Print article

International Smaller Companies: Under the Radar

Milena Mileva, Investment manager

Part 6 - Alignment.

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.

Under the Radar

International Smaller Companies

Much of our task as investors is to resist the lure of certainty. The act of investing inevitably entails a leap of faith. Perhaps harder is the ability mid-leap to hold onto the promise of what might come, the potentially significant (but never guaranteed) rewards we hope to land. It can be a very long and lonely jump. Company management face a similar predicament and need the same ability to hold their nerve.

The courage to carry on in the face of terrible uncertainty, even in the most unprecedented of circumstances like global pandemics and economic recessions, often can’t be derived from extrinsic goals of reward, remuneration, or share options. The renowned French author Antoine de Saint-Exupéry writes of courage and beating the odds in his book Wind, Sand and Stars. He tells the story of a friend who crash-lands his monoplane in the Andes. Stranded far from civilization without supplies he trudges for days amid a snowstorm. It is when he is about to give up that he thinks of his wife and children and determines to keep going. Driven by thoughts of his family, he summons the energy to crawl up onto an area of exposed rock and from this vantage point he is at last able to see through the whiteout. Owing to this final gathering of strength he is discovered, and his life saved.

The determination to persist through the hardest of battles cannot merely be imitated nor simulated. Companies and founders who face lonely depths of uncertainty, where the odds are stacked high against them, must have their hearts and minds set to a greater, longer-term purpose. There will be times that alongside their daily business they must navigate complex obstacles, not knowing what lies ahead of them. Few companies have the cultural ingredients and the leadership necessary to successfully circumnavigate an uncertain environment and ultimately realise their potential. Most never make it out of the snowstorm. 

This is why the consideration of alignment is an integral part of the International Smaller Companies analytical framework, as we seek to identify businesses with large market opportunities and competitive positions strong enough to allow them to capitalise on those opportunities over many years. For us, alignment constitutes an attempt to answer the question: Can we trust management (and, more broadly, the culture underpinning the organisation) to steer the companies we invest in on your behalf onto a path towards long-term success?

We seek to identify businesses with large market opportunities and competitive positions strong enough to allow them to capitalise on those opportunities over many years.

A long time coming

So, what are the key manifestations of corporate alignment that we are looking for when we consider potential holdings for the portfolio? As very long-term investors, we place most emphasis on identifying a strong alignment of time horizons. It is an unfortunate truth that financial markets have become exceptionally short term. The dramatic fall in holding periods of stocks over the last 30 years, a significant increase in market volatility and much greater turnover of corporate CEOs (as investors seek immediate performance) are all symptoms of the growing impatience and myopia afflicting our industry1.

John Bogle’s famous indictment of the stock market as “a giant distraction from the business of investing” arguably rings truer than ever. However, the real danger strikes when the suboptimal behaviour of market participants spills over into the corporate sector and starts shaping business decisions. The evidence also suggests this is happening; there is a meaningful and growing divergence between the cash flows that listed firms are directing towards organic investment in capital expenditure and research and development (R&D), and the amount they are returning to shareholders in the forms of buybacks and dividends. Indeed, the latter category is where the rising trend worryingly lies.

In our experience, many corporate management teams talk about long termism, but it is often lip service. When push comes to shove, the reality is that most would rather play the quarterly game. They would rather boost short-term earnings per share by buying back stock than initiate long-term projects with large payoffs but very uncertain outcomes. The Covid-19 pandemic brought with it the challenge for companies to manage the immediate future with agile and resilient decision-making, while building the necessary structures for operating in an uncertain long-term environment. Companies that were already executing their capital allocation strategies with the longer term in mind, with strong internal and external processes, robust brands, good human capital, and agile, scalable business models have stood out. 

