Artisan Focus Fund Q1 2024 Commentary

“There are windows of time where opportunities emerge. You must capitalize on these opportunities when that window presents itself.”

-Jason Robins

During the quarter, we hosted Jason Robins, CEO and co-founder of DraftKings (DKNG), as a guest in our Peak Insights series. Throughout this series, we have held in-depth conversations with business leaders with ties to companies relevant to our portfolio. During this discussion, Jason remarked about specific windows of time where opportunities arise that play into the strengths of his organization and amplify its competitive advantages. He emphasized how critical it is to be ready and able to capitalize on those windows of time.

The first quarter of 2024 was such a window for us at the Antero Peak Group. This was driven by a sharp recoupling of stocks to their respective fundamentals. This played into our wheelhouse, rewarding earnings and fundamental differentiation, which have been the backbone of our process over the last seven years. We were in a position to capitalize on this as a direct result of process discipline throughout a perplexing 2023.

Performance Review

The Artisan Focus Fund (Investor Class) gained 15.86% in Q1, exceeding the S&P 500® Index by 5.30%. We are off to an excellent start in 2024, particularly compared to the challenges that Q1, or January, has brought in recent years.

Our performance in Q1 can be directly tied to strong fundamental research execution. Our portfolio has seen positive earnings revisions of 5% year-to-date, far exceeding the S&P 500® Index, where estimates have remained flat. The contribution to our portfolio was also much more diversified than the benchmark, with high alpha positions across insurance, health care and industrials, as well as tech and artificial intelligence-related themes. This compares to the benchmark that, once again, was dominated by tech. This relative result is noteworthy in the context of overall risk levels. We achieved our return with an average beta of 0.97 and a slugging ratio of 5.7X. On a factor basis, our risk model kept us in a very mild range.

What Changed?

As we have previously discussed at length, 2023 was an unusual year for the S&P 500® Index. In fact, it was the only year in the last 15 in which companies that revised earnings higher, on average, did not outperform the S&P 500® Index. This dynamic was most pronounced within the Magnificent Seven (M7), where large upward moves in both Apple (AAPL) and Tesla (TSLA), despite negative earnings revisions, amounted to roughly 400bps of negative alpha for us given our lack of exposure to these stocks. In contrast, thus far in 2024, the market has distinguished performance around earnings in a much more normalized way (i.e., companies that revised higher in 2023 struggled versus the index, and that is now reversing). Notably, this occurred even within the M7.

As you all know, our process is centered around earnings differentiation, and the reversal of this trend in 2024 has had a positive impact on our performance.

As the primary drivers of performance normalize, we expect our process to continue to generate ongoing opportunities for relative alpha.

The Active-Passive Pendulum

In last quarter’s letter specifically, we wrote about the exceptional performance of the S&P 500® Index in 2023. Just 28% of constituents outperformed the index, and the index had the highest slugging rate in history-in 2023, S&P 500® Index winners gained 12X the amount the losers lost. This narrow construction and high slugging rate represented a rare pair of three standard deviation events. In other words, the market itself was a near perfectly optimized portfolio, and breadth was exceptionally low. Beating the market in 2023 amounted to locating the proverbial “needle in a haystack” while demanding aggressive sizing among those needles.

Historically, there is a notably tight relationship with the performance of active large-cap managers and overall market breadth. That is, as breadth rises, active managers do much better. So unsurprisingly, 2023 was a bad year for the industry.

Yet, at a starting point with current breadth so low (25-year lows to be exact), history tells us that the coming years could be much better for active management as conditions normalize. The last time breadth hit current levels (just before the end of the tech bubble in 2001), just 13% of active large-cap funds from the Morningstar Large Blend Category were able to outperform the S&P 500® Index. However, the three years that followed were the best for active large blend funds in the last 30 years, with approximately 62% of these managers outperforming the index, including periods where nearly 80% of these funds outperformed. Today, just 15% of active large blend funds are outperforming the index, and we believe it seems likely to sharply improve going forward.

While 2023 was very unusual in magnitude, it was not unusual in basic construction. Over long periods of time, the S&P 500® Index will naturally display a positively skewed distribution. This means that each year, while breadth is usually much wider, it is very common for a large portion of the returns to be attributed to just a handful of stocks.

In mathematical terms, this means that the median stock in the S&P 500® Index usually underperforms the average stock. In a long-term study by Dow Jones over a 20-year period beginning in 1997, the median stock compounded at just 2% annually. This is a massive difference compared to the average stock, which compounded at 6%. This occurs for two simple reasons. First, the downside of a stock is capped at -100%, while the upside of a stock is theoretically limitless. This is a structural characteristic of the stock market and one that does not exist in a normally distributed statistical set of data. Second, this occurs due to the compounding nature of returns over time, amplified by accelerating gains from scaled companies, often in winner-take-all markets. This positive skew over time is what makes beating the market so hard-the job of picking a portfolio that consistently includes the best stocks is a formidable one.

