Walter Scott Global Equity Hedged (MAQ0557AU) Report & Performance

• The Fund returned 3.06%, net of fees, in June 2023, compared with a return for the Benchmark of 3.12%, with the ongoing resilience of the American consumer and better-than-expected US export growth driving a higher revision of US Q1 GDP data and supporting equity markets.

• Nearly all market sectors rose in June, with Consumer Discretionary and IT representing the largest contributors to index returns. For the Fund, the largest relative sector contributors included holdings in Health Care, such as Edwards Lifesciences and West Pharmaceutical Services, partially offset by holdings in IT, namely Keyence. During the month, Walter Scott completed the final sale of Jardine Matheson, to raise funds for other portfolio companies with more compelling fundamental characteristics.

• Having just reported excellent first-quarter results (sales up 15% and gross margins at an all-time high for the same period) it was little wonder that representatives from Inditex were in a buoyant mood when members of the Walter Scott Research team met with the company in June. Management spoke of the consistency of the business and strong strategy execution that was reflected in broad-based growth across physical stores and online, concepts and geographies. The current strength of Inditex and its Zara brand is in many ways the culmination of a decade-long strategy that pivoted the business towards a pure sales growth model. Central to this was a ‘store optimisation’ program that involved fewer but larger stores supported by an online business utilising the very same logistics infrastructure. Today, Inditex is completely agnostic as to the channel through which consumers choose to shop.

• Investor sentiment arguably reflects a nascent ‘goldilocks’ scenario, founded on hopes of peaking interest rates, and economic growth proving more resilient than expected. The latter has certainly been the case, considering the dire forecasts for global economies of early last year. However, inflation has not been entirely conquered and its lag effect on consumer behaviour may yet to be fully felt, while there is a danger that central banks go too far in their attempts to rein in inflation. Quality companies have shown resilience and indeed growth in the face of this mixed macroeconomic climate, as these businesses benefit from market leadership, financial strength, good management and their adaptability in challenging times. These are attributes that are evident in the portfolio’s companies and give Walter Scott confidence in their ability to deliver strong returns over time

• The Fund returned 1.72%, net of fees, in February 2023, compared with a return for the Benchmark of 2.09%, with ongoing uncertainty over the future path of inflation and interest rates challenging investor sentiment.

• The largest sector drivers of the market’s positive result in February included IT, Industrials, Financials and Consumer Discretionary. For the Fund, holdings in IT, including Adobe and Cognex, and holdings in Financials, including AIA Group and Prudential, were the largest relative sector detractors; these were partially offset by holdings in Health Care, led by West Pharmaceutical Services and Novo Nordisk, and holdings in Materials, namely Linde.

• During the month, Walter Scott completed the initial purchases of Lonza Group and O’Reilly Automotive, and the final sale of Johnson & Johnson. Lonza is the global leader in the contract development and manufacturing organisation (CDMO) industry, which provides outsourcing services to the global pharmaceutical industry, most importantly manufacturing services for therapeutic drugs. Market growth and increased outsourcing should support double-digit industry growth for years to come. O’Reilly Automotive was purchased due to its resilient qualities, evidenced by 30 years of consecutive comparable sales growth. O’Reilly demonstrated strong share gains throughout the pandemic and momentum continued into 2022. The business is well-placed to continue consolidating a highly fragmented market whilst returning significant cash to shareholders. Johnson & Johnson is facing multiple headwinds, including a significant ongoing litigation challenge relating to its talcum powder-based products. There is also a more uncertain outlook for the company’s pharmaceutical division, where several products are past, or nearing, key patent expiry.

• As always, Walter Scott are focused on analysing and assessing how portfolio companies are navigating the various hurdles or indeed seizing the opportunities presented by these volatile times. Although in some cases they have not been immune from demand contraction or cost pressures, looking through the recent slew of earnings results, many have continued to show resilience and indeed growth. Thanks to their market-leadership, financial strength, pricing power and an ability to adapt to the vagaries of economic cycles, the companies the Fund holds remain well positioned to deliver strong earnings growth over the long term.

The Fund returned -3.55%, net of fees, in December 2022, compared with a return for the Benchmark of -5.19%, with investor concerns growing about the economic outlook for next year as central banks cautioned that a longed-for ‘pivot’ in monetary policy would not be forthcoming any time soon.

The IT and Consumer Discretionary sectors led the market lower in a month without a positive sector contributor. For the Fund, holdings in Consumer Discretionary, including NIKE, Compass Group and Inditex, and in Health Care, such as Novo Nordisk and Stryker Corporation, were the largest relative sector contributors, while holdings in Communication Services, namely Alphabet and The Walt Disney Company, were again the largest relative detractor. During the month, Walter Scott completed the final sale of Colgate-Palmolive, with the company facing cost pressures that have diminished its earnings power, amid strong competition for capital in the portfolio from other businesses with superior fundamental outlooks.

Several portfolio companies have had to navigate their way through a challenging operational environment; however, their inherent strengths are starting to come to the fore. News that NIKE was making progress on clearing its elevated inventory levels was well received by investors. While the backlog remains high — up 43% compared to a year ago — it appears that the peak has passed. Management expects levels to normalise in the months ahead, although gross margins will be squeezed while this happens. Spanish-listed fashion retailer Inditex has shown more than resilience in the face of shrinking consumer wallets, with sales up 20% in constant currency terms in the first nine months of the year. Furthermore, management reported that business conditions since have remained strong. Growth is predominantly coming from recovery in physical store sales in the wake of their post-pandemic reopening, but online sales are also up on prior year levels.

