2024 in Review

The Fund underperformed its benchmark during 2024, delivering investors a 13% return, 7 percentage points less than the MSCI World SMID Index. Since inception in 2018 the Fund has now delivered investors a 13% p.a. return and 3% p.a. outperformance which is in line with Fairlight’s long-term objective. From an operational perspective, the underlying portfolio companies collectively grew revenues by 2% and EPS by 5%. These metrics are below the Fund’s long-term average and reflect mainly a cyclical slowdown across industrial end-markets but also weak demand for IT infrastructure investment, particularly hardware, across small and mid-sized businesses and public organisations which affected several of the Fund’s holdings.

Measuring Our Performance

Given the Fairlight investment time horizon of 5+ years, we believe the table below provides investors with the best clarity into the long-term performance track record of the Fund.

Other metrics we believe provide insight into the decision making of the Fund are the Upside/Downside Capture, Hit Rate and the Win/Loss Ratio (for detailed discussion on these metrics please see 2020 in Review and 2019 in Review). 2024 was a below-average year for the hit rate, and was the first year that we’ve produced an upside capture number below 100%.

Spirax Group (stock profile) is a UK-headquartered manufacturing company with a history that stretches back to 1888. Today, the business has three main divisions: Steam Specialties, for the control and management of steam; Electric Thermal Solutions, for electrical process heating and temperature management solutions; and Watson-Marlow, for peristaltic pumps. Spirax has encountered two main issues during the year – general softness in the industrial market leading to weak demand for its steam solutions, and, secondly, a downturn in the biopharmaceutical market affecting demand for peristaltic pumps. We believe both these issues will prove to be cyclical rather than structural.

Bechtle provides IT services and resells hardware to small and mid-size businesses and public organisations such as councils, schools and hospitals mostly in Germany. Bechtle’s revenue growth has slowed down significantly in 2024 as small businesses have been delaying replacing their hardware due to the weak German economy. Historically, the public business has provided some growth support during periods of weak economic activity but this wasn’t the case in 2024 due to uncertainty around public funding. Pleasingly management has not cut costs aggressively to ensure Bechtle can support clients adequately when IT demand inevitably recovers. We expect EPS to decline 20% in 2024, to recover in 2025 and to resume growing at double-digit in 2026.

Bytes resells software to small and mid-size businesses and public organisation in the UK. Bytes’ gross profit and EPS grew 9% and 20% respectively over the six months to August despite a challenging economic backdrop. Despite these strong results, the share price ended the calendar year down 22% due to the news that the company’s major supplier, Microsoft, will lower the rebates it will pay to its channel partners for reselling licenses to mid-size corporations under Enterprise Agreements to almost zero. We believe that Bytes will recoup the lost profits by focusing more on Microsoft products, such as security and artificial intelligence, and alternative licensing structures, where the rebates available have been increased.

Of the three top contributors, all have been held for at least three years with the most recent addition being Lennox which was purchased in September 2021. This distribution points to two interesting insights: 1) quality companies tend to resist reversion to the mean and outperform for longer than expected and 2) patience is required to fully reap the benefits of a successful investment thesis.

Scout24 (stock profile) is the dominant online portal in the German real-estate classifieds market, having approximately a 65% market share. Scout’s goal is to create a complete digital marketplace that connects all three stakeholders in the value chain: (1) users (property buyers/tenants), (2) agents, and (3) homeowners (property sellers/lessors). Scout’s core customers are the real estate agents who can upload basic listings for free or upgrade the listings/access ancillary products for a membership fee. As the dominant player in a fast digitising market, Scout should be able to continue to add more value and monetise new parts of the value chain well beyond 2024.

Diploma (stock profile) is a collection of niche distributors operating in three areas: seals, controls, and life sciences. Diploma looks to sell products that are low-cost but essential to the ongoing operations of its clients. Diploma’s specialised distributors have historically been able to deliver aggregate annual growth of 5% on average outpacing the rate of growth of GDP. Diploma has then been able to grow double-digit thanks to a well-crafted acquisition strategy which allows it to add quality niche distributors to its existing stable at attractive valuations. This strategy continued to prove successful in 2024.

Lennox International is one of the leading manufacturers of premium heating, ventilation and air-conditioning (HVAC) systems to residential and commercial customers in the US. Lennox generates 80% of its sales from replacement demand, giving its revenues a degree of resilience. The HVAC installed base grows consistently each year and the industry has several long term tailwinds, including the need to replace ageing systems with more modern energy-efficient products. Unlike many of its competitors Lennox operates a direct distribution model, selling directly to the contractors who are responsible for installing and servicing Lennox products. This high-touch sales model results in strong customer retention and a long track record of consistent market share gains. All these quality characteristics came to the fore in 2024.

Portfolio Changes

Portfolio turnover in 2024 was 20%, the lowest figure recorded since the inception of the Fund.  As a result, the total cost paid in brokerage equated to only 0.01% of the Fund. Portfolio changes are generally driven by two factors: 1) valuation becoming unattractive or 2) identifying mistakes or thesis drift. Fairlight is of the view that once we have found a high-quality business which is compounding earnings it is best not to interrupt this process unnecessarily with high turnover. This approach has a secondary benefit of keeping transaction costs low and deferring taxes for our investors.

Pleasingly, the team were able to find six attractively priced businesses for purchase this year. Regarding sales, MonotaRO was successfully exited on valuation grounds, whereas Henry Schein and Nordson were sold completely due to thesis drift concerns.

The Fairlight View

As the Fund enters 2025 it has an operating margin of 28%, cash conversion of 98%, Net Debt/EBITDA of 0.7x and is trading on a valuation of 23x forward earnings (consistent with last year). Our estimates are for portfolio earnings growth of 13% in 2025, which is in line with the historical growth delivered by the Fund. As we reflect on the past 5 years, we note that we have witnessed a wide range of market emotions and conditions; from pessimism and despair at the beginning of the COVID pandemic and in 2022 to the extreme optimism and enthusiasm seen in 2021 and perhaps in 2024. Stocks, sectors, geographies and investing styles have all come into and out of favour. Throughout all this, the Fairlight strategy has remained unchanged: we believe share prices follow earnings and that over the long-term, a portfolio of the highest quality businesses, purchased with valuation discipline will outperform whilst protecting and preserving client capital.

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