1. GROWTH INVESTING

    Quarter 2 2016
    THIS PAPER IS INTENDED SOLELY FOR THE USE OF PROFESSIONAL INVESTORS, UK INTERMEDIARIES AND US RETAIL INVESTORS AND SHOULD NOT BE RELIED UPON BY ANY OTHER PERSON. IT IS NOT INTENDED FOR USE BY NON-US RETAIL CLIENTS.
  2. Not so long ago I read an article describing the typical start to the day for certain CEOs in the United States. Many of them rise at an unholy hour, exercise in the gym, watch some TV, spend quality time with their families, make vital phone calls and power through their emails, much of it simultaneously and all before 7am apparently.
  3. Wow. I wasn’t sure whether to laugh or cry. This is about as far removed as it could possibly be from my own morning routine. However, I quickly got over any feelings of inadequacy. After all, I strongly suspect I am in the majority and we all have to work out the best way to manage the day.

    Investment managers have to work out the best way to manage portfolios. At Baillie Gifford we are growth managers. We search for companies that have the potential to generate superior long term growth in revenues, earnings and cash flow in the belief that this will be reflected in long term share price outperformance. As such, we fulfil a clearly defined role for our clients, more often than not as part of a wider stable of managers.

  4. Why Growth?

    What is it that persuades us that growth investing is the best way to generate superior returns for our clients over the long term? In short, it’s the connection between economic success or failure, as reflected in a company’s growth record, and share prices. This is demonstrated in the chart below, which describes the dollar denominated earnings profile of a global universe of equities, covering a 25 year period up to April 2016 and divided into quintiles of realised earnings growth over five year time horizons:

    Delivered Median Total Returns on Earnings Growth Quintiles
    Rolling 5 Year Horizons (1990 – 2016)

    Source: Factset/Worldscope (USD).

    The right hand axis shows that the stocks in the top quintile have achieved median levels of profit growth of 24% per annum in excess of the universe over those periods, whereas those in the bottom quintile have realised median levels of contraction in profits of 21% per annum relative to the universe. The dotted line describes the relative annual returns of those same stocks and can be seen on the left hand axis, showing that share price returns follow delivered earnings growth. The median top quintile stock outperformed the universe by 9% per annum whilst the median bottom quintile stock underperformed the universe by 8% per annum. And, reading from bottom left to top right, the relationship of share price performance to delivered earnings holds good for the entire series.

    Not only that, but the relationship was consistent throughout the time under review and has not been skewed by a few outlying periods, as we could not find any rolling five year periods when a lower earnings quintile outperformed the highest earnings quintile:

    Earnings Growth Quintiles and Relative Returns
    Rolling 5 Year Horizons

    Source: Factset/Worldscope (USD).

  5. FUTURE DIFFERENT TO THE PAST

    So far so good, but that was yesterday and the nature of the investment opportunities available to us is changing rapidly and dramatically, so is it a useful guide to the future? Today, technological progress is so relentless and all pervasive, affecting countless aspects of our lives and providing forward thinking and entrepreneurial management teams with huge growth platforms, that it has rarely been clearer that the past is no guide to the future. Frank Zappa once said that “you can’t be a real country unless you have a beer and an airline”, and in the not too distant past the same might have been said about a real portfolio, but that’s becoming increasingly hard to support.

    Nor can benchmarks properly reflect the march of technology. Large swathes of the most widely used indices are populated by industries and ‘blue chip’ stocks vulnerable to the disruptive power of the new generation. Whilst it is old news that Amazon, and others, have decimated traditional high street retailing, the vulnerabilities are now much more broadly based than just shops. How do the large pharmaceutical companies react when advances in genetic knowledge are giving rise to the emergence of a whole range of young, innovative companies that are threatening the incumbents by developing better and more accurate treatments for diseases? How will the financial sector cope with increased competition from ‘fintech’ companies that harness modern technology, are faster moving and unencumbered by legacy costs? Will ever-falling alternative energy costs spell the end for the oil and gas behemoths? What is the value of the billions of dollars invested in the internal combustion engine when Tesla’s Model 3 electric vehicle can receive 325,000 reservations as rapidly as one week after its unveiling?

  6. In this 31 March 2016 file photo, Tesla Motors unveils the new lower-priced Model 3 sedan at the Tesla Motors design studio in Hawthorne, Calif. More than 276,000 people pre-order the Tesla Model 3 in less than a week. Is it the Tesla phenomenon, or has the $35,000 electric car with a range of 200-plus miles taken finally taken the electric car to the masses? © AP Photo/Justin Pritchard.
  7. At the same time, and in good part as a result of the above factors, portfolios managed by Baillie Gifford have been migrating to a greater or lesser extent towards younger companies with very impressive revenue growth but relatively immature profit profiles. Over recent years, we have sold out of a range of stocks that, although previously successful, possess increasingly compromised growth prospects, and reinvested the proceeds in some of the less mature and faster moving companies that are challenging the old order. Five years ago it wasn’t unusual to find a decent proportion of stocks such as travel agents, bricks and mortar retailers and cigarette manufacturers in portfolios. Since then, however, a number of those holdings have been sold and the proceeds reinvested in companies such as those at the forefront of the e-commerce revolution, chip designers, online retailers and biotech stocks.

    A defining characteristic of many of these younger disruptive companies is that they possess a seductive mix of growth and profitability, owing to the relatively capital light nature of their business models. The ubiquity of cheap computing power and the availability of the cloud allow growth to be achieved at much lower cost than previously, while for certain online businesses ‘network effects’ can drive up revenues rapidly. And, importantly, many of these companies are happy to use their cash flows to invest in the business for the long term, even if it means sacrificing margins in the short term.

