I’ve neglected the blog since my last quarterly review back near the beginning of April. I’ve had rather a lot on my plate with work and family and haven’t had the time or mental bandwidth to get my thoughts down on paper. This has unfortunately coincided with the unpleasant but fascinating carnage unfolding in economies around the world and in the stock market. This has left my portfolio battered and bloody at the half-way point this year. I should have a bit more free time over the coming months to resume writing here. First I have a bit of catching up to do on my recent trades.

Concerns about inflation have continued to wreak havoc on the markets as the Fed has toughened its rhetoric about doing whatever it takes to get it under control. More recently attention has been turning to the prospect of a nasty impending recession as high prices and economic uncertainty shatters consumer and business confidence. This ‘bad news’ could turn out to be good news for growth stocks if it relieves pressure on central bankers to continue hiking interest rates. However, this is far from certain. It seems more likely to me that the bad news will turn out to be just that, if the recession we are heading towards is bad enough and tightening monetary policy makes it worse, while potentially also failing to control inflation. The economic outlook in Europe is rather worse than in the US, making the prospects of sustained interest rate rises seem less likely and providing the fuel for a rocketing Dollar, which looks set to cause serious problems for emerging economies with dollar-denominated debt.

Given this backdrop, there is a lot of talk at the moment about whether we are at the bottom or whether there are more falls to come. I’m ambivalent. While I’m still pretty bearish about the overall macro outlook, it feels like we could currently be near an inflection point, with the bond market showing signs of bottoming and some growth stocks starting to bounce. Growth stocks have had quite a pounding and valuations have come down a lot, though there is still scope for them to get a cheaper before they are at bargain-basement levels. I’m optimistic that monetary policy isn’t going to get much further with tightening before it becomes apparent that recession is more of a concern than inflation, though I don’t have a lot of conviction in this view. On the plus side at the moment investor sentiment seems very pessimistic, which means it probably wouldn’t take much to set everything off on an upwards trajectory again.

Since fairly early on this year I decided that to increase my allocation to cash and this has proved sensible (though it feels like a case of ’too little, too late’ in hindsight). The size of my cash balance has gradually grown over the last quarter and at the moment it is quite high at around 25%. I don’t want to let it get much higher and am looking to reinvest some of it when decent opportunities come along.

I have traded quite actively over the last quarter in an attempt to limit my losses and best position myself for the eventual rebound. Generally speaking I’ve been trying to move away from more cyclically exposed to more defensive investments. I have also been looking for cases where the valuation just seems too low or where the share price has performed more strongly and the stock appears more likely to have ’bottomed’. I sold the following:

• Adobe: I sold my holding in Adobe back in mid April for a small profit. The previous results had been lacklustre and the prospects of it rebounding quickly seemed remote.
• Shopify: after prematurely patting myself on the back for my purchase of Shopify just before it rebounded 40%, I ended up with a slap in the face. I got cold feet after Amazon’s profit warning and sold out for a small loss.
• Somero: this was my largest position near the beginning of the year but I had been slowly offloading it as an imminent recession seemed more and more likely. I finally ditched the remainder in May, nailing down a decent overall profit. Despite the superficially cheap valuation the risk that profits here will take a big hit is too high.
• Autotrader: I sold my holding in mid-May for a small loss as the price broke downwards. Autotrader is a pretty resilient business but I don’t think the prospects for the used car market seem very positive right now.
• Adyen: I sold for a fairly significant loss in early June (though my holding was relatively small). The business still seems to be doing well but the valuation looks high and Adyen’s fortunes are tied to retail/e-commerce transaction volumes where prospects don’t look so hot right now. Much as I like the business, the share price has been relatively weak and I figured it could probably fall a lot further. I don’t seem to have much luck with Adyen and have lost money on it a few times now. Need to be more careful next time.
• Diploma: I sold Diploma in mid-June for a loss. The business seems to be performing well and the valuation had come down a lot but the share price was performing relatively weakly and I preferred to swap it for something that was showing more promising signs of rebounding.
• Finally, I recently also sold my gold-related positions. I hadn’t anticipated the strength of the Dollar and the significance of this for the gold price and decided to cut my losses quickly and hold more cash instead.

To replace these I bought Judges Scientific, FICO, Xpel, Sartorius, Veeva Systems, Gamma Communications and JD Sports. I’ve held Judges, Gamma and JD previously so won’t write them up again. Judges and Gamma seem reasonably valued and defensive, JD is rather more exposed to a slowing economy but nevertheless seems too cheap.

