It was the best of times, it was the worst of times, it was the age of AI.
While it was a quarter of light and spring of hope for all things AI, 2Q 2023 was a more challenging period for diversified equity funds. It’s not quite a winter of despair but a lack of exposure for many funds to the Information Technology and Communication Services sectors (+15% and +7% respectively during Q2) powered by a small cohort of Mega-cap technology stocks, has seen a significant percentage of active funds underperform. In the US alone, ~75% of active funds at the end of H1 were underperforming the S&P500.* Healthcare, Consumer Discretionary and Consumer Staples all came under pressure during the second quarter, while the likes of Apple, Microsoft, NVIDIA, Broadcom, Tesla, Amazon, Google and Meta drove ~55% of global returns.*
A Tale of Two Cities
We have written previously about the past decade being dominated by Big Tech but that coming out of the pandemic, Healthcare and Consumer Health would lead the economy, prolonging healthspans, extending lifespans and driving more efficient delivery of healthcare. Putting a frustrating Q2 to one side, we remain steadfast in this belief that Healthcare and Consumer Health are becoming more desirable areas for investment. In turn, an extended wealth accumulation phase from longer working careers will drive increased demand for financial planning and insurance services – notably savings, wealth transfer and annuity products. With the Tech sector’s renaissance, we see attractive valuations for high-quality, growth-oriented companies in other parts of the market however, with the current AI euphoria, it is difficult to predict when the market will re- align to fundamentals. As the NVIDIA’s of the world shoot up in value as Chat-GPT and Bard capture people’s imagination, we are confident that many of our holdings will be able to harness AI to enhance their own products and services.
We caught sight of this potential during our annual European Healthcare field trip in May. Meeting the senior leadership teams from 19 of the world’s biggest healthcare businesses was reassuring. Many of these companies have been using machine learning and internal NLP/LLMs for several years to improve operations. Companies have been using AI to lower the cost of finance functions, assist in drug discovery and development, and drive more efficient marketing spend. AI is not merely being used to improve operations, many of the companies we met are using AI to improve patient outcomes. For example, AI is being used to develop treatment planning software that can help doctors deliver more precise care, selecting the best therapies for patients with cancer or monitoring patients remotely for early warning signs of health problems. The furore surrounding AI was a significant factor in the strong performance of Tech during Q2, as investors flocked indiscriminately to companies perceived to be beneficiaries. Very few of the Longevity and Social Change fund holdings participated in this rally and yet we believe many are set to transform and revolutionize the healthcare industry through their deployment of AI.
Several non-healthcare holdings in the fund are owners of exceptional and proprietary pools of data which are likely to be long-term beneficiaries of AI. Take for instance Ulta Beauty and its over 40mn Ultamate Rewards members. Its app users spend 2x as much and visit store twice as often enabling higher share of wallet and deeper insights into what its customers want. What about the more than 10 years of data on 8 million Pets at Home consumers? Pets at Home already enjoys a 20% spend uplift from its VIP club members with average spend per member around £160 per annum. Imagine the revenue uplift from more targeted data driven insights. Pets at Home estimate increasing the Average Customer Value by just £10 would drive £77m of incremental consumer revenue – equivalent to a 5% revenue uplift. We remain highly attuned to these unique datasets and remain focused on identifying high quality companies with proven operating models and strong innovation characteristics that not only have exposure to the durable and resilient growth offered by the Longevity and Social Change theme but also stand to benefit from the utilisation of AI.
Engaging on the “S” within ESG
Q2 was a demanding time for corporate engagement, with a high concentration of AGMs taking place during the period. We took every opportunity to exercise our proxy votes, consulting ISS SRI governance research and recommendations, and backing this up with our own research and benchmarking. We believe that companies with strong ESG profiles do better over time. We therefore analyse a company’s ESG practices alongside conventional financials, excluding those operating in harmful sectors or conflicting with our principles of extending healthspans and lifespans.
As we approach our second year of running the portfolio, we saw corporates make progress in many areas, such as depth of disclosure and introduction of new ESG goals. However, we also voted against a number of director reappointments, particularly to the nominating committees, in cases where more could be done to drive diversity on executive teams and on the board level. In line with our strategy, we also had a number of direct engagements, focusing on elevating the Social pillar of ESG. We stressed the importance of having explicit and ambitious diversity targets in place, as well as the need to link these to management incentives.
