1. How do we do what we do?

    EMERGING MARKET INVESTING

    Tim Campbell and Andrew Keiller. Second Quarter 2018.
    THIS PAPER IS INTENDED SOLELY FOR THE USE OF PROFESSIONAL INVESTORS AND UK INTERMEDIARIES AND SHOULD NOT BE RELIED UPON BY ANY OTHER PERSON. IT IS NOT INTENDED FOR USE BY RETAIL CLIENTS.
  2. All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk.

  3. Last year we wrote a paper entitled ‘Why Do We Do What We Do’, which explored our growth philosophy in more detail, providing evidence to support our long-term, active approach. On reflection, we probably stopped short. The ‘why’, is of course important. Indeed, personalities like Simon Sinek, have made a career out of this single notion. However, some questions lead on from here. How do we go about implementing our philosophy in practice? How do we translate this ‘why’ into a portfolio that stands the best chance possible of delivering excess returns for our clients?
  4. To recap, our analysis showed the striking correlation between superior long-term earnings growth and stock price returns for the Emerging Markets (EM) universe.


    Median Absolute 5 Year Return by 5 Year Earnings Per Share Growth Quintile

    Source: Baillie Gifford & Co, Factset, Worldscope and relevant underlying index provider(s).
    MSCI Emerging Market and FTSE Emerging Market Indices constituents as of the end of December of each year between 1997 and 2017 and with a market capitalisation larger than time-adjusted USD1bn. Earnings growth rates are based on previous fiscal year data, all in USD.


    Hence why our investment process is singularly focused on identifying those companies that can grow much faster than the market over prolonged periods of time. But distilling this process into something that fits neatly into a diagram is a challenge. By its nature, much of our process relies on the interplay of data, experience, educated creativity and probability. This does not lend itself to a matrix or a flowchart.

    But, we do have a very clear view of the inefficiencies we are aiming to exploit.

  5. In Search of Fat Tails

    Our investment criteria dictates that any company put into client portfolios should be one where we can envisage at least a two-times total return in hard currency terms over five years. This doesn’t mean 15% per annum growth in a straight line, but we do look for it to come from underlying earnings growth rather than simply a re-rating of the shares. The cruel truth, however, is that only 37% of stocks in our universe meet this criteria (based on a 20-year sample size of rolling five-year periods from 1997 to 2017). In fact, 32% fail to generate a positive return at all. Our criteria is highly ambitious. 


    EM Stocks – Range of Rolling 5-Year Returns Per Annum
    EM Stocks in MSCI EM Index or FTSE EM Index

    Data from December 1997 – December 2017 in US dollars. This graph covers a 20-year period, split into rolling five-year periods rebalanced at the end of every year. It shows the proportion of EM stock observations that delivered five-year share price growth in each of the four different quantums. For instance, 68% of the stock observations grew positively and 37% exhibited growth of more than 15% per annum over five-year periods. Source: Factset and relevant underlying index providers. As at 31 December 2017.

    Going further, it is evident that only a small selection of companies contribute to EM returns over meaningful time periods. Over the 10 years to December 2017, for instance, there were 1,549 stocks in the MSCI EM index. Just three out of these 1,549 stocks made up 100% of the total return in US dollars. While many of the others were positive, in aggregate, the other 1,546 simply netted off to zero. Clearly, finding the strongest performers requires us to be ambitious and demand a lot from the companies in which we invest.

    How do we do this? We look for fat tails. Or to put this another way, we look to exploit the market’s consistent refusal to accept the possibility of extreme outcomes. Consider the following chart which compares the average sell-side forecasts on earnings growth to the reality.

    Looking at three-year forecasts1, we immediately see that the majority of sell-side broker research predicts 0–20% p.a. growth from companies in EM (grey bars). The reality (blue bars), is far more widely spread. We present this chart not as a dig at forecasting skill, as we would be the first to admit that forecasting precisely is impossible. It does, however, show a few interesting things. To begin with, the inherent bias in the sell-side means negative estimates are very uncommon compared to actuality (only 11% of the forecasts predicted negative earnings versus the reality of 38%). More importantly, there are a number of companies delivering very strong growth, as shown by the blue bars at the right hand side of this chart.


    EM Stocks – Range of EPS 3-Year Compound Annual Growth Rate (CAGR)
    EM Stocks in MSCI EM Index or FTSE EM Index

    Data from December 1997 – December 2017 in US dollars. Source: Factset and Thomson Reuters EIKON. As at 31 December 2017. The chart shows the range of 3-year earnings-per-share growth (per annum) delivered by EM stocks over the last 20 years (blue bars) with the 3-year earnings-per-share broker predictions (grey bars) at 31 December 2017. 

    These are the fat tails that we are targeting and it has proved to be a rich hunting ground, not least because the market consistently underestimates the likelihood of such growth occurring. 

