By James Budden, director of marketing and distribution at Baillie Gifford
Summer has arrived – yet the investing environment remains wintery. Russia is still assaulting Ukraine and tensions continue between the US and China. Economically, we struggle with inflation and its antidote of interest rate rises following the Covid era.
After a decade of strong returns, this confluence of factors has made things difficult for growth investors – which necessarily includes those who invest in Baillie Gifford funds and trusts. As a business, we can take some solace in the fact that, in most cases, five and 10-year performance is decent – but we must acknowledge near-term numbers are unhealthy and 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 is justified, as companies have been addicted to cheap money; in others, however, we have seen downgrades regardless of strong operational progress.
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.
At one point last year, for example, Netflix’s share price slipped 40% in two days after losing 200,000 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 this holds, perhaps because growth is not a generic thing.
The fundamentals of growth
Plenty of companies can grow in a higher interest rate environment, relying on expansion driven by GDP growth. Companies that disrupt the status quo, that hold a competitive advantage or that offer an innovative business model are poised to grow in spite of macroeconomic headwinds. 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.
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 is about searching for the few great opportunities that drive outsized returns.
As a business, 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.
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. They grew from underdogs to incumbents but now we must acknowledge their best investment days are largely behind them.
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. 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. Yet, if we have robots in retail stores and on the roads, why not in hotel receptions or hospital surgeries?
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 would not claim to have all the answers yet, we know we must approach this task with an open mind.
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.
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, for example, that the green revolution will gather pace and companies like Northvolt and Climeworks could become market leaders.
The challenges around aging populations and the cost of healthcare are evident. Here the confluence of data, artificial intelligence and genetics will hopefully 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, meanwhile, but the digitisation of services is set to continue, powered by Moore’s Law. Here, Amazon’s AWS Cloud offering, and Nvidia and ASML with their chip technologies sit in the box-seats.
None of these businesses 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, which are the beneficiaries of relatively predictable structural changes, that we can look through the considerable noise of stockmarkets 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.
