The Monks Investment Trust PLC (MNKS)
Legal Entity Identifier: 213800MRI1JTUKG5AF64
Results for the six months to 31 October 2023
The following is the unaudited Interim Financial Report for the six months to 31 October 2023 which was approved by the Board on 7 December 2023.
Chairman’s statement
Performance
During the first half of the financial year, the Company produced a net asset value (NAV) total return of -3.3% compared to +2.1% for the comparative index (FTSE World in sterling). The share price total return was -7.3%, as the discount widened from 8.7% to 11.6%. The investment trust sector is trading at discounts last seen during the financial crisis.
This is disappointing. Beyond the seven mega-cap stocks in the US, growth stocks have been out of favour during a period of rising interest rates. We believe that in the long run growth stocks will continue to deliver better investment returns, particularly as technology continues to transform economies in sometimes unpredictable ways. We also share the investment managers’ optimism that the period of sharply rising rates is now behind us. Some of the underperformance, however, has been driven by specific stock selection, and commentary on the largest detractors from performance over the period is included in the Managers’ report.
Discount management
Apart from challenging the manager, an essential role of an investment company board is to determine the company’s policy in respect of discount management.
Monks has bought back approximately £300m of its own stock since the beginning of last year, when the Company’s shares moved from a premium to a discount. Repurchasing shares provides NAV accretion, reduces share price volatility and reassures shareholders and potential investors that the Board is alive to the question of discount management. The Board therefore intends to continue to buy back while the Company’s shares trade at a substantial discount to NAV. It continues to evaluate the range of alternative options at its disposal to seek to address the discount.
Gearing
An advantage of the investment trust structure is that the Company can deploy borrowing to enhance returns in the long run. In 2020, the Board took advantage of low interest rates to issue debt to an insurer to provide structural gearing, securing £100m of borrowing with a maturity of 30 years at an interest rate of 1.8%. The Board believes that it is beneficial for the Company to have flexibility in its capital structure, so not all of the Company’s borrowing is structural. The Company also has a revolving debt facility of £150m at a floating rate of interest, the cost of which has risen with market rates. This facility expires in November 2024. The Board is considering potential options to replace this facility and will update shareholders in due course.
The Board
As previously reported, Jeremy Tigue has indicated his intention not to offer himself for re-election at the AGM in September 2024 and, accordingly, Belinda Richards has succeeded him as Senior Independent Director (‘SID’) in order to oversee the necessary recruitment and succession planning. A recruitment process is under way to add further members to the Board. We expect to be in a position to announce the new appointments before the end of the Company’s current financial year.
Outlook
Monks has a well-diversified portfolio of growth stocks, with less than 4% underlying exposure to unquoted companies. The Board believes that the Company’s diversified approach offers investors exposure to a wide range of growth opportunities that are likely to drive returns in the years ahead.
Karl Sternberg
Chairman
7 December 2023
Interim management report
The investment performance of Monks’ portfolio in the first half of its financial year has been disappointing. This continues a run of poor relative returns that began two years ago, which has erased – for the time being – the superior returns delivered for shareholders since the Global Alpha team took over eight years ago. This stands in contrast to our view of the long-term growth prospects of the companies in the Monks portfolio.
Rapidly rising inflation and the increases in interest rates that began in the first half of 2022 suppressed investors’ appetite for growth assets and precipitated sharp share price falls of companies held in the Monks portfolio. The portfolio was too concentrated in rapidly growing, earlier-stage companies that bore the brunt of share price declines. We have taken action by selling holdings poorly positioned in an environment of persistently higher inflation and interest rates, while restoring greater balance across the portfolio’s three growth profiles (Stalwart, Rapid, Cyclical). Furthermore, we have strengthened the analytical inputs to our investment process, specifically, those related to valuations and stock correlations.
