International Alpha: year-end reflections

As we mark time on 2022, a tumultuous and incredibly challenging year for long-term growth investing, it feels appropriate to reflect on what has happened and consider the lessons we can learn. This being said, it is equally important to look forward – it is by looking forward that we generate returns for clients. Although sentiment remains fragile and there will almost certainly be further headwinds ahead, rarely have we been this excited with the opportunities available to clients.

Reflections on 2022

The process of normalisation from the Covid 19 pandemic inevitably presented challenges for investors, as behavioural changes, policy responses and the speed of reopening varied across the world. Whilst in isolation this would be challenging to navigate, it has coincided with increasingly fraught geopolitics, a seismic shift in global monetary policy, Russian-instigated war in Europe and the rise of some commodities not seen since the 1970s. Any of these factors individually would be significant, but in concert they have underpinned a period of extreme dislocation and led to surging inflation and faster-than-expected rises in interest rates.

Against this backdrop, and with time horizons shortening commensurately with uncertainty, there has been a marked impact on the valuation of growth equities. Companies with values based on profits expected in the future have suffered most; whereas those with more of their value derived from near term cashflows have performed well. In particular, energy companies and banks are experiencing windfall profits harvested from rising rates and commodities. We see these as one-off beneficiaries of external events, rather than long-term quality growth businesses. However, our approach of investing in a variety of different growth types has offered clients little protection as quality and growth stocks have fallen out of favour in tandem. 

Although central bank policy in China has diverged from elsewhere, your portfolio's exposure there has further contributed towards poor returns. Holdings in the behemoth Chinese internet platforms have suffered from a triple whammy of regulatory crackdowns, weakening consumption and rising competition. We have felt wrongfooted here, particularly by regulation. At the same time, frictions between China and the US have hampered the investment case for some biotech holdings that had previously been well positioned to grow quickly in overseas markets. China will undoubtedly remain important to the global economy and the fortunes of many companies in the years to come; however, we have been rethinking your positioning there to reflect lower conviction. 

As hard as the past year has been, during its twenty-year history the International Alpha strategy has been through significant challenges before. During the initial period after the strategy’s launch, performance outcomes were remarkably similar and there were a number of parallels with the current time. Back then, as now, the oil price was rising sharply, monetary policy was being tightened, commodity stocks were outperforming, and growth and quality indices were out of favour. Our clients experienced several years of poor returns as sentiment and macro factors preoccupied investors; however performance subsequently recovered as share prices ultimately followed fundamentals. 

Some of the strategy's holdings today were in the portfolio during this time. One such company is Swedish industrial Atlas Copco. Not only did it struggle during our initial investment period, but it has experienced no fewer than ten drawdowns of 20% or greater, and four instances when it has fallen by more than 40%. Despite this, Atlas Copco has consistently outperformed the market over meaningful periods, and features among the fund's largest positive contributors since inception. Whether we reflect on the portfolio as a whole or one of our favourite companies, the conclusions are similar: sustained periods of uncomfortable performance are inevitable but ultimately they will pass and great businesses will endure and be rewarded.

The process of enduring setbacks or difficult periods can often lay the foundation for improved outcomes in the future, however hard it may be at the time. For example, we saw this in Japan when several manufacturers found ways to lower breakeven costs when faced with a much stronger yen after the financial crisis. More recently the Covid 19 pandemic has validated and supercharged the prospects of the mRNA technology that your holding in BioNTech has pioneered, in doing so greatly increasing the likelihood of developing vaccines quickly for unmet health needs.

In this context we have taken the opportunity to reflect on learnings we can take from the past year and what we could do better. We remain confident in our principles of long-term bottom-up stock picking and delivering a patient and repeatable process that will stand the test of time. We seek outstanding businesses with deep competitive advantages and when we reflect on those index stocks that performed well in 2022, few would fit into this mould. However, there are undoubtedly some learnings for us.

First, we have been giving more thought to portfolio context for new holdings. We deliberately take a bottom-up, best ideas approach to stock selection, with regular oversight of the overall portfolio and any residual themes to ensure sensible diversification. During the pandemic, new idea generation became more skewed towards rapid growth stocks, which offered the potential for high returns, but also a greater range in outcomes. This resulted in some unintended doubling up of similar types of investment cases in the portfolio and contributed towards the heightened volatility our clients have experienced in the past year. We want to continue investing in the fastest growing companies but at the same time not lose sight of the portfolio context of adding a new holding. Exor, a European holding company which benefits from a collection of attractive assets, has a war chest of cash to deploy and trades on a significant discount to NAV, is a good example of a different type of growth opportunity that we purchased during the quarter.

