Analysts to explorers: Investing in European equities.

Nearly a dozen years ago, in my early days at Baillie Gifford, I proudly introduced myself as being an ‘investment analyst’ when meeting the management of existing or prospective holdings.

The title seemed apt. After all, wasn’t it my job to comb through reams of a company’s filings, critically assess statements made by its executives and rigorously apply logic and reasoning to determine if it was an attractive investment?

Sure, I had heard talk of investing being more art than science. But that seemed a bit fanciful to someone who barely grasped accounting’s most basic concepts.

I have since become rather sceptical of the term ‘analyst’. It describes part of our job, but curiously it focuses on attributes, practices and character traits that have become mere table stakes.

In today’s hyper-competitive world, achieving extraordinary returns for our clients requires more than traditional analysis. We must shed the self-image that most professional investors have of being uber-rational, cold and calculating automatons.

At Baillie Gifford, we seek companies with the potential to be exceptional. Businesses that can endure and thrive, which we can own for years if not decades. This is as much a behavioural as an analytical challenge. It requires a change to our whole mindset.

One of the reasons why exceptional companies can be structurally mispriced is that their earnings power grows rapidly and exponentially over a long period. Humans – including investors – struggle to come to grips with this.

It strikes me as misguided to approach such opportunities with a fixed view of what successful businesses look like based on metrics assessed over short timespans.

Instead, we must foster an open-minded attitude. An appreciation that extraordinary companies, as the adjective implies, have a habit of looking more and more different to their peers as time passes.

We must extend our time horizons.

The daily experience of owning an exceptional company experiencing exponential progress is not necessarily that different from owning a mediocre peer progressing linearly.

But when you think in decades, separating the great opportunities from the rest becomes easier.

Spotting rare potential and thinking about how the future might pan out above all require creativity and imagination.

Crazy ideas, unusual and extreme scenarios are all welcome.

Perhaps we should call ourselves ‘explorers’.

Spotify’s tipping point

Two holdings strike me as having the potential to be the biggest pay-offs to our imagination.

The first is a household name: Spotify. Many of us use the music and podcast service, and those that don’t have heard of it.

Founder Daniel Ek and his team have done a fantastic job. But our investment case doesn’t rest on extrapolating from the past.

Instead, what’s exciting about Spotify is its opportunity to change the whole audio industry.

By all accounts, we are still in the early innings:

• radio still commands a large ‘share of ear’ and a sizeable chunk of industry revenues
• record labels are still around, although their original role is now mostly fulfilled by others, chief among them Spotify
• most creators still cannot live off their work
  
  

The conventional approach would be to linearly extrapolate forwards.

So while Spotify has managed to almost double its revenue over the last four years, its economics have remained broadly the same: the firm passes on about 75c of every $1 earned to record labels.

We have spent much time exploring and imagining what change could look like.

We believe record labels might eventually disappear. That could lead to a fairer distribution of profits and cement Spotify’s central role in the ecosystem.

Given its increasing scale and the data that comes with it, the possibilities for the company to improve and extend its services to listeners and creators alike seem endless.

It could help artists learn even more about their fanbases, delight listeners by letting them stream live concerts and other kinds of currently unavailable content, and find better ways to connect creators with consumers to the benefit of both.

It’s almost unfathomable to what degree complexity science, as practised and progressed by the Santa Fe Institute, remains underappreciated by the wider investment and business communities.

We have been lucky enough to learn from the institute and its thinkers, including the economist W. Brian Arthur and the physicist Geoffrey West, directly for several years.

Phase transitions, a concept they have discussed, is pertinent to Spotify. Just because the current balance of power between artists, record labels and Spotify appears stable doesn’t make it so.

As Spotify continues to scale, the industry could reach a tipping point that results in a dramatic, irreversible change.

We don’t know when this will occur or how extreme the outcome will be, but I’m confident that the odds are increasingly in Spotify’s favour.

Auto1’s new direction

The second company is Auto1. It’s seeking to transform Europe’s used cars market.

The traditional way of buying and selling used cars is broken. It’s lengthy, inconvenient, and opaque. It’s suboptimal for both car dealers and consumers.

Dealers struggle with not knowing in advance what vehicles private sellers will offer to them. Having limited inventory capacity – a dealer’s forecourt is only as large as their finances allow – they typically offer less than fair value.

Consequently, consumers face little choice but to sell at suboptimal prices.

And when they look to buy a car from the dealer, the selection is usually limited and there’s always the worry of being saddled with a lemon.

Online classifieds made the process better, but only marginally.

They enabled both sides to expand their view. Consumers could see what was on offer around the country, and dealers could reach beyond local markets. But the fundamental mechanics of the process remained the same.

Auto1 aims to change this completely. Its direct-to-consumers Autohero division buys from and sells cars to the public without going via a dealer.

This involves going beyond the world of bits and investing heavily into the world of atoms: refurbishment and quality control centres need to be built, and logistics and delivery infrastructure needs to be created.

It also demands embracing a completely different business model to that of high-margin, capital-light classifieds.

Auto1 needs funding and balance sheet strength to succeed. The model is capital intensive and low margin.

It’s easy to dismiss such a strategy, especially given the comparison with its existing online classifieds businesses.

But the potential rewards of imagination could be tremendous in this case. If Auto1 manages to make the model work and delights consumers by delivering used cars at attractive prices and of consistent quality straight to their homes (with the opportunity to return a car within seven days), then it has a real shot at transforming this industry.

The spoils that scale efficiencies promise should allow Auto1 to earn attractive returns on capital despite the low margins.

Today’s used car market is highly fragmented. Auto1’s scale advantages could lead to a situation where it becomes the dominant player in a much more concentrated market.

We can imagine a future in which Auto1 creates a marketplace so liquid and a logistics backbone so strong that consumers change their habits at a more fundamental level.

Why shouldn’t consumers exchange their car more often to better match what they have in the garage with what they need for daily life? Why should Auto1 confine its ambition to used cars when its infrastructure could also be used to sell and service new cars? Why should Auto1 stop at merely being the middleman?

Its presence at such a pivotal moment of the transaction process means it could expand its revenue base by providing additional, adjacent services and products, from insurance to financing.

This could drastically expand its revenue opportunity and profitability.

Risk and rewards

Imagination is risky. It exposes us to the risk of being wrong. We may end up looking naïve and overly optimistic in hindsight.

But this is also the opportunity. Most investors prefer conformity of process, philosophy and portfolios.

To quote the Sequoia Capital venture capitalist Michael Moritz, they aren’t willing to bear the cost of having egg on their faces from time to time. They would rather bear the cost of their clients missing out on spectacular winners.

So what does it take to become great explorers?

Three elements spring to mind:

• Rather than defining our work too narrowly, we should aim to learn from many disciplines to create fertile ground for new and better insights into how the world works
• Exploring is not a solitary task. It’s a huge source of joy to be surrounded by fellow explorers of different backgrounds who bring their unique experiences, ways of thinking and viewpoints to the table
• Investors typically worry too much about the latest news and extrapolate from the past or analogies. But to achieve extraordinary returns you must dare to be different. One way to foster the courage required is to make our teams safe spaces to discuss ideas, especially the wackier ones
  
  

These are traits we must constantly strive for and can improve upon.

What a wonderful challenge it is to explore in this way!