    1. Ideally we’d have used five-year forecasts but unfortunately these are too far out for most sell-side analysts.

  6. Time and again we see examples of where the market refuses to recognise the likelihood of rapid growth. It may be that this growth is lumpy, or represents a step change from a company’s recent history or simply flies in the face of the law of big numbers, but our universe does present opportunities for those willing to break out of the confines of simply extrapolating recent history.

    Just looking at our own client portfolios is instructive here:

    Range of EPS 3-Year CAGR
    EM Stocks in MSCI EM Index or FTSE EM Index vs Baillie Gifford EM All Cap 

    Rolling 3-year periods between December 2005 – December 2017, in US dollars. Source: BG Fund Reporting, Factset, Thomson Reuters EIKON and relevant underlying index providers. As at 31 December 2017. Baillie Gifford Emerging Markets All Cap data based on a representative portfolio.


    The skew of the grey bars to the right hand side of the chart demonstrates our commitment to finding superior growth companies. But identifying these names requires a number of particular disciplines. 

    First, it is far more profitable to spend time considering what could go right rather than what might go wrong. Portfolio returns will be overwhelmingly driven by a small number of companies that do extremely well, so making sure you invest in these companies is critical. It matters more than obsessively worrying about all the risks that are inevitably present in any investment decision. But this can be uncomfortable, indeed it requires a conscious rejection of our natural tendency to loss aversion.

    It necessitates that our analysis of companies is better than the extrapolation of most recent trends, that it correctly weights the possibility of extreme outcomes, of fat tails. And when we are faced with a small but credible chance of profits increasing by far more than the market expects, in a portfolio context, we should invest in size.

  7. Ignore the Immediate

    Experience has taught us that any attempt to forecast the near term with any level of precision can be seriously damaging to your wealth. Consider the following two long-standing holdings of our EM portfolios.

     

     

     

    It would hardly be motivating or stimulating for an investor to be questioned every time a target was missed or there was a big short-term swing in earnings for one of these companies. Nor would this have been a profitable use of time. The volatility of short-term earnings masks a significant rise in these companies’ earnings power over the long term. We spend all our efforts trying to understand the drivers of the latter, which requires a discipline in ignoring the former.

    We would go further here, arguing that some of the greatest inefficiencies we encounter in EM are in companies where profits will be volatile from one quarter to the next, often as a result of investment or product cycles that are years in the planning. The market has shown a disdain for such companies, preferring the predictability of smooth profit generation even if the long-term growth rate turns out to be a fraction of that achieved by those more willing to reinvest in their business with greater ambition. This presents us with fantastic investment opportunities, but it requires an approach and culture that allows you to ignore near-term volatility. 

    You cannot invest in this way if you pay your investors for generating short-term performance. Quarterly or even annual earnings releases matter if you’re paid on annual performance but ultimately, this is likely to be counterproductive. We pay our investors exclusively on rolling five-year performance. This ensures that we remain focused only on what really matters, bearing in mind the next year or two have very little bearing on the terminal value of a company. 

  8. The volatility of short-term earnings masks a significant rise in these companies’ earnings power over the long term.
  9. Inflection points matter

    Another great inefficiency resides in the interaction between top-down and bottom-up investing. 

    EM investors do not have the luxury of ignoring the macro. Purely bottom-up investment is a path to ruin in a universe where industrial and economic cycles can dominate investment returns over multi-year periods. This also provides opportunities.

    Our analysis shows that while it may pay to invest in those companies that display consistently high levels of profitability (as defined by those in the highest quintile of return on equity), the strongest returns are to be found in those companies that transition from poor levels of profitability to high (i.e. those that transition from the bottom two quintiles to the top quintile). 

     

    5-Year Stock Growth Percentiles by Quintile of ROE at the Beginning of the 5-Year Period
    Stocks in Q1 of ROE at the end of the 5-Year Period

    This graph shows the results of our analysis of EM returns data from 1996-2017. We split this into 5-year return periods, rebalanced annually, and we studied quintiles of 5-year US dollar ROE. It shows that stocks transitioning from low ROE quintiles to the top quintile have often displayed strong returns. For example, 20% of the observations grew more than eight times over 5-year periods, as shown by the blue line. Source: Factset. As at 29 September 2017. Based on equities defined as Emerging Markets by MSCI or FTSE.

  10. This may seem obvious – rising levels of profitability are normally accompanied by a re-rating, thereby providing a two-fold kicker to share price performance – but identifying the drivers behind this change is the key and has been a significant source of excess return for our EM portfolios.

    Over the last 20 years, broadly speaking, we can identify four separate inflection points that triggered significant changes to our EM portfolios. 

     

    Canton Tower, China.
  11. It is largely impossible to time these inflection points perfectly but when you have an investment horizon measured over many years, successfully anticipating the future direction of travel is hugely valuable. As one of our investors put it, we’re not interested in the weather, but in climate change.

