Tilting the odds in your favour

Tesla has become the poster child for phenomenal innovation, genius leadership, and exceptional returns. Few remember that Elon Musk struggled to get funding for his project from the capital markets, a fact the writer Michael Lewis reminds us about in The Fifth Risk. It was the US Department of Energy which lent money to Tesla to build its factory in Fremont, California, when the private sector would not. Would Mr Musk have built his factory in South Africa had that government been able to lend money, or China had they been willing to do so? America has long been the leader in putting risk capital to productive work, and having policies and rewards in place to encourage entrepreneurship.

If it seems unusual to start an ‘International’ paper referencing a US company, it is worth remember that in financial markets, it is the rate of change and its direction that dominates, and in this regard, it may be the International market place that has the US in its rear view mirror in the coming decade.

Pick the right markets

The international asset class finds itself under pressure and has been eclipsed in performance terms by US stocks in more recent times. We think it is time to question if this can continue. Our experience in managing international portfolios dates back to the 1980s, but investing overseas is more deeply embedded in our firm’s DNA. Indeed, Scottish Mortgage Investment Trust was founded in 1909 and has been managed by Baillie Gifford for 112 years. We first wrote about the international opportunity set in 2019, and this paper looks to build on that original piece, expanding on some of the arguments highlighted back then, specifically, how the international horizon looks for an active investor over the coming years and why its attraction is growing.

For the purposes of this report, we define our investible universe as stocks with a market capitalisation above $2bn. The universe is summarised below.

Our Investible Universe

Source: Bloomberg. As at 31 December 2020.

When we wrote the first iteration of this paper, the dollar value of the US market was higher than the combined international markets. In three short years that situation has now inverted.

Since 1996, the broader universe of US-listed securities has declined from a peak of 8,090, to a 2018 count of 4,397, a 46 per cent drop. Today, there are fewer US-listed companies than in the early 1980s, when the US economy was less than half its current size.

US Listed Companies

Global Listed Companies

Source: World Bank.

There is no such shrinkage in international equity markets. Quite the opposite in fact, with internationally listed businesses growing from 26,432 to 38,945, a 47 per cent increase. For several years, Ernst and Young has tracked global IPO trends. In 2014, its research showed that the Americas accounted for 25 per cent of all new listings and 38 per cent of the proceeds of those. By 2020, the US share had fallen to 21 per cent and the proceeds to 36 per cent, with much more fallow periods in the intervening years.

RECENT IPO ACTIVITY

Selected IPOs by Proceeds

Source: PwC, Ernst & Young, Global IPO Trends, 2016, 2017, 2018, 2019, 2020. The IPOs selected represent the top three listings by proceed in each quarter between 2016 and 2020. Note: Baillie Gifford does not necessarily hold these companies.

For several years, Hong Kong and China have topped the IPO league table. As the chart below illustrates, we can expect this trend to continue as emerging market companies redressing the imbalance imposed by legacy benchmarks. The link between GDP and market cap is far from linear, but the direction of travel seems clear to us.

US companies are over-represented in global benchmarks

Source: Refinitiv Datastream.

Over the years, the level of interest in US domestic equities versus international equities has waxed and waned, most commonly when one asset class has enjoyed a prolonged period of outperformance. We are at one such juncture today. Taking three-year rolling returns for the S&P 500 and the MSCI EAFE index as our comparative benchmarks, domestic US equities have enjoyed 11 consecutive years of outperformance against international equities. As this is one of the longest periods of relative strength in the past 45 years, it is not surprising that more people are calling for more assets to be allocated domestically. However, after such a lengthy period of outperformance, history tells us this may not be the best time to make that switch.

Three-year rolling returns – S&P 500 vs International Index

Source: Refinitiv Datastream.

What matters most is the transformation in ambitions. The thriving tech ecosystems in various European cities – from Paris to Berlin to Stockholm – have provided nurturing environments that allow entrepreneurs to aim high.

And aiming high they are. Spotify’s Daniel Ek is taking on American giants Apple and Amazon in music streaming. He is winning the battle for subscribers with over 130 million paying subscribers, more than Apple and Amazon combined. Classifieds marketplace operator Adevinta – which runs several real estate, car and job marketplaces around Europe – is about to become the largest in the world as it digests eBay’s classifieds division. Then there’s Jitse Groen, the ambitious founder of Dutch online food delivery business Takeaway.com, which recently merged with the UK’s Just Eat. He is currently in the process of trying to acquire American peer Grubhub, a deal that would crown Just Eat Takeaway as one of the biggest online food delivery businesses in the world.