We believe that good times are ahead for the portfolio. The inflation and interest rate environment is stabilising and we expect the portfolio to deliver substantially higher levels of earnings growth than the market. Indeed, the three-year forecast earnings growth of portfolio companies is more than double the market average (+12.8% p.a. compared to +5.5% p.a.), its highest level relative to the index in a decade. The forecast price-to-earnings ratio of the portfolio companies in 2024 is 17.5x, an +18% premium to the index (14.8x). This is an attractive trade-off that we believe will drive future returns for Monks shareholders.
Performance
During the first half of the financial year, the Company produced a net asset value (NAV)* total return of -3.3% compared to +2.1% for the comparative index (FTSE World in sterling). The share price total return was -7.3%. Since our team took over the management of the portfolio in March 2015, the Company has produced a NAV total return +119.3% compared to +132.2% for the comparative index. The share price total return was +114.4%.
Among the largest detractors from performance were the holdings in The Schiehallion Fund (a closed-ended investment company managed by Baillie Gifford that invests in late-stage private companies), Pernod Ricard (spirits and drinks), and Shiseido (cosmetics).
Although the NAV of the Schiehallion Fund fell by 5%, it was a widening discount between the share price and NAV (from 25% to 50% in the period) that drove its underperformance. This reflects a more challenging operating environment for companies and investors’ aversion to assets whose valuations are founded on long-term potential. This has contributed to share price weakness across the portfolio more broadly too. We continue to favour a modest level of exposure to private companies (3.9% of the portfolio, of which Schiehallion is 1.5%), but are enthusiastic about the potential of both Schiehallion and the handful of directly held private securities (which include Bytedance and SpaceX that are also held in Schiehallion).
The sharp share price falls (20-30%) for Pernod Ricard, the French spirits business, and Shiseido, the Japanese cosmetics company have, in part, been down to weaker demand from the Chinese market. Consumer appetite in China has been slower to return post-pandemic, which has been felt most acutely in ‘premium’ products of the type sold by Pernod and Shiseido. We believe that these developments are temporary. For example, in the case of Shiseido, it continues to focus on its ‘prestige’ brands (Cle de Peu, Anessa and Zanessa) in the Chinese market where we believe volumes and operating margins will be materially higher (versus 2019 levels) in the next 2-3 years.
On a sector basis, the portfolio’s healthcare holdings have accounted for around 40% of the underperformance relative to the index over the period. For most of these, we remain enthusiastic about their long-term growth potential. For example, Moderna, the infectious disease vaccine producer, has seen revenue growth slow after demand for Covid vaccines fell. Whilst the share price spiked through the pandemic to over $400 and has fallen sharply, Moderna remains a relatively new position for Monks (purchased just two years ago) and the current price is above our initial purchase price (~$77 per share). Moderna has proven itself capable of executing and we believe that focusing on near-term demand for Covid vaccines ignores the strength of Moderna’s pipeline of treatments (36 programs in clinical trials deploying mRNA technology to make infectious disease vaccines). Our conviction in Moderna’s ability to be one of the leading biotech companies of the future, solving health challenges for millions of people, remains intact.
In contrast, where long-term growth prospects are faltering, we have taken action. This is true for Illumina (gene sequencing). We have sold the portfolio’s holding as a result of significant management changes and poor operational execution of its acquisition of Grail (cancer testing), which it continues to contest with regulators.
Despite the poor share price reactions we have seen, the operational progress of a majority of holdings remains on track. Several of our long-established cyclical operators, such as building and aggregates businesses Martin Marietta and CRH, have contributed positively to NAV. These companies continue to demonstrate exceptional capital allocation discipline and very strong pricing power that has driven robust growth in profitability. For example, Martin Marietta increased pricing by 17% and grew gross profits by 38% year-on-year.
