Growing up: a long-term approach to early-stage companies

December 2023 / 4 minutes

Key Points

  • During 2020 and 2023, higher interest rates, inflationary pressures and geopolitical tensions contributed to market uncertainty
  • Small-cap investing continues to offer opportunities for long-term investors who focus on the underlying worth of the companies and their potential for future growth
  • Companies held in the Edinburgh Worldwide Investment Trust portfolio, such as Alnylam Pharmaceuticals, LiveRamp and Oxford Nanopore, benefit from long-term growth trends including automation, digitisation and clean energy

Your capital is at risk.

The period between 2020 and 2023 has seen significant changes in the investment environment. Share prices have fluctuated more consistently than at any point in the past decade, on the back of extreme market spikes not seen since the 2008 financial crisis.

Factors such as central banks raising interest rates, inflationary pressures, geopolitical tensions, and uncertainty about the economic cycle have contributed to a cautious and uncertain market.

This has led many investors to question whether the investment landscape has fundamentally shifted and if the conditions remain supportive of investing in early-stage companies.


Bigger is not necessarily better

Some investors assume that because higher interest rates result in higher borrowing costs for businesses and more cautious lenders, companies earlier in their growth story will be stifled by an inability to access the capital needed to grow.

Certainly, it appears that this is what the market believes. For the first time in over a decade, small-cap equities – businesses with a market capitalisation below $5bn – look at historically cheap levels relative to large-cap equities.

However, the portfolio managers of the Edinburgh Worldwide Investment Trust (EWIT) do not think the argument is as clear-cut as that. There are still significant opportunities within small-cap investing if you are prepared to take a long-term investment approach that looks beyond the here and now.

First, although capital is less plentiful and funding for earlier-stage businesses is scarcer, it is still there for high-potential businesses demonstrating operational progress. Axon, Alnylam Pharmaceuticals, QuantumScape and Ocado are some examples of companies that have recently raised additional capital.

Second, history demonstrates that small-cap investing can work in periods of higher central bank rates. For example, in the three years after interest rate increases in the US in 1986, 1994 and 2004, shares in smaller companies prospered.

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.
The Russell 2000 Index is a small-cap U.S. stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index.

Third, as unsettling as the current period is, we are confident it will ultimately pass. Stock markets

should normalise as the shocks of the pandemic, inflationary pressures and higher interest rates work their way through the system and companies adapt to the changed environment.

We would then see a return of an investment environment more in tune with the underlying worth of companies. And, while we wait, the blatant conflict between the long-term business potential and the current market price presents opportunities for us as long-term investors.


What should investors focus on?

The key to navigating these uncertain times is to focus on the long-term growth potential of businesses and their ability to generate future cash flows. 

If the portfolio managers do their core task well – identify immature, high-potential, progressive businesses early in their lifecycle and patiently hold them as they scale and grow – the resulting sales and earnings growth should deliver attractive returns, regardless of today’s lower valuations.

Indeed, analysis of EWIT’s most successful investments demonstrates that most investment returns are attributable to operational growth, with a company’s sales, cash flow and earnings growth being the main drivers of share prices in the long run.

Changes in today’s investment environment can affect a company’s ability to generate future cash flows. Therefore, we consider whether a business has the financial resilience to navigate the near term and if there is a material impact on its long-term growth potential and returns profile.


Investing for future growth

The EWIT portfolio contains businesses at different growth stages. Most can fund their daily operations through the generation of positive earnings or cash flows, but not all.

While circa 40 per cent of the portfolio relies on money held on their balance sheet, most of these companies have multiple years of cash reserves on the balance sheet. That means they still have access to the capital they need to grow.

While some investors may be wary of investing in unprofitable businesses, it’s important to remember that growth requires investment. Many successful companies, such as Tesla, were initially unprofitable as they made investments that led to future profitability.

Where we hold such names, it is on the understanding that they are making investments now to improve the likelihood of future profitability. As long as these companies have a strong operational performance and access to capital, they remain attractive investment opportunities.

We anticipate a number of holdings becoming profitable within the next two to three years and that this could be an attractive source of portfolio performance. The market has been significantly rewarding businesses that pivot into profitability.

Exact Science’s share price, for example, rose meaningfully recently on the news that it would become profitable 12 months ahead of schedule.


Long-term growth trends continue

The scale of market opportunity, and relative need for solutions, are key determinants of a business’s overall growth. EWIT is investing in companies that are taking advantage of significant long-term growth trends, such as automation, digitisation and clean energy.

If anything, these structural changes will become even more important and necessary in the coming years as all economic sectors look to become more efficient in response to less economic certainty.

The next two to three years could be a transformational period for many of our holdings thanks to what are exciting but currently undervalued areas of opportunity.

For example, we can foresee progress in Alnylam’s drug pipelines, LiveRamp becoming the de-facto curator of digital identities as online cookies are phased out, and new sequencing machines from Oxford Nanopore making genetic sequencing accessible to many more for the first time.

© Oxford Nanopore

Every oak was once an acorn

In conclusion, the current higher interest-rate environment may be challenging, but it is certainly not over for small-cap investing. There are still opportunities for long-term investors who focus on the underlying worth of companies and their potential for future growth.

By staying patient and investing in businesses with strong long-term prospects, investors can potentially achieve attractive long-term returns.

Risk factors and important information

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.

This communication 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.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). The investment trusts managed by Baillie Gifford & Co Limited are listed on the London Stock Exchange and are not authorised or regulated by the FCA.

A Key Information Document is available at

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this communication are for illustrative purposes only.

The investment trusts managed by Baillie Gifford & Co Limited are listed UK companies. The value of their shares, and any income from them, can fall as well as rise and investors may not get back the amount invested.

The Trust invests in overseas securities. Changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up.

Unlisted investments such as private companies, in which the Trust has a significant investment, can increase risk. These assets may be more difficult to sell, so changes in their prices may be greater.

The Trust can borrow money to make further investments (sometimes known as “gearing” or “leverage”). The risk is that when this money is repaid by the Trust, the value of the investments may not be enough to cover the borrowing and interest costs, and the Trust will make a loss. If the Trust’s investments fall in value, any invested borrowings will increase the amount of this loss.

Market values for securities which have become difficult to trade may not be readily available and there can be no assurance that any value assigned to such securities will accurately reflect the price the Trust might receive upon their sale.

The Trust can make use of derivatives which may impact on its performance.

Investment in smaller, immature companies is generally considered higher risk as changes in their share prices may be greater and the shares may be harder to sell. Smaller, immature companies may do less well in periods of unfavourable economic conditions.

Share prices may either be below (at a discount) or above (at a premium) the net asset value (NAV). The Company may issue new shares when the price is at a premium which may reduce the share price. Shares bought at a premium may have a greater risk of loss than those bought at a discount.

The Trust can buy back its own shares. The risks from borrowing, referred to above, are increased when a trust buys back its own shares.

The aim of the Trust is to achieve capital growth. You should not expect a significant, or steady, annual income from the Trust.

The Trust is listed on the London Stock Exchange and is not authorised or regulated by the Financial Conduct Authority.

Ref: 79736 10041506

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