Investing Through a Difficult Year
After a difficult year for markets in 2022, Sands Capital’s portfolio managers are confident that investors will be able to benefit from long-term trends like artificial intelligence, cloud computing, and gene sequencing.
Sands Capital’s portfolio managers Wesley Johnston, Danielle J. Menichella, and Dave Levanson acknowledge that 2022 has been one of the most difficult years for financial markets in a century. Still, amid these challenges, they are optimistic about the future and believe that the firm is well-positioned to identify compelling opportunities.
The year 2022 has been a challenging one for financial markets, especially for long-duration assets. Wes, can you provide an overview of what the current market climate is?
Wesley Johnston, CFA, senior portfolio manager and research analyst: It’s not news to anybody that this has been a difficult year on the inflation front. Because of that, we’ve seen a rapid rise in interest rates globally as central banks attempt to get inflation under control. We’ve had a reset of the discount rate that we use for valuing any asset. That has had a much greater impact on the valuation of growth stocks because earnings and free cash flow potential for growth stocks is now further out on the time horizon than we’ve seen with any other asset classes.
While we are not prognosticators on short-term inflation trends, when we talk to companies, we hear that they feel much better about their labor situation today than they have at any point in the past 18 months. The supply chain has also improved a lot.
When I look at the yield curve [see Exhibit 1], the point I take away is that we were expecting a 75-basis point increase in the federal funds rate a year ago, but now we’re going to be close to a 400-basis-point rise. The yield on the 10-year Treasury note has more than doubled this year. I don’t know if the process of rate increases is entirely complete, but I believe that rates won’t double again over the next year. I’m also confident that inflation and discount rates won’t be the topics we’re discussing at this forum by the end of next year. That pain is already factored into prices, in my view. Prices have been reset, and we believe the companies we focus on will be able to pass on any lingering issues they have with inflation because they are monopolies or have very strong competitive positioning in their industries.
Conditions have been difficult for many businesses since the pandemic began. If you look at retail sales at the national level [see Exhibit 2] and think about the U.S. economy as a single company, you see a couple trillion dollars in revenue every quarter. If you look at it before the pandemic, it bounces around a little bit, and then in March 2020, the bottom falls out as retail sales fell 20 percent. That’s about a $2 trillion decline in sales per quarter, and we have never seen a drop like that.
A couple of months later, the economy starts to reopen, and you see an increase of 10 percent to 15 percent. A couple months after that, there was another acceleration of revenue growth, and everyone was feeling pretty good at that point.
But then supply chains got jammed up, and it became more difficult to source labor. Then war broke out in Eastern Europe. The complexity of all these developments has made it very difficult for investors and investment managers to figure out what is going on and determine how to invest over the next couple of years.
Many investors have thrown up their hands. They moved into big pharma, insurance, and consumer staples stocks, because they want the certainty and simplicity these sectors provide.
We understand this mindset, but we also believe that the growth businesses we invest in can get stronger in periods like this. We’ve lived through past disruptions. Not all of them have been as bad as this one, but we understand that change and volatility can allow the dominant players to consolidate market share and reform their marketplace.
One example of this, with a company that we own, is Floor & Decor, which is a retail hard surface floor provider in the United States. It has about 200 stores nationally, and it competes with Home Depot and Lowe’s. However, its main competitors are about 5,000 small, mom-and-pop operators that have one or two local stores.
It’s been a tough period for Floor & Decor. It has experienced all of the national trends that I discussed. But because the business has the scale, is vertically integrated, and sources directly from 20 different countries, it saw this coming. It locked up a bunch of sole suppliers. It could rent out an entire container ship because it has the end market for that. Because it is large, it has also been able to pass along those cost increases to its customers. Its small competitors haven’t had those options. The smaller retailers usually work through wholesalers, and because the retailers have been out of stock, they’ve had to eat whatever prices the wholesalers give them.
