Finding Opportunity Beyond Volatility

September 2022

The pain and volatility emanating from financial markets are completely natural, normal, and very much expected. While we can’t predict their timing, magnitude, or duration, we always know they are lurking. And we appreciate that times like these are a great opportunity to revisit and refresh our investment cases.

The valuations of many of our businesses have been compressed, and we have seen fundamental pressure as well, in terms of actual results, guidance, and expectations. This has created volatility and poor stock outcomes. There’s a very good possibility that we will experience more stock price declines and that more companies will face real or feared difficult short-term outlooks. However, for the most part, we believe we own businesses that can stand the test of time, because many sell products and services that add significant value to the purchasers.

It remains to be seen how the business models wrapped around these outputs and the competitive environments in which they operate will evolve and how the valuations will shake out over time. As a result, we will continue to carefully analyze developments.

Now What?

At Sands Capital our mission is to add value over rolling three- and five-year periods. And over that time horizon, we expect businesses’ underlying growth and earnings power to be the primary driver of stock prices.

Accordingly, we:

• Are truly long-term
• Are concentrated in our highest-conviction ideas
• Own great companies—and own them in the weights and mix that our portfolio construction process dictates
  
  

However, there’s a limit to how much pain we can avoid as long-term investors in fast-growing companies that usually trade at premium multiples. Our approach doesn’t allow us to eliminate the things we fear, such as mistakes, business fundamentals failing to meet our expectations, or valuations rolling over. Still, our approach endeavors to ease the ultimate pain of these events and provides some rough guardrails to 1) explicitly keep the portfolio where we want it to be from a blunt “risk” perspective and 2) prompt discussions when the market is bringing the portfolio out of line with those guardrails—and we are in such discussions right now.

We should remember that Sands Capital’s overall investment philosophy and process are based on simple, sound tenets that have stood the test of time. We have been applying this approach for 30 years, but much of what we do is as old as investing itself. This will continue to be true. Periods of underperformance—including occasional periods of significant underperformance—are inevitable. We are not a hedged fund; our hedge is the passage of time.

How We Got Here

In our Global Growth strategy, we take an unconstrained approach to seeking the best growth businesses anywhere and work to incorporate a mix of high-growth/high-valuation (HH) companies and those which we place in what we call the classic-growth category.

We tend not to shift companies between the HH and classic growth categories much unless they evolve along our maturity S-curve. Too much precision here starts to create noise and waste energy; this simple portfolio construction framework was always meant to be a rough, easily communicated tool.

The recent peak in our allocation to HH stocks was about 51 percent back in 2020’s third quarter. Since then, we’ve explicitly aimed to keep the maximum weight around 50 percent because we could see near-term valuations continuing to rise.

In hindsight, maybe we should have cut HH to 45 percent or 40 percent. The difficulties of timing the market precisely and overcoming the momentum of continuing to invest in our current holdings are tough real-world obstacles. That’s especially true for growth investors like Sands Capital that are big believers—and rightly so over the long term—in the power of optimism and innovation. 

Facing the Fear

In our Global Growth strategy, we have been aware of high near-term valuations for a while, which we expressed through not allowing HH companies to exceed 50 percent of our portfolio, avoiding a few newer HH opportunities, and concentrating in our smallest number of holdings ever so that we’re focused on our highest-conviction stocks. Given the ongoing valuation-oriented volatility, HH is now closer to 40 percent of the portfolio. That relatively low percentage, combined with some softening short-term (and perhaps longer-term) business fundamentals, activate my instinct to start leaning away from the fear and into greed. Some of this is informed by quantitative metrics like valuations and portfolio construction. Imperfect though they may be, significant changes like what we’ve seen deserve our attention. Some of it is also just my own experience and judgment having lived through significant shifts like this several times during my career, despite maintaining some paranoia that my pattern recognition might not be valid this time.

Owning strong long-term holdings may not seem like leaning against the fear, but we actually do just that in many ways. Our holdings are concentrated (34 holdings in Global Growth currently, down from 37 about two years ago, and a peak of about 43); they are long term (12 of our 34 holdings have been in the strategy for 5+ years); and we often continue to own our holdings when they are questioned, as is happening right now.

