Early-stage investing: looking beyond rate hikes

November 2023

Key points

  • Small-cap equities are currently at historically cheap levels relative to large-cap equities
  • Small-cap investing can work in a higher-rate environment, and, as history tells us, the current market volatility will eventually settle
  • As operational growth is the primary driver of investment returns in the long run, the current environment presents opportunities for long-term investors in small, growing, disruptive businesses

Your or your clients’ capital may be at risk.

In time, many economic and sociological theses will undoubtedly be written about the period 2020–2023. We have all witnessed tremendous changes in the investment environment, but for us, a notable one has been the return of market volatility. Recently, there have been market spikes not seen since the 2008 financial crisis and more consistent volatility than at any point in the past decade.

This has prompted ruminations of whether we’re experiencing a paradigm shift in investing regimes. And whether the conditions that persisted through the previous decade, accommodating monetary policy, plentiful resources and geopolitical stability, have ended.

We’re not economists in the Global Discovery Team, yet still view it as likely that the coming period will be characterised by a higher cost of capital, constrained resources and prioritising productivity over growth at any price.

Fears of regime change have contributed to the present valuation gap between small (eg businesses with a market capitalisation below $5bn) and large-cap businesses. Currently, small-cap equities look at historically cheap levels relative to large, reversing a decade-plus trend.


Small vs. large (price divided by 10-year average earnings)

Source: Baillie Gifford & Co.

The prevailing narrative attributes the recent ups and downs in the stock market almost exclusively to central banks aggressively hiking interest rates. Further, we have heard suggestions that the higher interest rates and accompanying increase in the cost of capital are prohibitive to investing in early-stage companies. It’s assumed that when interest rates go up, earlier-stage smaller companies will be less attractive to investors who will want to put their money into investments which offer greater short-term certainty.

We question, however, whether this relationship is as simple or robust as many would have you believe.

Partly, our thinking is formed by looking at previous interest rate increases and the subsequent performance of US small caps in the aftermath. Historically, small-cap investing has worked in periods of higher central bank rates. While the aggressiveness of today’s hikes may be usual, the actual numbers are far from it. In similar conditions, historically, shares in smaller companies have prospered (eg the three years following 1986, 1994 and 2004).


US Federal funds effective rate (%)*

*A volume-weighted median of overnight domestic unsecured borrowings in US dollars by depository institutions, representative of the level of central bank rates within the economy.

Source: Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [DFF], retrieved from FRED, Federal Reserve Bank of St. Louis;, November 13, 2023.

Russell 2000 index returns following fed funds rate increase
  Hike date 3 months after 12 months after 18 months after 36 months after
01 01/02/1983 17.3 17.6 5.1 48.4
02 01/10/1986 0.0 28.9 8.6 39.5
03 04/02/1994 -2.5 -2.7 16.9 47.6
04 30/06/1999 -6.3 14.3 7.6 5.1
05 30/06/2004 -2.9 9.5 15.9 46.0
06 15/12/2015 -5.4 22.6 27.4 30.0
  Average 0.1 15.0 13.6 36.1

Source: Baillie Gifford & Co.

So, higher rates are not in and of themselves terminal to smaller companies investing. Therefore, today’s singular narrative that this alone has led to the recent downward adjustment of valuation multiples by the market looks hasty. In many ways, we understand this since people often reach for simple heuristics when confronted with complex situations, but to do so misses the nuance of what is happening today.

Instead of myopically looking at one factor, we’d argue that a confluence of stressors has prompted the current volatility. The cumulative shocks of a pandemic, inflationary pressures, and yes, a monetary pivot as central banks have raised interest rates, but also escalating geopolitical tensions and not being able to pinpoint where we are within the economic cycle have led to a paralysed and shell-shocked market psyche.

Amid this much uncertainty, investors’ horizons have shrunk to the point that they are unwilling, or perhaps unable, to consider organisational developments or proposition enhancements at a company that do not positively impact returns in the next 12 to 18 months.

We readily admit that this is not a prosperous environment for our investment style. As long-term investors, we typically consider a company’s relevance over at least five years. We are used to having a longer horizon than most, but we cannot remember when it felt this extreme. Being a long-term investor in small, growing, disruptive businesses currently feels powerfully contrarian.

But this will ultimately pass. Partly as shocks work through the system and partly due to innate human adaptability. We will return to an environment more sensible of the underlying worth of the company.

As Benjamin Graham, the American economist and professor, notes, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In the meantime, with such blatant dislocation between the long-term business potential and current market price, this environment presents opportunities for our portfolios.


Business building, not valuation model tweaking

The market price for any equity can be broken down into projected earnings or cash flows and what the market is willing to pay for these at that given time (variously described by its price-to-free cash flow (P/FCF), price-to-sales (P/S) ratings or price-to-earnings (P/E) multiple).

We have always invested in businesses where the scale of the opportunity and their ability to execute are much more influential on our terminal projected value – what we perceive the implied value of a company to be beyond our five-year investment horizon – rather than how much higher we expect the multiple to rise.

Investing over the timeframes we do, the skill is judging the scale and likelihood of future cash flows rather than financial mathematic gymnastics. Moreover, the eventual growth of cash flows swamps any possible rating changes.

