Artisan Select Equity Fund Q3 2024 Commentary

Market Overview

Central banks took the spotlight this quarter. Perhaps the most anticipated Fed interest rate cut of the decade finally landed on September 19 with a 50bps adjustment. The Fed telegraphed further rate cuts to follow. However, as we now write in October, expectations for further aggressive rate cuts are wobbling with recent inflation and employment data implying a more cautious path.

While we don’t have any meaningful insight into how rates will evolve in the near term, we do observe many factors underpinning inflation that did not exist during the easy money days of the past 15 years: energy policy, climate policy, and massive and persistent government deficits, most notably. It is interesting that the Dow Jones Industrial Index significantly outperformed the NASDAQ Composite Index® this quarter, moving ahead by 8.7% versus 2.8%. Aren’t falling rates supposed to be good for expensive growth companies and not so good for boring, slow-growth industrial companies? It just goes to show that if you are trading the market, even if you are lucky enough to get a point-in-time prediction right, you still have to nail the second and third derivatives.

Interestingly, despite the conventional wisdom that inflation is all but vanquished, gold reached new highs, up 13% during the quarter.

Falling rates in the US did help foreign markets, at least in dollar terms. While international markets barely advanced in local currency terms (except China, see following paragraphs), they gained in dollars as the euro, yen and pound sterling strengthened. Falling rates in the US made dollars less attractive from a current yield perspective, and currency markets adjusted. It’s worth noting that these trends have partially reversed. The 10-year US Treasury yield is now back at 4.1%, after bottoming at 3.6% in mid-September, and the US dollar has started to strengthen again against most major currencies. Markets are always adjusting, and these movements illustrate how fraught it is to try to predict market movements at any point in time.

China reminded us this quarter that it’s the unanticipated that moves the market the most. While the world was watching and waiting for the Fed to do what everyone knew it was going to do, China’s government came forward with surprise actions to stimulate its struggling economy. It announced a slew of measures to lift an economy weighed down by the bursting of a large property bubble, the bad debt associated with it and a general lack of consumer and investor confidence. Geopolitical tensions and trade wars have not helped, either. The announced measures include lower rates, lower reserve requirements, cuts to rates on existing mortgages and smaller down payments for second homes. Interestingly, it also announced efforts to reinvigorate the corporate sector and the stock market. It wants to see more M&A and better financial returns for shareholders, including more dividends and buybacks, and stronger profitability. In short, it wants stocks to go up.

The challenges China faces are significant. In the immediate term, the country is facing the aftermath of a property bubble. Property peaked at about 30% of GDP in China, compared to around 15% in the US. We all know how much damage the bursting of the property bubble in the US caused in 2008. China is starting, unfortunately, on a much larger scale. In addition, housing remains extremely expensive relative to income in China even after recent price declines, and the homeownership rate is already more than 90%. There simply has been too much housing built in China and not enough buyers in need of a primary residence. Property is the main investment for most Chinese households. Stock market investing is not widespread. This trend goes back decades. Housing used to be provided by the state. When housing was privatized, citizens bought houses at very low prices and subsequently accumulated tremendous wealth as housing values exploded with privatization and economic growth. People did well with property and put all of their financial eggs into that basket, so to speak. The market responded by providing lots of new houses. But how many households want three or four when they already have one or two?

How to clear this inventory overhang is a major question facing China. Should it destroy older homes and incentivize people to move into the excess inventory of new homes? Should it change the rules to allow foreign residents to buy property? We know from other large-scale property bubbles that time is of the essence. The longer it takes to clear excess inventory and bad debt, the more painful the aftermath and the harder the recovery. Just look at Japan. It still has not recovered from its 1990s property bubble. And China shares some other important similarities with Japan: a shrinking population, lack of immigration and a moribund corporate sector.

This comparison explains in no small part why the Chinese government is focused on developing a more dynamic capital market infrastructure. For one, if Chinese companies create value for their shareholders, there will be an attractive alternative to property for savers. Stock market wealth creation could offset to some degree the wealth destruction from the property market. It could also help reverse the massive exodus of foreign capital out of China, which has hit the stock market as well as direct investment flows. A thriving capital market is, of course, necessary to finance and develop a thriving technology sector in the age of artificial intelligence. This is a national security issue for China.

Will these efforts be successful? The stock market is certainly encouraged. China was the best performing global market by far this quarter, up almost 24%. However, valuations in China had gotten so depressed that even after this move, they remain among the cheapest in the world. In our view, the rise in stock prices reflects a reduction in the Chinese risk premium, rather than great confidence that the economy is going to roar back. It also likely reflects investor support for the government’s new pro-shareholder policies. Post rally, China trades at about 11X earnings, less than half the US market multiple and below European benchmarks as well.

We don’t believe the announced measures will be enough to clear the property log jam.

Portfolio Discussion

Our largest contributor to return this quarter was Alibaba (BABA)(OTCPK:BABAF), up 47%. Nothing much happened here except investors piled into China on the stimulus news. The company reported results in August, but the stock sold off a bit in response. Revenue grew a little; profits grew a little. What we liked in the results was the acceleration in gross merchandise value sold through its main platforms, Taobao and Tmall. It is trading current margins for greater user engagement and growth, and we think this is the right strategy. Its cloud business also accelerated. It also continued to buy back stock, which we believe to be very value accretive at current valuations. Even after the recent move, the stock trades on a single-digit earnings multiple net of its significant cash and investments.