Predicting economic and market vagaries forms no part of Walter Scott’s investment process. In these turbulent times, it is all the more important the investment team ‘sticks to its knitting’ as they seek out the world’s great businesses that they believe can deliver strong earnings over time. That earnings generation, irrespective of economic and market volatility, will be the driver of portfolio returns.

The Fund returned 7.46%, net of fees, in November 2022, compared with a return for the Benchmark of 5.43%, with leading companies showing operational resilience despite economies remaining under pressure, and investors increasingly confident that an end game on rising interest rates may be in sight.

The Energy sector was the sole market detractor in November, as Materials and Financials led the index higher. Holdings in Consumer Discretionary, including LVMH, Nike and Inditex, and in IT, including Taiwan Semiconductor, Microsoft and Texas Instruments, were the largest relative sector contributors for the Fund, while the main relative detractor was holdings in Communication Services, namely The Walt Disney Company. There were no initial purchases or final sales within the portfolio during the month.

It was a busy month on the road for the Walter Scott Research team, with visits to the US, the Nordic countries, South Africa, Australia, New Zealand, Spain, Turkey and London, speaking to the management teams of companies held and potential portfolio candidates. Walter Scott met with CFO of Finnish elevator and escalator company Kone at their headquarters just outside Helsinki. This global business has a leading position in the Asia Pacific and Chinese markets, and the lockdowns and real estate sector downturn in China have been unwelcome headwinds of late. However major elements of Kone’s business are still performing well, most notably servicing and modernisation, and the company is also benefiting from the adoption of digital services (elevator analytics and smart building technology). Management has been flagging for a long time that new installations in China would eventually slow and that servicing and modernising the existing installed base would grow in importance. That is proving to be the case, and momentum for now is extremely strong.

The ‘Santa’ rally has started early this year. However, it remains to be seen to what extent equities have discounted an economic downturn and a tighter monetary environment. Walter Scott will stick to the rigour and consistency of their investment approach, one which is based on bottom-up, fundamental analysis as they look to invest in businesses that are capable of compounding high levels of wealth generation over the long term.

The Fund returned 6.18%, net of fees, in October 2022, compared with a return for the Benchmark of 7.22%, as equity markets rallied on investor hopes that weaker growth, gradual supply chain improvements, and commodity price reversals will eventually bring an end to monetary tightening as the drivers of inflation wilt.

The IT and Health Care sectors were among the largest contributors to a strong month for the index. Holdings in Financials, including AIA Group and Prudential, and a lack of exposure to the Energy sector were the largest relative sector detractors for the Fund, while the main relative contributors were holdings in Consumer Discretionary, such as TJX Companies, Booking Holdings and LVMH, amongst others. During the month, Walter Scott completed the final sale of Fanuc, to provide funds for more compelling investment candidates.

Economic turbulence does not yet seem to have blunted indulgence too much, judging by LVMH’s excellent nine-month results which highlighted the resilience of luxury spending and the company’s pricing power. Luxury is not recession proof, but LVMH’s customer base enjoys a differentiated consumption profile compared to the general population. Sales growth was positive across all business divisions, with the all-important Fashion & Leather division (almost half of group sales) growing ahead of expectations. Geographically, Europe, the US and Japan witnessed robust local demand, with sales also helped by the recovery in international travel. While Asia was less buoyant, growth accelerated in the third quarter in response to an easing of pandemic-related restrictions. Mainland China saw ‘‘flattish’’ year-on-year growth, with management expecting trends to recover ‘‘soon’’.

Markets will continue to ponder the scale and extent of the gathering downturn. Notwithstanding the operational resilience many leading companies have displayed so far, potentially stiffer tests lie ahead, and some may experience earnings volatility. By virtue of their market-leadership, financial and competitive strengths, and management teams experienced in navigating through cycles, Walter Scott remains confident in the ability of portfolio companies to deliver excellent returns over the long term.

• The Fund returned -8.10% in September 2022, compared with a return for the Benchmark of -8.91%, with equity markets facing a turbulent month as concerns about inflation, higher interest rates and a tilt towards recession in Europe preyed on investor sentiment.

• Another monthly fall for the index in September was driven by the IT and Industrials sectors, with Health Care the sole positive contributor. The Fund’s holdings in Industrials, including Experian, SGS, and Kone, and an underweight to Real Estate were the largest relative sector contributors. The main relative detractors, meanwhile, were holdings in Financials, namely AIA Group, and an underweight to the sector. There were no initial purchases or final sales within the portfolio during the month.

• ‘‘Good in good times, but better in not so good times’’. So said Oscar Garcia Maceiras, CEO of Spanish-based retailer Inditex in a conference call after the company’s excellent first-half results which saw sales up 25% (including an impressive 16% in the second quarter), and operating profit rise 44%. Reflecting on the current environment, he stated the concerns about macro conditions and consumer behaviour are understandable, but history suggests that macro conditions are not a good proxy for Inditex’s results. Discretionary spending is clearly under pressure, particularly in Europe, so Inditex is competing for a smaller consumer wallet against peers but also against non-apparel spending alternatives. Growth in the first half of the year was driven by a rebound in traffic in physical stores. Online sales were roughly flat in the period. In the post-period trading update sales strength continued, so in that context management still believes there is the potential for strong sales in the second half of the year. In some markets Inditex has seen some trading down from consumers from higher price points into Inditex stores, but in general there has been no significant change in consumer behaviour.

• The coming months will test the mettle of many companies as the full extent of the downturn unfolds. Balance sheet strength, a high margin cushion, a market-leading position, the ability to offer a differentiated product or service, pricing power, good cash flow generation, and management teams experienced in navigating through cycles and crises are hallmarks of the companies held in the portfolio. They are attributes which investors are increasingly likely to focus on in a fraught market and economic environment.