    When you combine the power of technological change with the changing face of the opportunity set, portfolio evolution and our preference for companies that are willing to invest for growth, it suggests that we should be considering factors beyond the earnings growth metrics outlined above.

  8. REVENUES AS WELL AS EARNINGS

    For a number of our portfolios, one of the most salient style tilts is to sales growth relative to the index, and thinking about revenues as well as earnings enhances the link between superior growth and outperformance. So let’s go to the top of the P&L, taking the same universe of stocks and time periods used for the earnings analysis above. The chart below plots the same data as that earnings analysis, but substitutes revenues for earnings.

    Delivered Median Total Returns on Sales Growth Quintiles
    Rolling 5 Year Horizons (1990 – 2016)

    Source: Factset/Worldscope (USD).

    The same strong and consistent patterns emerge. Companies in the top quintile delivered median revenue growth of 17% per annum in excess of the universe, and the median stock outperformed by 6% per annum, whilst companies in the bottom quintile saw median revenues contract by 10% per annum relative to the universe, and the median stock underperformed by 5% per annum.

    And, similar to the earnings analysis, the relationship becomes more stable the longer the time scale. Whilst individual one year periods inevitably contain an element of randomness, over five year periods there are only two periods out of twenty one where a lower quintile group outperforms the top quintile.

    Sales Growth Quintiles and Relative Returns
    Rolling 5 Year Horizons

    Source: Factset/Worldscope (USD).

  9. PATIENCE AND THE ASYMMETRY OF RETURNS

    Patience is the key. The relationship between both earnings growth and relative performance and revenue growth and relative performance is robust over five year time frames but less persuasive over shorter time periods. It gets stronger over time. Given the amount of noise in markets this should come as no surprise and is further confirmation, if it were needed, that it makes no sense to measure either company or portfolio performance over short periods. In essence, it comes down to the frequently quoted Ben Graham comment about the stock market being a voting machine in the short term but a weighing machine in the long term.

    As a shareholder you can only capture the real benefits of growth if you are prepared to hold stocks for multi year periods and to accept that there will be times when you will look wrong. We need to give companies time to develop their plans, engage with them where appropriate and support them through difficult times. Of course this is much easier to say than do, but you don’t even have to get more than half of your decisions right. The asymmetry of stock market investing, where you can make many multiples of your initial investment on the upside but lose only as much as you put in on the downside, means that the benefit of as few as one or two big long term winners can more than compensate for the inevitable mistakes that all investment managers make. We can help ourselves find these big winners by thinking about stocks in the context of their broad long term potential rather than getting bogged down in overly precise and inevitably flawed short term financial projections, by specifically incorporating ‘blue sky’ upside scenarios into our analysis, and by trying not to worry or engage in blame when stocks don’t work out.

    Asymmetry also means running your winners – fund managers are sometimes tempted to take profits in stocks that have been performing well (the old market cliché being “it’s never wrong to take a profit”) and, similarly, clients can be tempted to allocate away from outperforming managers, typically on the basis of mean reversion, but if you adopt this approach then you are of course giving up some of the benefits of asymmetry. If you find a stock, or an investment manager, that has generated good returns and that you think has the structures in place to continue to do so, why would you want to dilute your portfolio by reducing your exposure?

    Incidentally, this also means that investors, and clients, should ignore the fluctuations of growth versus value benchmarks. Style indices are flawed in terms of their construction, cyclical in terms of composition and subject to high turnover. And, as we know, the distinctions between growth and value managers can be blurred. Consider a selection of well known US domestic large cap value funds, where it is far from unusual to see a healthy selection of stocks classified as growth by index providers in the top ten holdings, at times more than half. So, when you see growth indices outpacing value, or vice versa, don’t just take it at face value and make too many judgements about the merits of one versus the other, or the merits of a manager measured against one of these indices. A far more meaningful decision is to employ a manager with a clear philosophy and process discipline.

  10. SUMMARY

    We believe that there is a strong correlation between a company’s long term economic performance and its long term share price performance. The analysis above illustrates that those stocks that have delivered the highest earnings growth have generated the best share price performance. And, in a world where the march of technology is leading to a rapidly changing opportunity set and portfolios are able to invest in a range of stocks with different financial characteristics, this applies equally to revenues.

    Underlying all this is the point that stock picking should be a simple exercise and it is our job to cut through the various pressures and agency issues that get in the way of that. As great American folk singer Pete Seeger said, “Any darn fool can make something complex; it takes a genius to make something simple.” I hope that none of us here at Baillie Gifford would claim to be a genius, but we are clear in the belief that growth investing provides the best platform to generate superior returns. The real value to our clients, of course, lies in the quest to successfully identify growth before it is recognised in share prices, so as investment managers ‘all’ we have to do is find the right stocks. How we go about that is perhaps the subject for another paper…

    Image: © Michael Melford/National Geographic Creative.

  11. Important Information and Risk Factors

    The views expressed in this article are those of Kevin Fenelon 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.

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  12. Kevin Fenelon

    Client Service Director
    Kevin graduated MA in German from the University of Edinburgh in 1981. He subsequently worked as an investment manager before joining Baillie Gifford in 2007 as a Client Service Director. Kevin is responsible for clients in a variety of strategies, mainly in Europe and the United States.

    Thanks to our investment risk team for their input to this article.