Sartorius Stedim Biotech

Sartorius is a European business worth around £26bn. Stedim Biotech is the main subsidiary of Sartorius AG but is directly listed. Sartorius supplies bioprocess equipment and related services – essentially many of the complex ‘picks and shovels’ required to produce pharmaceuticals as efficiently as possible. Some of its main products are bioreactors – Needless to say, the production of pharmaceuticals is incredibly complex with exacting standards required, so there is a lot of value to be added in optimising the processes involved. Most of Sartorius’s revenue comes from high-specification single-use products, such as bioreactors, and consequently a lot of Sartorius’s revenues are recurring.

Sartorius has an explicitly acquisitive strategy, whereby it aims to regularly make bolt-on acquisitions of businesses that own technologies that are complementary to its existing portfolio (providing opportunities to integrate technologies and to cross-sell). I’m a big fan of this sort of buy-and-build model, especially when it is backed up by an excellent track record.

Quality

• Business economics: Sartorius is highly profitable, with both operating margins and returns on capital of around 30%. It has been making substantial capital investments in recent years to increase its production capacity and support its international expansion, suggesting that its ’steady-state’ latent profitability is even higher.
• Track record: Sartorius has an excellent track record. Sartorius AG has been around for over 150 years, though the Sartorius Stedim biotech business was created after a merger with Stedim fairly recently in 2007. The performance of this business in recent years has been excellent with very consistent growth in profits and revenues.
• Competitive advantage: Sartorius does face some competition, though this is fairly limited. The main point is that there are very high entry barriers from regulation and technological complexity. As one of main established players Sartorius is an active voice in regulation and standard setting. It also has strong customer relationships and reputation. This means there is very limited competition from smaller players and Sartorius largely competes in an oligopoly with a small number of large mainly US-based players, such as Merck, Danaher and Thermo Fisher. Competition from these players is also limited. Many of Sartorius’s products are used in validated processes so customers only switch supplier when introducing a new product. This means that losing (or gaining) market share takes time. Over the longer term innovation is key and it is critical for Sartorius to have an excellent understanding of its customers demands and the ability to develop, acquire and rapidly integrate new technologies.
• Growth prospects: one of the main draws is that Sartorius operates in a defensive secular growth market with lots of well-documented long term drivers. Sartorius is a big business but still seems to have plenty of scope to get bigger, particularly through expansion in the US and Asia.

Price

I bought my position in Sartorius after the share price had fallen substantially along with many other growth stocks. While momentum in the share price has faltered, the business has been performing very strongly. It has been a major beneficiary of pandemic-related drug development and this has created some uncertainty over its medium term trajectory as things ’go back to normal’, though the outlook is positive. The valuation has come down a lot from the highs. While not obviously cheap, it seems reasonable given the quality of the business.

Veeva Systems

Veeva supplies cloud-based software to help its customers develop products efficiently, bring them to market and manage customer relationships. Veeva belongs to the cohort of high-flying software-as-a-service (SaaS) businesses, though is somewhat more mature and profitable than many of these peers. It is also another ‘picks and shovels’ business for the life sciences industry, with a market cap of £27bn, similar to Sartorius. With recession looming and expectations for interest rate hikes baked in, it seems like a good time to be investing in this sector.

Quality

• Business economics: Veeva is a profitable business that makes little in the way of capital expenditure but, similar to some other IT businesses, expenses a lot of its software development as a cost. It has high and increasing operating margins of around 25% and decent returns on capital of around 17%. It is extremely cash generative with free cash flows consistently well in excess of profits.
• Track record: Veeva is a young company, founded in 2007, by a Salesforce executive who believed that the future of CRM cloud software lay in specialising to serve specific industries. This vision has been executed very well and Veeva has performed excellently, delivering very rapid growth in revenues since it launched and also reaching profitability very quickly for a SaaS business.
• Competitive advantage: Veeva’s competitive advantage looks pretty solid. Switching costs for customers are likely to be very high given the mission-critical nature of the service and its complexity. Veeva is a clear market leader in a specialised niche with little in the way of direct competitors. The main one is Iqvia, which is primarily a contract research organisation and data supplier rather than a CRM supplier. Veeva and Iqvia are embroiled in a long running legal battle stemming from allegations that Iqvia has been abusing its ‘monopoly’ over data by denying access to Veeva products (and Iqvia in turn accusing Veeva of stealing some of its data). I went down a bit of a rabbit hole looking into this but couldn’t really find much to suggest that this is a material threat to Veeva. I think that the main concern in the long run is that Veeva is the sort of business could be vulnerable to more wholesale technological shift, ie a rival coming up with an entirely new way of doing things. However, I can find little reason to believe this is on horizon.
• Growth prospects: Veeva’s growth prospects are promising. Revenue, having grown rapidly for the past few years is now decelerating as Veeva rounds the bend of the s-curve. However, there is still plenty of scope for further growth. Veeva had the advantage of operating in a steadily growing defensive market and has plenty of opportunities to launch new products, as it has been consistently doing for the past few years.