Elevating the Social dimension of ESG is acutely important given the profound societal impact of demographic shifts. For example, women typically outlive men by approximately 5 years. However, by the time a woman reaches retirement age, her pension pots are typically 30-40% less than a man’s. We also believe there is alpha in the “S” with an academic paper published** in late 2021 reporting that companies that treat their employees the best, earn an excess return of 2%-2.7% per year. Environmental performance was also part of our dialogue, particularly where transparency and measurement of performance could be improved. We engaged with a range of companies in the Financials, Consumer, and Healthcare sectors, including Carlyle (querying the nature of infrastructure/cyber investments in managed funds and ESG process when allocating capital on behalf of LPs), Pets At Home (audit committee resignations and ethnic diversity strategy), and Transmedics (environmental disclosure and diversity strategy). We received prompt and detailed replies to our queries. We were reassured that progress on ESG factors remains integral to the strategy of our corporates, with many already best in class.
Portfolio positioning and performance
The Pacific Longevity & Social Change strategy underperformed the MSCI World Index during Q2 due to its lack of exposure to the Mega-cap Tech and Communication Services sectors. While the Fund does have exposure to other types of “Tech”, such as Biotech, Medtech, Healthtech, and Fintech, it does not have any exposure to traditional Mega-cap Tech companies. This is because the growth drivers of these companies are not closely aligned with the longevity industry, which is the Fund’s primary focus. The top three absolute contributors to the Fund’s performance in Q2 were Conmed, Exact Sciences, and Icon PLC and the top three absolute detractors were Catalent, Tandem Diabetes Care, and Ulta Beauty.
Looking at the Longevity & Social Change performance by theme, the Longevity Consumer was the top contributor, with strength seen in Companionship (Pets At Home) , Travel & Leisure (Booking) and Life & Non-Life Insurance subthemes.
Within Later Living, Home-Health & Nursing and Care Services were the leading subthemes, while Health Insurance was the main laggard on the back of higher utilisation trends. Initial Q2 results from UnitedHealth and Elevance would suggest these concerns were overstated with both companies beating expectations for the quarter and raising FY23 guidance.
In Education and Wellbeing, Screening posted a strong quarter led by Exact Sciences, which reported a strong Q1 update (beat and raise), positive clinical data for Cologuard 2.0 and a reassuring Capital Markets day where long-term targets were provided for sales and EBITDA. This was offset by weakness in Fitness & Nutrition, primarily attributable to Columbia Sportswear which derated on concerns around inventory overhang and general weakness among US focused apparel names. Education also lagged, with Adtalem’s first investor day since 2019, while broadly reassuring on long term targets, driving a disappointment on softer than expected FY24 outlook for margin. We tactically increased our position on weakness as we remain confident in secular drivers of Adtalem’s business as labour shortage in the US healthcare systems is likely to grow as the population ages and current practitioners retire. Ulta Beauty drove the underperformance in Aesthetics & Vision. The company delivered an in line set of results and maintained FY23 EPS guidance on the back of solid revenue momentum but downgraded margin guidance by 20bps noting a higher incidence of store theft – a trend also highlighted by several other consumer stocks including Home Depot and Walmart. We increased our position on weakness as the magnitude of the derating was out of sync with steady earnings projections.
Healthcare was the weakest performing theme in Q2 driven by Drug Development & Manufacturing (Catalent) and Pharmacy (Horizon Therapeutics) while the Medical Devices subtheme was broadly flat with mixed performance across individual holdings, Conmed leading the group and Tandem Diabetes the main laggard.
Outlook
The equity market appears to have embraced the concept that the global economy will achieve a soft landing and that, with central bank tightening cycles soon in the rear-view mirror, the road ahead is clearer. However, the possibility of central bank overtightening, geopolitical uncertainty and eroding savings represent tangible risks to growth. We remain cognisant that interest rate increases tend to impact the real economy with a lag and that the challenge of persistent inflation, tight labour markets and higher rates is ultimately likely to manifest into a recession. Indeed, we have seen a string of negative earnings pre- announcements ahead of Q2 reporting season (outnumbering the number of positive pre-announcements). FY2023 and FY2024 earnings expectations are declining, but it’s more like a gentle breeze than a storm. In the meantime, employment remains robust, AI hype is supporting global indices and across the globe, populations continue to age. This creates opportunities for companies that provide products and services which cater to changing consumption patterns driven by shifts in demography. The longevity strategy is focused on identifying high-quality businesses with such exposure, that will drive sustainable returns over the long term.
*Bloomberg as of June 30, 2023
**Employee Satisfaction and Long-run Stock Returns, 1984-2020, Financial Analysts Journal, 78:3, 129-151”