Blue Whale’s Stephen Yiu: why we are well positioned to recover 2022 losses

Stephen Yiu, manager of LF Blue Whale Growth Fund, has seen performance come off the boil in 2022, due to higher interest rates devaluing the future earnings of growth stocks. In this interview, Yiu explains why the fund is well positioned to win back losses made in 2022, the importance of active fund managers justifying their fees, and why he has sold out of the big US technology names – except Microsoft. Yiu also explains why the fund has less in technology shares than it appears.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio, I have with me Stephen Yiu, manager of the Blue Whale Growth Fund. Stephen, thank you for joining me today. So, Stephen, you aim to find the highest-quality businesses at an attractive price. So, how do you go about doing that in practice?

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Stephen Yiu, manager of the Blue Whale Growth Fund: The way we do it is we do all our research in-house. So, we don't use any outside research, we don't speak with outside analysts. And there are five of us on the investment team. And we just go through all the primary sources that we can get our hands on in terms of information from annual reports to transcripts, conferences, looking at competitors and trying to get a good feel about the quality of our businesses. And at the same time, after we've done all the research, we would translate our understanding of the business into a unique financial model. And that is when we then make forecasts in terms of how much money this company would make in the next couple of years, and then that's how we gauge whether the valuation of these companies would be attractive.

The other thing which probably differentiates us little bit is that we run a high conviction portfolio of about 25 or 35 stocks. On average it's about 25 stocks in the fund, and five of us doing that. So, if you just do it mathematically, we just ended up spending a lot more time looking at the company we have in the fund versus some other teams that might have less resource or that are covering more stocks.

Kyle Caldwell: Since the fund launched, which was just over five years ago, you've outperformed your average peer in the global fund sector, but the past year has been a more challenging year for performance. Could you explain why fund performance has come off the boil in 2022?

Stephen Yiu: This year's performance has been quite disappointing from our perspective. But to put it in context, I think that out of the five years that we've been running the fund, the first four years were very good and then this year has been very disappointing. Of course, if you marry the level of underperformance this year, then it has probably eaten away a lot of the outperformance that we generated in the first four years. But I would probably categorise this year as like an un-normal year because of the interest rate cycle going up quite quickly from the beginning of the year until today on the back of high inflation, on the back of the Ukraine crisis and all that stuff.

And I would see this year as similar to the pandemic year. That is probably not a repeatable year. So, unless you believe that the interest rate cycle is structural, not cyclical, which means that interest rates just forever keep going up, that is probably not a good place to invest in equities or any asset classes to start with. We don't believe that. We believe that the interest rate cycle is cyclical. So, at some point interest rates are going to stop going up.

At some point, if we do go into recession, the interest rate would start coming down. So, basically, what it means is if you look at the valuation of many companies, including the ones that we have got in the fund, of course, there's been a big reset in multiples this year because the interest rate has gone higher. So even using Microsoft Corp (NASDAQ:MSFT) as an example, Microsoft shares have gone down about 25% year-to-date. But the quality of Microsoft, and also its earnings growth trajectory in the coming years, is still very much intact.

So, we do believe that there's a good proportion of this 25% reset in share price this year they would be able to recover that in the next few years despite a high level of interest rates. So, I think what we hope people would do is if our investors can take a medium-term view, I think they are very well positioned from here that we should be able to recover quite a lot of the losses in the next coming years.

Kyle Caldwell: As you just mentioned, the fund performance in 2022, has had an impact on the longer-term numbers. And if you look at how the fund has fared versus the MSCI World Index over five years, both have returned a similar amount. So, are you confident on a 10-year view that you will outperform that index? And how would you try to convince an investor to back you as an active fund manager rather than just simply buying the global market through an index fund or ETF?

Stephen Yiu: First, we are committed to delivering significant outperformance versus the market. So, the MSCI World Index would be one of those and the IA Global Sector Average would be another one. And that is how we decided to set something up five years ago. And the way that we go about this is we do reckon now the market is very efficient and hence there's a lot more money going into passive trackers or ETFs in the last five to 10 years and, of course, that has continued recently as well in terms of that trend.

