Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested.
This article originally featured in Baillie Gifford’s Autumn 2019 issue of Trust magazine.
This is not an easy article to write. It comes with an apology to any readers who think it is too dogmatic. But the investment industry has turned in on itself in a fateful way for our economies and societies. We need to rediscover a sense of purpose beyond competing with each other for assets, immediate returns and via Byzantine metrics that rarely make any sense other than to consummate insiders. If this sounds arrogant then so be it. It’s too important an issue to be ignored.
What’s the point of capital markets? There are surely two fundamental components behind any satisfactory answer. The core objective, even the genius, of equity capital is to utilise the savings of society to provide the necessary risk capital in order to both drive economic progress and deliver returns to savers. This is in one sense the canonical description of stock exchanges as the enablers of industrial achievement best remembered in railway and railroad epics of the 19th century in Britain and the Americas. It’s also not too far away in substance, if not form, from the Chinese economic transformation of the last decades. The remarkable savings of the population were transmuted into world-leading industries, if without adequate reward.
But the ideal of productive investment is long gone in most equity markets of today. This is especially true of developed markets and above all in Britain. Companies pay out far more money in dividends and share buybacks than they receive for new issues or to provide new risk capital. Indeed it’s worse than that. In aggregate, companies invest less of their cash flow than they spend on dividends. When new capital is urgently required it rarely appears from British institutional investors. When banks desperately needed more money it was taxpayers who found the necessary billions. When ARM required heavy investment it was taken over by Japan’s SoftBank.
Why is this so? Is it what retail investors want or require? For sure, income has its uses and certainly companies can be tempted to over-invest in a declining future. But the critical problem is far less misjudged capital expenditure by individual companies than the risk and loss aversion of those who determine the overall framework for capital allocation.
That is fund managers. The intermediation of the savings system by trained professionals is a recent phenomenon. At earliest it dates from after 1945 and its dominance from only the 1980s. But inserting the industry between savers and companies changes far more than we are accustomed to think or commentators are willing to examine. The only acknowledged impact is that of fees. There was once a famous book entitled Where are the Customers’ Yachts? These days yachts are but minor trinkets to billionaire hedge fund managers.
The hidden issues are more warping. They are both practical and theoretical. They combine to deadly effect. The reality is that to stay rewarded and regarded in the profession a fund manager cannot afford to underperform indices for long. So the principal task for the individual and the fund management company is to preserve their job and the firm’s assets by not underperforming the index. Big, safe cash-rich companies are built for this task. The ideologues of academic portfolio theory and their avid followers in the strange trade union that is the Chartered Financial Analyst (CFA) qualification then turn this into intellectual conformity by defining risk as volatility around an index measured over short-time historic horizons.
But it’s clear that if a company is trying to build a great business for the future in a complex and uncertain world then it almost always needs to take large risks and endure extreme volatility of results and share price. The possibility of failure is inevitable, necessary and far from shameful. This is not just what economic progress requires but what produces stock market returns. I apologise for sounding like a broken record to some of you but the record is that stock market returns are dominated by the identification and compounding of a very small number of great companies. In the US since 1926 half the added return from equities has come from just 90 companies.
So what must we do? We have to pursue everything we can to help companies that we believe have even a slight chance of attaining a rarefied level of success. That’s true at each stage of their evolution. We should only give up once this chance dissolves. We must ask ourselves if our presence makes or has made any difference.
There are some companies in our portfolio that might not have existed without our backing. Two examples are the digital advertising platform You & Mr Jones, which now seems to be finding its path, and Recursion, a candidate to eventually revolutionise drug discovery, which because of its youth has struggled to gain initial financing.
In other instances support at moments of difficulty is vital. This can translate into relationships and insights that are transformational. We’ve experienced this with companies that are now giants far beyond our imagining but are still happy to communicate with us. This applies to Alibaba, to Tencent and to Amazon. It applies to Illumina, which we defended from takeover and angst in difficult moments, and through which we have gained access to a world of genomic innovation. It applies to Zipline, which prefers us as a partner to SoftBank. It applies to Spotify in its attempts to demonstrate that a European company can dominate an online industry.
I’d like to make a few comments about such relationships. The objective is to be involved with people who are far more perceptive, far more knowledgeable and far better at seeing the future and building a business than us. We want to be learning not preaching. We have absolutely no belief that we could run any of our companies. At times we can help in communicating with capital markets and governance matters. Tesla provides an example of this on both sides – we may be able to assist but the notion that we can, or should, tell Mr Musk how to reinvent the world is laughable.
What we do provide is patient support in search of extraordinary opportunity, the understanding bad times will always happen and empathy in dealing with fate. This often involves accepting that there will be years of struggle before instant success. That’s bad for our monthly volatility relative to indices but we believe it’s powerful for long-term shareholders and might even assist in reviving economic progress.
Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates. Scottish Mortgage Investment Trust has a significant exposure to unlisted investments. The trust’s risk could be increased as these assets may be more difficult to buy or sell, so changes in their prices may be greater.
The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research.
Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions.
A Key Information Document is available by visiting www.bailliegifford.com
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James has managed Scottish Mortgage Investment Trust since 2000. James is a partner at Baillie Gifford and was a member of the Advisory Board of the Kay Review.