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The American economist Milton Friedman was serious in his belief that a company’s sole purpose was to create value for shareholders, but we imagine Scottish comedian, Billy Connolly would have thought he was having a laugh.
The BBC legend Michael Parkinson conducted some unforgettable interviews in his time, with the likes of John Lennon, Muhammad Ali, and Orson Welles. As the deadline for writing this investment piece loomed and inspiration didn’t, a memorable exchange Parky once had with genius Scottish comedian Billy Connolly, and songwriter Sting, kept springing to mind. I tried to ignore it and get back to investment report brainstorming, but it wouldn’t go away.
Parky asked them both when they first thought they were going to be rich.
Connolly was a welder in the shipyards on Glasgow’s river Clyde (where his nickname ‘The Big Yin’ was born), who entertained his pals during break times playing the banjo. “I would tell a joke between doodles and people laughed. So, the jokes got longer and the banjo bit shorter and before I knew it I was being booked to do comedy gigs”. A few years later, as the world’s most successful stand-up, he could sell out the Albert Hall for a week, then fly to Sydney and fill the Opera House. And yet “the idea that with this career I would make lots of money never registered. I couldn’t believe – I still can’t – that people pay me all this money to do what I love doing in the first place.”
They were driven to be exceptional at something, to practise and refine their craft to that magical degree
Over to Sting. An uncannily similar reflection from a man who as a boy also grew up in the shadow of a shipyard. As a high school teacher of English he loved writing songs at home at night. A natural lyricist, one day he got his break and the song writing took over. He formed a little band in Newcastle to play those songs, as that was what he loved to do. The idea that he would end up receiving royalties on 100 million Police albums “never even occurred to me. I mean, I’m glad to be well-off, but the way I got there strikes me as absurd.”
Most of Parky’s guests over the years happened to be very wealthy people, yet almost none of them ever set out with financial accumulation as a goal. Instead, they were driven to be exceptional at something, to practise and refine their craft to that magical degree where the rest of us pay money just to see them in full flow.
Then I realised that some of the companies in our LTGG portfolio and their founder-leaders have a lot in common with Billy Connolly and Sting. They are what Professor Abraham Maslow called ‘self-actualisers’ who find themselves at the very top of Maslow’s hierarchy of needs, almost literally ‘living the dream’ by doing what they love.
And I also realised that herein lies the essence of what is different about the way these companies are run compared to most companies, and how we as investors take a different tact from most market participants on the urgency of profitability. The famous American economist Milton Friedman said “The only purpose of a company is to make profits.”1 Almost half a century later he still has a lot to answer for, as most CEOs still think like Friedman. As do most shareholders. In recent years probably our second most common question from clients has been “But when will XYZ be profitable? How will it get there?”2 If we don’t have a concrete answer to this, on a finite time frame, it raises anxiety for them, and confirms the LTGG zealots at Baillie Gifford have finally gone mad.
1. He’s quoted slightly differently on this each time. On 13 September 1970 in The New York Times Magazine his exact quote was “The social responsibility of businesses is to increase its profits”. You get the idea.
2. The most common question: “How much longer can this streak of growth equities keep up?”
So, despite more discussion recently about the broader purpose of capitalism and companies, particularly after the 2008 Global Financial Crisis, most investors yearn with urgency for profitability.
We are more relaxed.
Several moments in 2019 encapsulated this difference, but none better than Alibaba’s annual investor day, which we have recently returned from. Note that the investor day now lasts half a week since there is a huge amount of current growth and profitability, and future growth and potential profitability across Alibaba’s suite of businesses to cover. But our key takeaway from such interactions is sometimes not just what the company said, but the questions from other shareholders. Two recurred at the ‘Baba retreat in November: 1. Why are shareholders only your third priority after employees and customers? And 2. When will (entertainment or any other business in the spend phase) turn profitable?
The assumption in the first question is that if shareholders aren’t first this cannot be good for them. It assumes that if the company’s primary goal isn’t to make profits then why be a shareholder? But we believe in obliquity3, a thesis which maintains that a far less direct route will ultimately lead to a more valuable outcome. We ourselves engage in obliquity with our own research efforts, where we spend more time with academic institutions around the world, who appear to have little directly to do with investable companies, than brokers telling us which stocks to buy. During the Edinburgh International Book Festival, you will find our investment teams’ desks deserted for three weeks. Does anyone want to see Goldman’s banks analyst? No thanks, I’m going to listen to Serhii Plokhy4.
The best way to create a hugely valuable company is by investing for the long term, creating a huge moat for competitors to cross, taking some chances along the way by funding long shots of which one or two might fly, and generally not focusing on profits for quite a number of years, if at all.
So, in the wider debate of what the purpose of public companies is, we are very comfortable with the enlarged stakeholder vision. In our 10 Question research process Alibaba would approve of our Q5: “Why do your customers like you? How do you contribute to society?”, not least because the meandering path less trodden can lead to far greater value creation than the direct one. Alibaba has been very successful since its IPO in 2014. We believe that if Alibaba can keep short-medium term shareholder interests in last place, those same shareholders could make 5x within 5–7 years from here.
Alibaba's six key values
And this is the LTGG paradox that some struggle to reconcile: we are probably the shareholders who demand the greatest upside – 5x the current valuation please! – for a company to be in our portfolio. But on the route to get there we are the least prescriptive, the least impatient, and the most laid back (some would say to the point of falling over) on duration and directness. But make no mistake – remaining patient like this for long periods of time takes considerable nerve, nerve which we observe few investors to have.
