1. How do we do what we do?

    EMERGING MARKET INVESTING

    Tim Campbell and Andrew Keiller. Second Quarter 2018.
  2. Investors should carefully consider the objectives, risks, charges and expenses of the fund before investing. This information and other information about the Fund can be found in the prospectus and summary prospectus. For a prospectus or summary prospectus please visit our website at https://usmutualfund.bailliegifford.com. Please carefully read the Fund’s prospectus and related documents before investing. Securities are offered through Baillie Gifford Funds Services LLC, an affiliate of Baillie Gifford Overseas Limited and a member of FINRA.

  3. Last year we wrote a paper entitled ‘Why Do We Do What We Do’, which explored our growth philosophy in more detail, providing evidence to support our long-term, active approach. On reflection, we probably stopped short. The ‘why’, is of course important. Indeed, personalities like Simon Sinek, have made a career out of this single notion. However, some questions lead on from here. How do we go about implementing our philosophy in practice? How do we translate this ‘why’ into a portfolio that stands the best chance possible of delivering excess returns for our clients?
  4. To recap, our analysis showed the striking correlation between superior long-term earnings growth and stock price returns for the Emerging Markets (EM) universe.


    Median Absolute 5 Year Return by 5 Year Earnings Per Share Growth Quintile

    Source: Baillie Gifford & Co, Factset, Worldscope and relevant underlying index provider(s).
    MSCI Emerging Market and FTSE Emerging Market Indices constituents as of the end of December of each year between 1997 and 2017 and with a market capitalisation larger than time-adjusted USD1bn. Earnings growth rates are based on previous fiscal year data, all in USD.

    Past performance is not a guide to future returns.


    Hence why our investment process is singularly focused on identifying those companies that can grow much faster than the market over prolonged periods of time. But distilling this process into something that fits neatly into a diagram is a challenge. By its nature, much of our process relies on the interplay of data, experience, educated creativity and probability. This does not lend itself to a matrix or a flowchart.

    But, we do have a very clear view of the inefficiencies we are aiming to exploit.

  5. In Search of Fat Tails

    Our investment criteria dictates that any company put into client portfolios should be one where we can envisage at least a two-times total return in hard currency terms over five years. This doesn’t mean 15% per annum growth in a straight line, but we do look for it to come from underlying earnings growth rather than simply a re-rating of the shares. The cruel truth, however, is that only 37% of stocks in our universe meet this criteria (based on a 20-year sample size of rolling five-year periods from 1997 to 2017). In fact, 32% fail to generate a positive return at all. Our criteria is highly ambitious. 


    EM Stocks – Range of Rolling 5-Year Returns Per Annum
    EM Stocks in MSCI EM Index or FTSE EM Index

    Data from December 1997 – December 2017 in US dollars. This graph covers a 20-year period, split into rolling five-year periods rebalanced at the end of every year. It shows the proportion of EM stock observations that delivered five-year share price growth in each of the four different quantums. For instance, 68% of the stock observations grew positively and 37% exhibited growth of more than 15% per annum over five-year periods. Source: Factset and relevant underlying index providers. As at 31 December 2017.

    Going further, it is evident that only a small selection of companies contribute to EM returns over meaningful time periods. Over the 10 years to December 2017, for instance, there were 1,549 stocks in the MSCI EM index. Just three out of these 1,549 stocks made up 100% of the total return in US dollars. While many of the others were positive, in aggregate, the other 1,546 simply netted off to zero. Clearly, finding the strongest performers requires us to be ambitious and demand a lot from the companies in which we invest.

    How do we do this? We look for fat tails. Or to put this another way, we look to exploit the market’s consistent refusal to accept the possibility of extreme outcomes. Consider the following chart which compares the average sell-side forecasts on earnings growth to the reality.

    Looking at three-year forecasts1, we immediately see that the majority of sell-side broker research predicts 0–20% p.a. growth from companies in EM (grey bars). The reality (blue bars), is far more widely spread. We present this chart not as a dig at forecasting skill, as we would be the first to admit that forecasting precisely is impossible. It does, however, show a few interesting things. To begin with, the inherent bias in the sell-side means negative estimates are very uncommon compared to actuality (only 11% of the forecasts predicted negative earnings versus the reality of 38%). More importantly, there are a number of companies delivering very strong growth, as shown by the blue bars at the right hand side of this chart.


