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Dear Investors and Friends,
The NZS Growth Equity strategy (“strategy” or “portfolio”) had a gross return of -0.58% and a net return of -0.75% for the third quarter as compared to +1.62% for the Morningstar Global Target Market Exposure Index (the “Index”) over the same period. Year-to-date, the strategy has generated a gross return of +13.36% and a net return of +12.78%, versus +12.80% for the Index.
Performance Overview
The third quarter market dynamics were a marked reversal from Q2, with software sharply rebounding after its underperformance in the first half of the year, and AI-related stocks largely experiencing weakness and lagging the benchmark. The optionality tail of the portfolio outperformed in the quarter, helped by a greater mix of software, while the resilient portion of the portfolio lagged with more AI mix. In aggregate, the strategy underperformed in the quarter, but we are generally pleased with performance amid the volatility year-to-date.
In the quarter, Information Technology and Healthcare contributed the most to absolute returns. Within Information Technology, strength in software more than offset weakness in semiconductors. Atlassian (TEAM), Workday (WDAY), Snowflake (SNOW), and Shopify (SHOP) were among the top -five individual contributors to the strategy, with strong sector performance driven by the market’s reassessment of the implications of AI (more on software below). Outside of software, Repligen (RGEN), which reported building momentum in demand for its bioprocessing equipment and consumables products, rounded out the top-five contributors in the quarter.
The Industrials and Materials sectors were the largest detractors from absolute returns, partially reflecting interest rate expectations and weakness in AI-related industrials. At the security level, the cool-down in AI weighed most acutely on our investments within the semiconductor ecosystem, including Lam Research (LRCX), Cadence (CDNS), BE Semiconductor (BESIY), and ASML Holding (ASML), which were all top-five detractors in the quarter. HEICO (HEI), which provides aftermarket parts for commercial airlines, was also among the top detractors, partially due to the rise in oil prices pressuring future air passenger traffic expectations.
Portfolio Positioning
We added to software in the quarter, responding to early datapoints indicating that, rather than the dystopian scenario the market had become fixated on, a more optimistic scenario may be playing out – i.e., select software businesses may ultimately leverage AI within their products and expand their TAM. Broadly across our software holdings, we’ve noted that fundamentals have thus far run counter to the bearish narrative that took hold earlier this year. The majority of our software investments have actually seen material acceleration to organic growth in 2026 compared to the same time period a year ago, while gross margins have overall been stable and operating leverage has been strong. Atlassian is perhaps the best example of this phenomenon, which explains its strong performance in the quarter. Against the narrative that the company (which sells seat-based software for software developers and other white-collar workers) was highly vulnerable to disruption/displacement by AI, Atlassian has delivered results that show accelerated topline growth, significant margin expansion, and early success in monetizing AI agents interacting with its platform. The range of outcomes for a business like Atlassian still remains relatively wide (particularly regarding seats); thus, when the position ran into the middle of the portfolio, we trimmed the position back into optionality and reallocated the basis points to other positions in software. We added Okta (OKTA) back to the strategy this quarter (after exiting our position in 2023 due to slowing growth) with the view that agents, like humans, are likely to require governance and authorization, in which case Okta’s fundamentals could prove asymmetric to that version of the future. Shortly after reinvesting in the stock, we increased the position further after the company reported acceleration in bookings growth. Similarly, we restarted an optionality position in ServiceNow (NOW) and added to a few of our other existing software positions.
We also continued to adjust the portfolio’s positioning within the AI ecosystem as the opportunity set evolved. We added to our positions in NVIDIA (NVDA), Quanta Services (PWR), Cadence, Lumentum (LITE), Lam Research, ARM Holdings (ARM), and Marvell (MRVL). We also introduced a new position in Bloom Energy, whose fuel cell technology is well suited for a role in generating behind-the-meter power for datacenter developers. We remain optimistic about the outlook for AI adoption and the infrastructure buildout to enable it; thus, our overall exposure to AI was increased on a net basis amid the pullback.
