How do we do what we do?
EMERGING MARKET INVESTINGTim Campbell and Andrew Keiller
All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk.
In the past we have written on ‘Why Do We Do What We Do’, exploring our growth philosophy in more detail, providing evidence to support our long-term, active approach. On reflection, we probably stopped short. The ‘why’, is of course important. Indeed, personalities like Simon Sinek, have made a career out of this single notion. However, some questions lead on from here. How do we go about implementing our philosophy in practice? How do we translate this ‘why’ into a portfolio that stands the best chance possible of delivering excess returns for our clients?
Our analysis showed the striking correlation between superior long-term earnings growth and stock price returns for the emerging markets (EM) universe.
Median Absolute 5 Year Return by 5 Year Earnings Per Share Growth Quintile
Source: Baillie Gifford & Co, Factset, Worldscope and relevant underlying index providers. MSCI Emerging Market and FTSE Emerging Market Indices constituents as of end December each year between 1994 and 2019 and with a market capitalisation larger than time-adjusted USD1bn. Earnings growth rates are based on previous fiscal year data, all in US dollars.
Hence why our investment process is singularly focused on identifying those companies that can grow much faster than the market over prolonged periods of time. But distilling this process into something that fits neatly into a diagram is a challenge. By its nature, much of our process relies on the interplay of data, experience, educated creativity and probability. This does not lend itself to a matrix or a flowchart.
But, we do have a very clear view of the inefficiencies we are aiming to exploit.
In Search of Fat Tails
Our investment criteria dictates that any company put into client portfolios should be one where we can envisage at least a two-times total return in hard currency terms over five years. This doesn’t mean 15 per cent per annum growth in a straight line, but we do look for it to come from underlying earnings growth rather than simply a re-rating of the shares. The cruel truth, however, is that only 33 per cent of stocks in our universe meet this criteria (based on a sample size of rolling five-year periods from 2002–2019). In fact, 34 per cent fail to generate a positive return at all. Our criteria is highly ambitious.
EM Stocks – Range of Rolling 5-Year Returns Per Annum
EM Stocks in MSCI EM Index or FTSE EM Index
This graph covers a 17-year period, split into rolling five-year periods rebalanced at the end of every year. It shows the proportion of EM stock observations that delivered five-year share price growth in each of the four different quantums. For instance, 66% of the stock observations grew positively and 33% exhibited growth of more than 15% per annum over five-year periods. Source: Factset and relevant underlying index providers. Data from end December 2002 to end December 2019 in US dollars.
Going further, it is evident that only a small selection of companies dominate EM returns over meaningful periods. Over the last 10 years or so, this pattern is clear. Between December 2009 and December 2019, there were nearly 2,000 companies in the MSCI EM index. Only 2 per cent of these drove all of the return. Of the other 98 per cent, although many obviously delivered a positive return, when added to those which were negative, they netted off to zero. Looking more specifically at our own client portfolios is also indicative of this pattern:
Stock Returns, EM portfolio, 10 years to end January 2020
Source: Baillie Gifford & Co, Factset.
Clearly, finding the strongest performers requires us to be ambitious and demand a lot from the companies in which we invest.
How do we do this? We look for fat tails. Or to put this another way, we look to exploit the market’s consistent refusal to accept the possibility of extreme outcomes. Consider the following chart which compares the average sell-side forecasts on earnings growth to the reality.
Looking at three-year forecasts1, we immediately see that the majority of sell-side broker research predicts 0–20 per cent p.a. growth from companies in EM (grey bars). The reality (blue bars), is far more widely spread. We present this chart not as a dig at forecasting skill, as we would be the first to admit that forecasting precisely is impossible. It does, however, show a few interesting things. To begin with, the inherent bias in the sell-side means negative estimates are very uncommon compared to actuality (only 18 per cent of the forecasts predicted negative earnings versus the reality of 35 per cent). More importantly, there are a number of companies delivering very strong growth, as shown by the blue bars at the right-hand side of this chart.
EM Stocks – Range of EPS 3-Year Compound Annual Growth Rate (CAGR)
EM Stocks in MSCI EM Index or FTSE EM Index – All in USD – December 1997 to December 2019
Data from December 1997 – December 2019 in US dollars. Source: Baillie Gifford & Co, Factset and relevant underlying index providers. As at 31 December 2019. The chart shows the range of 3-year earnings-per-share growth (per annum) delivered by EM stocks over the last 22 years (blue bars) with the 3-year earnings-per-share broker predictions (grey bars) at 31 December 2019.
