Global Income Growth Q4 investment update

As with any investment, your capital is at risk. Past performance is not a guide to future returns.

Seb Petit (SP): Hello, and welcome to this quarterly investment update on the Baillie Gifford Global Income Growth Strategies. I'm Seb Petit, I'm an investment specialist, and I'm delighted to be joined today by James Dow, portfolio manager and head of the team.

Now, as a reminder, our Strategy aims to invest in quality long-term compounders, companies which we expect to deliver attractive rates of growth for earnings and dividends over the next decade, and with business models which are truly resilient through the cycle. So above-market growth with below-market volatility.

Now, in this update, we'll talk about the operational progress of our holdings. We'll talk about the year 2024 and performance. We'll talk about transactions before ending on a brief outlook for 2025.

Welcome, James. And let's start with what really matters for long-term returns, which is the operational performance of holdings in the portfolio. So when you look at a portfolio now, what do you see in that respect?

James Dow (JD): Well, we're big believers, as we've said many times, in the virtues of dividend growth as a great signal of compounding. And so when we're looking at the operational performance of the portfolio, one of the key metrics that we're looking at is, well, what earnings and dividend growth have we actually seen delivered by the companies that we're investing in?

In the past year, we've been able to collate the latest annual results from the companies, stack them against the prior few years to give us a sort of five-year run that smooths out some of the noise of individual years. And what we're seeing there is really encouraging. The average company within the portfolio, if you weight it by capital, has delivered 10 per cent dividend growth annually over the past five years. And that's very similar to the earnings growth of the companies as well. Again, 10 per cent on average across the portfolio.

So what that's telling us is that the underlying growth and compounding in those earnings and dividends continues to be robust and solid and exactly what we've been looking for. And that's really why, for the year just ended, we're going to be able to distribute to clients healthy growth again in the dividend that we pay out. For our Responsible variant, that's going to be somewhere around 8 per cent or 9 per cent growth year-on-year. For our Global Income Growth Strategy, a little bit lower due to the timing of a couple of transactions. But really solid growth, beating inflation in pretty much any market that you'd be based in as an investor. And a solid year, I think, in terms of the underlying operational performance of the companies.

SP: Thank you. So now, looking back at 2024, the portfolios returned solid returns, but lagged exceptionally strong markets, which were driven by a narrow set of US equities. How do you reflect on 2024?

JD: Well, you're right. Solid, I'd say, solid absolute return. We've got that dividend growth coming through, but clearly lagging the global [equity] index, which is up, I think, 20 per cent, something like that, in the course of the year. We know why it is. We know we can pick apart the numbers and work out exactly why that gap exists. And it's really down to three things, as you've alluded to.

One is the US weighting of the portfolio. For diversification purposes and focusing on the best long-term compounders, we have about 40 per cent of the portfolio invested in the US, whereas the benchmark, the global [equity] index, is really dominated by the US. It's more like 70 per cent. And because the US has been exceptionally strong in the past year, I think the S&P [was] up 25 per cent or something like that for a variety of reasons. That's a big chunk of the performance gap. It's just because of the relative US weighting of the portfolio and our broader diversification.

Another chunk of it, the flip side of that, is that Europe has been very unloved by investors during the past year. And so our weighting in Europe, great companies, great prospects, but people don't care about it at the moment. Europe is sort of in the doghouse for a variety of reasons in the past 12 months. So that's another part of it.

And then the last piece of the performance gap is really around what we own in the portfolio in the US versus, as you said, the rather narrow range of companies that have done exceptionally well in the US. And I think there's no more telling example of that than Microsoft, which folks will know, heard over the years I say, big holding for us, fantastic company, perfect fit for what we do, fantastic returns. But in the past 12 months, it's underperformed the index. It's up only 15 per cent, whereas companies in the AI space or in deep cyclicals, or Tesla is a good example. I think Tesla was up 60 per cent or something like that last year. NVIDIA, a few names are driving the index.

We're focused on long-term quality growth and resilience. And so again, that's part of the performance gap. In the last quarter of the year, we only saw that accelerate post the re-election of Donald Trump. Some of those names, the cyclical names, banks and so on, flying.

But look, if I reflect back on 2024, what I see is that solid underlying performance operationally, the good dividend growth coming through. I think we're doing what we've always said we do in terms of the growth and resilience and the compounding. We're not chasing that short-term performance. And I think it's, I believe, a good result without taking a lot of risk for clients, is how I'd sum up 2024.

SP: Thank you. Let's talk about transactions. In the last quarter of the year, you sold out of Sonic Healthcare. Can you give us a rationale there?

JD: Yes, so longstanding holding, I think 10 years we've been invested in Sonic. It's a lab testing business, takes samples from hospitals and patients in doctors’ surgeries and puts them through its advanced labs and turns them around in quick time and so forth. In a nutshell, the reason we've divested is because the growth was okay, but it was a bit dull. Dividend, very resilient, has compounded a bit, but just not meeting that 10 per cent hurdle that we look for.

