Investor webinar: follow-up topics

At Baillie Gifford, we are first and foremost stock pickers, and resolutely bottom up. Our starting point is detailed company analysis. Whilst we share some of ARK’s views on a number of long-term technological drivers, we will not invest behind those tailwinds unless we can unearth individually special companies with differentiated cultures, competitive advantages and financial characteristics.

The portfolios that result from this approach are global and they are underpinned by a range of drivers. In contrast, ARK’s funds tend to focus on individual themes.

Baillie Gifford has been investing globally for over 110 years. Our investment approach has therefore been tested and improved through a multitude of different geopolitical, technological and monetary environments.

Baillie Gifford has over 1,800 staff spanning 65 nationalities and over 230 academic disciplines. Over 130 of those staff are equity analysts, so Baillie Gifford has a substantially higher level of resource dedicated to investment research.

Baillie Gifford manages over £220bn for a global client base. The business is highly diversified by client type and geography.
Baillie Gifford is wholly owned by people who work full time in the business. The absence of any external shareholders means that:

i) We offer an exceptional level of client alignment because we have no external shareholders placing demands on us to grow the business. We will therefore only take on new clients if it is in the interests of our existing clients to do so. We have a long history of sharing economies of scale that arise from any business growth by reducing fees. By the same token, we have no issue closing to new business to protect the interests of our existing clients. The incentives of both our client-facing and investment staff are tied to our clients’ satisfaction and their long-term investment performance, not their assets under management. Long only, growth investing has been our sole focus for over a century, and we have no intention of diversifying into other areas. We have always been investment led and we will remain so. In that sense, our primary motivation is to continually improve as investors.

ii) Our structure has remained unchanged for well over a century. This exceptional level of corporate stability provides the foundations for an exceptional level of long termism. Over decades, Baillie Gifford has developed a global reputation for investing with great patience and our hold discipline is at the heart of our competitive advantage. When we deploy capital to companies, we support the visions of corporate leadership teams with a long-term view that very few other investment firms can emulate. As a result, the management teams of the companies in which we invest offer us exceptional levels of corporate access. This applies to both the private and public equity markets. Our superior access enables our investors to both evaluate corporate cultures and assess emerging companies in a way that very few other equity market participants can match. Many companies see Baillie Gifford as a shareholder of choice, and they approach us on that basis – a significant competitive advantage that has arisen somewhat by accident, but an enduring one all the same.

iii) Our independent ownership structure enables us to cultivate cognitive inputs that are very different. By positioning the investment role as one of open-ended inquisitive exploration rather than pure financial modelling, we attract and recruit investors from exceptionally broad academic and cultural backgrounds. With over 50 different academic degrees and over 40 different nationalities represented across our investment floor, our investors have a degree of cognitive curiosity and open-mindedness that is unusual, if not unique, within our industry.

It would not be appropriate to speculate on the extent to which the advantages above apply to ARK but they certainly make Baillie Gifford very different to most other industry participants.

Scottish Mortgage does not have direct exposure to Silicon Valley Bank (SVB) and has negligible exposure to banks. When we learnt of SVB’s collapse, we contacted every private company in the portfolio. We were quickly reassured by deposit guarantees by the Federal Deposit Insurance Corporation, an independent agency created by the US Congress to maintain stability and public confidence in the US financial system, and the communications from our companies that they had access to their deposits. To reiterate, at the stage in which we invest, our companies have sophisticated and diverse access to banks and typically do not rely on a singular financial institution.

At the time of writing, it is too early to say what the medium to long-term impact of the collapse of SVB will be. As an industry full of innovation and competition for business, including fintech, it seems unlikely that the vacuum left by SVB will remain unfilled for long. Traditional banks such as JP Morgan and Morgan Stanley saw inflows, and it was announced that First Citizens Bank would buy much of SVB. It will take on all the deposits and loans and operate SVB’s 17 branches. Reports suggest First Citizens Bank’s chief executive is committed to SVB’s business with private equity and venture capital firms.