A quick look at a discounted cash flow model, which seeks to value a company based on its expected future cash flows, speaks to this. This calculation is much more sensitive to a percentage change in the terminal growth expectation, the constant rate at which a company is expected to grow forever, versus a percentage change in the discount rate.

But more powerfully, this is a lived experience with our most successful investments. Analysis has shown that most investment returns can be attributed to operational growth. To the extent that the multiple could have shrunk by 70, 80 or 90 per cent from the initial investment and still delivered an attractive two-fold return. Even in today’s environment, such multiple compression would be an extreme and frankly unlikely occurrence.

Scenario: how much can a company’s price-to-sale ratio reduce by and you still can double your initial investment?
Security name Price return (%) PS multiple change (%) Sales growth (%)
Tesla Inc 100 -94 3,455
DexCom Inc 100 -85 1,211
MercadoLibre Inc 100 -94 3,117
Alnylam Pharmaceuticals Inc 100 -87 1,417
MonotaRO Co Ltd 100 -69 542

Source: Baillie Gifford & Co.

Our research shows that in the long term, share prices are reliably driven by the company’s operational performance (such as sales, cash flow, and earnings growth). However, examples such as the above illustrate the striking extent to which these operational metrics drive overall share prices.

If we do our core task adeptly – identify immature, high-potential, progressive businesses early in their relative lifecycle and hold them for the long term as they scale and grow – the resulting sales and earnings growth should entirely swamp the market multiple or rating and deliver attractive returns.


Operational impact

Within our approach, the more pertinent question is the operational impact of any changes to the investment environment and whether it influences a holding’s ability to generate future cash flows. Crudely, this can be broken down into:

  • Does the business have the financial resilience to navigate the near term?
  • Is there a material impact on the business’s long-term growth potential and returns profile?

Capital is now less plentiful, and funding for earlier-stage businesses is scarcer. Still, we are observing that capital remains available for companies demonstrating strong operational performance (shown by recent capital raises by Axon, Alnylam Pharmaceuticals, QuantumScape and Ocado). But markets now need to see progress before companies can access additional funding.

The Global Discovery Team’s approach can often hide that the portfolio contains businesses at different stages in their growth. Most strategy holdings can now self-fund their daily operations by generating positive earnings or cash flows. However, circa 40 per cent of the portfolio is not at that point and relies on balance sheet capital. Notably, most of these names have multiple years of cash reserves on the balance sheet, meaning they still have access to the capital they need to grow.

We do not think investors should shy away from owning unprofitable businesses. The market is currently discounting these, but many of our most successful holdings have initially been cash-consumptive and unprofitable (eg Tesla).

© Axon

Growth requires investment; this has always been a fundamental principle of business building, and we continue to support it. We hold such names on the understanding that they are making investments now to improve the likelihood of future profitability. For businesses at this stage, we examine:

  • Are there observable positive unit economics, eg revenue per unit of sales less cost of goods sold, which speaks to how the business could generate future positive earnings?
  • Do they have the capital to progress to a self-sustaining point of maturity or to a sufficient point to unlock additional capital?

Further, we have seen the market significantly reward these businesses as they pivot into profitability. Notably, Exact Science’s share price meaningfully appreciated on the news that it would achieve profitability 12 months ahead of schedule. Pleasingly, we foresee a group of holdings making this transition in the coming two to three years and might expect this to be an attractive source of portfolio performance.

As with all investing, this is a view on a risk-adjusted return – we will not get all of it right – but on balance, we think the odds of very attractive long-term returns from these holdings look favourable. These are fascinating, high-potential early-stage businesses; precisely because of the market’s presently fearful approach, we should look for opportunities to be optimistic and greedy, as Warren Buffett might say.

The next question is – does the changed environment impact the portfolio’s ability to generate growth? No business operates in a vacuum; all have a greater or lesser connection to where we are in the economic cycle and general patterns in consumption. Yet primarily, our holdings deliver growth by taking advantage of long-term growth trends.

Bluntly, the changes in market sentiment over the past three years have not reduced our need for improved patient outcomes, better efficiency in health care or clean energy. Indeed, the current push for greater efficiencies seen in many sectors suggests that investment themes, such as automation or enterprise digitisation, should be all the more necessary and important.

Reflecting on the portfolio’s most significant holdings, it is hard not to be excited by what is to come and conclude that this could be a transformational period for many.

<p">The next two or three years have the potential to be incredibly rewarding. To name but a few, the progression of Alnylam’s clinical pipeline with its sector-leading success in bringing drugs to market, the opportunities for LiveRamp to become the de-facto digital consumer identifier across the internet with the removal of cookies, or Oxford Nanopore’s introduction of new sequencing machines which make genetic sequencing accessible to many for the first time. Each of these looks exciting and undervalued areas of opportunity.

© Oxford Nanopore


Much has changed over the past three years. Interest rate increases have undoubtedly impacted markets and captured investor attention. Yet, we would urge people not to conflate these with fears of a regime change which invalidates our approach.

The historical data suggests that small-cap investing can work in a higher-rate environment. What today demonstrates is that what small caps cannot do is prosper in an environment afflicted by this extreme uncertainty.

Therefore, we are sticking to investing over reasonable periods alongside committed management teams, executing against attractive market opportunities to deliver significant operational growth. Evidence suggests this remains a recipe that could produce vibrant long-term investment returns.

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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 December 2023 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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