The strongest contributors have demonstrated increasing earnings power this year. This is true of Meta (social media) and Amazon (ecommerce and cloud). Mark Zuckerberg announced 2023 as Meta’s ‘year of efficiency’, indeed, revenue growth is returning to faster growth (+23% year-on-year) and net income rose 164% year-on-year. We believe this is only the beginning of a material uptick in Meta’s profitability. Its advertising estate (that includes Facebook, Instagram and Whatsapp platforms) reaches 3.6 billion users and is under-monetised. We are excited about its potential and have added twice this year. Amazon invested heavily in its logistics network during the pandemic. Utilisation rates are growing and its retail division is becoming more profitable, while its highly profitable Cloud computing division, Amazon Web Services, continues to make strong progress. Recent deals struck with other ecommerce platforms (such as Shopify and Pinterest) to provide fulfilment services for transactions on their platforms have underlined Amazon’s credentials as the leading provider of infrastructure in this market.
Elsewhere, there are similar stories of strong execution at the likes of The Trade Desk (programmatic advertising) and Doordash (food and grocery delivery). Doordash – led by founder Tony Xu – has a relentless focus on improving customer service and profitability. The business has taken its time to develop its business model in the suburbs of the US and is now proving its strength in city centre locations. The latest results saw its earnings grow just under 300% year-on-year.
Gearing
We continue to believe in the value of gearing to enhance long-term shareholder returns. Gross gearing has increased from 7.2% to 8.3% in the period. We drew down a modest sum from Monks’ revolving debt facility which has supported both ongoing share buybacks and additions to existing positions. The £100m of structurally low-cost (1.8%) gearing secured for a 30-year term in 2020 has provided an excellent foundation from which to generate future excess return for shareholders and afforded us the latitude to consider the merits of further borrowing on behalf of investors.
Positioning and opportunity
Macroeconomic factors have been a key driver of share prices. Nevertheless, we continue to revisit the underlying growth drivers that underpin Monks’ portfolio. We remain confident that the growth tailwinds will either endure despite global economic challenges or strengthen because of them.
The critical imperatives for upgrading crumbling infrastructure, decarbonising the economy and better meeting the needs of ageing populations have not gone away. Nor have structural bottlenecks in critical resources, cloud infrastructure and logistics networks. At the same time, we believe that machine learning remains in the foothills and that deepening fissures between the US and China will broaden innovation into new developing markets. All these tailwinds remain intact, regardless of the market’s focus.
These themes are consistent with our Research Agenda which outlines a handful of potentially rich seams for stock pickers. We have continued to pursue opportunities in these areas and have been adding selectively to the Monks portfolio. We highlight below some of the themes and positions which informed recent additions to the portfolio:
1. New Growth Frontiers – if the growth engines of the past decade were the internet, mobile, and software, the next decade will be based on the cloud, data, and artificial intelligence. These technologies are likely to bridge the digital and physical world, having potentially profound implications for a range of industries.
We consider semiconductors to be the “picks and shovels” of this modern ‘Gold Rush’, underpinning many of these exciting growth trends. Research on various semiconductor opportunities has seen Monks’ overall exposure to semiconductors double to 6% of assets in the past twelve months. Among the most recent new purchases in this area are Advanced Micro Devices, Samsung Electronics and NVIDIA. The latter is a market leader in graphics processing units (GPUs) that are essential in a world that has an insatiable demand for ever-increasing computing power. Around 90% of generative AI (artificial intelligence) programs are trained on NVIDIA hardware, and 3 million of the world’s machine learning engineers (nearly all of them) have used NVIDIA’s tools. Its dominant position in GPUs (as a fundamental enabler of AI model learning) supports attractive upside. We can see a plausible case for NVIDIA’s revenue growing at 40% per annum over the next five years. Its dominant position should afford it pricing power and control of margins. While, even with a derating, the expected operational performance can drive a doubling of NVIDIA’s share price through to 2028.
2. Infrastructure Upgrade – we have continued to invest where companies may be beneficiaries of an ‘Infrastructure Upgrade’, particularly in the US. There are several factors including re-shoring trends and infrastructure spending bills which are likely to support a material uptick in capital spending on areas including roads, energy and digital networks.
