Managed Fund quarterly update.

The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.

The horrifying humanitarian crisis in Ukraine highlights that the ability to live in peace and freedom are privileges, not to be taken for granted. The Baillie Gifford Managed Fund had de minimis direct exposure to Russia (0.9 per cent as of end January 2022) through two equity holdings and one corporate bond. The latter position has been sold. We attempted to sell the equity holdings. Unfortunately, liquidity was limited before market access became technically impossible as the clearing networks withdrew. Consequently, we are now carrying these shares at a fair value of zero. We will continue to monitor the situation and comply with international sanctions.

The Baillie Gifford Managed Fund delivered a negative absolute return and underperformed the peer group over the first quarter of 2022 as well as the 12-month period to end March. We know this is difficult whether you’re a newer investor in the Fund or a longstanding client who has the benefit of returns remaining strong over five years and beyond. We therefore hope that what follows provides some perspective on recent volatility and what we are (and aren’t) doing in response to this.

What has driven weakness in returns?

Concerns about quantitative tightening, sharp increases in commodity prices and inflation, Omicron, Chinese regulation, as well as supply chain disruption have dominated the minds of many and resulted in significant volatility across major stock and bond markets since the turn of the year. This has given rise to an environment where the share prices of many of the Fund’s holdings have been hit indiscriminately, whether underlying companies are performing well operationally or not.

This is not to dismiss the extent of weakness as simply a factor of “the market being short term”. However, it is an unavoidable reality that the backdrop is one where worries about the extent and duration of rapidly rising inflation (and resultant interest rate rises) have impacted the share prices of the fast-growing companies in which we invest. The theory being that interest rate hikes potentially devalue companies with long duration earnings streams ie those businesses with earnings further in the future, as opposed to those with long-established earnings.

On top of this, we have found that any hint of uncertainty about the coming year, whether this be lower-than-expected revenue forecasts or reduced margins through increased spending for future growth, has tended to result in significant market selling of a company’s shares.

Which holdings have been particularly weak?

Several holdings have sold off since late 2021, with those viewed as beneficiaries of the lockdown environment, and those dependent on consumer appetite for borrowing, being particularly hard hit.

For ecommerce platform Shopify, its recent results were strong with revenue growing well ahead of expectations despite tough comparisons given the strength of last year’s results. The company is entering an investment phase and plans to reinvest all its gross profits throughout 2022 to build out logistics. By controlling more of its fulfilment network, Shopify hopes to improve the quality and cost of the service, and to simplify pricing. While we are looking for eventual increases in revenue expectations to justify the investment, this is exactly the type of behaviour and long-term focus we look for in the Fund’s holdings and we are therefore supportive. However, the news was taken poorly by the market.

Similarly, Delivery Hero’s share price fell sharply following the release of results. This was, in our view, a consequence of the company pushing out the achievement of profitability while prioritising the growth and scale required to drive long-term earnings. We believe there are multiple levers the company can pull to achieve profitability and added to the holding during the quarter, taking advantage of what we viewed as an attractive valuation. In the case of Wayfair, however, while the long-run opportunity for the online home retailer remains significant, a higher interest rate environment could impact consumer spending and the rate at which the company is able to fulfil its potential. As a consequence, we made a small reduction.

For some companies, the unexpected pandemic-prompted growth boost has done more harm than good to the long-term investment case. We sold the online user car dealership Vroom amid signs it was struggling to cope. Meanwhile, Peloton appeared to get ahead of itself in building for unsustainable levels of demand. It remains a holding as we weigh up the cost control medicine it is taking versus the appeal of what remains a special business model.

Russian holdings SberBank and Norilsk Nickel, the miner, were also among the larger detractors as were a few other holdings with Russian exposure. For example, Dutch-listed Prosus, which invests in a range of online businesses from classifieds to ecommerce and fintech. Prosus has a stake in two Russian companies, social media site VK and online classifieds business Avito. The former has been written off while Prosus recently disassociated itself from the latter. News flow regarding Chinese platform Tencent, in which Prosus invests, also prompted share price falls. There is no change to our long-term case for Prosus, which remains compelling.

There were, of course, some holdings that saw positive share-price performance over the quarter. Unsurprisingly, this was mainly the small number of companies held with commodity exposure such as Brazilian oil and gas producer Petrobras and the miners Rio Tinto and BHP. B3, the Brazilian securities exchange operator, was also a positive. The Brazilian stock market has been one of the strongest globally this year and, given the nature of its business, B3 is very much tied into the movements of the wider Brazilian market (which is in turn sensitive to commodity prices).

How are you responding to this?

As long-term investment managers, some might imagine we’re impervious to periods of inevitable underperformance, particularly after 35 years of running the Fund. However, this isn’t the case. There have been 12 occasions in the Managed Fund’s 35-year history where it was down by 10 per cent or more in a 12-month period. That means we understand it’s tough and that it has impacted your savings. It also means that while we don’t know what lies around the corner, we do know that challenge and support are required during such difficult times.