A second area of learning for us is valuation. We strongly believe that great businesses justify a premium and we wish to retain our laser focus on earnings growth as the primary driver of long-term share price returns. However, seeing a number of your holdings rapidly derate whilst broadly delivering on our expectations, suggests that during the pandemic we may have purchased some of your holdings at an unfavourable entry point. The combined effect of several unpredictable macro factors has played a significant part in these share price falls; but regardless, we feel we could apply more peripheral vision in our valuation discipline.

Looking forward

Recent performance has been disappointing, and there are some valuable learning points for us as investors. That aside, when we look forward five years and beyond - our most important task as long-term growth investors - we feel incredibly optimistic. This optimism is built on two pillars: our confidence in the current positioning of your portfolio and the healthy flow of new ideas being generated by the team. Indeed, it may be that competition for capital is among our greatest challenges in the year ahead; a nice problem to have.

A comprehensive exercise which involved our independent risk team assessing seven equally weighted factors including balance sheet strength, capex intensity and cash burn, shows a portfolio which is much more resilient than the benchmark. We plan to share some of the output of this with you in the coming months. We can also observe that 93 per cent of the fund's holdings are both profitable and free cash flow generative, which compares favourably to the market at large. In 2022, holdings have suffered more than the benchmark in share price terms; but as we enter the new year we are confident they are better placed: they are growing their earnings faster, with better returns, on stronger balance sheets.

Structural growth far outlives periods of negative sentiment and even economic cycles, and our portfolio drivers mapping exercise, which we referred to in the previous quarterly letter, serves as a reminder of this. Whether it be special brands, master consolidators or those companies exposed to the rise of emerging markets; each portfolio driver offers a large profit pool and many years of growth. This exercise also reinforced the variety of different types of opportunity your holdings are exposed to. It is easy to forget this after a year when most growth stocks delivered similar outcomes in share price terms.

A key feature of using a Portfolio Construction Group, which includes some members of regional strategies and also has support from scouts operating in specialist areas, is that we benefit from a broad funnel of new ideas. During the final quarter of the year, we have taken three new holdings. In addition to Exor, we have also purchased shares in Abcellera, a Canadian provider of antibody-discovery services using a unique software platform; and MIPS, a Swedish company that has pioneered a 'Brain Protection System' to insert into helmets and significantly improve survival rates from crashes. Several other opportunities have also been debated, some of which will be prioritised for further work. 

In the short term, share prices are being dictated by a rapid shift in the macroeconomic environment, and investors and businesses alike are digesting this. In the long run, exceptional businesses will emerge stronger, and share prices will ultimately follow fundamentals. The main task for investors seeking above average returns over the long run is to focus on finding those exceptional businesses and to stick with them as they grow. As highly esteemed investor Bill Miller so eloquently put: 'time, not timing, is the key to building wealth in the stock market'. Through our patient investment approach we can use time to your advantage. 

Risk Factors

This content 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 content 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.

The most significant risks of an investment in the Baillie Gifford International Alpha Fund are Investment Style Risk, Growth Stock Risk, Long-Term Investment Strategy Risk and Non-U.S. Investment Risk. The Fund is managed on a bottom up basis and stock selection is likely to be the main driver of investment returns. Returns are unlikely to track the movements of the benchmark. The prices of growth stocks can be based largely on expectations of future earnings and can decline significantly in reaction to negative news. The Fund is managed on a long-term outlook, meaning that the Fund managers look for investments that they think will make returns over a number of years, rather than over shorter time periods. Non-U.S. securities are subject to additional risks, including less liquidity, increased volatility, less transparency, withholding or other taxes and increased vulnerability to adverse changes in local and global economic conditions. There can be less regulation and possible fluctuation in value due to adverse political conditions. Other Fund risks include: Asia Risk, China Risk, Conflicts of Interest Risk, Currency Risk, Emerging Markets Risk, Equity Securities Risk, Environmental, Social and Governance Risk, Focused Investment Risk, Geographic Focus Risk, Government and Regulatory Risk, Information Technology Risk, Initial Public Offering Risk, Japan Risk, Large-Capitialization Securities Risk, Liquidity Risk, Market Disruption and Geopolitical Risk, Market Risk, Service Provider Risk, Settlement Risk, Small-and Medium-Capitalization Securities Risk and Valuation 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 Alpha 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.

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.

Source: Bank of New York Mellon and relevant underlying index provider(s). Net of fees, US dollars. Returns are based on the K share class from 28 April 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 MSCI All Country World ex US Index is a free float-adjusted market capitalization weighted index that is designed to measure equity market performance in the global developed and emerging markets, excluding the United States. This unmanaged index does not reflect fees and expenses and is not available for direct investment.

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/internationalalphafund 

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 fund’s current prospectus, as revised and supplemented from time to time.

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