Liontrust SF Cautious Managed Fund

The Fund returned 1.7% over the quarter, underperforming the IA Mixed Investment 40-85% Shares sector average (the comparator benchmark) of 2.7%*.

Volatility remains rife, with violent moves between sectors and factors and uncertainty surrounding new strains of the pandemic. Macroeconomic debate continues to centre on long-term versus transitory inflation and the ability of central banks to control prices without disrupting recovery, and we saw the US Federal Reserve outline eight potential hikes over the next three years at its December meeting. As we said last quarter, increasingly hawkish policymakers have caused a rotation back into the ‘value‘ part of the market and many of our favoured quality growth companies have lagged.

Global supply chain issues are exacerbating inflationary forces as aggregate demand recovers from the depths of the pandemic and pricing power remains critically important for businesses to protect margins as costs rise. As always, our process looks beyond these shorter-term issues and focuses on the themes that are driving our economy in the next decade and beyond as it becomes cleaner, healthier and safer.

Asset allocation was a negative factor over the quarter, largely due to our overweight corporate bond position, which underperformed other asset classes despite marginally positive returns. While our underweight Government bonds and overweight infrastructure equities offset this to some extent, poor performance of credit was a feature for the period. Equities were the best-performing asset class and we currently hold a neutral position, having moved back from overweight in September. As we said last quarter, we were last neutral back in February 2020 in advance of initial pandemic fallout but moved back overweight a couple of months later as we felt the long-term opportunity for equities was increasingly compelling post-selloff. Our recent shift back to neutral reflected how far we feel markets have come over the last 18 months.

On the equity side, top holdings over Q4 included US healthcare name Thermo Fisher Scientific. As we have highlighted before, the company’s logo, as the world leader in serving science, is healthier, cleaner and safer (a slight variation on the cleaner, healthier and safer at the heart of our Sustainable Future approach), and it is a strong fit for our Enabling innovation in healthcare theme. Healthcare needs to become more efficient and a key part of that lies in early diagnosis of diseases based on genetic make-up; Thermo Fisher contributes to this by selling medical technology products across areas as diverse as mass spectronomy, allergy/auto immunity testing, food safety testing, cancer testing diagnostics and post-transplant tissue testing.

Its shares have continued to rise on the back of quarterly numbers, with the company announcing a 9% rise in Q3 revenue to $9.33 billion as well as a range of new launches and expansions. These included products to enable advancements in oncology, cell and gene therapy and to provide increased sensitivity in low-flow liquid chromatography, plus a new Bioprocess Design Centre in South Korea and, as part of a strategic partnership with CSL (which we also own in the Fund), assuming responsibility for a biologics site in Lengnau, Switzerland.

Cadence Design Systems is another long-term outperformer under our Improving the efficiency of energy use theme, with the company continuing to broaden its chip design software offering to new customers, as the likes of Amazon, Google and even Tesla invest in this area. Cadence’s software is essential to this design, and demand from these businesses, as well as more traditional chip manufacturers, will drive growth over the short and long term. Again, the company’s shares have benefitted from stronger-than-expected Q3 numbers, with revenue of $751 million compared to $667 million for the same period in 2020 and an operating margin of 26%.

Having exceeded guidance on all key metrics for the third quarter, Cadence raised its outlook for the year, citing accelerating demand for its solutions and highlighting four significant new products in Q3, including the Integrity 3D-IC Platform. 

VeriSign also reported solid Q3 performance over the period, with this provider of domain name registry services and internet infrastructure held under our Enhancing digital security theme. This is a simple business but it performs a critically important service for the global economy in operating two of the most important internet root servers. This provides registration services and authoritative resolution for the .com and .net top-level domains, enabling global communication and most of the economy’s e-commerce.

Alphabet has been an ever present in our top performers over the year and the company’s shares continued to grind upwards over the quarter, with the market remaining positive on Google’s ability to pick up business as the economy reopens and withstand potential regulatory changes. Announcing Q3 profits and earnings above analysts’ estimates, CEO Sundar Pichai said he highlighted a vision to become an AI-first business five years ago and latest results show how the company is building more helpful products, with ongoing improvements to Search for example. For us, Alphabet stands out because the core Google Search business makes the internet a more efficient place through its indexation and democratisation of information. This is provided free to the vast majority of users and has become an integral part of everyday life, which is why the company sits in our Providing education theme.

