LTGG first quarter 2024: The opportunity in risk

“Why are we so stupid?”

This was, verbatim, a question that a small group of Baillie Gifford investors asked themselves back in 2003, in the aftermath of the Dotcom Bubble’s implosion.

What bothered them was the fact that several attributes of successful investors – such as long-termism, low portfolio turnover, high concentration, benchmark-agnosticism, and a stock-specific valuation methodology – were well known, but rarely ever put into practice in the investment industry. The result? Manias and bubbles. Tulips and Dotcoms. Speculation instead of investment.

Therefore, a few months later in early 2004, we started an experiment. Going back to first principles on risk and reward, we launched the Long Term Global Growth (LTGG) strategy that would harness all of the attributes listed above.

It quickly became clear to the nascent LTGG team that the post-Dotcom years of the mid-2000s were replete with opportunities for those willing to invest differently

The team took a holding in Amazon in 2004 whose story is well-known to our clients today, but they also invested in a range of companies no longer held in the portfolio – such as industrial compressors company Atlas Copco, oil major Petrobras, and mining company Vale. Strikingly, all three still feature after Amazon as the top contributors to portfolio performance 20 years later.

More market crises would follow, such as the Global Financial Crisis of 2008-09, the European sovereign debt crisis in the early 2010s, and the US Taper Tantrum in 2018. Time and time again, despite bouts of painful market volatility and uncertainty, the aftermath of each downturn brought fresh opportunities.

Amid the turmoil, the team selected names such as Tencent, Baidu, Apple, Meta, Tesla and NVIDIA. They, like the earlier generation of names before them, would in due course ascend to the ranks of the portfolio’s top all-time contributors.

Now as the LTGG strategy celebrates its 20^th anniversary, we find ourselves still in the wake of the 2021-22 post-Covid stock market decline – the second most severe drawdown in the history of the LTGG strategy (after the Global Financial Crisis). Much like we did back in 2003, we have sought to learn lessons from this recent period and refine our investment process for future, as described in our multiple writings to you over the past couple of years.

As challenging as it has been, we are cognisant that we are now in that most exciting of times again. It is a time in which rich opportunities abound. A time to plant the seeds for the portfolio giants of the future.

Opportunities

It is a false mental shortcut to assume that all opportunities are new. In fact, our greatest opportunities often reside inside the portfolio of existing holdings. This largely boils down to a matter of starting points.

The portfolio already contains what we believe to be some of the greatest and most adaptable growth companies in the world. Years of research and relationship-building give us the conviction to hold the very best of them at scale in the portfolio.

From such sizeable positions, their impact on portfolio performance (for better or worse) is often far greater than that of a new and smaller holding. For example, all things being equal, if the share price of an existing 2.5 per cent holding were to double in value, a new 1 per cent holding would need to quintuple in value to deliver the same contribution to portfolio performance.

A further reason to seize opportunities among existing LTGG holdings is their robust and strengthening fundamentals. Consider for example that, at time of writing, the weighted average revenue growth of the portfolio holdings is around 35 per cent year-on-year, versus around 21 per cent this time last year. Meanwhile, over 90 per cent of the portfolio is now self-financing, versus around 80 per cent a year ago.

The strong appear to be getting stronger in this challenging macroeconomic and geopolitical environment. This is precisely what we would expect from a portfolio of what we believe to be among the most adaptable growth companies on the planet.

All the while, the deep structural transformations that many LTGG holdings are either pioneering or disproportionately benefitting from remain unstoppable – such as electrification of transport and energy storage, revolutionary healthcare solutions, and artificial intelligence. And yet, despite the recent equity market highs that have been largely driven by a very narrow segment of stocks (notably the ‘Magnificent Seven’), temporary dislocations still exist between the fundamentals of many exciting growth companies and their share prices.

All this presents us with compelling opportunities.

With this in mind, we have recently added to our holding in Meituan, the Chinese service-on-demand platform. At a mid-teen P/E ratio and just over 1x 2024 sales, the stock feels like a metaphor for current investor sentiment in the Chinese market. The share price has round-tripped back to 2019 levels. Yet sales have grown five-fold over the last five years and gross margins are rising.

Our addition reflects our greater confidence in management following a meeting with the founder CEO and CFO during our research trip to China in January, in which we discussed Meituan’s expansion from food delivery into grocery, pharmaceutical and health testing.

Assumptions for significant upside from here seem unchallenging, though we continue to monitor the as-yet-unresolved competitive battle with Douyin for the in-store business.

Our addition to Meituan follows additions made to SEA (the southeast Asian e-commerce, gaming and fintech platform) and Coupang (the South Korean e-commerce platform) in late 2023, both of which similarly presented opportunities to buy more shares at undemanding entry points in companies that are progressing very well toward our investment theses.