Price

In a dismal wider market for growth stocks Veeva’s momentum is relatively good. The share price has been performing relatively strongly for the last month or so. The last results were strong. I think this sort of business should do well in the current environment. However, while the valuation has come down a lot from the highs, it is still quite demanding. This makes me cautious about adding to my holding too much too quickly.

FICO

Formerly known as Fair Isaac, FICO is a US business worth around £9bn. There are two main parts to the business: its consumer credit scores, which are nearly universally relied on by consumers, banks, insurers and other lenders as the standard measure of consumer credit risk in the US and related analytic software it provides to businesses.

Quality

• Business economics: FICO is capital-light and super-profitable with operating margins above 40% and returns on capital above 50%.
• Track record: Fair Isaac has been around since the fifties but the FICO Scores were created in 1989 and became a standard measure of US consumer credit risk since the mortgage giants Fannie Mae and Freddie Mac required their use by primary lenders in the nineties. Since then the Scores became widely adopted and it has more or less been plain sailing for FICO (though obviously the Financial Crisis was a significant blip!). In recent years FICO has been able to grow its revenues and profits very consistently.
• Competitive advantage: FICO’s competitive advantage stems from its access to data and proprietary algorithms which have been refined over time. Its competitive position has been assured since its Scores became the de facto regulatory standard. This has granted FICO very strong pricing power that enables it to effectively determine its own growth rate eg it talks about how it can adjust pricing levers to compensate for a weaker overall market. The main risk it currently faces is the possibility that lender choice of alternative scoring models is approved by the US mortgage giants. Allowing this competition is currently being considered by the FHFA (the regulator that oversees Fannie Mae and Freddie Mac) so there is some risk here to FICO. However, this would not be an easy decision for the FHFA to make as allowing cheaper inferior scores it could introduce instability to the mortgage approval process (and wider economy) and would be expensive to adopt. Even if competition is allowed, I don’t think this is an existential threat to FICO. I think it is likely that the end-state would be a duopoly in which FICO would still have the better product and a significant degree of pricing power.
• Growth prospects: FICO is not the fastest growing business but looks to have good potential to continue to compound its profits for some time. There are opportunities for it to expand its software business.

Price

Momentum is relatively decent. After performing less strongly in 2020 and 2021, likely due to the possible FHFA decision (and possibly due to overblown fears of AI-based competition from the likes of Upstart) FICO has performed relatively strongly over the past few months, though this isn’t saying a great deal.

It also looks to be very reasonably valued given its profitability. In contrast to Sartorius and Veeva, which are more expensive looking in a more defensive sector, FICO is cheaper-looking in a somewhat more cyclical sector and arguably faces greater competitive risks.

Xpel

Xpel is a relatively smaller (just over £1bn market cap) business that makes paint protection film for cars, protecting the paintwork from roadside debris and ’self-healing’ after scratches. Xpel is a US business but has recently been rapidly expanding internationally. Xpel distributes primarily though independent dealerships but also uses distributors for certain geographies.

Quality

• Business economics: Xpel is very profitable with 15% operating margins and returns on capital consistently above 30%. Its free cash flow generation has been held up in recent years as it has been investing heavily in international expansion and ’bolt-on’ acquisitions.
• Track record: Xpel was founded in 1997. More recently it shifted focus from the software used to design protective film to selling the film and paint products themselves. It has done incredibly well in recent years with very rapid growth in revenues and profits. The share price has risen around 10 times in the last two years as the business has expanded internationally.
• Competitive advantage: I see this as the weak point in the buy case. Xpel has some competitive advantage from its technology. It has integrated the protective film itself with its software (which enables it to be designed and cut effectively) as complete package to dealerships, which differentiates it from competing products. This gives Xpel a bit of an edge but it doesn’t seem like an insurmountable moat. The other threat Xpel may face in the long term is if automotive manufacturers decide to develop and incorporate similar technology into new cars.
• Growth prospects: the growth potential is the main draw. Xpel has been growing very rapidly and has lots of runway to continue. There is a lot of scope for its products to become more widely adopted, for further international expansion, and for its products to be used in other applications. It has recently made small bolt-on acquisitions to establish itself in supplying film for car windows, homes and bicycles.

Price

The business has been performing very strongly, consistently beating expectations, while the share price has slumped along with other growth stocks, though has started to recover relatively well over the past month or so. Xpel isn’t the kind of business that would be immune to a recession but even accounting for this the valuation seems too cheap, given how quickly it is growing.