Any other business: answering more of your Disruption Week 2024 questions

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An infrastructure renaissance

Monday 18 November

You mentioned strong demand for infrastructure construction and the labour shortage: how do you think that dynamic will impact the earnings and profit margins of infrastructure companies?

We get very excited by infrastructure businesses when we can see a clear path to increased demand and constraints on supply.

Serious spending is required to bring a lot of basic infrastructure back up to scratch in the US, while more spending is needed to respond to a changing set of demands. These capture both technology changes, like electrification and data requirements, and extend to supply chain resilience and the return of domestic manufacturing champions.

On the labour question specifically, we invest in several infrastructure businesses that use this as a source of edge themselves. Advanced Drainage Systems makes plastic drainage elements that are easier to handle on-site and come prefabricated. They are much less labour-intensive to install than traditional concrete alternatives so when labour is tight, they become an even more attractive choice.

Builders FirstSource have spent years moving up the value chain. They supply the lumber required to build a house but increasingly provide finished elements like prefabricated trusses, panels, door frames and windows. They estimate that this takes weeks of labour out of a typical house build. Installed Building Products, another Baillie Gifford holding, has developed a business model specifically around labour. They take simple but awkward elements like insulation fitting and complete it for main contractors.

This means that contractors don’t have to worry about storing bulky and easily damaged materials on site or source the workforce to install it. IBP supplies both and contractors are happy to pay for the service. For any of our companies that facing hiring pressures of their own, then the tendency is obviously for that to drive wage cost inflation which can weigh on margins to the extent that companies are not able to pass those costs on.

The companies we hold in this space tend to be driving more efficient systems of working and/or have pricing power because of scarcity. So while it’s always worth watching closely, we’d always look for companies with the ability to raise prices.

How do you see the US moving to increased use of natural gas? Mid-stream infrastructure players seem especially interesting. Could that be a long-lasting trend as well?

Natural gas will remain a significant energy source under most scenarios out to 2030, with global demand currently projected to peak near that date. Predicted drop-off rates vary widely beyond that point and will inevitably be influenced by policy decisions that have not yet been made.

The US is clearly keen to pursue energy security and this may result in greater domestic development of fossil fuel sources than was previously expected. Estimates vary widely, but yes in terms of infrastructure investment capital spending could rise as gas production increases and additional pipelines are required.

This trend could last for several years. LNG exports from the US (already the world’s largest exporter) are expected to double over the next several years and expanding that capacity will drive further capital expenditure (capex). At a much earlier stage, growth in the carbon capture industry could also drive a big uptick in pipeline and gas transportation capex, particularly if hydrogen production takes off. Depleted oil and gas reservoirs could be used to store captured carbon.

What is the best form of power generation? Do you have an example of a company here in your portfolios?

It depends on your perspective. Generally, and looking back over a long history of energy usage, the best forms of energy generation tend to be those that are available to individual countries at low cost, at reliable supply and in a form that stores easily.

High energy density has generally been prized, too. Oil and gas fulfil many of those criteria, particularly for countries with large and accessible reserves. Renewable energy generation delivers on some of these features but has fallen short on the storage piece in particular, which is essential for being able to match generation to demand.

The deployment of battery storage into electricity grids at scale is changing that. Being able to moderate the peaks and troughs of irregular supply makes renewable sources of energy much more attractive. Solar is the most abundant source of energy we have access to by a distance, and the costs of solar generation, particularly at the utility-scale level have fallen to a level that’s cost-competitive with oil and gas in several parts of the world.

As the ongoing collection cost is close to zero, the longer they last, the more cost-competitive they become. We own several businesses involved in the modernisation of the grid and the solar supply chain across Baillie Gifford portfolios. These include Tesla, CATL and Enphase to name a few. We also own oil and gas producers and service providers because we recognise that the best operators can still generate attractive returns from here.

The absolute level of oil and gas consumption is still rising, even if their proportion of the energy mix is declining and new forms of production come online. For example, we own the onshore US producer EOG Resources and the Brazilian major Petrobras in some strategies. We’re interested in watching the potential for a resurgence in nuclear power, where some of the world’s largest technology companies are moving to secure nuclear power for their datacentres.

In short, the best form of power generation is generally a mixture that provides resilience and reliability, but we see the balance tipping towards renewables which will get cheaper as they mature.

What is the higher conviction way of accessing these opportunities within the Baillie Gifford portfolio? It looks like the Monks has invested in a number of these infrastructure ideas, for example.

The Baillie Gifford Global Alpha Growth Fund (OEIC) and the International Fund (OEIC) hold several of the names Michael mentioned, as does the Monks Investment Trust.

When you visit a company to identify it as a potential investment, what are you looking for?

We look for management teams that can articulate a long-term strategy for their business, that demonstrates a deep understanding of what gives the company an advantage over its competition.