Of course, we are also looking beyond the existing portfolio to new ideas. The fact that four new purchases have met the high bar for entry into the portfolio in the past quarter alone reflects the many exciting new opportunities we are finding in the current environment. The diverse group of names include:

• Luxury brand Moncler – what if this strong, durable brand can steadily compound returns for the next decade or beyond? As we have learned from Hermès, held since our inception in 2004, the wonderous power of compounding can generate exceptional multi-bagger returns.
• Warehouse automation business Symbotic – what if this company pioneers the US transition towards automated warehouses (the majority of which today are entirely manual)?
• Electric pick-up truck company Rivian – what if Rivian can continue a rapacious pace of production (currently doubling year-on-year), gradually move from the premium segment towards the mass market, and progress toward double-digit operating margins? As we know from holding Tesla since 2013, this is a challenging capital-intensive business, but with potential for outsized returns.
• Latin American fintech Nu Holdings – what if Nubank can replicate (or surpass) its rapid rollout in Brazil, where over half the adult population has become Nubank customers in just over a decade, in the other Latin American countries to which it is now expanding?

The risk of low risk

For all this talk of opportunities, what about the risks? This was also a topic of our “Why are we so stupid?” musings back in 2003.

If we are to achieve LTGG’s objective to deliver exceptional long-term returns for our clients, and if we recognise the asymmetry of returns in the portfolio (i.e. only very few stocks drive the vast majority of performance), then the overwhelming risk that we must optimise for is always the risk of missed opportunity.

The risk of bouts of volatility along the way, while painful, is ultimately irrelevant to LTGG’s long-term objective – not least because the highest-growth stocks over the long term are also the most volatile.

This is why we need to be clear that volatility, as uncomfortable as it can be, is not in fact risk. In contrast, the risk of permanent loss of capital on failed investments is a real risk, but such losses (up to 100 per cent maximum on any single investment) are vastly outweighed if even just a few exceptional multi-baggers are held at scale and over time – such as those mentioned at the outset of this article and as evidenced in our 20-year performance attribution. For the LTGG portfolio, failure to identify multi-bagger opportunities is therefore the greatest risk of all.

Crucially, LTGG is not – and has never been – about trying to minimise risk in this portfolio, at least in the sense of conventional risk metrics. Indeed, a low-risk approach would amplify the risk of missed opportunity, which could be deleterious to achieving our LTGG investment objective.

Mark Urquhart, one of the investors present in our “Why are we so stupid?” discussion 20 years ago, co-founder of the LTGG strategy and head of the team today, sums this up as follows:

Without embracing being wrong, I wouldn’t have got some things right: most probably there wouldn’t have been Amazon without eBay; Hermès without Burberry; Tesla without Q-Cells; and PDD without Alibaba. The asymmetry of equity markets mean that my successes are disproportionately more valuable than my failures. But this wonderful feature of only being able to lose 100 per cent in any individual holding is very hard to hold onto when faced with an individual holding whose share price is down 50, 75 or even 95 per cent.

To me this speaks to some of the behavioural challenges of being wrong – human beings are wired to be praised, to be liked, to look clever and to be right. Admitting mistakes is hard, which is what leads to widespread loss aversion. No one ever got sacked for owning IBM, or the FAANGs or the current plat du jour in the form of the Magnificent Seven.

In seeking transformational businesses for our portfolio, it is inevitable that some will be damp squibs – they won’t take off, they will be outcompeted, the economics don’t work, or a better innovation comes along. This is ok. This is indeed normal with long-run statistics showing us most businesses fail with only 25 per cent making it to 15 years or more. In looking for outliers we should expect failures – this is easy to say but hard to do. There is embarrassment with both colleagues and clients – we are meant to be really smart, so how did we make such a dumb investment decision?

In fact, the only thing I can say for certain that will happen in the rest of my career is that I will be wrong. But this doesn’t matter; in fact I embrace it.

Missed opportunity also explains why we’re sometimes criticised for being slow to sell holdings. An example from the past quarter is Alibaba. Having initially taken a holding in China’s leading e-commerce platform Alibaba in 2014, the company grew to become one of China’s largest companies with an over $830 billion market capitalisation at its 2020 peak.

Since then, Alibaba has endured regulatory scrutiny, heightened competition (not least from PDD and Meituan, also in the portfolio), and dwindling foreign investor confidence in China as a whole.

Consequently, its market capitalisation currently stands at around $180 billion – roughly a round trip in absolute share price terms since our initial purchase and deeply disappointing after a decade of ownership. We had held onto the shares during the decline in recent years because our fundamental research and company engagement led us to the view that Alibaba’s e-commerce business had a decent chance of a revival, that the growth of its cloud business would continue, and that the previously-announced spinoff of the cloud business would realise value – all of which could have presented an attractive opportunity for upside.

However, as our confidence in these potential growth drivers gradually waned over time, we trimmed our holding and – only once the case appeared materially broken – sold. Always in the search of opportunity, we put the proceeds towards the new purchase of Symbotic.

Have we sold Alibaba too late? Probably. Or have we sold too early? Possibly – time will tell. Faced with the risk of missed opportunity, we must always satisfy ourselves that we don’t sell too soon. As a reminder, many of our most painful missed opportunities in the past 20 years have been companies that we sold too early, such as Microsoft (2007) and Apple (2014), which subsequently delivered multi-bagger returns.

