2023 Letter to Shareholders

David Loevner, CFA

Aaron Bellish, CPA
Chief Executive Officer

Ferrill D. Roll, CFA
Chief Investment Officer

October 31, 2023

Over the past 12 months, global stock prices have risen appreciably, especially when viewed in their local currencies. Most local equity indexes have regained or surpassed their pre-pandemic highs. So why do growth investors feel like they’re still grinding through a bear market? Because, since the first COVID-19 vaccine was approved in late 2020, growth investors, including our shareholders, have been feeling the pain of a relative bear market induced by central banks’ aggressive interest rate hikes, in which growth stocks generally have been trounced by value stocks. This is especially true for non-US stocks: the MSCI ACWI ex US Value Index has outpaced its Growth counterpart by more than thirty-five percentage points of cumulative return over the last three years.

We lived through a similarly inhospitable period for shares of high-quality, fast-growing companies nearly 20 years ago, when global markets were recovering from the dot-com bust-caused recession of 2001–02. We believe that the challenges of the current period will pass, and the fundamental merits of the growth companies we favor will regain the appreciation of investors at large. But if we’ve learned anything over our thirty-plus years in this business, it’s that we should regularly re-examine our beliefs. What if past is not prologue? Is it possible that this time will be different?

The steady decline in global interest rates that began 40 years ago appears to have ended, the underlying forces having run out of steam. The integration into the world economy of a vast pool of cheap labor from emerging markets, particularly China, suppressed global wage increases; facilitated by freer trade and loosening capital flows, we do not expect it to recur. Within affluent societies, the greying of populations will further reduce the supply of labor, and put pressure on governments’ budgets, especially for medical care. Rising geopolitical tensions presage an upturn in military expenditures, reversing the post-Cold War downward trend of more butter and fewer guns. Moreover, if monetary policy fails to adjust accordingly, the potential for money supply to outpace real output could exacerbate inflationary pressures. Less globalization and more government spending portend stickier inflation and higher borrowing, which we anticipate will keep real global interest rates from revisiting some of the lowest levels in the last 800 years, with negative implications for the budgets of the average individual, company, and government.

With US mortgage rates reaching heights not seen since the early 2000s, the country’s domestic housing sector is poised to become a drag on economic expansion. The squeeze it will place on consumer spending is twofold: directly, as the rise in mortgage expenses eats into disposable income and, eventually, indirectly, as slower house price growth dampens the wealth effect. Europe’s consumer outlook is somewhat less dire, thanks to smaller rises in mortgage rates, but more rapid aging of its population is likely to lead to a similar outcome simply from shrinking appetite. China’s situation is more precarious, with its property sector burdened by debt, and property prices that haven’t yet settled to equilibrium. All these forces should conspire to make consumption growth, in general, lackluster for some time.

Higher borrowing costs are set to limit companies’ ability to invest for growth, placing firms that lack substantial free cash flow at a disadvantage compared to their more liquid peers. With revenue growth already flagging, the looming need for significant debt refinancing at steeper interest rates threatens to compress profit margins further over the next few years. Smaller companies are at greater risk, given their limited access to bond markets relative to their larger counterparts, many of whom have already availed themselves of low rates to prolong debt maturities, insulating them for a time from those rising borrowing costs. Additionally, companies reliant on private equity and venture capital are likely to experience strains as funding becomes scarcer and more expensive.

As the threat of the pandemic recedes, governments show few signs of finding the will to reduce the large income support and social expenditures they incurred while fighting it, while the revival of industrial policy aimed mainly at spurring the energy transition has put further pressure on government budgets and balance sheets. This is occurring in parallel with heightened spending on strategic security objectives such as re-shoring semiconductor manufacturing and extending military aid to Ukraine, among other nations.

Looking ahead, these trends portend a more challenging environment for corporate growth and profitability. In our view, it favors shares of financially strong companies capable of funding operational needs and growth initiatives from their own cash flows. We expect that firms with adroit and ambitious management will see and seize opportunities to capitalize on the struggles of their financially insecure rivals, sometimes by acquiring them. Businesses in the strongest competitive positions will deliver more robust profits, and their resiliency and growth will again be more highly prized by investors for being rarer.

In sum, this time is no different from similar periods in the past in which our taste for high-quality, rapidly growing companies has been out of step with market fashion. We foresee an eventual return of investor focus on such fundamental factors in the face of uncertain and slower economic and corporate profit growth. We therefore remain committed to our favored targets, while reinforcing our attention to the price we are asked to pay for them.

We are, as ever, grateful for your ongoing confidence in us.

David Loevner

Aaron Bellish
Chief Executive Officer

Ferrill D. Roll
Chief Investment Officer

Investments involve risk and loss is possible.

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