We look for actions that demonstrate that it lives by that strategy in good times, and particularly in tougher moments. We look for clear alignment between its interests and those of our clients. Where we can, we like to get out of the boardroom as well and speak to a wide range of people who work in the company. That can be a huge help in assessing how deep the strategy and culture of a business runs, which gives us an insight into how successful it is likely to be.

We compare and contrast what we see at the companies we visit with their competitors. We test what their suppliers and customers say about them to try to build a coherent picture of how the business really operates.

Finally, when we have already formed a view of a business, then we use company visits to seek out answers to outstanding questions and to test the key elements of our investment case with both confirming and disconfirming views. Because we invest in companies on a long-term view, we’ll often see management teams several times over our holding period. This changes the nature of our interactions from one-off visits to opportunities to assess gradual shifts and trends within each company.

What are typical growth rates for these companies’ earnings? How do the markets currently rate them and how would you expect that to play out if the growth story builds as you expect?

Growth rates can vary significantly, as can a company's share price relative to its earnings per share. Through the cycle, we often look for high single-digit or even low double-digit organic growth rates from the material and basic components manufacturers that Michael talked about.

These businesses will often supplement their growth by making acquisitions. These will often be small deals that, over time, help to deepen and expand distribution networks by rolling smaller individual operators up into their businesses. This can raise revenue growth into the low to mid-teens per annum. We look for opportunities that can sustain us for very long periods. Profits should grow faster than revenues as margins expand based on both operating leverage and pricing power.

The valuations of these businesses can rise and fall with wider market sentiment, but we generally look to be able to make a two-times return in five years or an over-10-per cent multiple of profits.

Businesses that operate in industrial niches and that are more akin to specialist manufacturers can often command higher profits multiples, but these companies often exhibit faster growth potential because of their ability to scale more flexibly than a commodities-like business. In those cases, it may be possible to pay a relatively high starting price-to-earnings multiple for a business (as high as the 30s) provided we’re confident that the company can outgrow that starting share price.

Current trends such as the rush to build datacentres look like a gold rush and receive a lot of attention. What do you see being the growth areas beyond this?

From an infrastructure perspective, we expect the emerging trends to be long-lasting and to drive elevated spending for a decade or more. Building the infrastructure to store and process the new essential commodity – data – is certainly in the spotlight now but we think it will drive spending for years. Microsoft has contracted to buy nuclear power from Three Mile Island in Pennsylvania to help it meet its datacentre ambitions. This will drive big changes to energy generation and distribution infrastructure.

Beyond that, the rebuilding of basic infrastructure such as bridges, rail and water distribution is a huge and long-lasting undertaking. Underinvestment has persisted for too long, and it now has the potential to be a productivity headwind for the US. This should not be the case for a country in the US’s position and it seems that there is bipartisan agreement on this point. We think this will last a long time.

Finally, we’re seeing that a change in attitude to global supply chains is driving spending. This is a geopolitical issue, but it is also a fundamental issue of security and resilience. The US is bringing key elements of supply chains back within its borders where possible, and that is likely to continue. This will drive greater spending on industrial and manufacturing facilities, as well as the support infrastructure required to support a 'reshored' set of manufacturing capabilities.

These may feel like relatively obvious areas, and we’d agree that they are. But the degree to which this will reward those companies with sustained supply chain advantages is, we think, still materially underappreciated in places. That’s the part that is less obvious, and that’s where we have sought out investment opportunities that are tied to these long-acting trends.

What are your thoughts on the infrastructure opportunity in emerging markets?

The headline numbers are striking here. The global infrastructure ‘gap’ (projected investment vs requirement for adequate infrastructure) by 2040 is $15tn according to some sources. Although the US needs are significant emerging market countries make up two thirds of this gap.

To give just one example of how the Emerging Markets team thinks about this in its portfolios: in Mexico and India we invest in leading cement companies. As many global businesses retool their supply chains for a multipolar world and look to diversify where they do business, we can envisage a scenario where demand for raw materials for infrastructure grows significantly. Emerging markets (particularly outside China) could be significant beneficiaries.

Elsewhere, many Emerging markets are providing other inputs the world will need for infrastructure growth in future. Importantly this is true across a range of industries, covering both traditional infrastructure and digital infrastructure. A few of the examples of areas with investment opportunities that we are enthusiastic about include:

• Companies providing metals and minerals for the renewable transition. EM is home the most significant deposits of many key minerals (eg copper, nickel, cobalt)
• Companies providing the semiconductors we need for the AI era, eg memory chips designed in South Korea or advanced logic built in Taiwan
• Companies providing the mobile data infrastructure for huge countries to prosper online, eg India

Misunderstood markets and emerging opportunities

Thursday 21 November

Isn’t there a great deal of geopolitical risk associated with TSMC?