    EM Stocks – Range of EPS 3-Year Compound Annual Growth Rate (CAGR)
    EM Stocks in MSCI EM Index or FTSE EM Index

    Data from December 1997 – December 2017 in US dollars. Source: Factset and Thomson Reuters EIKON. As at 31 December 2017. The chart shows the range of 3-year earnings-per-share growth (per annum) delivered by EM stocks over the last 20 years (blue bars) with the 3-year earnings-per-share broker predictions (grey bars) at 31 December 2017. 

    These are the fat tails that we are targeting and it has proved to be a rich hunting ground, not least because the market consistently underestimates the likelihood of such growth occurring. 

    1. Ideally we’d have used five-year forecasts but unfortunately these are too far out for most sell-side analysts.

  6. Time and again we see examples of where the market refuses to recognise the likelihood of rapid growth. It may be that this growth is lumpy, or represents a step change from a company’s recent history or simply flies in the face of the law of big numbers, but our universe does present opportunities for those willing to break out of the confines of simply extrapolating recent history.

    Just looking at our own client portfolios is instructive here:

    Range of EPS 3-Year CAGR – EM Stocks in MSCI EM Index or FTSE EM Index vs The Emerging Markets Fund

    Rolling 3-year periods between December 2003 – December 2017, in US dollars. Source: BG Fund Reporting, Factset, Thomson Reuters EIKON and relevant underlying index providers. As at 31 December 2017.


    The skew of the grey bars to the right hand side of the chart demonstrates our commitment to finding superior growth companies. But identifying these names requires a number of particular disciplines. 

    First, it is far more profitable to spend time considering what could go right rather than what might go wrong. Portfolio returns will be overwhelmingly driven by a small number of companies that do extremely well, so making sure you invest in these companies is critical. It matters more than obsessively worrying about all the risks that are inevitably present in any investment decision. But this can be uncomfortable, indeed it requires a conscious rejection of our natural tendency to loss aversion.

    It necessitates that our analysis of companies is better than the extrapolation of most recent trends, that it correctly weights the possibility of extreme outcomes, of fat tails. And when we are faced with a small but credible chance of profits increasing by far more than the market expects, in a portfolio context, we should invest in size.

  7. Ignore the Immediate

    Experience has taught us that any attempt to forecast the near term with any level of precision can be seriously damaging to your wealth. Consider the following two long-standing holdings of our EM portfolios.

     

     

    It would hardly be motivating or stimulating for an investor to be questioned every time a target was missed or there was a big short-term swing in earnings for one of these companies. Nor would this have been a profitable use of time. The volatility of short-term earnings masks a significant rise in these companies’ earnings power over the long term. We spend all our efforts trying to understand the drivers of the latter, which requires a discipline in ignoring the former.

    We would go further here, arguing that some of the greatest inefficiencies we encounter in EM are in companies where profits will be volatile from one quarter to the next, often as a result of investment or product cycles that are years in the planning. The market has shown a disdain for such companies, preferring the predictability of smooth profit generation even if the long-term growth rate turns out to be a fraction of that achieved by those more willing to reinvest in their business with greater ambition. This presents us with fantastic investment opportunities, but it requires an approach and culture that allows you to ignore near-term volatility. 

    You cannot invest in this way if you pay your investors for generating short-term performance. Quarterly or even annual earnings releases matter if you’re paid on annual performance but ultimately, this is likely to be counterproductive. We pay our investors exclusively on rolling five-year performance. This ensures that we remain focused only on what really matters, bearing in mind the next year or two have very little bearing on the terminal value of a company. 

  8. The volatility of short-term earnings masks a significant rise in these companies’ earnings power over the long term.
  9. Inflection points matter

    Another great inefficiency resides in the interaction between top-down and bottom-up investing. 

    EM investors do not have the luxury of ignoring the macro. Purely bottom-up investment is a path to ruin in a universe where industrial and economic cycles can dominate investment returns over multi-year periods. This also provides opportunities.

    Our analysis shows that while it may pay to invest in those companies that display consistently high levels of profitability (as defined by those in the highest quintile of return on equity), the strongest returns are to be found in those companies that transition from poor levels of profitability to high (i.e. those that transition from the bottom two quintiles to the top quintile).

