrow. We have maintained our exposure to the shares. 

Source: Bloomberg, 17th July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. Portfolio holdings are subject to change at any time without notice. This information should not be construed as a recommendation to purchase or sell any security.

Dusting off the 2009 playbook

On balance, the outperformance of the portfolio as a whole demonstrates we got more right than wrong during the first half of 2020. The Hyper Growth element of the portfolio delivered the strongest returns, with a positive contribution also from our Special Situations holdings. Secular Growth stocks modestly detracted from returns, whilst our Cyclical Potential and Recovery exposures were weakest in aggregate.

This is perhaps unsurprising, given the investment backdrop. Stocks that are exposed to the economic cycle or those that have already experienced operational challenges, will inevitably tend to be more vulnerable to external shocks. We have responded with characteristic discipline, selling positions where events have undermined the investment case, holding on where conviction has been maintained and adding to holdings where we believe that the share price has over-reacted to the downside.

Invariably, volatile conditions like those through which we have just navigated can change the opportunity set dramatically. Recovery situations, in particular, become much more abundant in times of market stress. It should not come as a surprise, therefore, for investors to learn that the fund’s exposure to recovery opportunities has increased over the last few months, to the extent that it is now the largest segment of the portfolio.

The last time this was the case was in 2009 as equity markets troughed in the aftermath of the global financial crisis. Then, recovery stocks such as ASML, British Airways (now IAG), Rational, Saipem and Temenos accounted for approximately half of our previously managed portfolio assets in aggregate, driving the significant outperformance of our funds during that year.

In effect, we have been dusting off the 2009 playbook in recent weeks, to see what tarnished treasures we can unearth.

Source: RWC Partners, 30th June 2020

Conclusion

Thus far in 2020, we have delivered a positive return in difficult market conditions. This provides further evidence in support of our disciplined approach to stock picking. We have continued to adjust the shape of the portfolio to ensure it is positioned appropriately for the future. This means more exposure to recovery stocks now than at any time since the global financial crisis. This is no coincidence – recovery situations become more abundant in times of market stress. Our investments in recovery have added value for investors historically. We are optimistic that history can repeat and look forward to providing more detail about our approach to recovery investing in a future article.

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. The names shown above are for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.

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