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.
Two recent conversations prompted me to write this note. Both were about Peloton, the connected fitness company and a recent addition to the LTGG portfolio. The first was a chat with an acquaintance at a competitor of ours who’d spotted that we were shareholders in Peloton. “It’s overvalued, 100 per cent definitely” he told me, adding for good measure: “Typical Baillie Gifford to own it”.
The second was a Covid-compliant discussion with my neighbour over the garden wall. He’s a bond guy, who himself happily works out on a Peloton exercise bike. On the company itself, he was less keen: “It’s like me and Bulgarian debt – I love it, but it’s definitely overvalued.”
Such comments are normally water off a duck’s back. In fact, I see them as positive, as they reinforce my sense of the prejudices of many market participants. In this case however, something about the striking levels of certainty shown by both of my interlocutors got me thinking about valuation.
I should stress I make no judgements about other investors as there are hundreds of ways to do the job. But their conviction that this particular security was overvalued was remarkable. I hope I don’t hold opinions in this way.
It made me think about LTGG’s views on valuation and why we appear to do it differently. The above conversations occurred in February and March 2020. Since then, the number of Peloton subscribers has doubled, speaking volumes about why we should strive to stay open minded.
Approaching my 25th year of learning about investing, many things continue to surprise me. Chief among them is the resilience of the capital asset pricing model (CAPM), the accepted formula for calculating risk versus return. It remains a fulcrum of the Chartered Financial Analyst Institute and other qualifications bodies and underpins the methodology often used to determine value.
Such longevity is astonishing given the model’s lack of intellectual rigour. Despite representing another spectacular failure of the dismal science, CAPM has come to dominate modern portfolio theory. Its flaws are too many to list in full here, but let’s remind ourselves of its main shortcomings, with apologies to those who have read this before over the 16-year lifetime of LTGG.
At the core of CAPM is the idea that the only variable that matters to a stock’s potential return is ‘beta’ – a proxy for relative volatility. Plug this in to the alluring equation of risk-free rates, the equity market premium and expected returns, and we’re promised an output that tells us if the price of a stock is consistent with likely returns.
That may sound logical, but it’s based on several fallacies. There’s no evidence that beta explains the performance of individual stocks over the short term or the long term. There is also the small problem of which risk-free rate one should use, with this picture muddied by a decade or more of very low interest rates. Also, the equity market premium can only be grasped by those who write equations in textbooks.
Despite having zero intellectual rigour and no empirical evidence to support it, the CAPM remains widely used. It is the modern equivalent of economists’ rational agency. That it should underpin so much passive investment (‘no point in seeking higher returns as that implies higher risk’) results from the collective amnesia surrounding this topic. Meanwhile the idea of high and low beta relying on past correlations has surely been laid to rest by the coronavirus pandemic. If algorithms can’t predict humans bulk buying toilet rolls, it seems unlikely that CAPM advocates can correctly predict the progress of stocks.
The real question is why we still think that a single number reflecting past price fluctuations can describe the risk and return of a security? My guess is that because investment is so hard and so uncertain, a simple equation is very alluring. But this is to fall into the trap with which we started: irrational certainty about future and current valuations. No number, on its own, can capture valuation.
It’s annoying if people think LTGG ignores or skirts over valuation. We think deeply about it, albeit in an unconventional way. Over our 16-plus years we have regularly been asked "isn’t X overvalued?" All of the questions have stemmed from the same root: a fetishisation of the spot number. In contrast valuation is as intangible a feature of our process as the answers to the other nine questions in our ‘10Q’ or 10 Question Research Framework (see below). The reductionist apparatus of the spot price/earnings ratio, or of any other metric, relies on the same CAPM-based premise that a number can tell us the answer. This approach is not so much a panacea as an obfuscation.
In my view, valuation touches every part of our 10Q. All of the questions are intertwined. I don’t disagree that the five or ten year returns of our holdings are based on the future cash flows generated, but in assessing the probabilities of those flows, we need to think about top-line growth, margins, competitive advantage periods, management culture and capital allocation.
To expand: looking ahead to those future cash flows, revenue growth is necessary but not sufficient. It’s a far easier starting point for future cashflows to be substantially higher if revenues have gone up several-fold. This is an obvious arithmetical outcome of compound growth but one often forgotten by a market focused on the next quarter. Margins and returns are the cogwheels of valuation: we can add a lot of value by unearthing companies that not only grow over the long term but become much more profitable as they achieve scale. The drivers of such growth and profitability are to be found in companies’ DNA: the culture set by management, their investment timeframe, their willingness to experiment, and their view of their societal contribution.
