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Clusters, Computers, and Classic Rock.

August 2021

Key points

Find out why small companies are one of the richest hunting grounds for long-term growth investors.

The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.

A lot happened in 1993. Among the headline-grabbing events, Bill Clinton was sworn in as the 42nd US president, the Ford Mondeo went on sale and the actress Audrey Hepburn died. Meanwhile, Whitney Houston’s epic power-ballad, I Will Always Love You, dominated the charts in the early part of the year – more of that later.

Elsewhere, Francisco Mojica, a young Spanish biologist became the first person to formally categorise a mysterious set of DNA sequences he dubbed CRISPR, laying the foundation for what is today the leading frontier of gene editing technology. And, in April, researchers at CERN opened up the World Wide Web to a global audience for the first time.

Also in 1993, Baillie Gifford launched its British Smaller Companies offering, aiming to offer clients exposure to the best young businesses in the United Kingdom. With hindsight, the ground-breaking innovations that emerged towards the end of the last millennium made small companies a rich hunting ground for long-term growth investors. And now, as was the case then, the UK is a world leading location in which to hunt for these businesses.

Why Small Companies?

Tim Berners-Lee, who first connected computers to form the network that today we call the internet, was without doubt a visionary. However, there was simply no way that he, or any of his peers, could have envisioned the sheer breadth of transformation his invention would cause. There are few places where this change has been as significant as the evolution of small companies. Step back 30 years and starting a business was a daunting task. Before even thinking about sales, there was a need to invest large amounts of capital in such things as infrastructure, warehousing, and computer servers. Once you had some inventory, you’d then have to find a way to tell your customers about it, without any idea who they were, where they lived, or really even exactly what they wanted in the first place.

Tim Berners-Lee. © Elise Amendola/AP/Shutterstock.

Even 20 years ago, advertising spend on outdoor displays such as billboards was twice the amount spent on online channels. Small businesses had to attract a majority of eyeballs just to find the small minority that might become customers. None of this came cheap, and suppliers often demanded payment in advance.

The world has changed, and with it the prospects for smaller companies. The same economies of scale that propped up the major corporations of the 20th century have been gradually co-opted and democratised by the small companies looking to outmanoeuvre the sleepy incumbents. Today, a fledgling entrepreneur has access to a vast global supply chain via smartphone. Warehousing and delivery can be outsourced through businesses such as the UK’s Clipper Logistics, cloud servers are available to rent from Amazon or Microsoft, and software is easily available through open-source or via low cost subscription. The internet has allowed brands to get closer to their customers than ever before, wherever they might be in the world, allowing for both targeted marketing and much faster feedback loops.

Scalable, off-the-shelf services are now a feature of most industries. We see it throughout our portfolio, whether it’s the rise of shared third-party video game engines – opening doors for companies such as UK indie developer Team17 to quickly build high quality games – or smart camera and video software allowing innovative real-estate businesses such as Purplebricks to offer home buyers an entirely virtual property viewing and purchase system.

We believe that the technological revolution has empowered small businesses to win at a global scale like never before. It is encouraging to see this play out in performance. Over the past 20 years, across markets, small companies have consistently outperformed their larger peers. In the UK since 2000, this equated to an annual gain of 3.9 per cent above mid and large-cap returns. Looking back further, there is evidence that small caps were triumphing long before recent technological change turbo-powered them. Between 1955 and 2014, the Numis Smaller Company Index produced a 15.3 per cent compound return, 3.4 per cent per annum above the FTSE All-Share. And we believe there are fundamental reasons why this return has persisted against all perceived market efficiency wisdom. The key factors in our eyes are a combination of alignment and agility.

Small companies are much more likely to have ambitious, highly aligned owners or founders, who have far greater influence over the company’s fortunes allowing for more manoeuvrability and ambition, than the sleepy giants they seek to disrupt. We see numerous examples of these traits throughout the portfolio. A small company run by an ambitious, motivated and entrepreneurial founder grabbing an opportunity – such as Morgan Tillbrook who had already made enough money to retire before starting Alpha Fx at the age of 25 – is unlikely to produce a run-of the mill outcome. It is more likely to succeed magnificently or fail spectacularly. This is known as asymmetry, meaning there is no limit to potential rises in share prices, while the downside is limited as the maximum loss is the amount of the initial investment. The positive skew increases the average expected return. The impact of this superior alignment has helped drive a small-cap effect for over 60 years. However, the opportunity today for these same entrepreneurs to address a much greater global audience in a much more agile technology-enabled fashion is greater and leaves us more optimistic than ever that small companies continue to offer exciting potential over the long term.

Why Britain?