Hence, we aim to select companies that do not behave in a self-defeating manner, that show an unwavering focus on the long term, alongside ambition and willingness to embrace risk. We believe these attributes mean that the companies should be well placed to grow sustainably for extended periods of time. The question for stock pickers, of course, is how to identify this kind of alignment ex ante. We think one reasonable proxy for corporate long-termism is to look for businesses with a significant degree of inside ownership (in the hands of a founder or other type of controlling shareholder). A significant portion of the International Smaller Companies portfolio is invested in such companies.

While the presence of a founder is not necessarily always an unequivocal positive, our experience suggests founder-led companies show greater propensity to focus on long-term value creation, even when it comes at the expense of short-term pain. Their average tenure also often extends far beyond a conventional CEO cycle, and this alignment in time horizons is particularly important in industries that are prone to sharp fluctuations in end-market demand and where the temptation to engage in unproductive financial engineering to shore up the numbers can be compelling.

1. For more on this subject, we would refer the reader to a 2010 paper entitled Patience and Finance written by Andrew Haldane, Former Chief Economist at the Bank of England.

Tuning out the noise

Our portfolio is home to some businesses with this strategic ownership and sight of the long game beyond such fluctuations. Chroma ATE is a Taiwanese maker of testing equipment for semiconductors and power electronics, with very high shares in its niche markets. The founder and his family own 13 per cent of the business. Chroma’s revenues can be lumpy and volatile, but the company has shown an admirable consistency to its high R&D spend (typically, roughly a third of the employees are in R&D, with no cutbacks during the 2009 short but sharp downturn). This focus on long-term investment through short-term bumps has enabled Chroma to maintain very strong positions in its core market of semiconductor testing but also to successfully expand into new exciting applications, such as video colour testing, testing for EV batteries (which they supply to Tesla) and VSCELs (the 3D sensing lasers in iPhones).

Another way in which the presence of a strategic owner with a long-term focus can create tremendous value for shareholders is through counter-cyclical capital allocation. Addtech is a Swedish holding company investing in niche technology and industrial businesses. Much of its success has been down to its strong corporate culture, which marries decentralisation with accountability. Through its 100-year history, Addtech has proven itself an astute acquirer, partly because it has been brave enough to step in during macroeconomic downturns, when fear reigns and great companies become available at heavily discounted valuations. The CEO at the time, Anders Börjesson, beautifully captured the essence of this approach in a shareholder letter in 1994, at a time when the company had made a sizeable acquisition at the height of the Swedish financial crisis: “Recession or boom. What is the difference from a management perspective? In my opinion there are no decisive differences. I believe that philosophy and overall goals are long-term approaches and should not be adapted too much to economic trends.” The acquired company, Ferro, proved to be a master stroke, growing strongly for many years after.

The flipside to Addtech’s story, of course, is that for every buyer there is a seller. A great deal of value can be destroyed by selling an exceptional asset too cheaply. Here, too, the influence of a long-term owner can be very helpful. Maytronics is the worldwide leader in robotic pool cleaning solutions. It is an unusual company in many ways but one of its most distinguishing features is its ownership structure. Maytronics is owned by a kibbutz, a type of agrarian commune in Israel. The long-term survival of the entire community is largely dependent on the enduring success of the business. Back in 2012, the company was approached for a takeover by US pool giant Hayward, at premium. While the certainty of a premium would have appealed to many, and Hayward’s move came at time of some uncertainty for Maytronics, the kibbutz and the management team concluded the bid undervalued the long-term prospects of the business and rejected the offer. Maytronics has gone from strength to strength since, compounding revenues at 16 per cent over the past nine years.

Recession or boom. What is the difference from a management perspective? In my opinion there are no decisive differences.

Anders Börjesson, CEO of Addtech in 1994.

Seeing through the whiteout

Strong alignment (like a company’s commitment to sustainability) can become a powerful source of competitive advantage that enables companies to exploit their growth potential even in an uncertain and rapidly changing world. However, it is often intangible and therefore difficult to measure or reflect in a financial model. This makes it tricky for investors to fully appreciate and price in its benefits adequately. Including alignment as a spoke in our radar methodology is our acknowledgment of this complexity and we see it as a potential source of competitive advantage within our investment approach. It is undoubtedly one of the most rewarding challenges we face as investment managers to navigate the elusive haze while improving our understanding and ability to identify alignment.