There is a significant amount of undeployed capital in venture capital funds. Investors will be keen to take advantage of the opportunities that arise, possibly at lower valuations than seen recently. We don’t expect a funding drought for the best companies. Indeed, a more challenging environment could play into the hands of many of our companies, allowing them to deepen their competitive positions.

We maintain a ‘working cash’ level within the portfolio, typically around the 1-2 per cent mark. This cash is available to fund new purchases or additions to existing holdings - whether private or publicly- listed. Share buybacks are typically also funded with this cash. On 31 January 2023, the trust held 1.3 per cent of cash.

Our cash level is not imposing any constraints on the management of the portfolio. The only constraint on our ability to invest more in private companies is the 30 per cent limit, measured at the time of purchase. The portfolio has been above the 30 per cent limit in private companies for about one-third of the past year, which capped our ability to deploy further funds to private companies. We have been below that limit for about two-thirds over the past year. This fiscal year, we have deployed circa $350m into private companies.

The skew of stock market returns would argue for a passive approach to investing, were it not for the ability of an active manager to:

1. Identify the outliers more effectively than the broader stock market
2. Hold them for a long time, in a concentrated portfolio and without excessive trimming of the gains so that the asymmetry of returns drives larger position sizes and a more positive contribution of returns

Regarding point (1), one component of the research that we have undertaken with Hendrick Bessembinder has identified that the long-term winners have several commonly observable characteristics. Most notably, top-performing firms have rapid asset growth and, in particular, have substantial cash accumulation. Top-performing firms are more profitable on average, despite higher research and development (R&D) spending. In terms of accumulated rates of return, top-performing firms tend to be younger and have more volatile returns than ordinary firms. These characteristics are all in evidence within the Scottish Mortgage Portfolio. Further work has identified that these observable characteristics can forecast outcomes.

Firms with the highest decade-horizon stock market returns tended to be:

• younger,
• had larger drawdowns than the prior decade,
• and had higher prior-decade R&D spending than more typical firms.

Firms with the worst decade-horizon stock market returns tended to be:

• more levered at the end of the prior decade,
• were less profitable,
• had lower spending during the preceding decade,
• and had more volatile prior-decade stock returns, as compared to more typical firms.

You can read more about Bessembinder’s work and how it has influenced our thinking here: Lessons from Bessembinder (magazinebailliegifford.com)

The long-term distribution of returns within the portfolio evidences our success in finding outliers. Over the past ten years (to 31/12/22), 235 holdings posted returns of between -100 per cent and +100 per cent. They accounted for less than 10 per cent of the cumulative absolute return over that period. A further 27 holdings posted returns of 100 per cent - 200 per cent. Another 27 holdings posted returns of 200 per cent to 500 per cent. And nine holdings posted returns of over 500 per cent (with the most significant returning 2,300 per cent).

With regard to point (2), it is not enough to find the outliers. Holding them in size is key. We have run several large outlier holdings up to over 10 per cent of the portfolio in recent years.

By way of illustration, the stock that returned 2,300 per cent was Tesla and its average holding size in the Scottish Mortgage portfolio over the past decade (to 31/12/22) has been circa 5.5 per cent. By contrast, Tesla’s average weighting in the index (and therefore a passive fund) has been less than 0.35 per cent. At no point has Tesla’s weighting in the global index risen above 1.4 per cent. This illustrates that the performance impact of an outlier such as Tesla is limited by the rebalancing within a passive fund. Similar observations could be made for other outliers, such as Amazon (average position size over the past decade: 8.7 per cent) and Tencent (average position size over the previous decade: 6.2 per cent). For broader context, the nine Scottish Mortgage holdings that have posted returns of over 500 per cent have collectively delivered half of the total portfolio return within the Scottish Mortgage portfolio over the past ten years. Again, this is a function of our ability to hold them in size.