The most recent purchase is Comfort Systems, an installer of heating, ventilation and air conditioning systems in the US. Over the last 25 years, Comfort has grown earnings before interest and tax at an annualised rate of 17%, and yet the opportunity to maintain this growth for many more years remains enormous. Industrial policy is spurring record construction starts, accelerating the growth outlook for various companies across the portfolio. Comfort joins that cohort. To meet our growth hurdle, Comfort needs to continue to consolidate the industry, although we are optimistic that growth may in fact accelerate on account of its strategic focus on smaller cities and large towns in the US. This affords it a cost advantage and allows it to better serve these communities by being based locally.
3. Increased Return from Patience – during periods of fear and uncertainty, time horizons shrink and investors focus on the here and now. As long-term investors, this gives us a heightened advantage in identifying secular growth companies that are facing near-term headwinds that are obscuring the potential for long-term growth.
We have been seeking opportunities to pick up a bargain where valuations look materially lower than history but the fundamental growth prospects remain intact. An example of this is the recent purchase of YETI Holdings (purchased on 16x forward earnings), a premium North American outdoor brand. Its appeal lies in its superior quality, built-to-last products such as beverage cups and coolers which are seen as premium outdoor products. Management is thoughtful in its approach to managing the brand while expanding the product range and growing the business outside North America. Another is Nippon Paint. A Japanese paint products manufacturing company, Nippon has a strong position in the Chinese market via its subsidiary, Nipsea. Brand and distribution are key competitive advantages and a well-aligned management team has a strong track record of success. China’s per capita spend on paint is one-third that of developed markets and we believe it has huge growth potential. Nipsea is already the market leader and well-positioned to capture growth in China and Asia more broadly.
On the other side of the ledger, we have moved on from holdings that looked more fully valued or where the growth outlook had diminished. Examples of the former include Booking Holdings (online travel) and Axon Enterprises (security and law enforcement services). In the case of Booking Holdings, we felt a combination of a strong post-pandemic recovery in travel and a sharp increase in the share price diminished the upside for the business, but were also cognisant of the potential competitive threat that artificial intelligence applications might pose to Booking’s online search platform. In Axon’s case, the share price had doubled in the prior 12 months taking the valuation on a price-to-sales basis to over 10x. This has been a successful investment for Monks since first investing in 2019 (its share price grew nearly three-fold), but the probability of hitting our returns hurdle (a doubling in share price over the next 5 years) had fallen significantly. A diminishing growth outlook underpins the sales of long-term holding and financial exchange operator Deutsche Boerse, Japanese auto part manufacturer DENSO, and Chinese food delivery business, Meituan. The latter was subject to regulatory pressure to reduce take rates and increase staff benefits which reduced profitability. The scale of the opportunity perhaps led us to hold on too long, but we have exited with the shares up nearly two-fold since purchase five years ago. Ultimately, an increasingly competitive marketplace and a capped upside led us to sell the shares.
Outlook
It has been a bruising period performance-wise. But beneath the difficult headline numbers resides a portfolio in robust health. Forecast earnings growth – at nearly twice the market average – is coiled and ready to drive returns for shareholders in the years ahead. At the same time, portfolio companies boast superior gross and net margins relative to the index (37.2% versus 28.7% and 11.3% versus 9.0%, respectively) and are materially less indebted, with net debt-to-equity of 20% versus the index at 50%. The superior financial robustness of our holdings supports their ability to allocate more capital to Research and Development (R&D to sales for Monks holdings is 7.3% compared to the index at 4.6%). These investments will extend their competitive advantages and enable our companies to outcompete peers in years to come.
We know from experience that this is exactly the kind of environment where patience will be handsomely rewarded. Managing the assets of the Monks Investment Trust is a privilege. Holding course and owning a portfolio of high-quality companies that will deliver superior earnings is the best way to deliver attractive returns for Monks shareholders in the years ahead.
* With debt at fair value
Baillie Gifford & Co
Managers
7 December 2023