Elsewhere, Q2 purchase NVR has had a strong early period in the Fund, with the US housebuilder exposed to our Building better cities theme: 100% of its homes built in 2020 were verified by an external party as more energy efficient than the average home built that year. The company is unique in the industry in that it exercises a capital-light business model by acquiring options to buy land, as opposed to having a large land bank. This is more costly in the near term but enables NVR to survive downturns in a cyclical industry; it was the only profitable homebuilder in the US during the global financial crisis. Despite that industry cyclicality, NVR’s returns have been strong and disciplined capital allocation has seen the share count fall by 50% since 2005. In its Q3 results, the company reported net income and diluted earnings per share up 29% and 33% respectively.

Familiar names such as Palo Alto, Intuit and IQVIA also featured among top contributors, as did larger financials such as Schwab and Rilba (Ringkjøbing Landbobank) and global leader in simulation software Ansys. We bought the latter after a 40% share price fall at the height of initial Covid panic in February 2020 and the stock has subsequently moved back towards its previous high, with its products helping customers get their own to market quicker, reducing risks around defects and improving innovation. Revenues are tied to R&D budgets, which we feel are less cyclical than other areas in which businesses tend to invest. In a similar vein to many of the holdings highlighted, Ansys reported record revenue, cashflow and its own ACV metric for Q3, exceeding guidance, with the acquisition of Zemax in October expanding its solutions into optical and photonics products.

In our UK portfolio, Croda was once again among top performers, with the speciality chemical company’s compounds helping increase energy and resource efficiency, reduce the use of toxic substances and improve efficacy of pharmaceuticals. Sitting under our Improving the efficiency of energy use theme, the business announced the sale of the majority of its Performance Technologies and Industrial Chemicals division to Cargill towards the end of December.

Private equity group 3i also registered a strong quarter, reporting a total return of £2.19 billion (24% on opening shareholders’ funds) over six months to end September. The company highlighted considerable momentum from its top investments over the period, particularly those in favoured value-for-money, e-commerce, consumer and healthcare areas. We hold 3i under our Increasing financial resilience theme, with the company’s model based on investing and supporting businesses for growth and helping develop the infrastructure and technologies we need in a sustainable transition.

Another top performer was Home REIT, which we added in the early part of the year. The company looks to a provide property to help alleviate homelessness in the UK and addresses a critical need, with an increasing homeless population but a lack of available and affordable housing to accommodate them. At present, local authorities are struggling to meet the cost of providing accommodation to the homeless, with the worsening shortage meaning they are forced into using more expensive bed and breakfast hotels and guesthouses. These relationships with local authorities and housing associations provides stability of rent for Home REIT, offering long-term leases at cheaper levels. In a December update, the company said it now has properties accounting for more than 7000 beds across the UK, following a significantly oversubscribed £350 million top up equity issue in September.

Weaker UK holdings over the period included Oxford BioMedica, despite announcing record first-half results (boosted by its role in the AstraZeneca Covid vaccine) and news it has extended its agreement for the manufacture of lentiviral vectors for several Novartis CAR-T products to the end of 2028. Echoing our arguments outlined for ThermoFisher, as a leading gene and cell therapy player, Oxford BioMedica is well placed to maximise opportunities, both in lentiviral vectors as well as other viral vector types. While the vaccine and its supply agreement with AstraZeneca grab the headlines, the investment case for Oxford BioMedica’s shares is primarily based on other conditions its technology can treat, varying from lymphoma to Parkinson’s.

Trainline also saw its shares falling despite reporting a return to profitability over the first half of 2021 as passengers came back and moved to digital ticketing. For the six months to end August, the company posted EBITDA of £15 million versus a £16 million loss in the same period a year ago, while revenue rose 151% to £78 million and net ticket sales were 179% higher at £1 billion. As a travel company, it has obviously been hit more recently as the Omicron variant led to concerns about renewed lockdowns and restrictions.