We believe that over the next couple of months, we’re going to see an even bigger divergence in terms of customer loyalty for these types of businesses. It only takes one bad experience to lose customers. Once a customer goes into a local store and sees it doesn’t have products available or competitive prices, those smaller retailers can lose that customer for life. As a result of all these recent pressures in its market, we believe Floor & Decor is going to end up in a much stronger place. We’re seeing similar developments with other portfolio companies that we own across various sectors.
There is no doubt that this period has been difficult, and we’re seeing right now what we believe is close to peak uncertainty in terms of the economy and valuations. Still, that is exciting to us because we’re seeing patterns that indicate to us the companies, we invest in should be able to get through this and get stronger on a long-term basis.
When we look at the opportunity set, consumer staples are trading about the highest they’ve been, relative to the broader market, in the past 10 years. Apple, at this point, no longer looks like a growth company. It’s trading more like a consumer staple. It’s trading at the highest multiple, relative to the Russell 1000 Growth benchmark, it has seen in the past 10 years. We’d much rather invest in the long-term growth opportunities that we have in our portfolio.
It’s definitely been a difficult backdrop for growth stocks as you described, but the climate has an even greater impact on the highest-growing businesses in the portfolio and on those unprofitable businesses in the portfolio.
Wes: Yes, and that’s because of the simple math of it. If you’re a growth company today and your earnings won’t come in for another three to five years, the math of discounting works even more aggressively against you as interest rates go up. As a result, the valuation hit for your unprofitable businesses is going to be much more significant.
Again, though, it’s the fear stemming from the uncertainty and doubt that is most difficult for investors. They’re asking questions like, “Am I buying a Peloton or a Coinbase, or am I buying an Amazon from 20 years ago?” Unless you have the conviction and the fundamentals, if they’re all unprofitable today, many investors don’t appear to be willing to do the work it takes to differentiate them.
If you look at a company like DoorDash, it’s going to generate almost $1 billion in operating profits in the United States with its core food-delivery business, but it’s taking those profits and expanding internationally and building out a convenience delivery business. So the knock against them comes from investors who ask, “If this company couldn’t make any money during the coronavirus pandemic, how is it ever going to make money?” But these companies are getting no credit from a valuation perspective because discount rates are up. They’re also getting no credit for reinvesting in their businesses and doing things that we think make sense for this market. But many investors don’t seem to want to do the work associated with that analysis, and that’s where you are seeing some of the biggest price dislocations today, in our view.
However, what these companies are doing is how you can get nonlinear growth. In a year or two, we don’t expect these companies to be growing operating profits at rates of merely 20 percent to 30 percent. With the DoorDash example, that $1 billion in revenue from its core business could be complemented by another $500 million to $1 billion in revenue from the other opportunities it pursued. You could see what looks to be massive linear growth because those investments are finally starting to bear fruit.
The prospect of a recession has also been in the headlines lately. Does that change the story for you?
Wes: Most of us, in our investment careers, haven’t been through an inflationary period like this. But we have been through recessions, and I would point to how the businesses we’ve been invested in have done over the past couple of years with all the volatility that markets have experienced. We’ve seen average revenue growth for the companies in our portfolios be five to six times higher than the average revenue growth for the companies in these portfolios’ benchmark indexes. [See Exhibit 3.]
It’s been a difficult environment, but these companies have been executing, and many are growing today. Some have slowed down because of the tough comparables, but we believe they are going to re-accelerate over the next couple of years. The starting point is that we believe we’re in a very strong position. In general, our businesses have done well in a difficult environment because they’re taking advantage of major secular trends like cloud computing or minimally invasive surgical devices.
One of the developments we’ve been paying a lot of attention to over the past six months has been innovation and progress on the reimbursement for Dexcom’s continuous glucose-monitoring device. It’s a technology that has been around for a decade, but it had been reserved for the smaller Type 1 diabetes patient population. It’s now seeing early adoption with the larger global Type 2 diabetes population. This inevitable adoption of technology that provides better outcomes, improves efficiency, or improves analytics happens regardless of whatever the Fed’s doing currently with the inflation dynamics and also regardless of whether we’ll have a recession next year or not.
