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Standing the Test of Time.

In troubled times, don’t ask about our sell discipline, our hold discipline matters more to long-term returns.

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. Past performance is not a guide to future returns.

Our long-term growth style has felt out of tune with market sentiment for most of this year, and returns have been volatile. One of the many things that we have learnt over the past quarter of a century (nearly) we have been running the US strategy is that this is inevitable. We must not overreact, or the next 25 years will not reap the same rewards for our clients as the previous.

US market pundits currently obsess about inflation, rising bond yields, China’s relationship with the US, and whether growth or value is in the ascendency. It isn’t that none of these matters, but there is little value in adding to the voluminous chatter. Investment is challenging enough without losing focus, or pretending we are wide-ranging experts. We aren’t. Our skill lies in finding exceptional, rapidly growing businesses and owning them for a sufficiently long-time period that their fundamental progress drives their share price.

*Source: FE, total return, in sterling terms.

The good news is that searching for exceptional companies is always the right thing to do on a long-term horizon. Irrespective of the starting point, market direction or market environment, companies that deliver high earnings or revenue growth, on a five-year view, outperform. The graph above shows the five-year return by five-year earnings growth quintile since May 2000.

On average, the top quintile by earnings growth outperforms by approximately seven per cent per annum and has outperformed over every five-year period. Exceptional businesses run by talented individuals adapt, many display anti-fragility: their business models and competitive advantages strengthen during the most challenging environments. And they need our support if investment is to add value to society.

Hold discipline

“We don’t have a sell discipline”

Helen Xiong, Baillie Gifford Partner, Global Alpha Portfolio Manager.

Focusing relentlessly on capturing those long-term returns isn’t easy. Human nature tends towards pessimism. If we delve back into our evolution as a species it was at times essential for our survival. We are cursed with the capacity to imagine, and tend to overestimate the likelihood of worst-case scenarios, particularly when managing our finances. It is also the most damaging trait for an equity manager, where market and portfolio returns are driven by remarkably few exceptional companies.

Helen’s response to our most frequently asked client question then proceeds to describe our ‘hold discipline’. It is an attempt to redress the balance, to highlight the need for optimism, a long-term mindset and creativity in our approach to analysing and investing in businesses. We cannot be both the world’s best holders and sellers of companies. The nature of equity returns means it is in our clients’ interest to relentlessly strive for the former.

The importance of hold discipline is evidenced by the returns of the portfolio’s holdings. The top 10 holdings (Amazon, Moderna, Netflix, Roku, Shopify, Tesla, The Trade Desk, Twilio, Wayfair and Zoom) constitute just under 50 per cent of the portfolio. As long-term holders of these businesses it has been a rollercoaster ride in share price terms, but ultimately a very successful one. All of them have experienced a drawdown of greater than 20 per cent since we invested. In total we’ve experienced 40 drawdowns of greater than 20 per cent, an average maximum drawdown of 49 per cent for each company, and a maximum peak to trough hit of 86 per cent (Wayfair) in holding these outstanding investments. The average total return since we invested is 677 per cent across the top 10, with Tesla topping the list with a 1,249 per cent in return.

So, how have we held our nerve as each of these highly successful holdings halves in value, as most of them have at some point? We stick to our process. In addition to a full research note and a stock discussion, we write a forward-looking hypothesis (FLH) and unlocking questions for each company. The FLH states our expectations for the company, why we hold it, and how we expect the company to deliver at least our 2.5 times over five years’ return hurdle. It is this return hurdle which conditions our valuation and hold discipline. We will only continue to hold a company if we believe it can deliver a 2.5-times return over the next five years with a significantly greater than average (20 per cent) probability. Investment research on portfolio holdings is a continuous process, we expect our understanding to evolve over time. The unlocking questions set out what we want to find out in future; the answers will either increase or erode our confidence in the long-term investment case.

It is almost as challenging to hold on when share prices rise significantly, rather than taking profits. If we don’t guard against it, it can feel undisciplined, and it certainly becomes an increasing focus of client discussions. We will do so if the FLH is intact and we believe the future return hurdle is achievable. With exceptional returns in 2020, we reviewed our positions with far greater regularity than is typical. Portfolio turnover rose to 25 per cent, compared to our usual 15–20 per cent, and we exited or significantly reduced some long-standing positions as the competition for capital in the portfolio remains intense. There is currently no shortage of opportunity for investors seeking innovative, disruptive businesses. The broad theme in our trading over the past 12 months has been a switch to earlier-stage companies as the most innovative companies of the past decade mature. We sold out of Alphabet and Facebook, and reduced Amazon. We trimmed Tesla five times as the share price started to catch up with our ongoing enthusiasm for its ability to transform two of the largest industries: automotive and energy.

Looking ahead to the next quarter of a century, the potential for a few innovative businesses to drive progress as well as stock market returns has perhaps never been greater. The only certainties are that there will be surprises along the way, and that hold discipline, rather than sell discipline, is how we as investors can contribute meaningfully to solving societies greatest challenges. Helpfully, it also provides the best chance for us to repeat the investment success our clients have come to expect over the past quarter of a century.

Important information

The views expressed in this article are those of Helen Xiong 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 November 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.

Annual past performance % to 30 September each year

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