As stock pickers, we don’t have any expertise in making top-down market forecasts. Still, based on a dataset spanning around 140 years of stock market history, students of CAPE (the cyclically adjusted price-to-earnings multiple) will point to a long-run average of just over 21x earnings. They’ll also flag that when long-term interest rates have notched up to the high single digits, the market multiple has commonly fallen to the low teens – and during a couple of exceptional periods (including 1981 when rates rose to almost 16 per cent), down into single digits.

While the overall market would respond positively to the prospect of ending the rate-tightening cycle, a return to the previous ultra-loose monetary conditions seems unlikely. On this basis, the historic skew of returns between stocks appears likely to persist, with aggregate valuation metrics masking an extensive range of underlying valuation distortions.

Historically, periods of economic hardship and monetary tightening can accelerate innovation, speeding up changes to complex systems and accelerating disruption. Today, there is a clear need to address evolving human needs with fewer inputs. This imperative arises not only from current economic pressures but also from our planetary boundaries. The accelerating changes within our transportation, energy, healthcare, food and commerce systems are giving rise to formidable and mispriced investment opportunities. The companies driving the changes that excite us will likely thrive regardless of when the rate-tightening cycle ends. Their operational progress is sufficiently strong that we do not require an upward rating driven by an end to the rate-tightening cycle to make a lot of money from them.

It is also worth mentioning that dead wood is burned in an environment where we see structurally higher costs of capital, making space for the green shoots of more capital efficient growth. The strong are separated from the weak, and those who survive are left more robust. As capital costs have increased, unruly companies have been required to pull back, while the disciplined outliers have been able to forge ahead and win share from those in retreat. The area of food delivery is a case in point, with Delivery Hero taking share as competitors retrench.

On the previous four occasions when inflation has spiked, the subsequent 10-year return (per cent per annum) for Scottish Mortgage provide historical evidence that high-interest rate environments have been good for stock picking:

When assessing individual holdings, we tend to place little emphasis on spot price-to-earnings multiples because they tell us very little about a company’s intrinsic worth. We need to think more about the future cashflows generated in assessing valuation. To determine the probabilities of those flows, we need to think about top-line growth, margins, competitive advantage periods, management culture and capital allocation.

For context, though – and with all of the caveats around excessive focus on a single spot multiple – metrics such as price-to-sales, price-to-earnings, enterprise value to earnings before interest and taxes and price-to-cashflows are all sitting materially below pre-pandemic levels.

The noise in financial markets over the past 18 months has been deafening as the market tries to process inflationary concerns, interest rate rises, the war in Ukraine, climate change, supply chain issues and geopolitical tensions. Against this backdrop of uncertainty, and the subsequent volatility, it is essential to remind ourselves what the purpose of Scottish Mortgage is: identifying the small handful of companies that could drive transformational change across the world over the following decades.

We do not claim to be macro-economists or experts at timing markets. We do not attempt to ameliorate volatility through our holdings or with derivatives. Over the long term, we know that share prices follow fundamentals and because of that, Scottish Mortgage will continue to do what it has always done. The strategy has not produced a good outcome for shareholders over the past 18 months, but as we have always said, you should only invest in Scottish Mortgage if your time horizon is five years or more.

We are always looking to learn and improve as investors, and as the pandemic subsides, we have been reflecting on several topics.

We view our internal Investment Risk Team as a valuable resource. Over the past twelve months, we have undertaken some detailed work with them to unpack the key drivers of performance prior to, during and subsequent to the pandemic. One of the observations arising from this work is that the strong performance of Scottish Mortgage between 2017 and 2020 was largely down to the strong underlying operational performance of the portfolio holdings, with no overall observable effect arising from multiple expansion. From March 2020, however, the portfolio experienced a significant performance tailwind from multiple expansion – a phenomenon that ensued for around a year. The effects of that multiple expansion have now more than reversed with significant multiple compression between late 2021 and late 2022, more than offsetting the continued operational growth throughout that period. Notwithstanding our view that we have little or no edge in trying to time the market, we have been reflecting on whether we could have taken more action regarding recycling capital following the period of multiple expansion during 2020.