Thus, to beat the market consistently, it requires an empirically based understanding of what works. This is why we focus on inflection points, accelerating fundamental trends that lead to earnings differentiation and ROIC expansion. These are empirically proven characteristics of outperforming stocks. In addition, it requires a concentrated portfolio, high idea velocity and the flexibility to make changes (which is also known as turnover and often viewed poorly despite its need). To achieve this, there must be repeatable processes in place and tools to directly compare the merits of ideas across sectors to identify the best areas. These are the very things we believe we have material competitive advantages in, and we have built our group around this over the last seven years. If you would like a better understanding of the tools we utilize to maximize objectivity and consistently move capital to our best ideas, we are always happy to walk through our infrastructure and/or share our insights.

Current View of the Revision Cycle

By the looks of the market, it is somewhat illogical to point out that we are now two years into a negative earnings revisions cycle. Since 1990, there have been five negative revision earning cycles which, on average, lasted 16 months. Suffice it to say, the current cycle is clearly maturing, and estimates appear to be finding a floor for now.

With that said, real risks remain to earnings estimates. Consensus still expects a sharp ramp in earnings growth as we move through this year. The ramp itself looks quite challenging on its face, particularly in Q4.

The picture is further complicated by historically high margins facing ongoing inflationary pressures yet bottoming leading economic indicators like the global Purchasing Managers’ Index. These moving variables again cause us to emphasize looking at the world through a bottom-up lens. We are currently finding opportunities across the spectrum of pro-cyclical and defensive areas and will continue to make decisions on a process-driven basis. This wide-ranging and emerging opportunity set of different investments serves as a signal to the cloudiness of the overall economic direction and the importance of focusing on bottom-up research.

Investment Updates

During the quarter, we benefited from our positions within auto insurance. In the post-pandemic cycle, insurance pricing growth reached 50-year highs as the costs of repairs skyrocketed due to a combination of inflation, part availability and labor shortages. This sparked the hardest market in modern history. Over the last year, the insurance sector broadly has seen the largest upward revisions of any non-tech subsector in the S&P 500® Index.

Progressive’s core estimates have risen 40% in the last three months, and expectations for growth have risen from the high single digits to mid-teens, the highest at any point in history. Allstate’s core estimates have risen 20%, as auto margins moved from negative to positive. Across both companies, the impact of pricing was severely mismodeled by consensus during 2023 and Q1 2024. Our differentiation upon initiating the positions reached 50% and 25% for Progressive and Allstate, respectively.

Our Aerospace theme, which we have held for several years, remains a key driver of positive alpha. Events within the group continue to elongate the cycle, which heavily benefits our aftermarket and engine positions across General Electric (GE), TransDigm (TDG) and Safran (OTCPK:SAFRF)(OTCPK:SAFRY). As original equipment manufacturers struggle to ramp production in the face of supply chain challenges, and in Boeing’s (BA) case engineering and quality control issues, end-demand continues to march ever higher. The industry is simply undersupplied with narrowbody aircraft. These aircraft are the workhorses of passenger travel, and there are only two models: the Boeing 737 and the Airbus A320. This shortage is causing the existing fleet to work harder and deeper into its normal service life, necessitating higher service levels, and ultimately upward revisions in these positions.

Notably, General Electric’s transformation from an opaque, complex conglomerate across energy, housing, financials, health care, aviation and power hit its final milestone in the quarter with the exit of Vernova, its wind power business. What remains at GE, we believe, is one of the best industrial assets in the world, where we continue to see both earnings and valuation upside.

We are also identifying a collection of opportunities in areas that historically focused on growth at all costs and are now revealing substantial profitability in unit economics. It’s a familiar formula-as new markets develop there is typically a surplus of cheap capital available for new entrants, a race for market share and a total indifference for profitability. Over time, however, near insurmountable moats are established and scale and brand recognition begin to create accelerating gains for the winners. Ultimately markets mature, competitive landscapes fall away, and the businesses become very profitable at the unit economics level. Examples of this include social media, Internet search, streaming video, mobile phones and countless software applications.

In our portfolio, we own several names where we believe we are at the inflection point of this curve. As an example, we see a phase of massive profitability expansion at DraftKings, with EBITDA shifting from an annual loss today to an estimated +$2 billion profit by 2026, well ahead of consensus as the duopoly in sports betting solidifies. Spotify is experiencing a similar dynamic. As the world’s most popular audio streaming subscription service with a community of 602 million monthly active users, focus is now shifting toward the economics of the model, which we think is severely underappreciated.

Summary

As we look to the remainder of 2024 and beyond, we feel good about the existing portfolio. Of equal importance, we feel confident in our execution and ability to find a steady flow of new, compelling ideas. Our thematic opportunity set is expanding, and with that, we are seeing accelerated idea velocity internally. We have stiff competition for capital within the team, which is always a strong indication.

We thank you for your ongoing trust with your capital. We will never stop our efforts to improve and will work tirelessly toward providing you with the best risk-adjusted outcomes.

Lastly, the team reads to further develop perspectives. This quarter, we have ordered the following books to enjoy: “The Scout Mindset,” “The Righteous Mind,” “The Hard Things About Hard Things” and “The Boys in the Boat.” An extended list can be viewed here.

Click to enlarge

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.