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Quarterly Market Commentary
The calendar often marks what are somewhat arbitrary posts along an investor’s journey and the year just gone as a case in point. The fourth quarter of 2023 saw a sharp equity rally, as the market moved to resoundingly price in peak interest rates and sharper future cuts, reversing the “higher for longer” third quarter sell off. Taking a step back markets rarely move in straight lines and the process of finding peak rates, following the second sharpest tightening cycle on record, was always going to be a choppy one. The starting point also mattered as the stock market bottomed in October 2022, setting up 2023 naturally well after the preceding bear market. It is hard to remember but back then most commentators expected a recession in H2 2023 which never materialized. All these factors helped the markets and the final quarter’s backdrop was very positive for Tema’s funds and all of them put in a strong performance.
This period also saw the launch of the Tema Obesity & Cardiometabolic ETF (HRTS), Managed by veteran life sciences portfolio manager David Song, MD, PhD, CFA. HRTS builds on the obesity drug revolution by investing in the recent burst of innovation addressing cardiovascular disease, the number one cause of death globally1. Such innovation is attractively priced by the market after a torrid downcycle in the life sciences sector. This downcycle, the worst on record, is starting to show signs of ending, punctuated by a strong rally this past quarter, which, if history repeats, could have a long way to run.
2024 Outlook Guiding Principles
As we look out to 2024, we thought it would be helpful to provide a few guiding principles, not predictions, of how we see things unfolding. These are grounded in what we are seeing bottom-up from analyzing and speaking to the companies we invest in, and somewhat contrast the market’s general consensus:
True Pricing Power to Shine Through – In 2022 most companies had an easy time raising prices as cost were often rising more rapidly. From the second half of 2023 onwards costs finally started to subside, creating a meaningful tailwind for margins. This dynamic was described by most analysts as pricing power. We think that as cost declines accelerate only firms with true pricing power will be able to hang on to or even raise prices further – a distinction that will be increasingly rewarded in 2024.
A Recession After All – Calling recessions is a fool’s errand, especially for long-term bottom-up investors. In recent years, however, it has been helpful to assess how the economic outlook stacks up against consensus views. Here we see risks in the second half of 2024 against a market that is strongly assuming a soft-landing. The tightening cycle will finally hit economic growth with its long and varied lags. Economic weakness is unlikely to be sharp, as there are simply not as many excesses as we have seen ahead of previous downturns. Regardless, markets move to price in recessions six months before they start suggesting a volatile year ahead.
Scarcity of Growth – In the face of a year of likely disappointing economic growth, investors will be left looking for other sources of growth. Here stocks exposed to megatrends become more valuable and I recommend reading our latest trend report to get a glimpse of areas we see as most promising. Reshoring for example could, as many management teams have highlighted, offset cyclical weakness in both sales growth and margins even in the most economically sensitive companies. Indeed, announced activity throughout 2023, including the exponential rise in manufacturing construction, will start to benefit firms in 2024 and beyond.
Need Diversification – It is no secret that the market in 2023 became a lot more concentrated. As we close out the year, seven stocks account for 30% of the total US market cap. Investors who think they own a diversified exposure are actually taking individual company risk in a group valued at 31x forward earnings. Diversification should serve investors well in 2024. This can be achieved for example from idiosyncratic return sources like biotech where scientific and clinical risks are uncorrelated to general market returns.
HRTS Obesity & Cardiometabolic ETF: Had a very strong partial quarter.
HRTS Obesity & Cardiometabolic: Had a very strong partial quarter.
HRTS had a very strong partial quarter.
Out of the gate a top contributor to the fund was Cytokinetics which first saw bid rumors before announcing positive phase III data for lead compound. Aficamten is a drug for the treatment of obstructive hypertrophic cardiomyopathy – an illness where parts of the heart muscle become too thick. This disorder is relatively common and is a significant cause of death among young people including well trained athletes. The data was a near home run with comparable safety to Bristol-Myers’ mavacamten (a $500m drug) and efficacy better than the market expected. This is a great example of the type of innovation the fund is investing in and why we see the cardiovascular and metabolic segment as more attractive than healthcare in general.
The year ended with two negative developments in the weight loss drug arena with the failure of Pfizer’s candidate (not owned in the fund) and poor early safety data from Structure Therapeutics (a small position in the fund and a key detractor). What these failures highlight is how difficult it is to develop a weight loss therapeutic, likely cementing the duopoly forming between Eli Lilly and Novo Nordisk. This is not to mention the large barriers to entry from conducting outcomes trials such as SELECT, which recruited 17,000 patients and took five years to complete1. Regardless, obesity therapeutics continues to attract considerable interest with Roche buying privately held phase II stage Carmot Therapeutics for $2.7bn.