But what is really important is if we can run a high conviction portfolio being very focused, investing in 25 to 35 companies versus the MSCI World Index, which has about 1,500 companies. And if those 25-35 companies are better than the 1,500 combined, then the potential for outperformance would be a lot higher. But I think what you have seen this year from our perspective is the level of underperformance has equally been magnified because of the interest rate cycle in terms of the valuation reset. And when you're running a highly concentrated portfolio, when you're not doing well, you would be even worse off in a negative environment.

But I think if take a medium-term view, if you can get it right, if you have done enough research that proves to be right, and you can have a repeatable investment process that can continue to deliver alpha time and time again, then we should be able to do better than the market, because ultimately this is the question that active managers like ourselves need to be asking is whether we can do better than the passive tracker, because if the answer is no, if there's no way or no chance that we can ever do that, then we don't need to have active managers in in a market.

I think the last point I would make is, we are big backer of passive trackers, of course. I mean, we need to do better than them to justify our fees. But then I think that makes the market very competitive, and hence we do work very hard to try to deliver that.

Kyle Caldwell: In terms of the portfolio, one of the big changes in recent years is the fact that you no longer have exposure to the FAANG stocks, which are five of the most famous tech companies in the US. Could you explain why you sold out of those companies?

Stephen Yiu: Yes, so throughout the five-year history we have never invested in Netflix Inc (NASDAQ:NFLX), which we deem as quite a low-quality business, and I'm sure people would have seen that at the moment now, given the inflation narrative that consumer disposable income is being squeezed, and there's a lot of churn, [and] you might subscribe to Netflix for a few months and then go to HBO, Now TV or other places, for another few months. So, the recurring revenue stream is never that sticky. So, Netflix is something that we never consider.

But in terms of the stocks that we actually invested in throughout the last five years that would include the likes of Amazon.com Inc (NASDAQ:AMZN), Google [Alphabet Inc Class A (NASDAQ:GOOGL)] and Facebook (Meta Platforms Inc Class A (NASDAQ:META)). And they come in different shapes or forms in terms of the investment thesis. As far as Facebook is concerned, we exited that quite early this year. We have held that for about five years, 4.5 years until that point. But the thing with Facebook is a lot more company specific, they have seen increased competition from TikTok, which wasn't the case a few years back. And, if you recall, Donald Trump was trying to ban TikTok in the US. If that was successful, then Facebook would not have seen the competition that they have now been seeing because TikTok is quite a robust technology in terms of recommendation and teenagers, they do spend a lot of time on TikTok.

Second, on the back of the changes to iOS 14.5 by Apple, and also followed by Android system, that it makes Facebook more difficult to target audiences like before. So, it is more difficult for them to get our data now compared to a few years back. So, then it means that advertisers would be spending less money because the return on investment is a lot lower compared to before. Then, which we think is a deal-breaker for us, there is Mark Zuckerberg’s commitment to go into the metaverse. Personally, I am a believer in the metaverse, in time. It might take 10 years, it might take 20 years. It might even be longer for us to have this conversation in the metaverse. But a problem for Facebook or Meta to go about this is that it's not clear that all the money that they spend in this arena is going to be translated into profit, because you could expect at some point, or already maybe in the pipeline, that Google, Microsoft and Apple are working on some shape or form of a metaverse.

So, what if all this money that Zuckerberg spent in the metaverse ended up being one of the many players just like Netflix, that you have many other alternatives, then the return on invested capital profile for this investment would be a lot lower than if you are the dominant leader. At the moment it's not clear, so I think that is very specific.

We exited Amazon late last year in Q4 and then we chose a Google position early this year and exited just before the summer. And for these two companies it's more just about the macro headwinds, it’s about the inflation narrative. If you're looking at Amazon, e-commerce, then of course, I mean, we’re spending a lot less money now in terms of buying discretionary gadgets and goods just because our incomes are being squeezed. At the same time for Google it's just about digital advertising it's going through some sort of structural headwinds when we are in a recession or when people don't have money to spend. So, at some point, I think that will resolved. And, of course, if you look at the valuation of Amazon and Google, I think it's probably looking more attractive now compared to before. But I think we might still have at least a couple of quarters to go before we know how the dust will settle for these companies.

Microsoft is still in the top 10. So why are you bullish on its prospects, given that you’ve sold, you know, some of the other tech companies?