Risk Factors

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect 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 March 2022 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

This communication 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 communication are for illustrative
purposes only.

Important Information

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. 

Persons resident or domiciled outside 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.

Financial Intermediaries

This communication is suitable for use of financial intermediaries. Financial intermediaries are solely responsible for any further distribution and Baillie Gifford takes no responsibility for the reliance on this document by any other person who did not receive this document directly from Baillie Gifford.

Europe

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. Baillie Gifford Investment Management (Europe) Limited is authorised by the Central Bank of Ireland as an AIFM under the AIFM Regulations and as a UCITS management company under the UCITS Regulation. Baillie Gifford Investment Management (Europe) Limited is also authorised in accordance with Regulation 7 of the AIFM Regulations, to provide management of portfolios of investments, including Individual Portfolio Management (‘IPM’) and Non-Core Services. Baillie Gifford Investment Management (Europe) Limited has been appointed as UCITS management company to the following UCITS umbrella company; Baillie Gifford Worldwide Funds plc. Through passporting 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. Similarly, it has established Baillie Gifford Investment Management (Europe) Limited (Amsterdam Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in The Netherlands. Baillie Gifford Investment Management (Europe) Limited also has a representative office in Zurich, Switzerland pursuant to Art. 58 of the Federal Act on Financial Institutions (‘FinIA’). It does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. The firm is currently awaiting authorisation by the Swiss Financial Market Supervisory Authority (FINMA) to maintain this representative office of a foreign asset manager of collective assets in Switzerland pursuant to the applicable transitional provisions of FinIA. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co. Baillie Gifford Overseas Limited and Baillie Gifford & Co are authorised and regulated in the UK by the Financial Conduct Authority.

Hong Kong

Baillie Gifford Asia (Hong Kong) Limited
柏基亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 and a Type 2 license from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of collective investment schemes to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited
柏基亞洲(香港)有限公司 can be contacted at Suites 2713–2715, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. Telephone +852 3756 5700.

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.

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.

Australia

Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth) and holds Foreign Australian Financial Services Licence No 528911. This material is provided to you on the basis that you are a ‘wholesale client’ within the meaning of section 761G of the Corporations Act 2001 (Cth) (‘Corporations Act’). Please advise Baillie Gifford Overseas Limited immediately if you are not a wholesale client. In no circumstances may this material be made available to a ‘retail client’ within the meaning of section 761G of the Corporations Act.

This material contains general information only. It does not take into account any person’s objectives, financial situation or needs.

South Africa

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

North America 

Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.

The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission (‘OSC’). Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford International LLC is regulated by the OSC as an exempt market and its licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.

Oman 

Baillie Gifford Overseas Limited (‘BGO’) neither has a registered business presence nor a representative office in Oman and does not undertake banking business or provide financial services in Oman. Consequently, BGO is not regulated by either the Central Bank of Oman or Oman’s Capital Market Authority. No authorization, licence or approval has been received from the Capital Market Authority of Oman or any other regulatory authority in Oman, to provide such advice or service within Oman. BGO does not solicit business in Oman and does not market, offer, sell or distribute any financial or investment products or services in Oman and no subscription to any securities, products or financial services may or will be consummated within Oman. The recipient of this material represents that it is a financial institution or a sophisticated investor (as described in Article 139 of the Executive Regulations of the Capital Market Law) and that its officers/employees have such experience in business and financial matters that they are capable of evaluating the merits and risks of investments.

Ref 22024 10011182

Author

Milena Mileva

Investment manager

Milena joined Baillie Gifford in 2009 and is an investment manager in the UK Equity team. She has also been a member of the International Smaller Companies Portfolio Construction Group since 2018. Milena graduated BA in Social & Political Science from the University of Cambridge in 2007 and MPhil in Politics from the University of Oxford in 2009. 

Back to top