For a full list of holdings, please visit the HRTS fund page.
TOLL Monopolies and Oligopolies ETF: Had a very strong quarter, building on a strong year
A lot of the monopolistic themes we identified at inception of the fund started to bear fruit. Often these involved second order thinking. A great example is the AI revolution. The market, quick to jump on hype, drove up the prices of first order AI beneficiaries such as Nvidia and AI companies. Often in investing it is important to identify second order effects. Our analysis suggested the long-term winners are likely to be owners of high quality, broad/deep and trusted data such as information services business. Companies like Moody’s, Reed Elsevier, Intuit, S&P Global have monopolies over unique data sets. As AI revolutionizes compute, making it cheaper and even more ubiquitous, the relative value of datasets should rise. We are seeing evidence of this already, especially as these firms start to roll out AI offerings. Several of these names were top contributors during the year.
We also believe scarcity will arise in physical semiconductor chips but prefer to play this through semiconductor tools, a monopolistic industry. This leaves us agnostic to who the actual designer of semiconductors will be (Nvidia, AMD or internal efforts by Meta, Microsoft and Google). It also exposes us to a trend of AI servers having 2-3x times more silicon content that itself is more complex, especially for CPUs and memory.
Detractors since inception were almost exclusively smaller positions, where we correctly took an initial more conservative view. An example was Knorr Bremse. We were attracted to this monopoly provider of rail and truck braking systems in part by the turnaround under a new CEO with a plan to shed non-core unprofitable business lines. The shares struggled despite multiple positive catalysts playing out. With those exhausted we felt capital was better deployed in monopolies that were due to make fundamental progress. This is a good example of competition for capital in our portfolios for the best opportunities.
For a full list of holdings, please visit the TOLL fund page.
LUX Luxury ETF: Had a strong quarter closing out a weaker inception year
Looking back at 2023 some of the top contributors was not owning certain luxury companies – a sign of prudent risk management. Estee Lauder continued to warn on profits as our work with local Chinese experts identified severe underinvestment in this vital luxury beauty market. Kering struggled as management change and other restructuring will take a considerable time to have an impact on what is essentially a monobrand company. Diageo, surfed the big rise in wholesale inventory that boosted sales post pandemic, but that is now leading to profit warnings as destocking is starting to crimp sales and profits.
A key detractor since inception was Farfetch. We initially got excited by the turnaround potential especially in light of the soon to close deal with YNAP. This would have created a unique luxury ecommerce leader.These types of turnarounds are difficult to execute in general but the toughening luxury environment made us reassess and sell the position. Though painful at the time we managed to save the fund from further losses as Farfetch essentially went under.
During the quarter the fund started to carefully deploy the cash it raised during the summer to weather further weakness in end markets. We have seen expectations and valuations adjust and continue to find opportunities to deploy cash. We have been adding to luxury spirits companies, for example Remy, which now trades at a market cap below the value of its assets plus its ageing stock of eau-de-vie, which would take multiple decades to reproduce. We have also bought new ideas, like beauty company L’Occitane which trades on just 8x EV/EBITDA2 and owns a collection of brands including the breakout hit Sol de Janeiro, a brand searched nearly one million times globally last month.
1Source: bloomberg. 2EV/EBITDA: The EV/EBITDA Multiple compares the total value of a company’s operations (EV) relative to its earnings before interest, taxes, depreciation, and amortization (EBITDA). In practice, the EV/EBITDA multiple is often used in relative valuation (i.e. “comps analysis”) to compare different companies in the same or an adjacent sector.
For a full list of holdings, please visit the LUX fund page.
CANC Oncology ETF: Strong first full quarter
CANC had a very strong first full quarter. Biotechnology stocks finally staged a rally into year end, narrowly rescuing the year from being a third down year in a row and possibly marking the end of the biotech bear market. There is a long way to go.
The rally was spurred by multiple idiosyncratic drivers. One was M&A. The fund benefited from transactions such as Bristol Myer’s acquisition of Mirati for $5.6bn (a 52% premium) and Abbvie’s acquisition of Immunogen for $10bn (95% premium)1, both some of the top contributors. Interestingly these transactions both relate to two of the top five key technology areas to watch in oncology that we identified.
In terms of detractors, since inception Ilumina shares struggled given volatility around restructuring plans of the newly appointed CEO, a not uncommon process we have seen in other turnarounds. We also had a few poor data read outs at Argenx and an IP lawsuit loss at Curevac. Although we continue to be constructive on the two former names, seeing these value hits as temporary, we exited the position in Curevac as this loss trumped any pipeline-based catalysts.