So, for the FAANGS in general, so including Microsoft, one thing that is another headwind for them is that over 50% of their revenue is overseas from the North America region. So, of course, on the back of a strong dollar and at the same time, Europe and Asia are not doing as well as the US, then you probably don't want to have too much exposure to this big tech company.

And Microsoft is one of those as well, it's a big tech company, it's the second-biggest company in the world. But I think the thing got us to continue to like Microsoft, is because its business model is a lot more sticky and high quality. So, if you compare the business model of Microsoft versus Google, one is done on digital advertising, which you can basically turn up and down in terms of your spend budget. So, let's say we were spending maybe £1,000 a day to target our audience, and given the macro environment, given that people are not buying new funds, that you could easily just turn it down to £100 a day. And of course, that would be a significant drop in revenue terms as far as Google is concerned.

But for Microsoft, they announced last year that they're going to raise prices by about 15% to 20% this year from April, in terms of subscription to Office 365. And as we all know, for professional workers like us, our life or our work is very dependent on Outlook, on PowerPoint, on Excel, and all that. And it’s just impossible for us to say no to Microsoft. Why don't we just consider an alternative? Maybe the Google G suite? I mean, no company would do that. And of course, at the same time, because the cost in itself is quite low.

So, we are still only talking about maybe $50 to $60 a month per head, which is not a lot compared to how much value the professional workers generate for the company. So, I think unless you think - which is obviously a possibility - that there is there going to be a massive round of redundancies in the professional services, let’s say, in Europe. Or at the same time, maybe some companies start to disappear, which basically [means] people lose their jobs who are Microsoft users, then they would get impacted. But for the time being, it's just because the business model is very sticky that they can continue to hold on to the business they're doing. Of course, they have other things working in their favour. So, when we look at the valuation of Microsoft and also the medium-term prospects, then we can still expect Microsoft to do quite well, irrespective of whether we go into a recession. But that's not the same case for Amazon and Google.

Kyle Caldwell: Just under half of the fund is in businesses that are classified as technology companies. Could you talk through some of the sub-sectors within technology that you invest in and name a couple of share examples?

Stephen Yiu: Yes, so I think the high-level categorisation of companies being grouped into technology, that's a bit unfair or misleading. The thing that people should always know is Mastercard Inc Class A (NYSE:MA), Visa Inc Class A (NYSE:V) and Intuit Inc (NASDAQ:INTU), which is a software company for QuickBooks and TurboTax Live in the US. They are considered [to be] technology companies, but for us they are considered financial services. Of course, MasterCard and Visa, as we all know, they are payment networks, [and] every time we make a payment, they would be making some money off us.

And so, of course on the back end it's powered by technology, it's not people filing the invoices, and making the payment itself is done by technology, but in fact it's actually a financial services company and the same for Intuit. So, I think for us, when we categorise many of the names that we have in the fund based on end-market-exposure, then we only have about a quarter of the fund in technology names.

So, the technology names that we have that we categorise as technology would be the likes of Microsoft, NVIDIA Corp (NASDAQ:NVDA), ASML Holding NV ADR (NASDAQ:ASML), which is a semiconductor company, but equally, we also have other software businesses like AVEVA Group (LSE:AVV), which is a leading software company for the pharmaceutical industry or the biotech industry. We have Autodesk (NASDAQ:ADSK), which is a software market leader for the construction and manufacturing industry.

So, we would probably want to categorise AVEVA as a healthcare company, rather than just technology, because the end market is healthcare and for Autodesk it's industrial because the end customers would be the likes of Balfour Beatty, or the housebuilders, architects, and some manufacturing facilities.

The last point I would make on this is just because a business model is much more high quality, because the software is subscription it's recurring then you would rather invest in this software company which services the end-market industry that are a bit more cyclical because the margin will be quite low for those sub-industry. But if you're the software company providing the backbone of how they operate, it actually makes them very high quality, so similar to Microsoft in a way that you want it to be the core of how the business is run.

Kyle Caldwell: Stephen, thank you for coming in. That's all we have time for, for today. You can check out the rest of our Insider Interviews on our YouTube channel, where you can like and subscribe. Hopefully see you next time.