The changing face of growth
- After a decade of strong returns, rising interest rates have created a wintery environment for investors
- Success doesn’t depend on GDP growth – company characteristics and shifts in our technological and cultural landscape matter more
- By investing in businesses that can exploit these shifts, we look past stock market noise for the chance of better returns
All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.
Spring has arrived at last, but the investing environment remains wintery. Geopolitically, Russia is still assaulting Ukraine and tensions continue between United States and China. Economically, we struggle with inflation and its antidote of interest rate rises post the Covid era.
Consequently, the cost of living continues to be an increasing burden for consumers, with energy prices particularly inflated. It comes as no surprise that investors remain cautious and myopic in the sense that horizons shrink in times of adversity.
After a decade of strong returns, this confluence of factors has made things difficult for growth investors such as Baillie Gifford and for the people that invest in our funds and trusts. We can take some solace in the fact that, in most cases, 5 and 10-year performance is decent, but we must acknowledge that near-term numbers are unhealthy and that those who bought our funds and trusts during recent highs have had a tumbling experience.
Conventional thinking dictates that in a world of higher interest rates future cashflows should be discounted, meaning growth becomes less valuable and is marked down. As a result, it is the here and now that matters for investors.
In the last 18 months this theory has been applied indiscriminately across swathes of growth businesses. In some cases it’s justified, as companies have been addicted to cheap money, but in others we have seen downgrades regardless of strong operational progress. We’ve been here before, as the table below suggests.
Return since inception
|5 of over 30 per cent
|8 of over 30 per cent
|5 of over 30 per cent
|3 of over 30 per cent
|5 of over 30 per cent
|3 of over 30 per cent
|1 of over 30 per cent
|4 of over 30 per cent
|4 of over 30 per cent
|6 of over 30 per cent
These companies have been exceptionally successful investments in the long term despite significant periods of share price weakness. Growth stocks have been experiencing a knee-jerk response to rising interest rates. Hence extreme fluctuations in price terms, often based on crumbs of market intelligence.
For example, last year Netflix slipped by 40 per cent in two days after losing 200 thousand subscribers out of 200 million. Indeed, this construct that growth outperforms value when interest rates are falling and vice versa is a relatively recent phenomenon – in the long run, there is no clear evidence that this holds, perhaps because growth is not a generic thing.
The fundamentals of growth
Companies that rely on GDP growth to expand are not typically very interesting, and there are plenty of companies that can grow in a higher interest rate environment.
Growth concerns disruption, competitive advantage, market share and completely new business models. Companies engaged in these areas will happily flourish if they offer better, cheaper, higher quality ways to meet people’s needs than they have now. There is always considerable change within the structure of economies, and it is driven by innovation, technologies and behaviours.
However, in times like these, it is crucial to reflect. We certainly don’t know everything. What if the world has changed around us? We should never blindly assume that what worked in the past will work in the future.
Nevertheless, as investors we keep coming back to the underlying reality: the things that ultimately matter are future earnings and cashflows, and share prices eventually reflect fundamentals. It’s about searching for the few great opportunities that drive outsized returns.
We have revisited the cashflow and competitive advantage profiles for all the companies we favour to understand if they can deal with a higher inflation environment. Can they exist in a more expensive funding environment? In most cases the answer is yes. Our portfolios have much higher cash balances, much higher competitive advantages and therefore better pricing power than the index.
Growth can do just fine when interest rates rise. This is because not all growth companies are the same. Some float on a rising tide and then sink, while others have the power to plough through heavy seas.
New decade, new innovations
The past decade was a golden period for consumer technology. An era of connectivity heralded by the arrival of smartphones enabled a new generation of consumer platform companies, characterised by powerful network effects and increasing return to scale.
These companies digitised and transformed large swathes of the consumer economy including media, retail, social, entertainment and gaming, and they emerged as the new leaders. They grew from underdogs to incumbents, but now we must acknowledge that their best investment days are largely behind them.
In an ideal world, innovation should seek to create, not destroy. It should look beyond the confines of existing industries and seek to solve unsolved problems.
Viewing innovation through this lens, entrepreneurs should not merely look to displace existing markets, but to create new ones. They should not just seek to serve customers better, but to serve the underserved or unserved. Innovation should not be a zero-sum game of shifting market shares from incumbents to disruptors.
As we look forward to the next decade, we must look towards new growth frontiers. If the growth engines of the last decade were the internet, mobile and software, the growth engines of the next decade will be based on data and artificial intelligence.
These technologies are creating a bridge between the digital and the physical world. We already have self-checkout lanes in supermarkets and self-driving cars on the road. These are nothing more than robots becoming more intelligent over time. But if we have robots in retail stores and on the roads, why not on factory floors, in hotel receptions or hospital surgeries?
Today’s internet is largely two-dimensional and artificial intelligence is in the cloud. The next phase of the internet will be three-dimensional and artificial intelligence will migrate from the cloud to the physical world.
The themes of the future
Who are the likely beneficiaries of these new growth engines? Which applications will be transformed? How will this affect broader society? These are just some of the questions we continue to investigate. While we don’t have all the answers yet, we know we must approach this task with an open mind. These businesses may look very different to the winners of the past.
Indeed, it concerns us that, in recent times, commentators have badged Baillie Gifford simply as a tech investing company. We do, of course, invest in tech but not exclusively, and technology is now so ubiquitous that its use as a specific label is rather pointless. Every company is a tech company but not every company is a growth company.
Baillie Gifford is a long-term growth investor and, as alluded to, that growth comes in different forms over different periods.
Some 15 years ago our global portfolios held the likes of Vale, Petrobras and Rio Tinto as we rode the commodity supercycle sparked by China’s great urbanisation.
Then followed the decade of the internet platforms, which saw a small number of global players such as Facebook, Tencent and Alibaba scale up massively with little need for huge capital investment.
So where are we looking for growth now? We hold companies in our portfolios because we believe they will be able to meet substantial increases in demand for their products and services over the next decade.
A different category of winners
While the precise timing and form of change is impossible to forecast with any reliability, slow-acting structural change is much more predictable.
We can see that the green revolution will gather pace and that companies like Northvolt (battery storage) and Climeworks (carbon recapture) could become market leaders.
The challenges around aging populations and the cost of healthcare are evident. Here we hope that the confluence of data, artificial intelligence and genetics will find ways to prevent and cure disease, as exemplified by Moderna and its burgeoning MRNA platform which conquered Covid and has now moved on to cancer.
Ecommerce may have stalled post pandemic but the digitisation of services and the way we live is set to continue, powered by Moore’s Law. Amazon’s AWS Cloud offering, and Nvidia and ASML with their chip technologies sit in the box seats. Then there is Duolingo, a language learning app whose management predicts its product will achieve parity with human capacity within three to five years.
None of these shifts depend on the interest rate environment, the health of the US banking system or access to cheap capital. It is by investing in growth companies, that are the beneficiaries of relatively predictable structural changes, that we can look through the considerable noise of stock markets in pursuit of much greater returns.
Our job is to find the winners of the future. The best of these can generate substantial returns for shareholders who are patient enough to hold their nerve when winter comes.
Representative Global Composite
Representative Global Composite
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