From our perspective, the investment decisions come back to answering the question: “Can businesses get stronger during these difficult periods?” We have the conviction that the companies we own in our portfolios are doing just that.
Recessions are not a point in time, they’re a process. Uber actually went through its recession two years ago. When the pandemic hit, it lost 60 percent of its revenues overnight. It ended up being a good thing for the long-term prospects of the business. It got rid of some bad R&D investments it had made in previous years. Uber made some difficult decisions in other parts of its cost structure, but it stayed committed to the core customer value proposition. It also stayed committed to serving its drivers.
Lyft, its main competitor in the United States, wasn’t able to do that. It didn’t have the same balance sheet capabilities. Now we’ve come out of that difficult period. Reopening happened, and people are travelling again. Uber’s market share is now close to 75 percent. Before the pandemic it was 60 percent. So it went through this difficult period and emerged as a stronger company. Its scale advantages have been borne out.
We believe you’ll see similar scenarios with companies we own across the portfolio. We have to consistently ask ourselves if we have the conviction that these are great companies, if they still meet our six investment criteria, and do we have the patience to continue to hold them regardless of what happens on a short-term basis.
Danielle, can you tell us more about what Sands Capital has been doing during this period of disruption? Have you been shoring up your thinking and gaining conviction that these businesses will continue to deliver as you expect?
Danielle Menichella, CFA, portfolio manager and senior research analyst: We aren’t doing much different during this time of volatility from what we normally do. We have experienced investors on our team. Our key decision-makers have been working together, on average, for over a decade, and we have a simple approach to investing that Sands Capital has maintained over its 30-year history.
Our six investment criteria [see Exhibit 4], our philosophy, and our process have all stayed the same. We continue to search the globe for leading, innovative, and high-quality growth businesses. These are companies that have sustainable competitive moats and are better at what they do than other companies are, and for that reason they can, in our view, continue to grow for the long term.
Every decision we make is driven by our six investment criteria, and that hasn’t ever changed. We do deep proprietary research. Often, before we buy a company, we have researched it for months and sometimes even years. The same amount of rigorous research continues once we buy the business. We remain focused on what really matters for the long-term investment case to play out.
An example of this is our approach with Visa. Visa is a big holding for the company. We hold it across portfolios. It makes sense that Visa’s growth would slow when we’re in difficult economic times because people will spend less money on their Visa cards. But, because of our long-term conviction in the research that we’ve done, we’re still confident that electronic payments will continue to take over paper currency payments, with little disintermediation risk for a company like Visa.
That is typical of what we do and what our thinking is. Still, there was a nuance here. This environment created an opportunity for our research process to be more standardized, with every analyst looking at every business that we own at the exact same time. It was an opportunity to go back to basics and to retest every assumption. We called it our re-underwriting project. We started from scratch with a clean slate and went back to the fundamentals. We rewrote every business case. We redid every model based on the information that we have today, not on what we thought we knew five or more years ago. Then we asked ourselves, “Would we still buy this company today for the first time?”
Our research process focused on our investment criteria and considered factors like the current market environment, risks, the competitive landscape, and the potential “next acts” for these companies. Then we tested, retested, and stress-tested our assumptions.
When we finished this work, we shared it with the entire investment team. Everybody debated, discussed, and had a chance to weigh in on each business in our portfolio.
We often talk about how Sands Capital has a special culture and how collaborative we are, and I think it’s important to emphasize that our research and investment teams are truly collaborative. We are inclusive. That is true at all times, not just in times of high stress like this. There was no finger-pointing. There was no blame game. We all just came together, put the health of the portfolios ahead of everything else, and wanted to get the best decisions.