These are the fat tails that we are targeting and it has proved to be a rich hunting ground, not least because the market consistently underestimates the likelihood of such growth occurring.
1. Ideally we’d have used five-year forecasts but unfortunately these are too far out for most sell-side analysts.
Time and again we see examples of where the market refuses to recognise the likelihood of rapid growth. It may be that this growth is lumpy, or represents a step change from a company’s recent history or simply flies in the face of the law of big numbers, but our universe does present opportunities for those willing to break out of the confines of simply extrapolating recent history.
Just looking at our own client portfolios is instructive here:
Range of EPS 3-Year CAGR
EM Stocks in MSCI EM Index or FTSE EM Index vs Baillie Gifford EM All Cap
Source: Baillie Gifford & Co and Factset.
Rolling 3-year periods between December 2005 – December 2019, in US dollars. Source: BG Fund Reporting, Factset and relevant underlying index providers. As at 31 December 2019. Baillie Gifford Emerging Markets All Cap data based on a representative portfolio.
The skew of the grey bars to the right hand side of the chart demonstrates our commitment to finding superior growth companies. But identifying these names requires a number of particular disciplines.
First, it is far more profitable to spend time considering what could go right rather than what might go wrong. Portfolio returns will be overwhelmingly driven by a small number of companies that do extremely well, so making sure you invest in these companies is critical. It matters more than obsessively worrying about all the risks that are inevitably present in any investment decision. But this can be uncomfortable, indeed it requires a conscious rejection of our natural tendency to loss aversion.
It necessitates that our analysis of companies is better than the extrapolation of most recent trends, that it correctly weights the possibility of extreme outcomes, of fat tails. And when we are faced with a small but credible chance of profits increasing by far more than the market expects, in a portfolio context, we should invest in size.
Ignore the Immediate
Experience has taught us that any attempt to forecast the near term with any level of precision can be seriously damaging to your wealth. Consider the following long-standing holding of our EM portfolios.
Taiwanese Semiconductor Foundry Company Earnings Per Share
Normalised to $100 as at 29 June 2009
Source: Bloomberg. As of 31 December 2019, USD.
It would hardly be motivating or stimulating for an investor to be questioned every time a target was missed or there was a big short-term swing in earnings for one of these companies. Nor would this have been a profitable use of time. The volatility of short-term earnings masks a significant rise in these companies’ earnings power over the long term. We spend all our efforts trying to understand the drivers of the latter, which requires a discipline in ignoring the former.
We would go further here, arguing that some of the greatest inefficiencies we encounter in EM are in companies where profits will be volatile from one quarter to the next, often as a result of investment or product cycles that are years in the planning. The market has shown a disdain for such companies, preferring the predictability of smooth profit generation even if the long-term growth rate turns out to be a fraction of that achieved by those more willing to reinvest in their business with greater ambition. This presents us with fantastic investment opportunities, but it requires an approach and culture that allows you to ignore near-term volatility.
You cannot invest in this way if you pay your investors for generating short-term performance. Quarterly or even annual earnings releases matter if you’re paid on annual performance but ultimately, this is likely to be counterproductive. We pay our investors exclusively on rolling five-year performance. This ensures that we remain focused only on what really matters, bearing in mind the next year or two have very little bearing on the terminal value of a company.
The volatility of short-term earnings masks a significant rise in these companies’ earnings power over the long term.
Inflection points matter
Another great inefficiency resides in the interaction between top-down and bottom-up investing.
EM investors do not have the luxury of ignoring the macro. Purely bottom-up investment is a path to ruin in a universe where industrial and economic cycles can dominate investment returns over multi-year periods. This also provides opportunities.
Our analysis shows that while it may pay to invest in those companies that display consistently high levels of profitability (as defined by those in the highest quintile of return on equity), the strongest returns are to be found in those companies that transition from poor levels of profitability to high (i.e. those that transition from the bottom two quintiles to the top quintile).
5-Year Stock Growth Percentiles by Quintile of ROE at the Beginning of the 5-Year Period
Stocks in Q1 of ROE at the end of the 5-Year Period
This graph shows the results of our analysis of EM returns data from 1996-2017. We split this into 5-year return periods, rebalanced annually, and we studied quintiles of 5-year US dollar ROE. It shows that stocks transitioning from low ROE quintiles to the top quintile have often displayed strong returns. For example, 20% of the observations grew more than eight times over 5-year periods, as shown by the blue line. Source: Factset. As at 29 September 2017. Based on equities defined as Emerging Markets by MSCI or FTSE.