Our first eight questions coalesce to provide answers to questions nine and ten: what the valuation might look like in ten years time and why the market might not realise this. Of course, it’s challenging to look a decade ahead, but that is our job. The use of probabilities helps us navigate this uncertainty and it’s better to be imprecisely right than precisely wrong. We should revel in the ability to see valuation differently. It allows us to use the imagination essential to all successful investment.
"...valuation touches every part of our 10Q"
This is not just a theoretical approach. What if we had fallen prey to thinking Amazon was fully valued in 2005 with its sales at $8.5 billion and that a market cap around $20 billion captured its future growth? Remember, this was the year that Amazon Prime was announced, locking in profitless growth in the eyes of many. Why would you own such a volatile, high-beta stock when you could buy Walmart or a retail ETF?
Of course, we have constantly asked ourselves what the valuation of Amazon implied (including conversations about companies being valued at more than $1 trillion). We continue to do so now. The point is that there were as many, if not more, people in 2005 saying that Amazon was ‘overvalued’ as there are saying this about Peloton today.
We could also run through Tencent’s 50-fold-plus increase in sales since 2008 or Hermès’ quadrupling over the last decade or so, at extremely high margins and with compelling longevity. In all these cases CAPM acolytes assured us the shares were overvalued a decade or more ago, just as my friends tell me about Peloton today. The same goes for Zoom, Cloudflare, Pinduoduo, Shopify or many other LTGG holdings.
We have no crystal ball, but we are prepared to entertain long-tail outcomes in valuation. We’ll also get investments wrong, in cases where operational outcomes tell us the companies were overvalued: from First Solar to Under Armour; from Belle International to UBS.
Peloton could achieve a wide range of outcomes. It is certainly possible for it to dominate the home fitness market, growing much more quickly now, allowing economies of scale and a profitable global franchise, and leaving gyms as old-fashioned curiosities. The possibility of a company whose sales rise very rapidly from around $2 billion this year seems to me over 5 per cent and makes the starting valuation of less than $20 billion potentially too low. Of course, the product could prove a passing fad with non-sticky customers and an eroded competitive advantage. In such a scenario it will be worth far less. What I do know is that I have no certainty about the myriad possible outcomes for this company or any of our other holdings.
Accepting that valuation is uncertain and intangible is one of the hardest things to do in investment. There is an alluring simplicity to a single number or equation bestowing faux certainty on our task. But a spot price/earnings multiple tells a long-term investor precisely nothing. It’s not a form of shorthand that foretells expected returns, it’s just a number. Moreover, it’s a dangerous number because it creates many hostages to the short term and douses imagination about the long term.
There is a perception of safety in constructing a complex spreadsheet, which makes fund managers look clever to their clients. But thinking about outcomes over ten years is inherently uncertain and should encompass a vast range of possibilities. Why are so many market participants in thrall to predictions precise to the last decimal place? Because it’s the easy option, the percentage shot, the safety of the herd. Uncertainty is hard to compute and the risk of failure looms large. Easier to reach for the elixir of the CAPM, a ready-made solution to the eternal investment conundrum.
Only it doesn’t actually work. Of that much I am certain.
The views expressed in this article are those of the authors 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 September 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.
Changes in the investment strategies, contributions or withdrawals may materially alter the performance and results of the portfolio.
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.
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.
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 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. It is the intention to ask for the 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 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 licence 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 Room 3009-3010, One International Finance Centre, 1 Harbour ViewStreet, Central, Hong Kong. Telephone +852 3756 5700.
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.
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.
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.
Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.
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. 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 Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.
Baillie Gifford Overseas is not licensed under Israel’s Regulation of Investment Advising, Investment Marketing and Portfolio Management Law, 5755-1995 (the Advice Law) and does not carry insurance pursuant to the Advice Law. This document is only intended for those categories of Israeli residents who are qualified clients listed on the First Addendum to the Advice Law.
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 document 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.
This strategy is only being offered to a limited number of investors who are willing and able to conduct an independent investigation of the risks involved. This does not constitute an offer to the public and is for the use only of the named addressee and should not be given or shown to any other person (other than employees, agents, or consultants in connection with the addressee’s consideration thereof). Baillie Gifford Overseas Limited has not been and will not be registered with Qatar Central Bank or under any laws of the State of Qatar. No transactions will be concluded in your jurisdiction and any inquiries regarding the strategy should be made to Baillie Gifford.
48668 INS WE 0661