We have asked ourselves whether the pandemic has structurally expanded the addressable opportunity for each holding or simply pulled forward future demand, leaving a smaller runway for growth from here. This consideration is particularly relevant to the handful of holdings whose operations were ‘turbocharged’ over 2020 and 2021 – the likes of Zoom, Shopify, Moderna and Netflix, for example. In Moderna’s case, we are increasingly confident that the structural opportunity has expanded materially since Covid-19. For Zoom, Shopify and Netflix, meanwhile, the considerations are more finely balanced, which is reflected in their relative holding sizes within the portfolio.

The third point relates to corporate culture. Some holdings have culturally blossomed in the light of Covid-19 and the subsequent challenges of a more demanding operating environment. Dutch payments company Adyen is a good case in point. Other companies are struggling somewhat in terms of both strategy and execution. In such instances, we need to balance engaging with the companies to help them navigate through challenging post-pandemic normalisation and moving on when we don’t see the progress we’re looking for.

As the managers acknowledged in the webinar, for the Chinese holdings in the portfolio, we were a little slow to recognise and respond to the changing dynamic between the Chinese government and some of the larger internet platform companies and the extent to which a more robust regulatory backdrop would stifle returns. From here, we are focused on monitoring signs of weaponised interdependence between the world’s largest superpowers. Technology is central to this clash, with the US and China focusing on similar areas. This creates a dynamic competitive landscape for western companies such as NVIDIA and ASML in advanced computing and Tesla in electric vehicles (EV). We continue to elicit external perspectives as we calibrate the balance between downside risks and upside opportunities.

We have considered how we assess competitive advantage in an environment where we see structurally higher costs of capital. At times like this, deadwood is burned, making space for the green shoots of more capital efficient growth. The strong are separated from the weak, and those who survive are left more robust. This differentiation between the healthy and the brittle is the overlooked positive consequence of a higher cost of capital.

When money is cheap, companies tend to spend first and ask questions later. In such environments, companies find it hard to maintain high capital allocation hurdles and a sense of direction about what not to invest in. When markets don’t force this discipline, it requires exceptional independence of mind and strategic clarity to exercise restraint. As capital costs have increased, unruly companies have been required to pull back, while the disciplined outliers have been able to forge ahead and win share from those in retreat. So, within food delivery, Delivery Hero is taking share as competitors retrench.

Finally, we also reflect on how we assess capital discipline more broadly. We have been evaluating whether any holdings have an unhealthy reliance on stock-based compensation. We have been working with our Investment Risk Team to assess cash burn rates and cash runways for holdings that are not yet profitable. This is especially relevant for early-stage growth stocks, including our private holdings.

As a reminder, our private company exposure is weighted towards the upper end of the maturity curve, focusing on late-stage companies that are scaling up.

12 months to 31 December 2022. *Private companies purchased after 1 January 2022 may not have been revalued 3 times.

One of the greatest perils of cheap money is that it can drive somewhat frenzied deal flow within the private markets, so stock pickers must remain highly disciplined and selective. This applies not only to Scottish Mortgage but also to Baillie Gifford as a whole. By way of context, in recent years, Baillie Gifford has invested in 38 of the 687 opportunities that have arisen from proprietary sources (a 5.6 per cent hit rate) and 10 of the 1,387 opportunities that have arisen from non-proprietary sources such as investment banks (a 0.7 per cent hit rate). Scottish Mortgage invested in a subset of that cohort – so we have remained highly selective.

From a valuation perspective, we have also been testing the resilience of the portfolio holdings to a period of prolonged economic challenge and structurally higher rates. Our valuation cases must be driven by strong operational progress rather than the requirement for an upward rerating in multiples from here. In other words, we see the potential for substantial returns for minority shareholders in the absence of multiple expansion and even if multiples compress further from here.