Our portfolio managers went deep on companies. Our analysts got to go deep on portfolios. That really built shared context, shared accountability, and it also enhanced risk-taking. It provided a good reminder of our view that nobody fails alone, but we also don’t succeed alone.
What did you find as a result of the re-underwriting project?
Danielle: The good news is that for the vast majority of our portfolio businesses, on the basis of fundamentals, we believe we are in as good, or better, shape than we thought we were before the pandemic.
With this re-underwriting project, each of our businesses fell into one of four buckets. The first was the companies where we expect no material changes to our expectations. Most of our businesses fell into this bucket. An example is Nike. It had some short-term headwinds during the pandemic because there wasn’t enough inventory. Now there is too much inventory, but our deep research gives us conviction that, over the long term, the trends in leisure are not changing and will continue to play out. But over time, we expect consumers will continue to want personalization and customization of their apparel and their shoes. We expect Nike, over the long term, to continue to use its data and its technology to widen its competitive moat versus its competitors. So for Nike, we foresee that things will continue to go on as we expected.
Our second bucket contained companies for which we did have to change our expectations, and, unfortunately, to change them on the downside. There are only a few businesses in this bucket, and this does happen from time to time but it is unusual. With our re-underwriting project, we looked at about 180 businesses and only came up with a low, single-digit number of businesses that fell into this category.
These were situations where the market changed. The growth potential for these companies isn’t what we expected, and they missed executing for different reasons. An example of this is Twilio. We sold out of it in August. It is a communications platform, and it was really negatively affected during the pandemic, to the point that it was having difficulty growing at the rate we expected. It couldn’t monetize the new services and its new value-added products. We think that its business model is hurt for the medium to long term.
Our third bucket also contained businesses where we’ve had to change and lower our expectations, and there were also only a few businesses in this bucket. The difference for the companies in this bucket is that they still meet our criteria. They are still growing. They are still market leaders. They have competitive advantages that we think could be stronger, as a result we continue to own them.
An example of the companies in this bucket is Netflix. It is still a very strong business in our view. It did disappoint a little bit after the pandemic, after having done so well during that period. We think that it needs to invest more to maintain the firm’s competitive moat.
The fourth bucket is companies that we are super excited to own. This bucket had the second-highest number of businesses in it. These are companies for which we did have to adjust our expectations, but we did so on the upside. These businesses are performing even better than we’d expected, and we think they will continue to perform better for the long term because they have an even greater opportunity over the long run. In general, this happens because of a secular shift combined with an even stronger competitive positioning. It’s the scenario that Wes was talking about when market leaders improve their leadership during periods of difficulty. Their weaker competitors leave the landscape. They’re able to build out their competitive moats, win more market share, and reinvest to make their products even better.
An example in this fourth bucket is MercadoLibre, the Latin American ecommerce player. It did well during the pandemic, based on the shift to ecommerce. It also invested in logistics and in improving its user experience. While its competitors were getting weaker, it was getting even better consumer satisfaction results. It now also has a second act. It’s going into payments. We think that will be a great opportunity.
If you look at our portfolios overall, the vast majority of businesses are doing what we expected or better. The growth is what we expected or better. The long-term opportunity is what we expected or better. But valuations are a lot less, and expected returns are some of the highest that we’ve seen in a very long time. [See Exhibit 5]
Dave, how do you put the work that Danielle described into a portfolio that can create value for our clients going forward?
Dave Levanson, CFA, a senior portfolio manager, research analyst, and executive managing director: The question that we’re asking ourselves and the question that our clients probably should be asking us is, “Are companies like DoorDash, Sea, Block, and Airbnb going to be the next great companies? Are they the future leaders of today and tomorrow?” We think they are.
What we do at Sands Capital is seek to predict the future for these growth companies in terms of estimating how much bigger the company can get, how much bigger the earnings and sales can be, and how much more important these businesses can be. We’re asking, “If all those things play out, how much value can we create by being investors in these companies over long periods?”
