Liontrust SF Cautious Managed Fund

• In a see-saw quarter, bond yields fell below 4% and equity markets recovered from a sharp sell-off in August to finish Q3 in marginally positive territory.
• From an asset allocation perspective, our overweight to corporate bonds and UK equities and underweight cash all contributed positively to performance. Offsetting this marginally was our overweight position in global equities (which underperformed UK equities) and underweight to strongly rallying gilts. 
• In terms of single-stock performance, Haleon and NVR were among the top performers following strong earnings releases, while ASML and Cadence Design Systems weakened following softening sentiment in the semiconductor space.
• Within fixed income, our long duration position was beneficial to performance during the quarter as yields fell.

The Fund returned 1.3% over the quarter, versus the 1.6% IA Mixed Investment 40-85% Shares sector average (the comparator benchmark)*.

Equity market overview   

Global equity markets endured a see-saw quarter, including a sharp sell-off in August, with Japanese equity markets enduring the worst fall, falling 20% from its peak at one point. The trigger for the sell off and market volatility was surprisingly weak jobs data from the US in early August. This created a changing narrative around US growth, as the idea of a hard landing in the US began to creep into the market’s thinking. This weakening economic backdrop was also clear throughout earnings season, particularly for the industrials sector and some companies exposed to US residential housing.

The dominant theme of global equity markets throughout 2024 continues to be the enormous investment in AI. An arms race has taken hold among the world’s largest technology companies, as they seek to ensure they have the leading AI engines, to provide AI adoption among their customer bases. Over Q3, news emerged that Nvidia’s new GPU chip, the Blackwell, would be slightly delayed. News that the US government was looking at incremental measures to curb semiconductor technology access in China also led to a sell off across the semiconductor space. While the large-cap technology giants underperformed for the quarter, the broader capital equipment suppliers took the brunt of the sell off.

September saw the long-awaited first cut from the US Federal Reserve, as it decided to cut 50 basis point (bps). The size of the cut reflects the weakening macroeconomic environment and the backdrop of disinflationary pressures emerging in the economy. Bond yields fell below 4% and equity markets recovered the losses in August to finish the quarter in marginally positive territory.

Fixed income overview

The view from bond markets has been consistent with our expectations of a somewhat bumpy ride. While there has been a decisive shift towards markets pricing more central bank easing than earlier in the year, the progression of economic data has been less straightforward, resulting in volatility both within and across the bond landscape.

The US has largely continued to lead the narrative in terms of the outright direction of yields among developed markets, with incoming data again providing competing narratives –evidence of strong economic foundations alongside the suggestion of potential threats. The weakness has been largely concentrated in the labour data, with the July labour market report (released in early August) galvanising a sustained rally across bond markets which had already performed well on the back of more benign US inflation data. This concern was then seen as validated by the Federal Reserve’s decision to reduce the funds rate by an initial 50bps in September, having held out for longer than many other developed market central banks. While the market expected only a 25bps reduction, chair Jerome Powell sought to reassure markets that the reason for the outsized move was not that the Fed was overly concerned about the underlying economy, but rather that this was an exercise in prudence: starting rates on a path to neutral and easing from a restrictive rate, having largely achieved the main tenets of its dual mandate. The incoming data will dictate the speed of further moves and ultimately the ‘terminal’ level of interest rates, but for now markets have largely bought into this narrative of a gradual cutting cycle, albeit having relinquished some of the gains given the scale of the moves. Having been as much as 80bps lower than where they started the quarter, 10-year US yields ended September around 3.75%, some 60bps below their opening level.

Watching UK bond markets has remained a somewhat frustrating activity, as they have retained their strong correlation with the US as yields rose, but struggled to maintain that relationship during rallies. This is partly attributable to the mix of economic data outturns, which have shown firmer GDP growth (which has been flattered by government spending), alongside some progress on services inflation and weakness in confidence measures. We maintain the view that UK yields should fall, as we believe the economic backdrop is not as strong as in the US, and if anything, will prove more akin to the Euro area longer-term. The BoE reduced rates by 25bps in August, but emphasised ongoing data dependence, striking a decidedly cautious tone. The ongoing uncertainty over the upcoming Budget has also done little to help the UK bond market of late, with fears of increased issuance and the risk of fiscal largesse fuelling hesitation among market participants. We remain sceptical that the government will be willing to risk its fiscal credibility to such an extent that it engenders further marked volatility, such as we saw in late 2022, though risks do remain.

