Owning a Collection of High-Quality Businesses in a Continued Strong Economy

Would you please discuss the key market drivers in 2023?

Four elements drove the strong market performance in 2023, particularly toward the end of the year: 

1.    The impact of falling inflation on businesses’ earnings. The core Personal Consumption Expenditures Index (PCE) fell from 4.9% at the end of December 2022 to 2.9% by the end of 2023. Although PCE remains higher than the Federal Reserve’s 2% target, the last six months have also averaged just 2%, which is right in line with the Fed’s target.
2.    The decline in long-term interest rates. 10-year Treasury yields fell from roughly 5% in October 2023 to approximately 4% in December 2023.
3.    The strength of the economy. In 2023, U.S. GDP was a strong 2.5%, even though consensus was more in the 2% range. In addition, 2.7 million jobs were added throughout the year.
4.    Potential rate cuts by the Federal Reserve. The fed funds futures expect 6 quarter-point decreases over the course of 2024.

We were surprised by the lack of market breadth. In 2023, the “Magnificent Seven” average return was 110% versus the S&P 500’s total return of 26.3%. These seven stocks accounted for about a quarter of the Index’s weighting at year end, which suggests that the other S&P 500 holdings averaged a high-single digit return for the year.

Given the concentration of stock returns, how has your watchlist changed?

Our watchlist of about 75 names is a collection of businesses our research has identified as competitively advantaged businesses with compelling reinvestment opportunities, strong management, and low tail risk. In general, these businesses are not in the portfolio because we do not believe their shares currently offer a strong risk-adjusted return. We may have lingering questions about a business or its management and therefore would like to continue to observe the company. 

One pattern we’ve observed in the watchlist over the past year has been the addition of more vertical market software companies. As a generalization, these businesses are attractive because they are asset light, have wide economic moats, and have pricing power. A number of these software companies are early in penetrating their total addressable market but already possess dominant market share and high switching costs. In most cases, these businesses trade at high valuations that already discount aggressive growth for an extended period of time. Occasionally, we find an exception as we did with the Fund’s newest position, Altus Group. 

Would you please share your investment thesis for Altus Group?  

Altus Group is a provider of commercial real estate services and software. The business has two segments—Commercial Real Estate Consulting and Analytics. The Commercial Real Estate Consulting segment, which is the original Altus business, provides property tax appeals on behalf of property owners. This is a very high margin business and generates a high level of free cash flow. In its home market of Canada, Altus has a 60% market share within this business line. In the UK it is the largest player with over 20% market share, and in the U.S., it’s one of the largest providers.

The second and largest business segment, Analytics, has two businesses: ARGUS Enterprise, which models and values commercial real estate properties, and Valuation Management Services (VMS), which provides valuation management software and data to institutional commercial real estate fund managers.

Collectively, we view Altus as an owner of high-quality commercial real estate-focused businesses that can grow consolidated revenue at a 6-7% annual rate and EBITDA closer to 9-11% annually as a result of material margin expansion from the Analytics segment.

Combined with the 6% free cash flow yield and sustained leverage, we believe Altus can grow free cash flow per share at a mid-to-high teens rate over the next decade. Given the distress in the commercial real estate market over the past several months, we believe the stock was significantly discounted, providing an attractive entry to invest. 

What are the earnings growth rates and valuations for the Fund vs. the Russell 3000® Index as of the end of 2023? 

As of the end of 2023, the Fund offered investors a lower valuation with a higher expected growth rate versus the Index. The Fund’s expected growth rate in 2024 was 18.3% and the Fund was trading at a price-to-earnings multiple of 18.8x. By comparison, the Russell 3000® Index has earnings growth expectations of 12.5% with a multiple of 19.6x.

Would you provide your market outlook going forward? 

Because the Fund’s holdings are predominantly a collection of what we believe to be high-quality, secular growth businesses trading at reasonable valuations, we continue to have a positive long-term outlook. Our expectation is that, on average, the Fund will own these businesses for five years or longer. Over this long-term time horizon, we expect the Fund’s returns will be determined primarily by the growth and earnings power of these businesses. Our expectation is for mid-teens earnings growth for the portfolio over a five-year horizon. 

Over the next year, we do not expect a recession in the U.S. Instead, we believe it’s more likely that economic growth remains strong. Economic growth should result from loosening monetary policy and fiscal stimulus. Wage growth remains strong and inflation is now running near the Fed’s target when you exclude food and energy. Both of these factors should result in consumers feeling better about their financial situation. In fact, consumer confidence has increased for three straight months and is at its highest level since December 2021. We would expect anticipated rate cuts to stimulate demand for some big ticket purchases that have been depressed over the past few years. In conclusion, we believe the year is shaping up quite well. 

Index performance is not indicative of fund performance. To obtain fund performance click fund name below.