We rarely worry as much as others about the second preoccupation at the Alibaba day either: time to profitability for the entertainment business or any other business area yet to get there. What we do worry about is whether our founder-leaders are enough like Sting or Billy Connolly. Or Wayne Gretsky. Or Serena Williams. Are they doing something they love, that they are quite obsessed with improving and refining, something that in some way the rest of us delight in? Are they driven by a voice which demands “there must be a better way?” as, legend has it, Reed Hastings was when returning his DVD to Blockbuster a year late and being fined 10x the value of the film?
3. See the book of the same name by Professor John Kay, a long-time friend and confidant of Baillie Gifford.
4. Author of Chernobyl, winner of 2018 Baillie Gifford prize for non-fiction. Now a Golden Globe winning mini-series for one of our holdings as it’s on Amazon Prime. Obliquity!
This is not to say that there is no downside risk to all this perfectionism before profit, even if it falls short of the downside risk run by Free Solo phenomenon, Alex Honnold.
The limiter on all this apparent idealism is capital. Even with today’s business models, which often require less capital than in previous eras, companies can’t invest for the greater good and run at a loss forever. In 2019 Tesla cut it quite fine – the ramping up of the Model 3, hugely important for the broadening of the EV (electric vehicle) growth story, required more funding than we expected and stakeholders might have been prepared to give. Nio – our Chinese EV/lifestyle start up – has fallen substantially since purchase and needs to make more sales and generate less costs quite soon. Delivery Hero, Pinduoduo, and our most recent purchase, Peloton, all have longish runways of investing ahead of them but one day their business models will, in turn, need to prove themselves. But for us that means in the next five years, rather than the next one or two.
We are also relaxed when companies elect to reduce profitability near-term regardless of disappointing the market. Continuing to innovate with a view to what could be big in five or 10 years’ time is far more important than worrying about the knee-jerk profit-estimate-huff the market might have on learning of the increased investment spend the next week. With Tencent there has been a lot of focus about gaming sales – due to the government moratorium on new titles that lasted for a number of months (now over). But, in the meantime, Tencent has been investing in its B2B services to drive future growth, though this made the dip from gaming more prominent. In the first half of 2019 Tencent’s sales in FinTech and Business Services have ‘suddenly’ got close to surpassing those in smartphone games.
And Spotify continues to try and reduce its dependence on labels, and the chunk of revenues paid to them. The main example is the development of non-music content with the purchase of a number of podcasting services. This pushes out profitability for Spotify but is the smart long-term play.
It is easy to forget how dramatically things turn around when investments start paying off. When we initially bought Facebook, which halved in the first six months of ownership, remember how sceptical observers were about two big questions
1. How will this work on mobile devices? and
2. How will they ever monetise their users?
Only a few years later Facebook has become one of the most profitable businesses we have ever seen. Indeed, they are doing their best to dampen the extreme profitability by – rightly – having hired 20,000 content checkers in 18 months. Despite this big surge of investing, operating margins are still an amazing 40%. And yet the prevailing opinion five years ago? They’ll never make any money! Patience with the right companies is rewarded.
Having said all this, our LTGG portfolio is probably more profitable than many clients might guess. Two-thirds of the portfolio by weight is in profitable companies, and nine of our top 10 holdings are currently profitable (I’m excluding Tesla otherwise it would be all 10). But several of these big holdings, like Facebook, Amazon, and Netflix, weren’t profitable when we first owned them. Over the coming years we’d expect to see the same pattern – the smaller holdings today will either scale, become profitable, and become big holdings, or fail and disappear: multiple upside vs 1x downside is a trade-off we happily accept.
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“We share the same biology, regardless of ideology"
In his Cold War classic Russians, Sting sang: “We share the same biology, regardless of ideology”, but sometimes we wonder if we even share the same biology as other investors. We are convinced demands for profits now destroy value rather than creating it.
Milton Friedman was wrong on two counts. First, his declaration of the profit-only purpose of companies was too narrow, especially for the world of today; second, the idea that such a narrowly defined purpose would be of benefit to shareholders has gone up in smoke many times through spectacular examples to the contrary.
The American economist was simply wrong to imply that seeking directly to make profits is the best way to make profits – the world’s most successful companies in the 10 years to 2019 have had higher and broader ambitions which eventually, almost accidentally, have engendered value creation unprecedented in the history of stock markets. This is the way forward for capitalism.
To finish we return to the Michael Parkinson show. Imagine a third guest has joined Sting and Billy Connolly on Parky’s famous sofa. It’s Milton Friedman. The free-marketeering-Nobel-Prize-winning economist expounds his theory on profit primordiality. Parky’s other two guests look unimpressed. Sting replies first with a lyrical flourish:
“Mr Friedman said
Go for profits or you’re dead
I don’t subscribe to his point of view
Believe me when I say to you
I hope other shareholders awaken too”
Then Billy Connolly: succinct, direct, the Big Yin’s fabled Glaswegian put-down delivered with a beaming smile and a shake of his shaggy mane:
“Milton Friedman – Ya Bass!”
This imaginary cultural clash is how to think of the central, existential, investment debate of 2020 and beyond. And most financial firms, to this day, are still with Friedman and the Chicago professors.
But in LTGG?
We’re with Sting, and The Big Yin.
The views expressed in this article are those of Scott Nisbet 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 in January 2020 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.
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.
Annual Past Performance to 31 December Each Year
Long Term Global Growth Composite Net (%)
Source: Baillie Gifford & Co. US Dollars.
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Scott graduated MA in English Literature and French from the University of Edinburgh and gained a Post Graduate Diploma in Translation from University of Paris. He joined Baillie Gifford in 1996 and worked in the North American and UK investment teams until 2003, when he moved to the Clients Department as a Director with responsibility for overseas clients. Scott became a Partner in 2007 and is a member of our CDMG (Clients Department Management Group). He is also a member of the Strategic Leadership Group.