Under the Radar
Part 1 OpportunityCharlie Broughton, Investment Manager. Third Quarter 2018.
Under the radar
International Smaller CompaniesIn this short series Baillie Gifford’s International Smaller Companies team explores how their radar framework helps them to uncover the most exciting small businesses from around the world.
PART 1 – opportunity
Sweden in the 1970s. A national epidemic looms as it emerges that as many as 80 per cent of Swedes are suffering from chronic back problems, the majority of which originated in childhood. Åke Nordin, a man who 20 years earlier had pioneered attaching frames to hiking backpacks to better distribute weight, sees an opportunity. His company, Fjällräven, quickly designs a new bag for school children. It has two straps to minimise strain on the back, and comes in a wide assortment of colours allowing children to express themselves. The bag is an overnight success. Åke had expected to sell 200 bags in his first year, he doubles that. The next year he sells 30,000. The rest is history. Today the distinctive red fox logo of the Kånken bag, largely unchanged 50 years later, is easily recognised on backpacks across the globe. Fjällräven is still controlled by the Nordin family, and its parent business is currently worth more than one billion euros.
The origins of Fjällräven capture the essence of how we think about opportunity. Almost all great investments begin with a problem. Good companies build solutions that address them.
Opportunities come in many shapes and sizes and often take time to materialise. At first glance there was nothing particularly notable about Japanese manufacturer DaikyoNishikawa, which had come together in 2007 as part of a complex three-way merger. However, later that year its new R&D department developed a unique resin recipe to create a lightweight plastic oil strainer for vehicle engines. Over the subsequent decade, environmental, engineering and cost pressures forced automotive manufacturers to find ways to lower the weight of their cars. Suddenly, DaikyoNishikawa’s expertise in making high-quality, light plastic components aligned it with this global challenge, and today it is reaping the rewards.
This is where patience comes into play. The greatest opportunities, the ones that can transform a business from a small player into an international leader, don’t unfold overnight. Overcoming technological hurdles, battling incumbents and changing mindsets all takes time. An analyst with a one-year time horizon in 2007 would have spent their energy calculating the financial impact of the DaikyoNishikawa merger, hypothesising about margin profiles and synergy potential. Over a decade, however, these traits simply don’t register when compared to the evolving demand for plastic substitution in automotives. Patient onlookers have seen DaikyoNishikawa more than triple its earnings in the last five years alone as the business’ plastics expertise plays its part in solving a long-term global problem.
This is the challenge we face as long-term investors at Baillie Gifford. Identifying big problems and opportunities is just the first step. For our clients to benefit, we need to find businesses that recognise these opportunities and aren’t afraid to chase them, and then we need to weather the ups and downs that go along with investing over long timeframes. This isn’t always as easy as it sounds. Over recent history markets have proven themselves less and less patient. The average holding periods of institutional investors has decreased, and a reliance on volatility measures like tracking error has increased. This can create a hostile environment for small businesses trying to capture large opportunities.
Over the summer of 2017, Zooplus, the German online pet food retailer, saw the market react negatively to the news that the business planned on ramping up investment to improve its offering, attract customers and stave off rivals. As a result, management lowered short-term financial guidance. Markets were quick to express their displeasure. It didn’t matter that Zooplus remained Europe’s largest online pet food retailer, and it didn’t matter that the business was still forecast to grow more than 20 per cent that year as it pioneered the shift from offline to online in a massive industry. The market still wanted Zooplus to offer smooth short-term results and chose to punish any sign of a struggle or any bold investment into an uncertain future. We believe that this can be both irrational and counter-productive. Focusing on opportunities and supporting the companies addressing them should, over long periods, generate far more value for shareholders than worrying about the bumps along the way. Online sales currently make up less than 10% of the pet food market in Europe. In the context of this striking immaturity, Zooplus’ 2017 earnings per share suddenly don’t look so important. If their investment helps drive online penetration to a meaningful size, the effect on their business will be transformational.
... Focusing on opportunities, and supporting the companies addressing them should, over long periods, generate far more value for shareholders than worrying about the bumps along the way....
Big opportunities offer the potential for big rewards, however, when thinking about growth over longer timeframes, we often need to go a step further. Good companies address problems facing their customers. Great companies address problems the customers don’t even know they have yet. Where we get really excited is when we find a business expanding into an opportunity while continually investing to uncover the next opportunity.