Timing a shift into more HH stocks is tough. At a time like this, we want to think through the companies’ long-term business potential and potential new dynamics around valuations and expected returns. We also need to think about shifts in relative conviction among our holdings and new opportunities, while spending less time worrying about things like how far something is off its highs (that’s more about volatility than valuation) or how valuations look relative to earlier market selloffs. 

In portfolio construction, our goal is to capture much of the wealth creation of the individual businesses as they become bigger and more important over many years, while at the same time not giving too much back during the inevitable, hopefully shorter, periods when we will be wrong as valuations change and business outcomes fall short of our predictions. The way we handle the competing forces of reward generation and risk mitigation is by maintaining an explicit balance between HH and classic growth stocks.

Valuation

To me, much of valuation boils down to 1) it’s an opinion (unlike a law of physics, for example); and 2) that valuation opinion is influenced by the contemporary market context. This means that, as investors in fast-growing and world-changing businesses, we ALWAYS look really smart when the businesses are delivering (and often valuation tailwinds are ramping up in the background) and we ALWAYS look stupid when things correct.

Our investment approach can’t avoid valuation pain indefinitely. However, once the pain starts, we need to doubly focus our thinking on acting, not reacting, so we execute our process instead of allowing our process to execute us. As noted, my bias in Global Growth is to shift from fear to greed. Although this isn’t extremely urgent, we are not looking for that elusive market bottom, and in many cases, we have the time to complete relevant and new research to see where we stand. This is especially true as we think about making a number of weights bigger and about funding by trimming some existing weights. This contrasts with the urgency when a more idiosyncratic issue happens to just one or two companies. That said, we may conclude that a period of accelerated renewal of the portfolio is warranted. It’s possible our collective work will lead us to move faster and in newer directions.

What Can We Do as an Investment Team?

Thinking about what we can do as an investment team, we focus on the areas where we have high conviction. At Sands Capital, we have high conviction in our ability to predict long-term potential for great companies. That’s on average and over time—including the ones that we end up getting really wrong! We do not have conviction in our ability to predict short-term stock price movements or valuations. We set up our investment process to capture the wealth creation of these great companies over the long term by focusing on what we do well—identifying growth and innovation, investing in concentrated positions, and benefiting from long-term compounding—while mitigating the things we can’t or don’t do consistently well. We do this by owning leaders and quality companies, exploiting our domain knowledge/experience, constructing portfolios thoughtfully, and understanding that “time is the ultimate hedge.”

Over the year, we have been aggressively revisiting, challenging, and building fresh and renewed conviction in all of our investment cases. Getting back to basic principles is a great way to clarify thinking on an investment case. It’s easy for “what matters” to become stale, for thesis drift to creep in (the drift itself is not bad, it’s not seeing it happen that is the problem), for key assumptions to be vulnerable to big changes. It is really easy, especially when something has been working for a long time, to become less critical about our views of a company’s future. We can become seduced into thinking that we are deep experts on a company when maybe we’ve really just been riding a trend that’s been working out. 

When we confront a shocking change to our thesis, sometimes it’s difficult or impossible for us to have seen it coming or to appreciate the change’s timing or magnitude, let alone understand how investors might react. Sometimes there are warning signs. But we also have to be careful not to see the wrong signs or to let the fear of the inevitability of being wrong mess up our long-term process. The conclusion should not be to take less risk, but to understand and appreciate the risks and opportunities more completely. 

The antidote to these issues is to start over from basic principles, challenging key assumptions and re-building high conviction in an investment case. Even if the new investment case is less exciting than the previous one, it can still be a great Sands Capital investment—often at more realistic valuations. And obviously some of these situations can do something special over time and accelerate wealth creation in some unexpected way.

Disciplined re-evaluation of our investment cases through the lens of our six investment principles can only strengthen our approach of applying analytical rigor and creative thinking to seek high-quality growth businesses that are creating the future. This process can help us in our quest to add value and enhance the wealth of our clients with prudence over time.