Europe, meanwhile, has seen a more marked deterioration in economic data. The manufacturing sector, in particular in Germany, has looked under severe pressure, with some forecasters looking towards potential German recession in the coming quarters. The ECB cut by 25bps for a second time in September, and having initially reiterated its data dependence, that data is now suggesting further easing at the next meeting in October.

Portfolio review

From an asset allocation perspective, our overweight to corporate bonds and UK equities and underweight cash all contributed positively to performance. Offsetting this marginally were the overweight position in global equities (which underperformed UK equities) and underweight to strongly rallying gilts.

Within fixed income, our long duration position was beneficial to performance during the quarter as yields fell. We continue to believe that there is value in the credit markets going forward and, as such, retain an overweight to bonds in general and more specifically an overweight to corporate credit versus gilts.

We used the strength in gilts to trim exposure further, increasing the underweight. Given the UK has participated less in the rally than the US, we think there is further potential for catch-up between markets here.

We have a constructive on the outlook for corporate credit, supported by strong fundamentals combined with favourable market technicals. Investment grade corporate balance sheets remain robust, with interest cover having reduced as the cost of funding has increased but remains above long-run averages, while issuance remains low and has been well received by investors. In addition, when central banks loosen monetary policy against a backdrop of low to no economic growth, historically this is a supportive backdrop for credit spreads.

The UK equity market continued to perform well over the quarter. The Bank of England embarked on a rate cutting cycle, and a new Labour government provided some signs that the political turbulence of the past years would begin to recede. Bond yields fell and this provided support for the equity market. Growth in the UK economy continues to be sluggish, but is no longer noticeably decelerating, as in the US. This ensured equity markets were more receptive to the news of the rate cut. This benefited smaller cap stocks and was a tailwind for our strategy.

We marginally increased our global equities overweight and reduced our overweight to infrastructure.

In terms of equity performance, the Fund’s top contributor in Q3 was US home construction and mortgage banking and title services business NVR. Exposed to our Building better cities theme, NVR builds high-quality homes that have better energy efficiency ratings than the average new homes built by competitors. The management team has built up a culture of focusing on efficiency and scale alongside excellent capital allocation. Similarly to the UK, there is a large shortfall in the number of homes being built every year and so homebuilders play a crucial role in meeting that demand.

In terms of financials, NVR exceed revenue expectations for Q2, with consolidated revenue increasing 12% year-over-year to $2.61 billion. The company’s shares moved steadily higher following the earnings release as investors priced in a larger 50 basis points cut to interest rates by the US Federal Reserve (which indeed took place mid-September) and its likely knock-on effects of lower mortgage rates, and higher housing demand.

Haleon, the consumer healthcare business spun-out of GSK, saw its shares rise after a well-received half-year results release. Held under our Enabling healthier lifestyles theme, Haleon’s second quarter revenue grew by 4.1%, in line with expectations, with price increases contributing strongly to growth. Underlying operating profit for the first half was up by 11% to £1.3 billion, reflecting revenue growth and easing inflation. The company also upped its full-year guidance to “high-single-digit organic profit growth”, following 6% growth for its power brands cohort, including double-digit rises for Sensodyne, Parodontax and Centrum.

Dutch payments company Adyen posted a strong earnings release, reporting a 26% year-over-year increase in its Q2 net revenues, reaching €475 million, ahead of consensus estimates. A major driver of this growth was a 45% year-over-year surge in total payment volume (TPV), which totalled €322 billion for the quarter. Adyen's solid revenue growth was complemented by a slight sequential improvement in its take rate − a key profitability metric for payment processors. The take rate increased to 14.8 basis points (bps) from 14.7 bps in Q1, surpassing market expectations. On the earnings front, Adyen's EBITDA grew by 32% year-over-year to €423 million, with margins improving by 3 percentage points to 46.3%.

Despite Dutch semiconductor chip equipment maker ASML reporting better-than-expected earnings for Q2, it was Fund’s largest detractor in Q3. Following a slump in growth in Q1, the company reported net bookings of €5.6 billion in Q2, up 24% from a year ago. While these strong sales figures are encouraging, it was overshadowed by news of more US restrictions on its business in China. Shares in ASML fell sharply after reports that the US is considering using the most severe trade restrictions available if companies including ASML continue to give China access to advanced semiconductor technology.

Held under our Improving the efficiency of energy use theme, ASML remains at the forefront of improving semiconductor fabrication through EUV development and holistic lithography. Smaller process nodes mean more chips per wafer in manufacture and smaller, cheaper, more reliable, more energy efficient and more powerful end products.