The UK is home to a cohort of exceptional small businesses with high growth potential. Yet, you’d be forgiven for not getting this impression from looking at the FTSE 100. While indices around the world are increasingly full of exceptional innovative companies disrupting incumbents and strengthening their competitive advantages as they grow, the FTSE 100 tells a sadder story. With a handful of exceptions, the UK large-cap market is still weighed down by old-world incumbents – the oil drillers, miners, and banks of the 20th century. While not necessarily poor investments, they are almost certainly not the growth champions of the next century. The nature of these companies reaffirms our view that ignoring the index is the route to adding the most value. In the UK, it is only by looking down the market cap spectrum that we start to identify exceptional growth businesses, many of which are already benefiting from, or directly enabling the technological revolution we have discussed.

Enablers include businesses ranging from the aforementioned Clipper Logistics, which is building a scalable logistics platform for old-school retailers moving online, to WANdisco, which has developed unique software to help businesses migrate their data onto cloud servers. The proliferation of online businesses has created second-order effects, such as opening opportunities for the recently listed Trustpilot, which provides consumers with reviews and helps inspire trust in making online purchases from fledgling brands, or for YouGov, which has seized the opportunity to provide these new businesses with detailed data on what their targeted customers really want. While these are undoubtedly exciting businesses, and it’s a testament to the potential of the UK small company market that they’re domiciled here, they don’t answer the question of why the UK offers this unique investment opportunity. To answer this, we need to look deeper. We believe the solution lies in the concept of clustering, a phenomenon that has led to incredible pockets of innovation emerging and thriving around the world.

Much like returns, the most incredible industries, innovations and entrepreneurs aren’t evenly distributed. They cluster. Whether that may be around a country, a city, a person, or even just an idea, the pattern is always the same. A group of people gather in one place and start doing something. If they are successful, and conditions are right, they just might inadvertently set in motion a flywheel. Initial success draws in more people doing the same thing, which brings in investors and suppliers to give those people what they need. This in turn makes doing the original thing even easier and draws in yet more people, investment, and knowledge. Around and around it spins.

The big global examples here are well known. One is the explosion of software innovation in Silicon Valley, born from the ideas and efforts of Stanford University’s engineers in the 1940s. Another is the rich automotive industry that grew around the headquarters of Porsche and Mercedes in the Baden­Württemberg region of south western Germany. A further instance is the raft of technology giants that have emerged in and around Shenzhen in China. Where the industry niches involved are big enough (ie tech in the US or automotive in Germany), the companies emerging from these regional clusters can grow to dominate that country’s economy. Where the niches are smaller, however, they will often dip under the radar. We believe that in all markets these pockets of exceptional businesses drive constant, self-reinforcing iterations of improvement and evolution among themselves, leaving competitors at a major disadvantage. Understanding this concept is vital to successful regional investing and holds the key to uncovering the most exciting UK small company investment opportunities.



The UK has several industries where density of expertise leaves it punching far above its weight, and it’s no surprise that these businesses make up the core of our Smaller Companies portfolio. Biotechnology is a field where there are few peers with the depth of experience, or track record of the UK. The cluster here is around the ‘Golden Triangle’ of elite research universities in London, Oxford, and Cambridge. This region includes three of the top eight medical schools in the world. Cambridge alone boasts 121 affiliates who have won Nobel Prizes. If it were a country, it would have the third highest number of these accolades globally. The opportunity for small company investors here is clear. Since 1990 the region has produced over 50 unicorns (private start-up companies with a value of more than $1bn), a number of which have passed through our portfolio. A notable example is Abcam, a world leading producer of antibodies that remains a large investment for us today. We also retain indirect exposure to more nascent innovations through our holding in IP Group, a venture capital fund focused on finding young gems born from the region’s universities. We recently had our holding in Cambridge-based Horizon Discoveries bought out by one of that company’s large peers. Horizon, fittingly, has built its business around the gene editing expertise that was born from Francisco Mojica’s 1993 work on CRISPR.

Cambridge also happens to be the site of the launch of one of the world’s earliest video games, a digitisation of Noughts and Crosses, in 1952. Indeed, today video gaming is a sector where the UK punches far above its weight, consistently finding itself among the top game producers globally. A number of cult titles have emerged from British studios over the years, notably Golden Eye 007, Tomb Raider and Grand Theft Auto, the latter still a dominant global franchise. The UK’s dominance here can be traced back to its pioneering role in the early days of personal computers.

In the 1980s, BBC and Acorn partnered to build affordable computers that were distributed to 80 per cent of UK secondary schools, spawning a new generation of amateur programmers who went on to form a rich ecosystem of game studios and publishers. This laid the foundations of the industry as we know it today. In 1984, David Braben used BBC computers to launch the revolutionary 3D game Elite. Today, he runs Frontier Developments and has overseen the evolution of the Elite series and several other hit franchises. Similarly, Debbie Bestwick, the CEO of Team17 was instrumental in the success of the hugely popular Worms series in the 1990s, and has since used that as a base from which to build a massively successfully indie game publishing studio. Evidence of the UK’s strength, and the gravitational pull it exerts on the wider global industry, is clear from the fact that we now have international video game businesses choosing to list in the UK. In early 2021, TinyBuild, a US/Eastern Europe-based game developer, chose London for its flagship IPO, in part to gain access to the remarkable talent and investment knowledge available there.