An excellent example here would be database software provider First Derivatives, which hails from Newry, a small city in Northern Ireland. Over the last 20 years the business grew from the founder’s spare bedroom into a billion euro company with 2,000 employees in offices around the globe. It did so by helping financial institutions tackle the challenge of processing vast quantities of time-series data for use in financial market analysis and forecasting. It now dominates this market.
Rather than resting on their laurels, however, management are already looking at where else they can apply the expertise they have developed, both in helping existing customers with new problems and in attacking markets beyond finance. The company believe that in doing so their target market has already expanded from $5 billion to $25 billion. We believe that First Derivatives’ vision and ambition mean this may just be the start as increases in computing power and the ability to gather data sets will drive the need for ultra-high performance data analytics in the future, regardless of which area a company operates in. For reference, database giant Oracle’s revenue last year was almost 30x larger than First Derivatives’ total market capitalisation. If this business can evolve and discover new uses for its skills the upside could be massive. The exciting part is that many of these new applications remain hypothetical. Industry analysts can’t fit them into financial models, and markets can’t effectively price them. This then is a fruitful hunting ground for patient, long-term investors comfortable with uncertainty. We are constantly looking for businesses growing their addressable markets in new and imaginative ways, and as long as we have established some faith in management’s ambition and competence, we are happy to support efforts to reinvent and reinvigorate growth.
The relationship between uncertainty and opportunity is difficult. Often an opportunity is clear, but the probability of a company successfully seizing it is low, or at very least hard to measure. This is perhaps most explicit in medical science. When developing treatments for cancer no one is questioning that the potential rewards are great (both for the business involved and for humanity). However, the latest studies suggest that the probability of getting an oncology drug from Phase-1 trials through to the marketplace is only around 4.3 per cent. This means that the vast majority of companies developing new cancer treatments will fail. One method we rely on when facing uncertainty like this is to focus on the incredible asymmetry in equity markets. In any investment the maximum downside is 100 per cent, whereas the maximum upside is theoretically uncapped. A large number of oncology businesses can fail, and yet it can still be a fruitful area in which to invest if the occasional winner can emerge and take share in a $130 billion plus market.
In any investment the maximum downside is 100 per cent, whereas the maximum upside is theoretically uncapped.
Our process then purposefully focuses on potential upside, and looks for ways to improve our odds of spotting the winners. When the opportunity is big enough, the success of those winners should more than outweigh our inevitable mistakes along the way.
Finding companies that solve big problems for their customers is key in what we do. To be long-term growth investors we need to find management teams brave enough to go after large opportunities, and ambitious enough to keep searching for new ones. In the same way that Åke Nordin was able to take his passion for the outdoors and his expertise in practical, lightweight apparel and use them to build Fjällräven into an international retail empire, we are looking for businesses we think have the potential to use their strengths to seize today’s opportunity while investing and adapting to seize the opportunities of the future. Often the odds are stacked against them, but given the potentially vast rewards on offer we believe that, as investors, we should work to cultivate bravery in the face of this uncertainty. Our process is designed with this at its core. Of course, our radar methodology includes a number of additional tools which we believe increase our odds of success, and we look forward to exploring these with you further soon.
Important information and Risk Factors
The views expressed in this article are those of the International Smaller Companies team 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.
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.
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.
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.
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.
Ref: 39289 INS AR 0528
Charlie Broughton Investment ManagerCharlie graduated MA (Hons) in Medieval History and Archaeology from the University of St Andrews in 2013. Charlie joined Baillie Gifford in 2014 and is an Investment Manager in the European Equity Team.
YOU MAY ALSO LIKEInsights.Visit Baillie Gifford's Insights page.The Truth Will Out: Dispelling the Myths of Emerging Market Investing.The golden age for EM economic growth is over, but for some EM companies, the opportunity set may be far larger than anything EM investors have seen to date. Will Sutcliffe dispels some common misconceptions surrounding EM investing.Making better sense of the digital ageVirtual goods and the value of digital data pose unresolved challenges to economists, investors and regulators.The case for small caps.Academia has taught us that size matters – provided you can effectively control for quality. Fortunately, as Steve Vaughan explains, that is the fundamental role of active stock pickers.