Looking forward, we continue to see M&A as an important driver as biotech buyers, especially large cap pharma, and sellers are finally meeting on valuation. We estimate that they have $838bn of dry powder which represents 70% of the entire S&P Biotechnology Select Industry Index market cap2. The need is pressing as nearly $350bn of revenue is at risk from patent expiry in the next five years and smaller biotech’s are a key source of innovation3.
1Company announcements. 2Source: Bloomberg, Evaluate Pharma Aug 2022. Dry powder defined as total Cash and Cash Equivalents on the top 20 large cap pharma company balance sheets as of 31/12/2022 plus total Free Cash Flow generation over the next three years as forecast by consensus on Bloomberg. The S&P Biotechnology Select Industry Index comprises stocks in the S&P Total Market Index that are classified in the GICS Biotechnology sub-industry. 3Source: Bioworld June 2023, Evaluate Pharma Aug 2022. Encompasses entire pharmaceutical industry, not just oncology. Timelines are estimates based on key patent expirations or patent settlement agreements, and the life of a brand can be lengthened or shortened unexpectedly due to various factors. Forecasts are inherently limited and should not be relied upon when making investment decisions. There is no guarantee projected growth will occur. In addition, there is no guarantee it will translate to positive fund performance.
For a full list of holdings, please visit the CANC fund page.
RSHO American Reshoring ETF: Strong quarter, topping out an outstanding inception year
RSHO had a very strong quarter, topping out an outstanding inception year. Since inception every single stock contributed to this performance with strength in both bellwethers, like Eaton Corp, and under-the- radar companies like Federal Signal.
A top contributor to the fund was ATI Inc (formerly known as Allegheny Technologies). The firm is a great example of how reshoring is transforming not only the titanium industry but also the company itself. Prior to 2020, 87% of the world’s titanium sponge (the primary material that is melted and fabricated into titanium aerospace parts) was controlled by China, Japan and Russia1. Multiple disruptions meant not only loss of 30% of supply but a blow out of lead times from a few weeks to 50-70 weeks. Seeing this bottleneck, ATI responded by announcing an expansion of its onshore aerospace and defense-grade titanium fabrication by approximately 45% by 20252. Simultaneously this will enable the firm to move further downstream into components (they target 65% of group up from 41% today) which means higher margins (19-21% from a previous 18-20%).
The driving forces of reshoring showed no signs of abating. The Panama Canal, responsible for 40% of US container traffic3, remained under continued drought. Attacks in the Red Sea, which accounts for 12% of global trade4, forced hundreds of ships to take routes last used in the 18th century adding weeks to transit times. Shipping costs are once again spiking. Even nearshoring suffered as the US was forced several times to close freight lines from Mexico. These continued global disruptions are making the calculus of reshoring to the US easier for companies.
1USGS (2022). 2ATI Q3 2023 earnings call. 3Bloomberg. 4Suez Canal, Financial Times Q4 2023.
For a full list of holdings, please visit the RSHO fund page.
ROYA Global Royalties ETF: Solid quarter benefiting from two major calls
ROYA had a solid quarter. The fund benefited from two major calls. The first is to have more exposure to gold royalties than to oil royalties, despite the oil price being a consensus long in the summer of 2023. Since then gold outperformed oil, especially as markets moved to price in peak rates. Indeed, oil royalties, like Permian Basin Trust and Texas Pacific Land have been a key detractor since inception. Gold royalties contributed positively. During the quarter Chris sat down with the team at Royal Gold, to discuss the industry and the firm's business model.
The second was having non-commodity related royalties which were big positive contributors. Tech was a bright spot. InterDigital's revenue and earnings grew strongly in 2023 fueled by strong uptake of its core video compression technology patents portfolio (>28,000 patents and growing1) across internet of things (IoT), auto, smartphone and consumer electronics and this was further supported by good cost control and a large buyback. Qualcomm exceeded 2023 investor expectations on the back of strong uptake of its new Snapdragon chip set designs architecture by its core mobile phone customers but more importantly by a growing number of auto manufacturers.
We see non-commodity holdings as a key differentiator for the fund. Most recently we topped up this part by adding a new position in McDonald’s, that earns most of its revenue from franchise royalties. The company sold off on worries about weight loss drugs offering a compelling entry point. We think they are poised to reaccelerate growth from new location growth, and increased initiatives such as digital after a period of restaurant refurbishment.
1Interdigital Q4 2023 Investor Presentation.
For a full list of holdings, please visit the ROYA fund page.