The trust’s liquidity policy can be found in the annual report. The board recognises that it is in the long-term interests of shareholders to manage discount/premium volatility. While the primary driver of discounts over the long term is investment performance, the relationship between the trust’s net asset value (NAV) and share price can be impacted in the shorter term by market sentiment. The board does not have formal discount or premium targets at which shares will be repurchased or sold, as it believes that the announcement of specific targets will likely hinder rather than help the successful execution of the liquidity policy. However, it can and does carry out buybacks to aid the efficient functioning of the market in its shares in normal market conditions. In the 12 months to 23 March 2023, Scottish Mortgage repurchased over 36 million shares.

Tom Slater and Lawrence Burns are both partners of Baillie Gifford. As such, each receives a base salary and a share of the partnership profits from Baillie Gifford. As with all the firm’s partners, their share is a percentage of the total partnership profits based on seniority, their role within Baillie Gifford, and their length of service, and is set by the firm’s Senior Partners. In this respect, their remuneration is oriented towards long-term contributions to both investment performance and the firm overall.

Tom Slater and Lawrence Burns have disclosed that they each have significant personal investments in Scottish Mortgage. Consistent with our peers, we disclose details of the Managers’ personal holdings in the biennial ‘Skin in the Game’ report compiled by Investec. Additionally they are reported to Baillie Gifford’s compliance department to comply with regulations.

At the end of March 2023, Baillie Gifford partners, staff, and their connected persons cumulatively held just under 9.5 million shares in Scottish Mortgage. This is spread across approximately one-third of the people working for Baillie Gifford.

It is important to reiterate that we are not early-stage venture capitalists. The private companies we invest in are multi-billion-dollar companies. The following table splits out our private portfolio based on size to demonstrate this:

12 months to 31 December 2022. *Private companies purchased after 1 January 2022 may not have been revalued 3 times.

A private company usually raises seed funding followed by Series A, B, and then C. Over 75 per cent of Scottish Mortgage’s private investments have been either ‘Series C’ or later. Typically, a company will have already received material validation by Series C. For this reason, it is often seen as the point where companies raise material funding to scale a business. Nearly 90 per cent of the total amount invested by Scottish Mortgage into private companies has gone into companies already generating revenue. Moreover, approximately 18 per cent of the current private company portfolio is cash generative. Therefore, the private companies we invest in have far more in common with the growth companies of public markets than a startup.

As with our publicly listed portfolio, we continually reassess the investment case for our private holdings. Our approach is consistent, and we will provide capital support to companies where we have continued or increased conviction in their potential for upside. If our conviction has abated, we will decline to participate in follow-on financing.

As long-term investors for whom IPO does not automatically mean exit, we assume that our ultimate exit route will be via sale in public markets. Over our investment time horizon, we expect many of the private companies held to have listed. Any companies still held privately may be exited in the secondary market. We could utilise several brokers for shares in private companies, although we have yet to use this route to exit holdings. Given the size and maturity of our companies, we expect the market to be active and liquid.

Scottish Mortgage is a closed-ended vehicle meaning that we are not forced sellers of private companies.

Full lists of the promissory notes can be found in the holdings section of the website www.scottishmortgage.com. Promissory notes made 0.9% of total assets as at 28 February 2023.

Promissory notes are a form of lending, essentially a convertible note. They are used in a variety of ways. Often they are used as a bridge to the next equity round, where it can be quicker and cleaner for the company to raise a promissory note if they decide they need capital. These notes sit above equity in the capital structure so provide Scottish Mortgage shareholders with more security. The notes we hold would convert into equity at a discount to the value of the next funding round.

Shareholders will find the most up-to-date portfolio data and insights on our website: scottishmortgage.com. We publish a monthly factsheet, a monthly portfolio valuation, a quarterly voting disclosure, and annual and interim reports on the website. We don’t publish valuation metrics; however, they are available on third-party websites such as the London Stock Exchange.

We do not disclose financial data related to specific private companies. We work with our private holdings to try as best we can to balance the transparency that shareholders require with the interests of the investee company.