Staying in the semiconductor space, chip design software specialist Cadence Design Systems reported first-quarter estimates that exceeded consensus estimates. However, a downward revision of its third-quarter and annual forecasts caused the shares to slip. Cadence projected third-quarter revenue between $1.165 billion and $1.195 billion, which fell short of analysts' average estimate of $1.20 billion, while annual EPS forecast was trimmed to $5.77 - $5.97 from an earlier guidance of $5.88 - $5.98 due to a lack of visibility from sales in China.

The market is watching closely to weigh up the potential impact of aforementioned bans in China, which do appear to be very small for the companies we hold, against the possible benefit of an improving semiconductor cycle, driven by AI and smartphone investment. As AI becomes more deeply integrated across industries, the need for energy-efficient semiconductors will only intensify. Both ASML’s cutting-edge lithography technology and Cadence’s design expertise are indispensable to addressing this challenge, making them key players in the industry's future. We believe that their strategic focus on energy efficiency, coupled with the rising importance of sustainability in technology, will enable both companies to outperform over the long term, regardless of short-term market movements.

Edwards LifeSciences, a global leader in both surgical heart valves and transcatheter aortic valve replacement (TAVR), disappointed the market at its latest quarterly earnings in July, explaining that it expected growth in its core TAVR product to be slower this year than previously expected. Following this aggressive sell off in the share price, the company has repurchased more than $1billion of its own shares. Our confidence in the longer-term recovery of this segment, as well as the early successes we are seeing them have in other areas in cardiology gave us confidence to add to our position at what we felt was an attractive valuation. 

In terms of trade activity, we added Core & Main, the US distributor of pipes, valves and fittings to help disperse and control the flow of water and wastewater transmissions under our Improving the management of water theme. The fittings are used to connect pipe sections, valves and other devices. These have outsized benefits from an environmental perspective, given the importance of managing water and water infrastructure effectively. The wastewater products enable water to be reclaimed and are used in a variety of applications from industrial processes to agricultural irrigation.

We also added US company TransMedics under our investment theme of Enabling innovation in healthcare. Already held in the Liontrust GF SF US Growth Fund, we believe TransMedics is changing the face of organ transplants as a company that makes organ transplant modules and facilitates a US based organ transportation service that eases the friction between donor and patient. TransMedics developed a variety of ‘organ care system (OCS)’ that keeps organs in a dynamic state – i.e. working in a near physiologic state – versus the current standard of care known as cold storage. Unlike cold storage, the OCS device provides monitoring and evaluation of the harvested organ before delivery and implantation into the patient. This expands the pool of organs that were not able to be assessed and often thrown out, particularly from older donors.

In terms of exits, we sold both Brown & Brown and IQVIA due to both companies’ management teams’ unwillingness to act on the engagement issues we had raised. In the case of IQVIA, the management quality rating was recently downgraded from a 3 to 4, and its reporting on issues related to patient safety and its own environmental footprint was very poor. Brown & Brown has been a good performer, but has been stubbornly rated a 4 in terms of management quality. We had hoped the management team would be more receptive to our desire to improve their ESG reporting, but this was not the case. A key tenet of our process is finding great businesses and helping them improve the way they measure and report on material ESG issues. In both IQVIA and Brown and Brown this improvement did not materialise, so we moved the capital on to new and exciting ideas.

Discrete years' performance (%) to previous quarter-end**:

*Source: FE Analytics, as at 30.09.24, total return, net of fees and income & interest reinvested.

**Source: FE Analytics, as at 30.09.24, primary share class, total return, net of fees and income & interest reinvested.

KEY RISKS

Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.

The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

All investments will be expected to conform to our social and environmental criteria. Overseas investments may carry a higher currency risk. They are valued by reference to their local currency which may move up or down when compared to the currency of the Fund. Bonds are affected by changes in interest rates and their value and the income they generate can rise or fall as a result; the creditworthiness of a bond issuer may also affect that bond's value. Bonds that produce a higher level of income usually also carry greater risk as such bond issuers may have difficulty in paying their debts. The value of a bond would be significantly affected if the issuer either refused to pay or was unable to pay. The Fund may encounter liquidity constraints from time to time. The spread between the price you buy and sell shares will reflect the less liquid nature of the underlying holdings. Outside of normal conditions, the Fund may hold higher levels of cash which may be deposited with several credit counterparties (e.g. international banks). A credit risk arises should one or more of these counterparties be unable to return the deposited cash. Counterparty Risk: any derivative contract, including FX hedging, may be at risk if the counterparty fails.

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