DocuSign was among our weaker names over the period, with the shares dropping more than 40% in a single day in November after the company released Q3 2022 earnings. While numbers actually beat expectations, delivering 42% revenue year-on-year to end October, the billings (which better reflects recurring-type revenue for a software as a service business) fell to 28% in Q3 versus the same period the year before. This was below the company's guidance of 34% and DocuSign also downgraded billings guidance for Q4 2022 to 22%. With consensus figures of 32%, the market is clearly concerned about the company slowing.

This business had been growing in the 40-50% range over 2020, which carried on over the first half of 2021 and into summer. It is clear many customers have materially increased their e-signature capacity, however, and over the third quarter, stepped back from growing at the same rate. The company also noted the sales team’s ability to upsell customers had fallen short of what they had been achieving pre-pandemic. DocuSign now has 1.1 million customers, a fourfold increase over five years. CEO Dan Springer said the disappointment stemmed from the fact sales were driven by meeting clients' orders, and as demand suddenly slowed, they have not been penetrating the ‘land and expand’ strategy that has been so successful.

After such a large move in share price, the question is what we feel the company can deliver and what is priced into the stock. We had expected DocuSign's growth to slow into 2022, from the 40-50% range to a medium-term 30%. The justification for this is low penetration of digital signatures (still only around 15%) and the ability for the business to work with clients to drive new use cases and expand the platform. DocuSign is exposed to our Increasing waste treatment and recycling theme and the company has created a unique product to digitalise the signature part of the document production process – an excellent example of a solution that makes the world more efficient. The company has a 70% market share for e-signatures globally but its addressable market is around 10 times larger than current sales, given it is effectively competing with paper.

PayPal shares also remained volatile, having issued revenue guidance for Q3 short of Wall Street targets, but this should be seen in the context of considerable growth over the last five years. PayPal makes transacting online safer and easier for merchants and consumers and the company’s management of major ESG issues is best in class, so we believe it remains better positioned than ever to take advantage of the growing trend towards digital payment as part of our Increasing financial resilience theme.

Another business penalised by the market despite a record third quarter was Splunk, held under our Enhancing digital security theme. The company saw its first billion-dollar cloud quarter, accounting for a record 68% of software bookings and up 75% year on year, but shares fell as CEO Doug Merrit announced he is stepping down, with concerns about rising competition from public cloud providers.

In terms of trades over Q4, after a long process of engagement and analysis, we decided to sell our remaining position in Kingspan Group towards the end of the year. We have invested in Kingspan for more than 15 years and have held the company in high regard for the benefits its products bring, playing a key role in energy efficiency in buildings and therefore carbon dioxide emission reduction. Revelations from the Grenfell Tower Inquiry, however, have raised concerns about the culture and controls within the insulation business.

We initially decided to downgrade Kingspan’s sustainability rating (in our proprietary matrix) from A1 to A4 in December 2020, a significant reduction in terms of management quality. This means we view a company as higher risk and its weighting in the portfolio fell substantially as a result. Our view at that stage was to reserve final judgement until after the Inquiry concludes and we could discuss the findings and recommendations with the company’s management and other parties. As part of continuing engagement, we requested a meeting with the new Chairman to understand his view of how the culture has changed, and needs to change further, towards safety. This has not been forthcoming, however, which is disappointing given our large holding and long-term support of the business. This lack of engagement has prevented us from improving our rating from A4.

There are also more fundamental issues to consider. With the share price currently around 105 euros, on our modelling, the company had to deliver faultlessly over the coming years for there to be upside. On balance, factoring in concerns on valuation, culture and management rating, we feel now is the right time to exit.

Elsewhere, we added Atrato Onsite Energy to our infrastructure equity portfolio, a renewable energy infrastructure fund that instals solar modules on industrial use roofs in the UK. They contract the sale of electricity from this to the willing occupier and the result is more lower-carbon electricity generated and lower power costs for customers.

Discrete years' performance*, to previous quarter-end:

*Source: Financial Express, as at 31.12.21, primary share class, total return, net of fees and income & interest reinvested.

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