We’re not people who simply trade stocks. Some investors, for example, might have sold these firms that we think are among the best companies in the world during this recent environment and bought companies like Exxon, John Deere or the food companies, and then estimated what the best time would have been to sell those stocks and get back into these long-term growth companies. But that’s not what we do. We look to find great companies, understand them at a deep level, and own them for the long haul while they work to become bigger and more valuable.
The second thing we do is apply an investment process that leads us to fishing in what we view as the most fertile ponds for our kinds of companies. Now, as part of this fishing, we pull a lot of fish onto the boat. We examine each one, and may often say, “This fish isn’t good enough for us,” and throw it back. This process of elimination can point us toward companies that would fit our investment criteria better.
We end up generally owning two kinds of companies. The first kind includes market-leading companies in which we think there is a lot of growth left, like Visa and Nike. When we first invested in Nike 12 years ago, it was already a 50-year-old company. I think there is a misunderstanding that you have to be super early to create wealth by owning these great companies. You don’t. In some cases, you just have to find great businesses and own them for a really long time to capture a big portion of the wealth creation that can come along with them.
The second profile of a company that we invest in is one that has what we view as a significant growth opportunity and can potentially become a leader over time. It’s critical to have research expertise, so you can understand what’s going to make one company grow long term, while recognizing why other companies might grow for a while and be exciting stocks for a few years, but not be the kind of company that we’d want to own in a Sands Capital portfolio for five, 10, or 15 years.
Some of the businesses that we have owned because they fit the profile of what we’re looking for, have been subject to investor skepticism from time to time. ASML, for example, is a business that we’ve owned for over a decade. It’s a company that makes machines that make semiconductors. There was a time not long ago, when we asked ourselves if, because Moore’s Law [the observation that the number of transistors on a microchip doubles every two years] was slowing, or even coming to an end, maybe you didn’t want to own these companies anymore.
Internally at Sands Capital, though, we have another law, named Pilling’s law, after Daniel Pilling, our analyst who covers the industry and posed that the things we can do with semiconductors are becoming more valuable than ever. So, even if the cost of the semiconductor doesn’t go down as fast as it used to, they’re becoming even more valuable, and we see the demand for them continuing to grow. The rationale for owning a company like ASML may seem obvious now, but there was a time when it was not.
It was a similar scenario with Google advertising on the internet. There was a time when we did most of our internet searching on a big screen on our computer. Then we started to use the phone to search, and there was a lot of skepticism that the ads on the phone wouldn’t be as valuable, and some investors saw that as a rationale not to own Google anymore.
Similarly, with Visa, there have been a lot of times over the past 15 years, when investors have been skeptical, believing that growth was over for Visa and that new ways of doing transactions were going to show up.
Of course, not every investment we’ve made at Sands Capital has played out that way and the skepticism can be warranted. But sometimes that skepticism can present a profound opportunity if you can truly be a long-term investor in certain companies and not get fooled into believing that the company will saturate its market, be competed out of its existence, or some other scenario.
A final point I would make is about the importance of the people on your team. An investment shop is really about making investment decisions with a commonsense process and taking appropriate risks. For us, it’s also about being bold and yet patient at the same time. That’s really the key. Essential to that are the cultural foundations of trust and shared context that Danielle talked about. It’s about succeeding and losing together as a team.
One of the reasons we have confidence in our holdings over the long term is that we have seen the counterintuitive process that Wes and Danielle talked about play out many times, as companies have gone through difficult times and then emerged as even better companies.
When these unexpected difficult markets happen, it also makes our firm much better because we’ve all lived through such a period. It really highlights that our six criteria provide a solid foundation to our research process over the long term.
1 The three strategies represent the three longest-tenured strategies, by assets under management and best represent the discussion, which is related primarily to growth strategies.
