Stay On The Road Less Travelled
Nowadays everybody has heard about ARK and the cool stuff they are doing in the US. However, just as extraordinary – both in terms of performance and in terms of investment philosophy – is Baillie Gifford’s Scottish Mortgage Investment Trust (SMIT). Based in cold, grey Edinburgh – rather than California – Baillie Gifford is one of the Scottish asset managers several of us in Marcellus grew up servicing when we were sell-side analysts in the UK 20 years ago. In fact, several of the SMIT team members were our clients and we have fond memories of working lunches in their offices over sandwiches and coffee. To top it all, our guru, John Kay, served for several years on the Board of SMIT. There is lots to learn from the level-headed, intelligent people at SMIT and in this piece, James Anderson, lays out the key learnings from his career:
- Investing has changed fundamentally over the past 30 years: “The investment world changed profoundly in the mid 1980’s” compared to the world Ben Graham grew up in where a growth stock was a company which doubled earnings in a decade. James takes Amazon as an example and points to its 41% CAGR over 20 years. “For those, like Graham, who prefer the bottom line then 2020 produced $31bn in free cash flow. This pattern of sustained growth at extreme pace and with increasing returns to scale has become more and more evident since the emergence of digital technologies as first exemplified by Microsoft (still growing after 35 years as a public company).” James says a big part of the challenge for contemporary fund managers is that their training leaves them ill-equipped to: (a) understand how the world has changed; and (b) make money in this altered world where Ben Graham’s nostrums don’t apply.
- Returns have become a polarised i.e. a handful of stocks now drive almost all the gains in the market: Companies like Amazon and Tesla will be rare but it is these rarities that will define your portfolio. An analyst who is trained to think in averages won’t be able to grasp this. “It is in these extremes that investing resides. Despite what the CFA foists on the young and innocent you cannot choose a level of risk and return along a classic bell-curve to suit your portfolio because that is neither accepting the deep uncertainty of the world nor acknowledging that the skew of returns is so extreme that it is the search for companies with the characteristics that might enable extreme and compounding success that is central to investing. But distraction through seeking minor opportunities in banal companies over short periods is the perennial temptation. It must be resisted. This requires conviction. The share price drawdowns will be regular and severe. 40% is common.”
- Understanding the qualitative aspects of a company and its leadership is now more important than ever: To do this well, one needs to ignore brokers, media commentary and other fund managers. “So how do we identify these stocks with extraordinary potential? How do we acquire the conviction to allow the compounding to work its magic? As Jeff Bezos steps down as CEO let’s look back at what we spotted, how we endured and what we failed to do for shareholders. The common factors that are most likely to recur in the narratives of great investments are that the company should have open-ended growth opportunities that they should work hard never to define or time, that it has initial leadership that thinks like a founder (and almost always is one) and that has a distinctive philosophy of business – almost always from independently thought through first principles. Now, I think that all these traits were identifiable in Amazon from the start. To read the initial shareholder letter of 1997 was to know that this was the ambitious, patient creation of a very special mind. To be frank our failure to recognise this was because of our own limitations not an absence of clues. We were simply too aware of market movements and too preoccupied with the terrible combination of short-term performance and fear of downside to be able to be committed owners. By 2005-6 we were less bad investors and could recognise some of the potential and endure more of the slings and arrows. Of those there were plenty: the share price fell 46% from peak to trough in 2006. I became used to peers at client conferences declaring Amazon their favourite short. They particularly disliked the costs of two projects – Prime and Amazon Elastic Compute. The latter became AWS. Gradually we learnt and understood. But we should apologise for our willingness to trim Amazon back repeatedly when our holding size approached 10% of assets. That was misguided.”
- Markets are inefficient when it comes to understanding long term outcomes: James illustrates this beautifully using Tesla as an example and we would strongly recommend that you read this piece if only to understand how badly most fund managers screwed up in understanding Tesla’s valuation and how useless brokerage and media commentary was on this subject. “If you believe that all information is built into the share price and simultaneously that it is near term investment outcomes that matter this leaves a vacuum of thought. There is no apparent rationale for deciphering the future. If this sounds abstract it’s not so. Let’s take a look at Tesla to illustrate the puzzle. When we first invested in the company seven years ago we thought, or rather observed, that the regularity and pace of improvement in battery performance and of learning in building electric vehicles was already clear in practice and well-elucidated in academic study. Since then both the pace of improvement and the level of confidence surrounding the data has risen consistently. This made it as close to inevitable as investing allows that at some point electric vehicles were going to be better and cheaper than the internal combustion engine – quite aside from environmental issues. That’s simply what happens when a 15% plus improvement rate meets a 2-3% snail.”
- ‘Growth vs value’ is an irrelevant debate now: The central investing issue of our age is no longer valuations; it is the investor’s ability to understand deep, massive change. “Tesla is but an example, if a crucial one, of the central issue for investing in our times. It isn’t growth versus value, it isn’t the level of markets, it isn’t the economic growth rate in 2021 or the progress of the pandemic but it is understanding change, how it happens, how much happens and its implications. The refusal to embrace this is probably a reflection of the doomed desire for security but it is also emblematic of a broader crisis in economic thought that is preoccupied with the mathematics of equilibrium. But if we switch our attention to studying deep change then there is less temptation to believe that investing has eternal verities that we can default to as a rule book. It’s not ‘this time it’s different’ that is the cry of danger but the refusal to admit that the world, and its reflection that is investing, is ever the same. The only rhyme is that in the long run the value of stocks is the long-run free cash flows they generate but we have but the barest and most nebulous clues as to what these cash flows will turn out to be. But woe betide those who think that a near term price to earnings ratio defines value in an era of deep change.”
- The next 10 years will be even more disruptive in a positive way: If you want to succeed in investing you need to accept that you cannot possible fathom the way the world will change over the next decade. Hence you need to keep learning from people who know more than you: “There will almost certainly be more wrenching, inspiring and dramatic change in the next decade than we have ever seen. I’m very envious of the opportunities and experiences that my successors will enjoy. Even in the last year, amidst the tragedies of the pandemic, there have been hints of what is to come…From the extraordinary revolution that will transform our societies for the better in renewable energy becoming mainstream to the emerging wonders of synthetic biology to the possibility that healthcare innovation becomes a regular series of beneficial revolutions rather than a complex and frustrating drain of resources the potential is wonderful and the threat to old empires looms. It would have been hard for us to have educated ourselves in these areas of unashamed excitement without our involvement in venture capital. We are forever grateful that we have found our way to interact with the extraordinary minds and energies in the unquoted world. Frankly, five years ago I would have been amazed at the access and opportunities that we have come to take as normal. We are very fortunate. It’s a privilege. Our former Board member, John Kay, taught us many things but one of the most valuable was the role of obliquity. By engaging with visionary minds and their companies we are simply seeking insight into the world of tomorrow. Often we are overwhelmed and puzzled more than comprehending. That’s the plan. The investment outcomes are but the eventual outcomes of the mentality and process.”