1. Under the radar

    Part 6 – Alignment

    Milena Mileva, International Smaller Companies
  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 Fundís 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. UNDER THE RADAR

    INTERNATIONAL SMALLER COMPANIES

    In this short series Baillie Gifford’s International Smaller Companies team explores how their radar framework helps them to uncover the most exciting small businesses from around the world.

  4. Much of our task as investors is to resist the lure of certainty – the act of investing inevitably entails a leap of faith. Perhaps harder is the ability mid-leap to hold onto the promise of what might come, the potentially significant (but never guaranteed) rewards we hope to land. It can be a very long and lonely jump. Company management face a similar predicament and need the same ability to hold their nerve.

    In this respect, even the most exceptional companies must bear some passing resemblance to the mythical Theseus. As brave as the ancient Greek hero Theseus was said to be, you can imagine his fear as he sets sail to Crete to face the monster. He knows that even after killing the monstrous Minotaur, he will then have to face the seemingly impossible task of navigating his way back out of the complex labyrinth in which the Minotaur is contained. He holds true to his purpose, despite his not knowing how the future will unfold.

    While companies may not have to slay a Minotaur as they go about their daily business, they too must find a way through the bewilderingly complex labyrinth that is reality, not knowing what lies ahead of them. Few companies have the cultural ingredients and the leadership necessary to successfully circumnavigate an uncertain environment and ultimately realise their potential. Most never make it out of the labyrinth.

    That’s why the consideration of alignment is an integral part of the International Smaller Companies analytical framework, as we seek to identify businesses with large market opportunities and competitive positions strong enough to allow them to capitalise on those opportunities over many years. For us, alignment constitutes an attempt to answer the question: 

    Can we trust management (and, more broadly, the culture underpinning the organisation) to steer the companies we invest in on your behalf on a path towards long-term success?

    At the risk of pushing the analogy too far, we see alignment as Ariadne’s thread guiding Theseus back out of the labyrinth. Unless all stakeholders are pulling in the same direction, the thread will snap, but if they walk in concert they will stay on the right path.  

  5. At the risk of pushing the analogy too far, we see alignment as Ariadne’s thread guiding Theseus back out of the labyrinth.
  6. Synchronising Watches

    So, what are the key manifestations of corporate alignment that we are looking for when we consider potential holdings for the portfolio? As very long-term investors, we place most emphasis on identifying a strong alignment of time-horizons. It is an unfortunate truth that financial markets have become exceptionally short term. The dramatic fall in holding periods of stocks over the last 30 years, a significant increase in market volatility and much greater turnover of corporate CEOs (as investors seek immediate performance) are all symptoms of the growing impatience and myopia afflicting our industry1.

    John Bogle’s famous indictment of the stock market as “a giant distraction from the business of investing” arguably rings truer than ever. However, the real danger strikes when the suboptimal behaviour of market participants spills over into the corporate sector and starts shaping business decisions. The evidence suggests this is happening. The data in the chart below illustrates a worrisome long-term trend: there is a meaningful and growing divergence between the cash flows that listed firms in the MSCI AC World index are directing towards organic investment in capital expenditure and research and development (R&D), and the amount they are returning to shareholders in the forms of buybacks and dividends. 

     

    Ratio of (Capex and R&D) to (Dividends and Buybacks) Over Time

    Source: Baillie Gifford and underlying index provider.

     

    1. For more on this subject, we would refer the reader to a 2010 paper entitled Patience and Finance written by Andrew Haldane, Chief Economist at the Bank of England. 

     

    Most corporate management teams talk about long termism, but mostly it is lip service. When push comes to shove, the reality is that most would rather play the quarterly game. They would rather boost short-term earnings per share by buying back stock than initiate long-term projects with large pay-offs but very uncertain outcomes. 

    Fortunately, not all public companies behave in this self-defeating manner. We aim to select those which show an unwavering focus on the long term, alongside ambition and willingness to embrace risk. We believe these attributes mean that the companies should be well placed to grow sustainably for extended periods of time. The question for stock pickers, of course, is how to identify this kind of alignment based on forecasts rather than actual results. We think one reasonable proxy for corporate long-termism is to look for businesses with a significant degree of inside ownership (in the hands of a founder or other type of controlling shareholder). A significant portion of the International Smaller Companies portfolio is invested in such companies. 