The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. All investments are subject to market risk, including the possible loss of principal. Differences in account size, timing of transactions and market conditions prevailing at the time of investment may lead to different results, and clients may lose money. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. Forward earnings projections are not predictors of stock price or investment performance, and do not represent past performance. Characteristics, sector exposure and holdings information are subject to change, and should not be considered as recommendations. The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients. There is no assurance that any securities discussed will remain in the portfolio or that securities sold have not been repurchased. You should not assume that any investment is or will be profitable. GIPS® Reports and additional disclosures for the related composites may be found in the Sands Capital GIPS Report. A full list of public portfolio holdings, including their purchase dates, is available here.
The businesses mentioned by the Sands Capital team illustrate the challenges and opportunities encountered as they managed portfolios up to and including 2022. Several are also used to illustrate the re-underwriting process that Sands Capital’s research team undertook throughout the year to evaluate the current and future strength of portfolios companies. With the understanding that 2022 was a challenging performance year, the team highlighted many portfolio holdings as examples of businesses we either still have high conviction in, continue to have conviction in or that we have lost conviction in and how we handled that. We also looked at unprofitable growth as a choice and what it means for portfolio businesses. In particular, the investment team sought to use specific company examples to describe the fundamentals for a variety of portfolio holdings across sectors, geographies, and across portfolio weights.
Airbnb is held in the Select Growth, Global Growth, Technology Innovators, and Global Shariah strategies.
Amazon is held in Select Growth, Global Growth, Technology Innovators, and Global Shariah strategies.
ASML is held in Global Growth, Technology Innovators, International Growth.
Block is held in Select Growth, Global growth, Technology Innovators, and Global Shariah.
Datadog is held in Select Growth and Technology Innovators.
Dexcom is held in Select Growth, Global Growth, and Global Shariah.
DoorDash is held in Select Growth, Global Growth, Technology Innovators, and Global Shariah.
Floor & Decor is held in Select Growth. Google is held in Global Growth, Technology Innovators, and Global Shariah.
MercadoLibre is held in Global Growth, Emerging Markets Growth, Technology Innovators, and International Growth.
Netflix is held in Select Growth, Global Growth, and Technology Innovators. Nike is held in Global Growth and Global Shariah.
Sea is held in Global Growth, Emerging Markets growth, Technology Innovators, International Growth, and Emerging Market Discovery strategies.
Snowflake is held in our Select Growth, Global Growth, Technology Innovators, and Global Shariah strategies.
Uber is held in Select Growth.
Visa is held in Select Growth, Global Growth, Global Leaders, Technology Innovators, Select Leaders, and Global Shariah.
Apple, Home Depot, Lyft, Lowe’s, Peloton, Coinbase, Robinhood, Salesforce, and Twilio are not held in any Sands Capital strategies.
All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional and economic developments. Sands Capital’s strategies are concentrated in a limited number of holdings. As a result, poor performance by a single large holding of the strategy would adversely affect its performance more than if the strategy were invested in a larger number of companies.
The Select Growth, Global Growth, Emerging Markets Growth, Emerging Markets Discovery, International Growth, and Global Shariah strategies’ growth investing style may become out of favor, which may result in periods of underperformance.
Due to their concentration in specific industries, the Technology Innovators and Global Shariah strategies’ returns could be more volatile than that of a strategy with a broader mandate. Technology Innovators is also subject to large investor risk, whereby a large investor may impact Sands Capital’s investment strategy by purchasing or selling interests in large amounts. Additional risks that may impact the strategy include derivatives risk.
Investments in emerging markets are subject to abrupt and severe price declines. The economic and political structures of developing nations, in most cases, do not compare favorably with the United States or other developed countries in terms of wealth and stability, and their financial markets often lack liquidity. Because of this concentration in rapidly developing economies in a limited geographic area, the Emerging Markets Growth and Emerging Markets Discovery strategies involves a high degree of risk.