January 13, 2022
2022 was a difficult year for the Fund, delivering investors a -24% return, lagging the MSCI World SMID Index by 11 percentage points. This disappointing performance was largely driven by three factors:
1) The rapid increase in interest rates required to quell rampant inflation resulted in a sharp derating of stocks where much of their value is derived from long-dated future cash flows. Fairlight’s quality focused investment philosophy results in a portfolio of businesses with long growth runways which were not immune from this derating. While a contraction in the multiple that the market is willing to assign to company earnings is painful in the short term, it is our belief that over the long term it is the compounding of earnings that will ultimately define the majority of investor returns.
2) Fairlight does not own businesses in the Utilities, Energy or Mining sectors given our view that over the long term these businesses tend to not sustainably earn high returns on capital. These sectors, which together comprise 13% of our benchmark, were one of the few asset classes to deliver positive returns in 2022 after energy prices spiked following Russia’s invasion of Ukraine. Our decision to not invest in large swathes of the market comes with the risk of relative underperformance as sectors fall in and out of favour, however we view taking this risk as necessary to deliver superior long-term results.
3) Our return was impeded by several stock specific mistakes made by the Investment Team, which we discuss in more detail below. Errors are an expected part of the investment process, and our focus is on fostering a culture where errors can be identified quickly and the capital reinvested into more prospective ideas.
Measuring Our Performance
Given the Fairlight investment time horizon of 5+ years, we believe the below table provides investors with the best clarity into the long-term performance track record of the Fund.
Other metrics we believe provide insight into the decision making of the Fund are the Upside/Downside Capture, Hit Rate and the Win/Loss Ratio (for detailed discussion on these metrics please see 2020 in Review and 2019 in Review).
Contributors and Detractors to Return
Given the disappointing performance delivered in 2022, we have included a more extensive discussion of the Top 5 Detractors below.
Temenos is the leading provider of core banking software in Europe. Fairlight first invested in the business in October 2020 after its stock sold off on concerns around declining license sales, which management suggested was due to a lengthened sales cycle resulting from the COVID pandemic. Nevertheless, the business had many quality characteristics including a long track record of double-digit earnings growth and what looked to be incredibly durable revenues derived from software maintenance payments. As time progressed the business continued to miss management’s revenue growth targets and costs increased unexpectedly. In October 2022 the company delivered a large profit downgrade as European banks paused decisions on purchasing software, coinciding with a sharp increase in staff turnover that pointed towards broader issues with the organizational culture and management. Where Fairlight identifies investment thesis drift or deteriorating business quality our response is to promptly sell the position and refocus on more prospective ideas. The Temenos position has been sold entirely.
Techtronic Industries (stock profile) is the manufacturer of Ryobi and Milwaukee branded power tools. The business has been held in the Fund since inception in 2018 and has been one of the largest contributors to portfolio returns. The business had a particularly successful COVID period with earnings growing 30% in 2020 and 37% in 2021 as the DIY market boomed. During 2022 the stock experienced a sharp derating from almost 30x earnings to 17x today as the market became increasingly concerned about its exposure to housing/construction related end markets and the degree of pull forward demand experienced in 2020/2021. We continue to be impressed by management’s investment in market share gains over the long term, especially when compared to their competitors who remain myopically focused on short-term quarterly results. Techtronic remains an important investment in the Fund.
Domino’s Pizza, the master franchisor of the American brand in the UK, was first purchased in the Fund in 2019 after the stock was sold off on concerns around deteriorating franchisee relationships, increased competition from delivery aggregators (Uber Eats etc) and poor performance from its international divisions. Under a new management team, the business made progress in resetting the franchisee relationships and divesting the underperforming International divisions. The business faced several setbacks in 2022, including the unexpected departure of its promising CEO (who was offered a compelling position at a FTSE100 company), and margin compression from inflation which we believe to be a timing issue in passing on cost to its franchisee base. The business continues to take share and a resolved franchisee dispute should see a return to growth in store numbers. The position is still held in the Fund.
Auto Trader (stock profile) is the UK’s dominant online used car marketplace and has been held in the Fund since inception in 2018. The operating performance of the core classifieds business has been excellent, with the recent result delivering the strongest revenue and profit growth numbers since the business listed in 2016. This was not enough for the business to escape the wider derating in quality assets, with the multiple compressing from 27x at the start of the year to 18x today. The market may also be concerned about widening losses in the recently acquired car leasing aggregator website (Autorama), which was a 4% headwind to EBIT in the recent result. Our initial reaction to the acquisition announcement was one of concern, given the high price paid, loss making nature of the business and management’s limited experience in integrating acquisitions. While the initial disappointment from this acquisition is frustrating, we don’t believe it is terminal to the long term investment thesis given >95% of the value is derived from the core classifieds business. The position is still held in the Fund.
Morningstar (stock profile) has been held in the Fund since 2019 and was one of the largest contributors to portfolio returns in 2021. That said, 2022 has been a more difficult year for the investment as the multiple derated from 35x to 24x today driven by the broader sell off in growth assets and the underlying business underperforming our expectations on margins. The margin compression was primarily driven by management’s decision to invest heavily behind the rapidly growing Pitchbook segment. While this has meant the business has missed our earnings estimates in the near term, we believe this decision is maximizing the long-term value of the business and hence the position is still held.
Without dwelling on the contributors, it is worth discussing Gartner (stock profile), which is now the largest investment in the Fund. Gartner, which provides research and consulting services to IT executives of large corporations, enjoys an almost unassailable competitive position (it is 10x the size of its nearest competitor) in a structurally growing niche. This dominant competitive position comes with a business model that delivers resilient subscription revenues that are paid up front, resulting in incredibly strong cash conversion. Management have proven themselves astute capital allocators, opportunistically repurchasing shares aggressively. After growing earnings an impressive 93% in 2021, the business is on track to deliver a resilient 9% earnings growth outcome in 2022. We believe the valuation remains attractive for the quality and growth prospects for the business and it remains a large holding in the Fund.
In 2022 Fairlight exited 14 positions and initiated 9 new investments. Of the 14 divestments 5 were where we identified thesis drift or mistakes, 7 were on valuation grounds and 2 were a result on the management teams making large, unexpected acquisitions. Of the 9 new investments, 3 had been held historically by the Fund and had been sold purely on valuation grounds. Total turnover was 39%, in line with our expectations, resulting in the total cost paid in brokerage for portfolio changes equating to 0.02% of the Fund.
The Fairlight View
While share price returns for the portfolio in 2022 were disappointing, the underlying operating performance of our investee companies was resilient and in line with our long-term expectations for the earnings growth of the portfolio. On an aggregate basis, the portfolio is on track to grow revenues 13% and EPS 13% in 2022. As we enter 2023 the portfolio today has an operating margin of 25%, cash conversion of 103% and Net Debt/EBITDA of 0.9x.
In terms of valuation, the P/E multiple has compressed from 28x at the beginning of the year to 20x today, one of the lowest levels observed since the inception of the Fund. The earnings growth delivered by the Fund is encouraging as we strongly believe that over the long term the prices of quality businesses will inevitably follow their growth in earnings. Despite a difficult year, our strategy remains unchanged, believing that a portfolio of the highest quality businesses, purchased with valuation discipline will outperform over the long term whilst protecting and preserving client capital.