    So how do we identify these inflection points? The first thing to say is that if you wait for all the evidence to be there that something has changed, you’ve already missed it. You will find very few estimates that assume a step change in return on equity. Dealing with incomplete information is the norm. Take the most recent transition, for example. Brazil and Russia are by no means out of the woods; their economies are still vulnerable to commodity shocks and volatile politics, but there are reasons to suspect the balance of probabilities is now more in favour of hard currency growth than further retrenchment. 

    There is no silver bullet here but, by way of an example, factors we have looked at to inform our more positive view on oil and commodities include:

    • the level of capex being spent on greenfield projects (many of the largest miners are scarcely covering maintenance capex let alone expansionary capex)
    • changes in demand (beyond the obvious global growth, what does a marked increase in electric vehicles mean for nickel and platinum group metals?)
    • changes in supply (shale oil may fill the need for light crude but what of the marked dearth of heavy crude, bearing in mind that most new sources of oil or materials require many years to come on stream?).

    The ability to research these sizeable topics on a global scale, then join the dots and work back to the EM companies that stand the greatest chance of benefitting from these shifts in cycles has been one of the great strengths of our process. It is also why we would politely question those who argue EM investing can be purely bottom up or those who rely heavily on backward-looking quant models. EM cycles are frequently long duration, which in turn means they can overwhelm strong company fundamentals for multi-year periods. So our process explicitly encourages our investors to make time to understand and anticipate cyclical change. Portfolio management and pure stock picking are very different skills and experience has taught us that marrying the macro with the micro helps not just with idea generation but ultimately in maximising your chances of consistent outperformance.

  12. Conclusion

  13. Risk Factors and Important Information

    The views expressed in this article are those of Tim Campbell and Andrew Keiller and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

    This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

    Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

    Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.

    Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018 and is authorised by the Central Bank of Ireland. Through its MiFID passport, it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co.

    Persons resident or domiciled outwith the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.

    Past performance is not a guide to future returns.

    Annual Past Performance to 31 March Each Year (%)

     

    2015

    2016

    2017

    2018

    2019

    Baillie Gifford Emerging Markets – Institutional Funds Unconstrained (Net)

    3.9

    -12.7

    22.0

    33.2

    -3.3

    MSCI Emerging Markets

    0.8

    -11.7

    17.7

    25.4

    -7.1

    FTSE Emerging Markets

    3.6

    -11.8

    18.0

    22.0

    -5.3

     

    Source: Baillie Gifford & Co, MSCI, FTSE. US Dollars.


    Changes in the investment strategies, contributions or withdrawals may materially alter the performance and results of the portfolio. The Baillie Gifford Emerging Market strategies are more concentrated than the MSCI Emerging Markets index.

    Stock Examples 

    Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style. 

    This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.

    All information is sourced from Baillie Gifford & Co and is current unless otherwise stated. 

    The images used in this article are for illustrative purposes only.

    Important Information Hong Kong

    Baillie Gifford Asia (Hong Kong) Limited 百利亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 licence from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of UCITS funds to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 百利亞洲(香港)有限公司 can be contacted at 30/F, One International Finance Centre, 1 Harbour View Street, Central, Hong Kong. Telephone +852 3756 5700. 

    Important Information South Korea

    Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Non-discretionary Investment Adviser.

    Important Information Japan

    Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.

    Important Information Australia

    This material is provided on the basis that you are a wholesale client as defined within s761G of the Corporations Act 2001 (Cth). Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth). It is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 2001 (Cth) in respect of these financial services provided to Australian wholesale clients. Baillie Gifford Overseas Limited is authorised and regulated by the Financial Conduct Authority under UK laws which differ from those applicable in Australia.

    Important Information South Africa

    Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa. 

    Important Information North America 

    Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in America as well as some marketing functions in Canada. Baillie Gifford Overseas Limited is registered as an Investment Adviser with the Securities & Exchange Commission in the United States of America.

    FTSE Legal Disclaimer

    Source: FTSE International Limited (“FTSE”) © FTSE 2019. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data and no party may rely on any FTSE indices, ratings and / or data underlying data contained in this communication. No further distribution of FTSE Data is permitted without FTSE’s express written consent. FTSE does not promote, sponsor or endorse the content of this communication.

    MSCI Legal Disclaimer

    Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

     

    Ref: 40554 PRO WE 0028

  14. TIM CAMPBELL

    Client Service Director
    Tim graduated BA in History from Trinity College, Dublin in 1997. He joined Baillie Gifford in 1999 and worked as an Investment Manager in the Emerging Markets Equities team before moving to the Clients Department in 2007 where he is a Client Service Director. Tim became a Partner in 2012, and is Chair of the Emerging Markets Product Group.
  15. Andrew Keiller

    Client Service Manager
    Andrew graduated from the University of Edinburgh with a first class honours degree in Mathematics and Business Studies (BSc) in 2011. Upon graduation, he joined Baillie Gifford as an Investment Operations Graduate Trainee and completed a two year programme of secondments across the firm. He now works as a Client Service Manager in the Emerging Markets client team. Andrew is a CFA charterholder.