This may seem obvious – rising levels of profitability are normally accompanied by a re-rating, thereby providing a two-fold kicker to share price performance – but identifying the drivers behind this change is the key and has been a significant source of excess return for our EM portfolios.
Over the last 20 years, broadly speaking, we can identify four separate inflection points that triggered significant changes to our EM portfolios.
It is largely impossible to time these inflection points perfectly but when you have an investment horizon measured over many years, successfully anticipating the future direction of travel is hugely valuable. As one of our investors put it, we’re not interested in the weather, but in climate change.
So how do we identify these inflection points? The first thing to say is that if you wait for all the evidence to be there that something has changed, you’ve already missed it. You will find very few estimates that assume a step change in return on equity. Dealing with incomplete information is the norm. Take the most recent transition, for example. Brazil and Russia were by no means out of the woods around 2017; their economies were (and are) still vulnerable to commodity shocks and volatile politics, but we believed there were reasons to suspect the balance of probabilities had shifted more in favour of hard currency growth than further retrenchment.
There is no silver bullet here but, by way of an example, factors we have looked at to inform our more positive view on oil and commodities include:
- the level of capex being spent on greenfield projects (many of the largest miners are scarcely covering maintenance capex let alone expansionary capex)
- changes in demand (beyond the obvious global growth, what does a marked increase in electric vehicles mean for nickel and platinum group metals?)
- changes in supply (shale oil may fill the need for light crude but what of the marked dearth of heavy crude, bearing in mind that most new sources of oil or materials require many years to come on stream?).
The ability to research these sizeable topics on a global scale, then join the dots and work back to the EM companies that stand the greatest chance of benefitting from these shifts in cycles has been one of the great strengths of our process. It is also why we would politely question those who argue EM investing can be purely bottom up or those who rely heavily on backwardlooking quant models. EM cycles are frequently long duration, which in turn means they can overwhelm strong company fundamentals for multi-year periods. So our process explicitly encourages our investors to make time to understand and anticipate cyclical change. Portfolio management and pure stock picking are very different skills and experience has taught us that marrying the macro with the micro helps not just with idea generation but ultimately in maximising your chances of consistent outperformance.
To invest in emerging markets one has to be an optimist. Underpinning any allocation is the implicit belief that developing countries can emerge and that shareholders can benefit from this growth. But to make the most of that opportunity requires a clear understanding of how to take advantage of the inefficiencies that present themselves.
Our process actively seeks out the potential for extreme outcomes. The evidence supports the thesis that truly rapid growth is more frequent than the market expects and is consequently mispriced. To do this requires a relentless focus on the long term. Volatility of earnings, while behaviourally uncomfortable, is often a rich seam to be mined, and our long-term remuneration structure is key to allowing our investors to focus only on what matters.
Finally, we look for inflection points. We encourage our investors to travel, to think in terms of structural shifts and to assess the impact of prolonged imbalances of supply and demand. It is these inefficiencies that have driven our idea generation and informed our portfolio positioning for over twenty years. It has allowed us to generate excess returns through different market conditions and several cycles.
As we embark on another transition within emerging markets, the opportunities for active growth seem as plentiful as they ever have been.
Annual Past Performance to 30 June Each Year (%)
Baillie Gifford Emerging Markets Composite
MSCI Emerging Markets
FTSE Emerging Markets
Annualised returns to 30 June 2021 (%)
Baillie Gifford Emerging Markets Composite
MSCI Emerging Markets
FTSE Emerging Markets
Source: Baillie Gifford & Co and relevant underlying index provider(s). USD.
Net of fees returns have been calculated by reducing the gross return by the highest annual management fee for the composite.
Past performance is not a guide to future returns.
The views expressed in this article are those of Tim Campbell and Andrew Keiller 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.
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TIM CAMPBELL Client Service Director
Tim is a Director in the Clients Department and Chair of the Emerging Markets Product Group. He joined Baillie Gifford in 1999, initially working as an Investment Manager in the Emerging Markets Equity Team. He moved to the Clients Department in 2007 and became a Partner in 2012. Tim graduated BA in History from Trinity College, Dublin in 1997.
Andrew Keiller Client Service Director
Andrew is a Client Service Director in the Emerging Markets Client Team and is a CFA Charterholder. He joined Baillie Gifford in 2011 as a Graduate Trainee and completed a two-year programme of secondments around the firm. Andrew graduated BSc (Hons) in Mathematics and Business Studies from The University of Edinburgh in 2011.
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