     

    5-Year Stock Growth Percentiles by Quintile of ROE at the Beginning of the 5-Year Period
    Stocks in Q1 of ROE at the end of the 5-Year Period

    This graph shows the results of our analysis of EM returns data from 1996–2017. We split this into 5-year return periods, rebalanced annually, and we studied quintiles of 5-year US dollar ROE. It shows that stocks transitioning from low ROE quintiles to the top quintile have often displayed strong returns. For example, 20% of the observations grew more than eight times over 5-year periods, as shown by the blue line. Source: Factset. As at 29 September 2017. Based on equities defined as Emerging Markets by MSCI or FTSE.

  10. This may seem obvious – rising levels of profitability are normally accompanied by a re-rating, thereby providing a two-fold kicker to share price performance – but identifying the drivers behind this change is the key and has been a significant source of excess return for our EM portfolios.

    Over the last 20 years, broadly speaking, we can identify four separate inflection points that triggered significant changes to our EM portfolios. 

     

    Canton Tower, China.
  11. It is largely impossible to time these inflection points perfectly but when you have an investment horizon measured over many years, successfully anticipating the future direction of travel is hugely valuable. As one of our investors put it, we’re not interested in the weather, but in climate change.

    So how do we identify these inflection points? The first thing to say is that if you wait for all the evidence to be there that something has changed, you’ve already missed it. You will find very few estimates that assume a step change in return on equity. Dealing with incomplete information is the norm. Take the most recent transition, for example. Brazil and Russia are by no means out of the woods; their economies are still vulnerable to commodity shocks and volatile politics, but there are reasons to suspect the balance of probabilities is now more in favour of hard currency growth than further retrenchment. 

    There is no silver bullet here but, by way of an example, factors we have looked at to inform our more positive view on oil and commodities include:

    • the level of capex being spent on greenfield projects (many of the largest miners are scarcely covering maintenance capex let alone expansionary capex)
    • changes in demand (beyond the obvious global growth, what does a marked increase in electric vehicles mean for nickel and platinum group metals?)
    • changes in supply (shale oil may fill the need for light crude but what of the marked dearth of heavy crude, bearing in mind that most new sources of oil or materials require many years to come on stream?).

    The ability to research these sizeable topics on a global scale, then join the dots and work back to the EM companies that stand the greatest chance of benefitting from these shifts in cycles has been one of the great strengths of our process. It is also why we would politely question those who argue EM investing can be purely bottom up or those who rely heavily on backward-looking quant models. EM cycles are frequently long duration, which in turn means they can overwhelm strong company fundamentals for multi-year periods. So our process explicitly encourages our investors to make time to understand and anticipate cyclical change. Portfolio management and pure stock picking are very different skills and experience has taught us that marrying the macro with the micro helps not just with idea generation but ultimately in maximising your chances of consistent outperformance.

  12. Conclusion

  13. Risk Factors and Important Information

    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. 

    Any stock examples, or images, used in this document 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. 

    As with all mutual funds, the value of an investment in the Fund could decline, so you could lose money. International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty and greater volatility. These risks are even greater when investing in emerging markets. Security prices in emerging markets can be significantly more volatile than in the more developed nations of the world, reflecting the greater uncertainties of investing in less established markets and economies. 

    Currency risk includes the risk that the foreign currencies in which a Fund’s investments are traded, in which a Fund receives income, or in which a Fund has taken a position, will decline in value relative to the U.S. dollar. Hedging against a decline in the value of currency does not eliminate fluctuations in the prices of portfolio securities or prevent losses if the prices of such securities decline. In addition, hedging a foreign currency can have a negative effect on performance if the U.S. dollar declines in value relative to that currency, or if the currency hedging is otherwise ineffective. 

    The most significant risks of an investment in The Emerging Markets Fund are Investment Style Risk, Growth Stock Risk, Long-Term Investment Strategy Risk, Geographic Focus Risk, Emerging Markets Risk, Asia Risk, Conflicts of Interest Risk, China Risk, Currency and Currency Hedging Risk, Equity Securities Risk, Focused Investment Risk, Frontier Markets Risk, Information Technology Risk, IPO Risk, Large Capitalization Securities Risk, Liquidity Risk, Market Disruption and Geopolitical Risk, Market Risk, Non-U.S. Investment Risk, Service Provider Risk, Settlement Risk, Small- and Medium-Capitalization Securities Risk. For more information about these and other risks of an investment in the Fund, see “Principal Investment Risks” and “Additional Investment Strategies” in the prospectus. 