More important than selling too late or too soon is whether the decision to sell is squarely anchored in our investment process – ie doing what we say we do. For the LTGG team, this means applying our 10 Question Stock Research Framework. For Alibaba (and Microsoft and Apple), we sold because we believed it could no longer answer those 10 questions with sufficient confidence to justify its place in the portfolio.

As ever, asymmetry matters. Alibaba’s disappointing round-trip in share price terms is vastly outweighed by the 5x return of its competitor PDD since we took a holding in 2018.

One may also criticise us for sometimes being too slow to buy a holding. One example from the past quarter is Nu Holdings. We conducted a review of this company in early 2023 and declined to invest at a market capitalisation of around $20 billion.

Following a year of further research and a recent three-hour meeting with the founder CEO and CFO, we finally took a holding – at a market capitalisation of over $50 billion. The 2-3x upside that we missed is painful. It echoes previous cases of missed upside, such as Netflix – which we first examined in 2011 but only invested in 2015, during which time the share price rose roughly four-fold.

Importantly, however, we followed our investment process. We took a holding in Nu Holdings now because its business model and competitive advantage are more thoroughly evidenced, profitability is proven, and its product/market fit has derisked and repeated in multiple geographies – enabling us to answer our 10 questions with greater confidence than before.

This has allowed us to entertain a scenario whereby Nu could achieve $10 billion net income within five years (compared to ten years when we looked at the company a year ago). On an undemanding 25x P/E ratio (vs. around 33x today), we believe Nu Holdings could plausibly be worth five times as much as it is today during our investment horizon.

In other words, we believe there is still vast opportunity here and it could be a risk not to invest. Coming back to our Netflix experience for illustration, while we missed the upside between our initial review and our decision to invest, it has still been a 9-bagger since we invested.

Probable optimism

It is often assumed that the LTGG team spends its days solely dreaming of the blue sky. Unbridled optimism can look naïve. In instances where it’s wrong, it can be value destructive.

But this characterisation of LTGG is misplaced. Yes, we can and must imagine what a blue sky scenario might look like for the companies in which we invest for the LTGG portfolio, because failure to do so could lead to massive missed opportunities. But every blue sky scenario that we consider is accompanied by (sometimes multiple) central and bear case scenarios. The fact that we tend to spend a disproportionate amount of time focussing on the blue sky scenarios is because Mr. Market spends a disproportionate amount of time focussing on the central and bear case scenarios. An ‘average’ scenario based on market consensus may generate returns that are…well…average. In contrast, we seek out the exceptional, and so we must spend time reflecting on what might go right.

Moreover, and unlike some of our peers, we attach a probability to every scenario we design. While the probability we ascribe to a scenario may turn out to be very wrong, it isn’t pulled out of thin air; it is an evaluation based on months, if not years, of fundamental quantitative and qualitative research.

What level of probability are we looking for? As a reminder, we shared a Baillie Gifford paper a decade ago entitled Blue sky and base rates. Based on thirty years of data, the analysis found there is just a five per cent chance that an investment selected at random in the index goes up fivefold over the next five years. This is the base rate. Therefore, we can have high conviction in a blue sky scenario without necessarily ascribing a very high probability – a better-than-five-per-cent probability may suffice to identify big winners.

By means of example, here is a blue sky scenario for new purchase Symbotic, the warehouse automation company.

From revenues of under $2 billion this year, we believe Symbotic could grow its topline by 25-30 per cent year-on-year to reach revenues of $20 billion within a decade. This is not unreasonable, as the company not only has an impressive order backlog but is also becoming faster and more capital efficient at deploying its automation modules to its customers’ warehouses. By that time, its business would account for only around five per cent of the current total addressable market for large warehouse operators in the US. The company would be very lowly penetrated in an absolutely enormous market that has very few competitors. In addition to revenues from the deployment of its modules, recurring software operation fees could likely become a growing part of the total revenue mix.

Being conservative, even if we were to assume the P/S ratio more than halves over the next decade to 5x, this would imply a market capitalisation of $100 billion (vs. around $20 billion at time of purchase). A greater-than-five-per-cent probability feels altogether plausible for this scenario.

Moreover, Symbotic is now also targeting the SME market, which could be at least as large if not larger than its core market, plus it may also expand into the chilled storage market to unlock yet more growth.

Maybe this blue sky scenario for Symbotic isn’t sufficiently azure; time will tell. After all, there are several examples from LTGG’s 20-year experience whereby our optimism has proved too tame.

Conclusion

Twenty years from now, on the 40^th anniversary of the LTGG strategy, it is probable that we – or more likely our successors (some of whom we think are already in the team) – will look back on the events of 2021-22 and recognise that the aftermath presented a once-in-a-generation opportunity to invest in exciting growth companies.

Our successors may note that some of these companies would grow to become the portfolio’s next giants. By 2044, it is altogether likely that a small handful will have joined the ranks of the top contributors to all-time LTGG performance, alongside the generations before them.

Not all holdings will enjoy such success and that’s fine of course. A core learning from that decisive discussion on “Why are we so stupid?” and the subsequent 20 years of managing the LTGG portfolio is that we must run the risk of hunting the leviathan opportunities, even if we only catch a few.

The worst thing we could do would be to pull in our horns and not catch any at all.

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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in April 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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