It may come as a surprise to learn that Tel Aviv (Israel), Vilnius (Lithuania), and Tallinn (Estonia) all rank in the top 50 cities in the world in Fintech. You may not yet have heard of many of their leading companies, but I’ll wager you will in the coming decade. Lithuania ranks number one in the world in terms of broadband speed and in the top five countries for Fintech innovation. Investment in the right infrastructure has given that country a head start it is not wasting.

Access to capital and need for less of it in today’s capital-lite, ‘free money’ world means more and more entrepreneurs, the geniuses who will lead the exceptional companies of tomorrow, no longer feel anchored to the US. 20 years ago, fewer than 15 per cent of Chinese students studying abroad felt compelled to return home, filled with ideas but lacking the capital to fund their ambitions. Today closer to 80 per cent see a much more favourable environment in which to put their western education to profitable use domestically.

Percentage of Chinese Students Studying Abroad and Returning to China

Source: National Bureau of Statistics of China, China Statistic Yearbook 2019. The figure is reproduced from American Academy of Arts and Sciences, The Perils of Complacency: America at a Tipping Point in Science & Engineering (Cambridge, Mass.: American Academy of Arts and Sciences, 2020).

Adding to the earlier comments on the popularity of the Hong Kong stock market, companies are increasingly eschewing an ADR listing entirely, preferring a Hong Kong local listing, with exchange regulators encouragingly supportive. For the Chinese company of the future, a dual listing may well mean H-shares (HK) and A-shares (mainland China).

In a world obsessed with buybacks (at the wrong time) and cost-cutting (at the wrong time), we look for investment and expansion. Here, the US is no longer the world leader it once was.

Gross Expenditure in R&D

Source: OECD, 2019.

Despite the protestations of politicians garnering votes in the almost unending US election cycle, the American chant ‘we’re number one’ is under pressure on multiple fronts, not just the perceived threat from the rise of China.

Europe’s regulatory regime shift, China’s R&D investment and Lithuanian’s infrastructure investment are but three small examples that show there are confluences of disruption, development, and innovation going on in corners of the world where such activity was previously unimagined. Our job as investors is to find those exceptional companies, purchase them on our clients’ behalf, and hold them in meaningful size above an index weight to generate better than average performance.

Pick the right manager

Finding those expectational growth companies is difficult, and it is very hard to outperform over the long term. Indeed, the work of Professor Hendrick Bessembinder at Arizona State University tells us that a tiny fraction of all internationally listed companies – 0.6 per cent, or 259 companies – have generated all the wealth in international markets since 1990. The value created by 27,635 firms was offset by the value destroyed by 16,141 others.

Total wealth created by all listed global stocks between 1990–2018

Source: Bessembinder, H., Cheng, TF., Choi G. and John Wei, K.C. Do Global Stocks Outperform Treasury Bills? (July, 2019). The first author acknowledges financial support from Baillie Gifford & Co. The data includes 61,981 CRSP common stocks from January 1990 to December 2018.

The right manager won’t find the exceptional growth companies of the coming decade by staring at a Bloomberg screen or tuning in to CNBC, and they won’t find it in the consensus. They won’t find it over a week, month or quarter either. The right manager supports the companies they invest client money with, encourages improvement where needed and challenges behaviours they disagree with.

For now, the tsunami of money flowing into (mainly passive) US funds continues unabated. An acceleration of that pattern cannot be ruled out, but the following table is illustrative for those who do believe in active international management. Taking the 10-year column as our example (very few do these days!), the benchmark has returned an annualised 5.4 per cent. A first quartile manager has returned an annualised 9.3 per cent, and the top 5 per cent  of managers have returned an annualised 12.7 per cent. Done correctly, truly active management can – and does – outperform. Glib statements that active international managers cannot add value are simply misleading.

ACWI ex US Active Management Universe

Source: Baillie Gifford and underlying index providers. USD. Net of fees.
Past performance is not a guide to future returns.

Annual Past Performance to 30 June Each Year (%)

Annualised returns to 30 June 2021 (%)

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.

Risk Factors

The views expressed in this article are those of Stephen Corr 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 April 2021 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

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.

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Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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