Elsewhere in the portfolio, we started new optionality positions in Charles Schwab (SCHW), Hims & Hers Health (HIMS), and nLIGHT (LASR). We exited Ingersoll Rand, Uber (UBER), and CoStar Group (CSGP). The results of our trading decisions in the quarter (excluding relative performance impacts) were net additions to Information Technology, Healthcare, and Financials and net reductions to Communication Services, Industrials, and Real Estate. We exited the
quarter with our largest overweight to IT in several years as the opportunity set remains robust across both the AI supply chain and in software. The portfolio remains modest ly overweight Healthcare and Industrials.
“Reappearing Edges”A continuation of Brad Slingerlend’s 2023 SITALWEEK post, “Vanishing Edges”
One of the most frequently asked questions in investing is: “What’s your edge? ” As the market becomes increasingly passive, and index returns power law into a concentrated, difficult-to-beat bogey, the question is more relevant than ever. Our quest to answer this same question nearly 15 years ago led to the creation of our Complexity Investing philosophy. In brief, we sourced our “edge” by building two portfolios – a resilient head and an optionality tail – in one, each populated with adaptable companies striving to create non-zero-sum outcomes. We have found this strategy uniquely optimal for investing in an unpredictable world rife with extreme events, power laws, and emergent phenomena. Over the years, we have also reflected on the historical sources of edge and how they have evolved over the last few decades. In the late 1990s, when I started as an investor, there were opportunities to connect the dots on publicly available information before it was widely known, given the relatively slower pace of information dissemination. Often, this information could be combined and analyzed to create a mosaic of insight. Further, this informational-analytical edge could also be expressed with a behavioral advantage at the portfolio level.
The informational/analytical/behavioral edge framework originated with investor Bill Miller, and I dove into more detail on why these sources of edge seemed increasingly ephemeral in 2023 in Vanishing Edges. I ruminated that the Internet and its democratization of information had all but eliminated informational advantages, i.e., effectively, everybody knew everything at the same time. Further, as tools advanced and investors became more sophisticated, analytical advantages became scarce. Lastly, behavioral advantages have evolved significantly with the advent of AI: in the past, even with equal access to the same information and analytical tools, an investor could still possess a behavioral advantage with respect to timing and position sizing. This behavioral advantage, I posited, has shrunk now that active, human investors are no longer the correcting force for short-term inconsistencies in the stock market. Rather, intertwined armies of AI agents, LLM-driven quant strategies, and levered retail investors are all sweeping up and down the stock market, driving volatility without much regard to the concept of the net present value of future cash flows. At times, we wondered whether Benjamin Graham’s proverbial “weighing machine” had lost the fight to the “voting machine”, and that, perhaps, AI’s perception of a company/sector could dictate reality. At the same time, we also saw the potential for the driving forces behind this new, chaotic market reality to create a window for active stock pickers to opportunistically benefit.
Over the last year, as AI’s influence on market dynamics has increased (and we suspect even the remaining active, fundamental investors may also be under the influence of AI), a new source of edge has opened up. We have seen several recent examples where the market forces appear to have lost their collective memory (e.g., see the comments above on software in Portfolio Positioning). Stocks are overreacting (both positively and negatively) to some news while failing to react to other key points of data. While we might call this opportunity a resurgence an informational-analytical edge, I believe it requires a broader framing. It’s an understanding of what matters and what doesn’t that seems to be eluding the market lately. As such, we call this emerging advantage a “contextual edge”. Of course, the market drivers’ misreads are isolated incidents, and this edge might be transitory while we wait for AI to gain enough intelligence to have contextual awareness. The majority of the short-term market forces appear to be driven by AI, and AI appears to be heavily influencing the narrative that controls retail – and perhaps even active – investors. Therefore, owning the market today, i.e., passively investing in market indices, appears to me to be akin to handing your money over to an AI that lacks the context necessary to post superior long-term returns. Thus, we find ourselves in strangely familiar territory: it’s as if we have traveled back to the 20th century of stock picking. How long this leg of the journey lasts remains to be determined.
Conclusion
Thank you to our investors for your continued trust, support, and insights. Interacting with our partners is a valuable part of our process. Please reach out to Alexandra Pope (alexandra@nzscapital. com) if you would like to connect and, as always, we appreciate any questions, comments, or ideas.
The NZS Team
Original Post
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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