    The Emerging Markets Fund seeks capital appreciation. There can be no assurance, however, that the Fund will achieve its investment objective. 

    The Fund is distributed by Baillie Gifford Funds Services LLC. Baillie Gifford Funds Services LLC is registered as a broker-dealer with the SEC, a member of FINRA and is an affiliate of Baillie Gifford Overseas Limited.

    Baillie Gifford has been managing dedicated Emerging Market portfolios since 1994 and launched the Baillie Gifford Emerging Markets Fund in 2003. This Fund follows the same philosophy and process as our other dedicated Emerging Market portfolios.

    The Baillie Gifford Emerging Markets Fund (Share Class K)
    as at

    31 March 2019

    Gross Expense Ratio 0.85%
    Net Expense Ratio 0.85%


    Source: Baillie Gifford & Co.

    Standardised Past Performance to 31 March 2019 (%)

      1 Year 3 Years 5 Years 10 Years
    The Baillie Gifford Emerging Markets Fund (Share Class K) -3.64 16.18 7.31 12.13
    MSCI Emerging Markets Index -7.06 11.11 4.06 9.31


    Source: Bank of New York Mellon, MSCI. Net of fees, US dollars. Returns are based on the K share class from April 28, 2017. Prior to that date returns are calculated based on the oldest share class of the Fund adjusted to reflect the K share class fees where these fees are higher. The Fund is more concentrated than the MSCI Emerging Markets Index.

    The performance data quoted represents past performance and is no guarantee of future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month-end performance please visit our website at www.bailliegifford.com/usmutualfund/emergingmarketsfund

    The Baillie Gifford fund's performance shown assumes the reinvestment of dividend and capital gain distributions and is net of management fees and expenses. Returns for periods less than one year are not annualised. From time to time, certain fees and/or expenses have been voluntarily or contractually waived or reimbursed, which has resulted in higher returns. Without these waivers or reimbursements, the returns would have been lower. Voluntary waivers or reimbursements may be applied or discontinued at any time without notice. Only the Board of Trustees may modify or terminate contractual fee waivers or expense reimbursements. Fees and expenses apply to a continued investment in the funds. All fees are described in each fund's current prospectus.

    Expense Ratios: All mutual funds have expense ratios which represent what shareholders pay for operating expenses and management fees. Expense ratios are expressed as an annualized percentage of a fund's average net assets paid out in expenses. Expense ratio information is as of the Fundís current prospectus, as revised and supplemented from time to time.

    The MSCI Emerging Markets Index is a free float-adjusted market capitalization weighted index that is designed to measure equity market performance in the global emerging markets. This unmanaged index does not reflect fees and expenses and is not available for direct investment.

    FTSE Legal Disclaimer

    Source: FTSE International Limited (“FTSE”) © FTSE 2019. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data and no party may rely on any FTSE indices, ratings and / or data underlying data contained in this communication. No further distribution of FTSE Data is permitted without FTSE’s express written consent. FTSE does not promote, sponsor or endorse the content of this communication. 

    MSCI Legal Disclaimer

    Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. 

     

    Ref: 40555 USM WE 0031

  14. Andrew Keiller

    Client Service Manager
    Andrew graduated from the University of Edinburgh with a first class honours degree in Mathematics and Business Studies (BSc) in 2011. Upon graduation, he joined Baillie Gifford as an Investment Operations Graduate Trainee and completed a two year programme of secondments across the firm. He now works as a Client Service Manager in the Emerging Markets client team. Andrew is a CFA charterholder.
  15. TIM CAMPBELL

    Client Service Director
    Tim graduated BA in History from Trinity College, Dublin in 1997. He joined Baillie Gifford in 1999 and worked as an Investment Manager in the Emerging Markets Equities team before moving to the Clients Department in 2007 where he is a Client Service Director. Tim became a Partner in 2012, and is Chair of the Emerging Markets Product Group.