At the end of the day, it boils down to, I think, although volume growth in the testing business is good. We're all getting tested more. It saves health systems money, et cetera. The problem is that the pricing in that industry has been really brutal. It's very difficult to raise your pricing if you're a Sonic. And, in fact, often governments are cutting the prices for these tests relentlessly.

Meanwhile, your costs are going up because you're paying your staff more when you're always investing in the latest machinery and so forth. So the earnings growth of the company and the dividend growth has been a bit dull. From our analysis, just going back through it, meeting the company again, talking to people in the industry, a lot more work on it, we don't think that's likely to change. So it just doesn't really make the grade for us and that's why we divested.

SP: Thank you. So you reinvested the money into a US software company, Paychex. What can you tell us about it?

JD: Yes, so a very different business model. The core of the business is processing payroll for small businesses in the US. So, if you're a small firm in the US, you've got a few employees. Every month when you pay them, you've got to negotiate this labyrinth of state regulations of tax deductions and rates and benefits and so forth. And most companies outsource that to, most notably, Paychex, which is dominant in its space.

And it provides this software that does all the calculations and the transactions and the time off and the vacations every month. And a lot alongside that in HR with healthcare and insurance and benefits as well. It's got a fantastic record of compounding earnings and dividends over a really long period of time. The founder is still involved and on the board and drives the culture of the company. And what we're really excited about is really a continuation of the many sort of drivers that have led to Paychex's success over many years continuing to compound earnings and dividends in the years to come. Whether it be health insurance or some of the newer benefits that small firms are trying to offer to employees, Paychex can allow them to do that in a super simple way. And that just grows its revenue per customer and ultimately its earnings and dividends as well.

The valuation on the shares has come back quite a bit in the past few years. We looked at it a few years ago. It looked really expensive. There was a lot of excitement in the pandemic that this was going to be a great place to be. It's derated since then. At this point, we think the growth, the compounding that our clients are going to get from this relative to what we're paying for, it looks really attractive. And so we've taken a holding.

SP: Thank you. Now I want to look forward to 2025. In the market, a lot of investors are very excited about US equities, very depressed about the rest of the world. What is your own outlook for the year ahead?

JD: Well, I'd say generally I'm pretty optimistic, I have to say, about the portfolio in 2025 and beyond. And there's a few different reasons behind that.

I guess it starts with what we talked about earlier with the kind of robust earnings and dividend growth coming through on an underlying basis from the holdings. That gives me confidence. And looking at our investment cases, I think that can continue for many years to come. And so that's really a bedrock of optimism is that the holdings are doing what we expect of them and they're in a really good place.

I think another part of that sort of optimism or, if you like, confidence about it is the valuation of the portfolio. Unlike, I would offer, some parts of the market, which to me look quite expensive and perhaps quite risky at this point in time, the sorts of names that we invest in are really sort of a bit out of favour at the moment. The valuation is not challenging at all. So I think that sort of valuation risk, or what we're paying for, that good earnings and dividend growth is quite attractive at this point.

And then I'd say, lastly, just the diversification that we have across the portfolio. We're not exposed to, you know, one or two names or, you know, crossing our fingers that everything goes well. We've got a really broad range of good businesses from lots of different industries, lots of different countries, and that diversification, I think, particularly at a time when, you know, the world is quite a choppy place. There's a lot of random stuff happening and daily shocks and political changes and so forth. Choppy waters, if you like. Particularly in that kind of environment, I think, a portfolio of robust, solid business models delivering steady compounding hopefully allows our investors to sort of sleep well at night, knowing that they're not going to wake up in the morning thinking “oh, what happened to my portfolio overnight!”. So [when] you put together the robust earnings, the valuation, the way that we're placed in the wider world context. I personally feel good about the portfolio, both in 2025 and in the years ahead.

SP: Thank you, James, for this review. There are three main takeaways for me. The first one is that operational performance of the holdings is in line with expectations and is what will allow those strategies to distribute an income growth around high single digit. The second point is that portfolio returns were very solid last year, although they lacked exceptionally strong markets driven by a narrow set of US equities. And the third point is that the focus remains on quality and resilience in the portfolio, particularly as we enter potentially a more uncertain and volatile period as Mr. Trump becomes president.

Thank you, everyone, for joining us today. And thank you, James, for your time.

Global Income Growth (including Global Income Growth and Responsible Global Equity Income strategies)

Annual past performance to 31 December each year (net%)

Annualised returns to 31 December 2024 (net%)

*Inception date: 31 December 2018.
Source: Revolution, MSCI. US dollars. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised.

Past performance is not a guide to future returns.

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