Four cardinal questions for investors in turbulent times
- In tough times, investment managers shouldn’t reach for yesterday’s answers to today’s challenges
- Amid uncertainty, it’s better to look for companies with the fundamental strengths to withstand economic and technological changes
- The qualities to look for are pricing power, free cash flow, reliable demand and the ability to change
All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.
In the 18th century, Britain’s Royal Navy had a scurvy problem. The human cost was appalling. Often 50 per cent of crew died from the vitamin C deficiency on long voyages. From the Admiralty’s point of view, it was also a staffing, and therefore a military, crisis.
Young Scottish surgeon James Lind rose to the challenge. Conducting possibly the first randomised clinical trial, Lind demonstrated that citrus fruit, in particular lemons, cleared the condition.
But there was a problem. Lemons were expensive. Most came from Spain, a country with which Britain was often at war. A cheap, plentiful and easy to produce alternative was proposed – malt wort, a by-product of brewing. The only downside? It had no impact on scurvy.
A desperate Royal Navy evaluated its options – and advocated malt as treatment for the disease.
When something is readily to hand, it is tempting to use it for purposes for which it is not fit. After a stormy year, investors today may look, like the Royal Navy, to easy solutions to help understand an uncertain market environment.
The temptation is to turn to the most readily available recent experiences to understand today’s turbulent waters. Perhaps that might be the systemic stress of the global financial crisis, the valuation crunch of the dotcom bubble, or even the toxic mix of low growth, high unemployment, and persistent inflation, the so-called ‘stagflation’, of the 1970s.
But are these comparisons actually useful? Every period has unique features. That might be structural stresses in the economy, like bad housing debt; or, paradigm shifts in technology, like the rise of the internet; or fundamental changes to input costs, which OPEC represented. Comparison risks ignoring what is unique about today.
It is extremely difficult to predict which way economies or markets may turn. There are no reliable guides. What is more possible is to look at the range of outcomes before each company we analyse and ask how they might be able to respond to storm clouds and choppy waters.
To map the range of these scenarios, we start with four cardinal points.
1. What if prices continue to rise?
For a business in an industry with volatile prices, we ask: is it a price taker, or a price setter? Most are the former. When prices are rising across the board we can’t tell exceptional businesses from unexceptional ones. The latter are probably pushing up prices in response to increases in input costs. When those fall back, so too must their prices: they have no control over what their customers are prepared to pay.
Commodity companies are often in this ‘price-taking’ category. Take the oil industry. Over the last 100 years, prices for a barrel of Brent crude have ranged from $10 to over $100, but returns to upstream oil companies, while volatile, have averaged 10 per cent – little different to their cost of equity.
For the precious few price-setting businesses, however, this doesn’t hold true. Rising prices aren’t an investment case, but pricing power is. Companies usually have it for three reasons:
- The product was simply under-priced: original price expectations haven’t been revised
- Lack of other suppliers: a powerful advantage, but one which can invite regulatory intervention
- Ever-increasing and unique value: The happiest scenario. The quality of the product or service means the company earns more and its advantage deepens over time. Happy customers keep the regulator at bay.
Companies with pricing power abound in Baillie Gifford portfolios – particularly those able to do so by adding more value. Take Doximity, the online network for medical professionals. It makes money by selling ad space to pharmaceutical companies. Growing engagement with its platforms has seen return on investment (ROI) for advertisers average 15-to-one. There is no comparable network elsewhere and its advantage deepens as engagement grows. Even if the service stopped improving, the company could still raise prices by 20 per cent a year for a decade before ROI dropped to the three-to-one industry standard.
A company such as Doximity will be able to keep raising prices long after price-takers have succumbed either to deflation or profit-eating input costs. Profits and returns, and therefore cash flows, should rise with revenue. Having a pricing power advantage is vital to thriving amid turbulence.
2. What if the cost of capital rockets?
Even if a company can raise prices, it may be hit by broader inflation and interest rate rises. Equity markets have been floating on an ocean of cheap cash for a decade or more. What happens to growth businesses when the tide turns?
For some, it will be a disaster. But this is a tremendous opportunity for the active stock picker. Low discount rates have provided cheap money and high equity values to average businesses just as they have to exceptional ones. The result has been a fiercely competitive environment. If rates rise, the best business models will thrive while the also-rans may fall away.
This may already be happening. In the first nine months of 2022, the amount of equity raised across the world was the lowest in 19 years. Declines were steepest in the US, falling 80 per cent year-over-year. US venture capital funding has withered by 37 per cent between Q2 and Q3 of 2022, while the cost of debt has soared and the amount raised has fallen 17 per cent.
The impact is beginning to be felt. One of our portfolio companies DoorDash, the food delivery business, has always had one of the best models in the sector with a burgeoning delivery network. Nonetheless it has been beset by fierce competition.
