A long-term approach to short-term performance

All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.

In recent months our clients have, quite reasonably, challenged us on the Managed Fund’s performance. Despite staging a partial and welcome recovery during 2023, the Fund is down 12.6 per cent over the past three years. In this note, we’ll explain:

1. Why the Fund performed poorly,
2. What we are doing in response and
3. When and how things will get better.

Background – the long and short (term) of it

Most readers understand that financial markets can be volatile in the short term. The Managed Fund’s objective is intentionally longer term, targeting capital growth over rolling five-year periods. This allows us to think and act in a different and more patient manner, taking advantage of the swings in market sentiment in any given month, quarter or year.

This has typically worked well, with the Managed Fund returning 8.3 per cent per annum since 2003. Even in the past five years, the Fund has risen by 41.9 per cent, or 7.3 per cent per annum. Lower than the long-run average but a respectable result given the backdrop.

As the chart below shows, this performance was not delivered in a straight line. While the Fund has endured numerous market crises along the way, the overall long-run compounded result has been excellent and significantly ahead of the Fund’s comparative benchmark.

However, we recognise that newer investors in the Managed Fund have yet to see the benefit of our long termism, and even longstanding shareholders will be far from happy with the more difficult recent performance. So, returning to the question above, why has the Fund done poorly in the past three years?

Why?

In large part, this is due to the 2022 decline as seen in the chart below, which illustrates the Fund’s performance versus its benchmark for the past five discrete calendar years.

Honing in on 2022, the Fund suffered due to market sentiment. Investors were spooked by sustained inflation, sharply rising interest rates and extreme risk aversion caused by, among other factors, the outbreak of war in the Ukraine.

This drove the most dramatic swing in sentiment seen since the technology bubble burst in 2000. Investors veered away from the growth equities we tend to favour towards more lowly-rated ‘value’ stocks. We state this not to excuse 2022’s declines but rather to explain the severe headwind we faced.

We also readily admit that we made mistakes and have learned much from this challenging period. For example, we have improved our risk approach by strengthening our Investment Risk Committee and developing new tools to provide additional and better inputs into our portfolio construction process.

What?

That leads us to the second question: what are we doing to help improve Managed performance?

Primarily, we will stick to our tried and tested philosophy and process that have previously delivered for our clients. Specifically, we will invest with patience in companies that we believe have the potential to produce above-average long-term growth in their profits and cashflows.

Work by our Investment Risk, Analytics and Research Team shows that these firms typically deliver the best share price returns over our long time horizon, a fact borne out by the Managed Fund’s successful track record.

But we are not passively awaiting an upturn in our fortunes. The business environment has clearly changed during the past couple of years, with the era of ‘free money’ ending and companies having to adapt to supply chain crunches and cost inflation.

We have reappraised every holding in the Fund in this light. In some cases, we concluded that the growth case had been irreparably damaged and the right thing to do was sell out and move on.

But in most cases our work reaffirmed our confidence in the Fund’s holdings. This should not surprise: we tend to invest in well-managed companies with sustainable competitive advantages.

These firms will usually have the resilience and adaptability to survive and thrive across different economic environments and, thus, are less likely to be derailed by, for example, higher interest rates.

That’s not to say that these firms will be immune to the day-to-day eccentricity of the stock market. Even the strongest of companies will endure periods when their share prices are out of favour. In fact, analysis by our Risk team shows that over the long run volatility is actually a feature of the best-performing investments.

This is clear in graph below, which shows that there is a strong relationship between long-term returns and volatility. The dots each represent a group of companies with similar returns over a ten-year period, plotted against their average volatility. The best returning companies were also the most volatile.

It is also consistent with the Managed Fund’s experience of holding stocks such as Amazon and Tesla. These have been hugely successful investments over the long term, but have also experienced considerable fluctuations year-on-year as they gained or fell out of favour with impatient investors.

The key to dealing with this level of short-term unpredictability is to keep returning to company fundamentals, which takes us to the final question we posed at the beginning of this note.

When and how?

Our work looking at the operational performance of portfolio holdings helps address the when and how returns will improve. Or at least it partially helps.

We do not pretend to know the precise point at which interest rates will peak, nor whether geopolitical tensions will ease. As we write this note at the beginning of 2024 there are reasons to be optimistic that central banks are winning their battle against inflation, but like the bogeyman in a horror film there’s always the chance that the villain reappears for one last scare.

However, when sentiment turns – and our long experience of running the Managed Fund tells us that turn it will – we believe the portfolio is poised to perform.

That is because the underlying fundamentals of the companies held in the Fund look fantastically strong: more resilient than the average, expected to grow faster and yet trading on little premium to the wider market:

• Net debt-to-equity for the Managed equity portfolio is much lower than the benchmark – 19 per cent versus 47 per cent. That indicates their greater financial resilience to economic shocks;
• Forecast earnings growth for the next three years is much higher – 10 per cent per annum versus 4 per cent per annum, suggesting our holdings have stronger growth potential than the average;
• The price-to-earnings ratio for the Fund is at its lowest premium since 2017 (when, in passing, the forecast growth premium was much lower). This feels far too low given the financial strength and growth potential as indicated above.

Over time, the market will better appreciate these superior characteristics and we expect performance to improve as a result. We have already seen encouraging signs of this in 2023, for example via holdings in chipmaker NVIDIA, music streaming platform Spotify and UK retailer Marks & Spencer. In each case, the company has demonstrated the ability to grow revenues and profits, despite a tougher economic backdrop, and this has been recognised and rewarded with a rising share price.

In summary, we understand and accept our clients’ challenge on recent performance. 2022 was incredibly tough as the change in interest rate environment saw our style of investment falling deeply out of favour.

While there are lessons to be learned from this, there are also many reasons for optimism. One of keys to the Managed Fund’s success over the past 36 years has been its consistent application of a long-term growth approach. We see no reason to fundamentally change course in that regard.

Moreover, we suspect most investors in the Fund are here to access a diversified range of fantastic growth companies from across the world. From that perspective, today’s portfolio looks in great shape – more resilient, growing quickly and good value. On that basis, we thank you for your patience and look forward to better days ahead.

Important Information and Risk factors

The manager believes an appropriate comparison for this Fund is the Investment Association Mixed Investment 40-85% Shares Sector median given the investment policy of the Fund and the approach taken by the manager when investing.

Past performance is not a guide to future returns.

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 January 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

This communication contains information on investments which does not constitute independent research.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this communication are for illustrative purposes only.

The specific risks associated with the Fund include:

Custody of assets, particularly in emerging markets, involves a risk of loss if a custodian becomes insolvent or breaches duties of care.

The Fund invests in emerging markets where difficulties in trading could arise, resulting in a negative impact on the value of your investment.

Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the Fund invests, particularly in emerging markets, may not be able to pay the bond income as promised or could fail to repay the capital amount.

The Fund has exposure to foreign currencies and changes in the rates of exchange will cause the value of any investment, and income from it, to fall as well as rise and you may not get back the amount invested.

Derivatives may be used to obtain, increase or reduce exposure to assets and may result in the Fund being leveraged. This may result in greater movements (down or up) in the price of shares in the Fund. It is not our intention that the use of derivatives will significantly alter the overall risk profile of the Fund.

The Fund's share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.

Further details of the risks associated with investing in the Fund can be found in the Key Investor Information Document or the Prospectus, copies of which are available at bailliegifford.com.

Legal notice

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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