Whitney Houston. © Redferns/Getty Images.

The Whitney Houston Connection

One other thing the UK did exceptionally well through much of the 20th century was make music. And while the UK’s influence on the global music industry may have declined in recent years, there remains a huge amount of talent and a depth of experience which has led to the formation of fascinating businesses, some of which have made it into our portfolios. Focusrite was established in 1985 to design and develop audio equipment for the growing number of high-end recording studios. Phil Dudderidge, started his career as a roadie for acts including The Incredible String Band, before becoming a live sound engineer for Led Zeppelin. The business has gone from strength to strength, driven in part by its large staff of musicians who have ensured consistent product quality and innovation over the past 35 years. Even the CEO had 20 years’ experience as a touring keyboard player before moving into business.

The UK is also home to an even more eclectic music business, the Hipgnosis Song Fund. Run by another music industry veteran, Merck Mercuriadis, Hipgnosis acquires the rights to the best songs in the world, then ensures that the artists receive fair payment, and that the songs in-turn are monetised to the extent they deserve. This leads us full circle, as the monetisation of songs today has been empowered by the technological revolution that has brought us online services such as music streaming and short-form video. This has allowed Hipgnosis to give new leases of life to artists, including Whitney Houston. She reigned supreme in 1993.The following year saw Mariah Carey release her festive classic, All I want for Christmas is You, a song Hipgnosis added to its catalogue in 2020. Under its active guidance, that same year the song finally secured the Christmas Number One chart spot, 26 years after its initial release, a testament to the talent and connections of its new owners.

These examples represent just a handful of smaller businesses that thrive in their rich, unique, and often overlooked UK ecosystems. We believe that the glamour and name recognition of global businesses often disguises the remarkable set of lower-profile, but equally attractive, businesses available to UK investors. This consistently plays out in the valuation discounts much of the UK investment universe trades at against many of its international peers. This, of course, is music to our ears.

Yet, we believe that to truly capitalise on these opportunities, it is essential to have an approach that differs from others in the market. It must be truly active, long-term, and based on fundamental analysis with a focus on quality factors such as company management.

Yet, we believe that to truly capitalise on these opportunities, it is essential to have an approach that differs from others in the market.

To benefit from such a large opportunity set, we need to be curious and willing to take broad perspectives. Only by doing this, and venturing beyond the common sources of financial insight, can we increase the chances of uncovering these unusual businesses. Everything at Baillie Gifford is set up to encourage this approach, whether it be the diversity in our investors’ academic backgrounds or our relationships with academic institutions.

Once these businesses have been unearthed, we believe they’re best understood through rigorous fundamental analysis. That is work which, rather than focusing on backwards looking metrics, attempts to understand what they could become over the next five years and beyond. Of course, company management is a crucial part of this, and we think the level of insight we can glean from inspirational figures like those at AlphaFX, Hipgnosis & Focusrite is far beyond what we would get with a conventional management team.

Patience is required, as experience has taught us that these businesses often take many years to develop and deliver on their early promise. Therefore, our investment horizon also needs to be long. Combined with this is the willingness and ability to be brave and withstand the inevitable bumps in the road. These are often young, immature businesses, still finding their feet, and there will be missteps. However, it is essential to see through these in order to capitalise on the asymmetry of equity returns and unlock the potentially significant, long-term rewards.

These are the key tenets of our approach, through which we continue to uncover a steady stream of ambitious UK businesses addressing large opportunities with unique solutions. In finding and backing these exceptional businesses, we firmly believe that we are well-placed to generate strong investment returns over the long term.

Risk factors

The views expressed in this article are those of Charlie Broughton 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 August 2021 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

Potential for profit and loss

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.

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, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) 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 30 June Each Year
  2016 2017 2018 2019 2020
UK Core Composite Net (%) 19.8 15.9 -2.9 -13.8 39.1
FTSE All Share (%)
14.8 10.8 -3.1 -15.5 35.8
Annualised returns to 30 June 2021
  1 Year 5 Years 10 Years
UK Core Composite Net (%)
39.1 10.1 6.6
FTSE All Share (%) 35.8 7.2 4.8

Source: Baillie Gifford & Co. and underlying index provider. US Dollars. Changes in the investment strategies, contributions or withdrawals may materially alter the performance and results of the portfolio.

Source: FTSE International Limited ('FTSE') © FTSE 2017. '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.

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