But the environment may be changing. Firms are now focusing on profitability, while those that can’t access capital – Buyk, Fridge No More and 1520, for example, have gone under. But those with strong unit economics can thrive. DoorDash has markedly positive core US margins. While it has to control expenses, that profitable core makes it far easier to expand than to beg venture capital firms for another IOU. Amid the turmoil, DoorDash has a funding advantage that suddenly matters. Compared to loss-making peers, it’s now producing hundreds of millions of dollars of free cash flow.
3. What if the global economy enters a long downturn?
When measuring the economy ‘GDP’ is a good indication of aggregate demand. But, it’s made up of so many complex variables that it can be simpler for the analyst to ignore it. Some businesses rely on specific rather than aggregate demand - either creating new ways to meet an existing need, or creating a new need entirely, as explored in Dave Bujnowski’s Engines of Growth paper. This allows some companies to expand cash flows regardless of the broader context. Moderna is a powerful example. If it can develop an mRNA vaccine that successfully treats recurring cancers, there’s very likely to be a market for it.
For most companies, some level of exposure to aggregate demand is inevitable. However, if a structural growth story can be overlayed, then economic worries present not a threat but an opportunity. Advanced Drainage Systems, a recent Baillie Gifford purchase makes plastic storm drains. Demand is tied to construction and therefore economic activity. However, plastic pipes are gradually taking share from concrete ones – specific demand is rising – and local oligopoly market structures mean the pricing box is ticked. Aggregate demand worries may have depressed the share price, but that’s to the advantage of the patient investor willing to watch the slow march of plastic drain dominance.
4. What if technological change destroys traditional business models?
Pricing power, funding advantage, specific demand strength – it’s a powerful combination. But is it all for nothing in the face of powerful technological change? The temptation in a volatile market is to hunker down and focus on what is known. But that is a high-risk strategy. Volatility spurs change: in difficult economic conditions, consumers sharpen their purchasing habits, looking for reduced costs or added functionality. There are only two options for the growth investor: either be the change yourself or at least be certain that the company you are investing in benefits from that change.
Both conclusions arise from the same analysis. Looking at young, ambitious companies and new business models helps us to understand older ones. Similarly, if a mature business is vulnerable we might better understand the opportunity for a challenger.
Baillie Gifford portfolios hope to own the leaders among the incumbents and the challengers. On one hand, we expect upstart enterprise software names such as Snowflake, Hashicorp and Datadog to revolutionise the way businesses operate in a digital world. On the other, unkillable legacy technology companies, such as semiconductor businesses Texas Instruments and Analog Devices, are making products that can ramp volumes for decades. Making these kinds of calls is a matter of judgement, but two-sided analysis gives the best chance of a positive outcome.
Rare but valuable prospects
The Royal Navy eventually realised their error. Wort was abandoned and sailors were routinely prescribed citrus juice, mixed with ‘grog’ [rum] to make sure sailors would drink it.
The result was a stronger navy and, perhaps, a contribution to besting Napoleon’s fleet in the 19th century. Investors may also emerge from a tough period better able to face adversity.
Pricing power, funding advantage, idiosyncratic demand growth, being on the right side of technological change: each quality on its own may seem commonplace. But stocks that exhibit all features are rare – and enormously valuable. Negative framing is limiting. This is a time to be optimistic and focus on achieving the best possible outcome.
What if a business could sustainably raise prices in all environments, access funding internally while competitors struggled with capital markets, grow regardless of macro conditions and drive or benefit from world-changing technology? What would that company be worth? We’d say a lot. Certainly much more than some newly diminished valuations today are suggesting.
The S&P 500 Growth Index has fallen from a price-to-sales ratio of over 6 times to a little more than around 3 times today. For many individual stocks and portfolios, the collapse is sharper. Several companies with the greatest structural opportunities for growth have seen their valuations compress not only sharply from recent peaks, but to levels well below their pre-pandemic valuations. It is precisely these businesses that are best able to answer the questions above – and they’re on sale. There has seldom been a better time to invest in growing equities.
Equity markets in 2022 were a painful place for growth investors. However, amid the flotsam and jetsam, businesses are emerging that cannot only survive but thrive across a range of different outcomes. Investing in Google or Apple during 2009 would have returned c.800 and c.2,300 per cent respectively over 10 years. Buying Amazon in 2001 returned c.2,300 per cent over the next decade. Walmart’s shares multiplied almost ten times from the depths of stagflation woes in the 1970s to 1980.
It is thrilling to think of the return potential of the best growth businesses, just now setting out on their voyage. With the right map, and the right awareness of the right four cardinal compass points, a patient investor can confidently set sail beside them.
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