    While the presence of a founder is not necessarily always an unequivocal positive, our experience suggests founder-led companies show greater propensity to focus on long-term value creation, even when it comes at the expense of short-term pain. This is particularly important in industries which are prone to sharp fluctuations in end-market demand and where the temptation to engage in unproductive financial engineering to shore up the numbers can be compelling. 

     

  7. Riding Out the Bumps

    Chroma ATE is a Taiwanese maker of testing equipment for semiconductors and power electronics, with very high market shares in its niche markets. The founder and his family own 14 per cent of the business. Chroma’s revenues can be lumpy and volatile, but the company has shown an admirable consistency to its high R&D spend (typically, roughly a third of the employees are in R&D, with no cutbacks during the 2009 short but sharp downturn). This focus on long-term investment through short-term bumps has enabled Chroma to maintain very strong positions in its core market of semiconductor testing but also to successfully expand into new exciting applications, such as testing for EV batteries (which they supply to Tesla) and VSCELs (the 3D sensing lasers in an iPhone).

    Another way in which the presence of a strategic owner with a long-term focus can create tremendous value for shareholders is through counter-cyclical capital allocation. Addtech is a Swedish holding company investing in niche technology and industrial businesses. Much of its success has been down to its strong corporate culture, which marries decentralisation with accountability. Through its 100-year history, Addtech has proven itself an astute acquirer, partly because it has been brave enough to step in during macro-economic downturns, when fear reigns and great companies become available at heavily discounted valuations. The CEO at the time, Anders Börjesson, beautifully captured the essence of this approach in a shareholder letter in 1994, at a time when the company had made a sizeable acquisition at the height of the Swedish financial crisis: “Recession or boom. What is the difference from a management perspective? In my opinion there are no decisive differences. I believe that philosophy and overall goals are long-term approaches, and should not be adapted too much to economic trends”. The acquired company, Ferro, proved to be a master stroke, growing strongly for many years after. 

    The flipside to Addtech’s story, of course, is that for every buyer there is a seller. A great deal of value can be destroyed by selling an exceptional asset too cheaply. Here, too, the influence of a long-term owner can be very helpful. Maytronics is the worldwide leader in robotic pool cleaning solutions. It is an unusual company in many ways but one of its most distinguishing features is its ownership structure. Maytronics is owned by a Kibbutz, a type of agrarian commune in Israel. The long-term survival of the entire community is largely dependent on the enduring success of the business. Back in 2012, the company was approached for a takeover by US pool giant Hayward, at premium. While the certainty of a premium would have appealed to many, and Hayward’s move came at time of some uncertainty for Maytronics2, the Kibbutz and the management team concluded the bid undervalued the long-term prospects of the business and rejected the offer. Maytronics has gone from strength to strength since, compounding revenues at 13 per cent over the past seven years.

     

    Recession or boom. What is the difference from a management perspective? In my opinion there are no decisive differences. 

    Anders Börjesson, CEO of Addtech in 1994.  

     

    2. The company’s major customer Fluidra had just acquired its rival Aquatron.  

     

     

    Stakeholder Value, Not Shareholder Value

    General Electric’s former CEO Jack Welch famously coined the term shareholder value, and for some time this was considered the ultimate expression of alignment between shareholders and the corporation. Numerous real-life events have subsequently done much to discredit the concept (for example, BP’s Macondo disaster), at least in its most dogmatic application. One of its main weaknesses arguably comes down to its narrow portrayal of alignment – namely, its championing of one constituency – shareholders – to the detriment of other important stakeholders such as the company’s employees, customers, suppliers, and even society at large. 

    We prefer a much broader concept of alignment where companies prioritise the needs of these other stakeholders just as much as they prioritise the needs of the owners of their shares. One of the main reasons the founder-led Swedish online investment platform Avanza appeals, for example, is because its business model is well-aligned with customers. The company has been willing to reinvest the operating leverage coming from its strong asset growth into lowering costs for the savers on its platform. This is driving market share gains – Avanza has over three per cent of savings capital in Sweden but is getting more than 10 per cent of net inflows in the market. We think its customer-centric mindset will enable it to outcompete large incumbent banks and insurance companies for many years.  