Progressive’s shares rose 22% during the quarter and are up 60% year- to-date. The business continues to perform exceptionally well. The growth rate of its overall customer base is in the teens, and its direct auto business is growing at a high-teens pace. Underwriting profitability is excellent, with the combined ratio tracking well below 90. In addition to solid underwriting profitability, the interest rate environment has boosted investment income by 50% compared to last year. All parts of its business are firing on all cylinders. While Progressive has many underlying secular advantages, it’s important to keep in mind that it still operates in the cyclical world of insurance. We view its customer base growth as structural and likely to be sustained. However, the underwriting is currently at above-normal levels and should not be capitalized. After making these adjustments, we believe its shares are roughly fair valued but with underlying growth that is still above our hurdle rates.

American Express’ (AXP) shares rose just under 18% and are up 46% year-to- date. The company continued to perform strongly, reporting high- single-digit revenue growth and double-digit earnings growth. The payments industry is attractive. Particularly beneficial is the shift away from cash and checks toward electronic forms of payment. Amex also benefits from inflation as it charges a percentage fee on the dollar volume that flows through its network. In addition, the company has been quite successful in gaining ground with younger, affluent cardholders who are now a powerful growth engine.

Our worst performer was Samsung (OTCPK:SSNLF), followed by Lam Research (LRCX) and Schwab (SCHW).

Samsung’s shares were down 20% during the quarter. The company recently preannounced disappointing Q3 results, with adjusted profits roughly the same as the prior quarter. The primary issue at Samsung is its memory semiconductor business, where it has been late to develop a type of high-end memory, called HBM3e, used in AI servers. These technology issues have prevented it from being qualified as a vendor to NVIDIA, which means it has not fully participated in the fastest growing part of the memory market. As a result, it has been more exposed to the lower end of the memory market, where the demand and pricing are less favorable.

These issues should be temporary. While it’s an understatement to say we are disappointed by the company losing technology leadership in parts of its core memory business, we are confident in its ability to regain its position. Samsung remains the largest player in the memory semiconductor space and has a long history of technology leadership. In addition, it’s important to internalize that other companies in the AI value chain are incentivized to help Samsung be successful. The industry needs Samsung’s production capacity to meet the growing demand for AI computing infrastructure. It’s no exaggeration to say that Samsung’s issues have prevented NVIDIA from selling more chips. This alignment of interests should result in Samsung receiving final qualification from NVIDIA in the coming quarters, which will go a long way to lifting investor pessimism. Samsung’s shares are attractively valued and are trading at around 1X book value, which is at the low end of its historical valuation range. Any positive news should prompt a rerating.

Lam Research’s shares declined 23% during the quarter. The shares had rallied strongly on expectations of a recovery in semiconductor capital spending, as well as enthusiasm for AI and the impact it may eventually have on semiconductor demand. Optimism on both fronts eased during the quarter, and the shares gave up recent gains. We believe that a recovery in semiconductor capital equipment demand is inevitable, though the timing is impossible to predict. We also believe that AI and other technological advancements will drive strong semiconductor demand well into the future.

Schwab’s share price declined 12% during the quarter. There was no meaningful news. The current operating results are still depressed by cash sorting, temporary high-cost funding and M&A integration. The underlying asset-gathering machine, which is the key driver of business value, continues to perform well. As the headwinds we just mentioned mechanically fall away over the next three to four quarters, the underlying earnings power should become more visible and drive significant profit growth.

We added Snap-on (SNA) to the portfolio this quarter. SNA is a unique and powerful business. It designs, manufactures and sells tools that are used in critical applications. Its largest business is selling tools through its franchised van network to auto mechanics. The distribution on one end and the customer on the other bookend the unique economic model. Van owners are entrepreneurs and control a defined geographic area. They call upon auto mechanics working inside their area to sell them unique tools designed to make auto mechanics’ jobs easier and more profitable. Mechanics tend to get paid by the job, and any tool that makes them more efficient and productive results in higher earnings for the mechanic. SNA stays close to mechanics through the van network, which helps it continually develop new and improved tools for what is an increasingly complex and variable car park comprised of internal combustion cars, electric vehicles and hybrids. The evolving and aging car park is positive for long-term auto repair demand. Older cars need more repairs. More complex cars require an ever-evolving assortment of new tools. There is also a shortage of skilled mechanics in the country, which underpins the earnings power of auto mechanics.

SNA also sells tools and equipment directly to auto dealerships, as well as to other critical industries that require high specification and uniquely tailored tools, such as the military and aviation.

SNA’s financial characteristics are fantastic. It consistently generates an operating margin of around 20% and a ROE in the high teens to twenties. Despite having a finance operation that provides capital to the van network, SNA operates with an unlevered balance sheet. Earnings have slowed over the past several quarters after a strong performance post-COVID. However, we are not concerned by this lull in demand and expect the company will revert to its trend of steady revenue and earnings growth. We believe we paid about 14X earnings for this powerful franchise.

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