You therefore won’t be surprised to hear that we’re sticking to our process. The boxer Mike Tyson reportedly said, “Everyone has a plan until they get punched in the face.” Sadly, all too often we see underperformance in the investment world leading to style drift. The time-honoured investment process goes out of the window when the punch in the face of (inevitable) poor performance arrives. However, changing your investment approach is a killer for client outcomes; it incurs costs and ultimately means investors hold a different product to that which they originally purchased. That’s before we even get to the question of whether one has the skill to time shifts in market sentiment (spoiler alert, we don’t). What it boils down to on our part is a commitment that we won’t change our long-established and successful investment approach, although we must acknowledge that it is one which comes with ups and downs along the way. Having a supportive long-term corporate culture is another invaluable asset in these times: we simply don’t have management breathing down our necks demanding we fix things. They know that would do more harm than good.

Our focus is therefore on the continual review of holdings in the Fund and answering the question of whether, from today’s starting point, they can meet our return hurdles over the next five years. We are humble in the face of significant volatility and are thinking carefully about what growth looks like in a sustained period of higher inflation. We are looking to ensure companies can sustainably grow business, demonstrate pricing power and resilience in the face of higher inflation and ultimately, significantly increase earnings. The agility and resilience of the portfolio are key and, if they come together, then share price outperformance should follow.

It is on this basis we can be optimistic about the long term. Although we are not spreadsheet obsessives – understanding the inherent madness of creating spuriously precise models of the future for each holding – we can access sophisticated databases to look at aggregate data of the Fund compared to the market, which can show some interesting things. For example, over the next three years, the Fund’s holdings are expected to grow sales over 80 per cent more than the market per annum. The ratio of net debt to equity stands at 15 per cent versus the market’s 50 per cent. This is a portfolio that has delivered earnings growth of 15 per cent pa over the past five years, 16 per cent ahead of the benchmark per annum. On top of this holdings are using free cash flow generated in recent years to secure long-term growth. This while the broader marketplace isn’t putting as much capital to good work in future growth opportunities, preferring instead the myopic certainty of dividends and share buy backs.

This matters because when we look at what drives global equities to be among the top equity performers globally over the long term, it is the ability to grow earnings. Using data from 1992 to end 2021, history tells us that if we identify and hold the fastest-growing quintile of stocks (and that’s what we try to do) then over five-year periods earnings progression has driven superior return outcomes across a variety of market conditions, including where there have been valuation headwinds.

Add to this the fact that a consistent investment approach does not mean we are standing still, stiff, and immobile. We continue to look for and find diverse growth ideas across a range of industries. Recent new purchases range from Nexans, a French manufacturer of cables which are critical to the energy transition, to AstraZeneca, the leading pharmaceutical company that we have been watching for some time.

What about the Fund’s bond holdings?

Exposure to innovative growing businesses is balanced by holdings in a best-ideas global bond portfolio (approximately 20 per cent of the Fund) and cash (approximately 5 per cent). Bonds play an important role in providing diversification while also adding to returns. Investing across developed and emerging markets, as well as high yield and investment grade debt, provides the broadest possible opportunity set.

Although bond holdings fell over the quarter (and marginally lagged the fixed income market as a whole), the decline was markedly less than that seen among equity holdings thus fulfilling the role of providing diversification. The impact of inflationary pressures and expected interest rate hikes caused yields to move higher globally (ie prices fell). We still expect to see interest rate hikes and there is room for developed market yields to drift higher but much of this is now reflected in bond pricing. Many emerging markets are at a more advanced stage of rate hiking, so yields are quite attractive, particularly in Latin America. Within credit, corporate fundamentals remain encouraging although the scale of investment grade and high yield exposures (particularly the former) were reduced earlier in the quarter as valuations were rich and we were attuned to the risk of a growth shock to the downside if inflation started to erode demand. With questions lingering about how central banks will react to a slower growth outlook while inflation is materially higher, we remain vigilant in reviewing the case for individual holdings, ensuring the willingness and ability of companies and countries to repay debt.

What’s your outlook from here?

We expect performance of the Fund to be very different to any benchmark or the peer group, given our active approach, as well as the Fund’s high allocation to equities. To deliver a differentiated return over the long term, the portfolio needs to be different. Easy to say but not so easy to execute. Thirty-five years of investing through several market cycles, a dotcom boom and bust, and even a Global Financial Crisis (or two) means we know that even the strongest technique will have to withstand the odd haymaker of a punch. However, no matter what gets thrown at us, the good technique drilled into us and having the experience to trust in it will (we believe) get us through challenging times. To paraphrase Muhammad Ali, the investor who is not courageous enough to take risks will accomplish nothing in life. Short-term underperformance is uncomfortable but it’s also an inevitable part of the path to superior long-term returns. The strength of conviction in our process leads us to the conclusion that this is the best way to maximise the probability of delivering tangible value over the next five years and beyond.

Important information and risk factors

The views expressed in this article 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 April 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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.

Custody of assets, particularly in emerging markets, involves a risk of loss if a custodian becomes insolvent or breaches duties of care.

The Fund invests in emerging markets where difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.

Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the Fund invests, particularly in emerging markets, may not be able to pay the bond income as promised or could fail to repay the capital amount.

The Fund’s share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.

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 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.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.