    Another business with a similar strategy of sharing economies of scale with customers to build a durable competitive advantage is German online pet supplier Zooplus. The company’s founder Dr Cornelius Pratt is adamant that fostering customer loyalty should inform every action and decision in the business. We hope this approach will enable Zooplus to compete effectively in this fast-growing market even against behemoths such as Amazon. 

    Companies can only really succeed in delighting their customers if their own employees feel motivated and committed. Strong employee alignment is arguably one of the key drivers of corporate excellence over the long term. Airtac is a Taiwanese maker of pneumatic equipment that has successfully expanded in the Chinese market. Its founder (who together with management and family own more than a third of the company) strongly believes in looking after employees and sharing the fruits of the company’s success with them. Pay packages are much more generous than their peers, there is equity ownership across the ranks as well as other perks such as the company-wide five day cruise to Okinawa in 2018! 

     

    We prefer a much broader concept of alignment where companies prioritise the needs of these stakeholders just as much as they prioritise the needs of the owners of their shares.

     

    Another company that sets great store by firm-wide employee equity incentivisation is Sensirion, a manufacturer of high tech environmental and flow microsensors founded by two physicists at the famous Swiss Federal Institute of Technology (ETH Zurich). Sensirion’s founders did not sell any shares in the IPO process but rather gave five per cent to the employees. They have sought to build a culture of engineering excellence and one where rank-and-file employees feel empowered and valued. This has meant they have been successful in attracting some of the brightest ETH Zurich PhD graduates even though they compete for talent with tech giants such as Google and IBM. 

     

    Sensirion’s LPG10 liquid flow sensor.

     

    Sensirion’s founders did not sell any shares in the IPO process but rather gave five per cent to the employees.

  8. On the Right Path

    Alignment is an intangible concept which is difficult to measure and reflect in a financial model – or to return to our analogy, an infrared thread, generally invisible to the human eye. This makes it tricky for investors to fully appreciate and price in its benefits adequately. This is to our advantage, because it plays to our investment approach. Strong alignment (like a company’s commitment to sustainability) can become a powerful source of competitive advantage that enables companies to exploit their growth potential even in an uncertain and rapidly changing world. Getting better at understanding and identifying alignment, that all but invisible infrared thread, is undoubtedly one of the most rewarding challenges we face as investment managers. 

  9. Risk Factors

    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 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. 

    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 Baillie Gifford International Smaller Companies Fund are Investment Style Risk, Growth Stock Risk, Long-Term Investment Strategy Risk, Geographic Focus Risk, Small-and Medium-Capitalization Securities Risk, Asia Risk, China Risk, Conflicts of Interest Risk, Currency and Currency Hedging Risk, Emerging Markets Risk, Equity Securities Risk, Focused Investment Risk, Information Technology Risk, IPO Risk, Japan Risk, Liquidity Risk, Market Disruption and Geopolitical Risk, Market Risk, New and Smaller-Sized Funds Risk, Non-U.S. Investment Risk, Service Provider Risk, Settlement 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 Baillie Gifford International Smaller Companies 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. 

     

    Top Ten Holdings as at 31 December 2019

      Holdings Fund %
    1. Li Ning 4.52
    2. Douzone Bizon Co 3.37
    3. Hypoport 3.25
    4. Avanza Bank 2.57
    5. Infomart 2.52
    6. ASPEED Technology 2.47
    7. Outsourcing 2.47
    8. Bengo4.com 2.45
    9. AirTac International Group 2.41
    10. KATITAS 2.40

     

    It should not be assumed that recommendations/transactions made in the future will be profitable or will equal performance of the securities mentioned. A full list of holdings is available on request. The composition of the fund’s holdings is subject to change. Percentages are based on securities at market value.

     

    45833 USM WE 0150

  10. MILENA MILEVA

    Investment Manager

    Milena joined Baillie Gifford in 2009 and is an Investment Manager in the UK Equity Team. She has also been a member of the Pan-European Portfolio Construction Group since 2014. Milena graduated BA in Social & Political Science from the University of Cambridge in 2007 and MPhil in Politics from the University of Oxford in 2009.