Yes, but TSMC is dominating cutting-edge semiconductor manufacturing globally, so the geopolitical issues that could disrupt it are also a risk to the rest of the world. TSMC’s customers, the large western tech companies, would quickly find themselves without a reliable semiconductor manufacturer in the worst-case scenario (Samsung is the only credible alternative in foundry but has been behind TSMC technologically for much of the last decade). The valuation of TSMC is at quite a discount compared to all its big customers, which reflects that a higher level of geopolitical risk is ‘priced’ in for TSMC.

Emerging markets (EM) offer a compelling investment philosophy of investing between growth and value. However, there can be a helpful but subtle distinction between expensive-and-overvalued and cheap-and-undervalued. What would inspire a sale of an asset even if it is an excellent company if it is overpriced, rather than merely expensively priced?

Any investment approach should have a defined growth hurdle for any company entering the portfolio in the first place. The main reason for selling a stock is when the company no longer meets this hurdle. We’re looking for companies that can deliver two-times growth over five years and expect this to be driven by underlying growth. If a company meets this hurdle when we first purchase it but then appreciates a lot, ahead of its fundamentals, then it may no longer meet the hurdle from this new starting point. At that point, we’re likely to moderate the position or sell it.

Regarding [Kazakhstani 'super-app'] Kaspi.kz, should we be concerned about potential Russian links, in terms of background or ownership of the company?

Yes, it’s a valid concern. Much of our due diligence effort was spent on understanding the potential political and geopolitical risks related to the investment case, including commissioning third-party research on the ownership background and potential sanction risks from the West. This highlighted a low risk of sanctions. However, given the country’s unique geopolitical position, Kaspi needs to ensure its compliance system is tight enough to ensure they are not unwittingly used by illicit trades with Russia. Its core business is domestic transactions between domestic users, only 1 per cent of its users are non-residents. The company has withdrawn from the Russian payments system and has no Russian counterparty banks. We think it’s in the Kazakh government’s interests to keep Kaspi operating well and compliant with international rules. The company is listed in the US, so is subject to SEC regulation as well.

In your view, how much exposure should a long-term growth portfolio have to emerging markets in the future?

If you look at MSCI ACWI today, around 62 per cent of companies with high growth expectations are EM companies. These are companies with forward earnings growth estimates of 20 per cent per annum or more in dollar terms. EM is only around 10 per cent of ACWI, so it’s clear EM is home to a disproportionate number of high-growth companies. By extension, it should be more than 10 per cent in global portfolio allocations. We’re confident these growth companies will be rewarded in future and that there is a significant ‘marginal buyer’ out there to drive valuations upwards.

Is a decrease in the value of the US dollar needed for the positive EM outlook to play out?

As we know, a stronger dollar is typically a headwind for EM. Since the Global Financial Crisis, the dollar has essentially been on an upward trajectory and this has had an impact on EM economies with high dollar exposures, notably in their debt. We have observed two important trends in more recent years which suggest the influence of a strong dollar on EM may be falling relative to the past. Firstly, more of the accumulated debt in major EM countries is in local currency. And secondly, intra-EM trade is rising. The old model of EMs simply selling to western economies is changing. Under a new model of greater intra-EM trade, which is now at all-time highs, it’s far more likely that deals will be denominated in EM currencies instead. And it’s far more likely that the profits from those deals will be recycled back into Emerging Markets.

Is there an argument for assessing companies and their prospects entirely from a country-agnostic perspective and then only overlaying the country or region for risk management purposes?

We understand why you ask the question, but don’t think it’s possible. In many instances, the bottom-up case for a company will be heavily influenced by macroeconomic factors. For example, the case for an EM bank will be influenced by the macro environment it's operating in (a stronger economy means a better lending backdrop). The case for an industrial company may be influenced by macro-related demand factors. The case for a materials company will be influenced by commodity supply and demand. We don’t think macro and micro are mutually exclusive and therefore are best considered together. Macro factors can lead to real headwinds and tailwinds for companies.

The elephant in the room is President-elect Donald Trump. What might be the impact of his protectionist policies on emerging markets?

We can’t speculate on an unpredictable president-elect before he has re-entered the White House. That said, Trump has made it clear that he views protectionist measures like tariffs as a key tool. Looking at China first of all, the proposed 60 per cent tariffs are likely to mean an increase in the costs for some Chinese companies, especially those that make money from the US. However, this won’t come as a surprise for Chinese companies, who have been carefully managing their supply chains in anticipation and pivoting their sales too. China exports about 375,000 cars per month to EM, Russia and Central Asia. That is about three times more than to developed markets. Also, currencies may simply adjust enough to counter their impact. In 2018/2019 we saw an 11 per cent fall in the RMB which offset almost two-thirds of the tariff hike. More widely, Trump has also pledged tariffs on all imports to the US, which would provide an incentive for other major economies to boost trade ties with China and is likely to further increase 'intra-EM trade', which has now reached all-time highs. This could be a real positive for emerging markets if it continues, as well as potentially reducing their reliance on the dollar over time.

On chips, Trump’s policies are unlikely to change the outlook for monopolies like TSMC and SK Hynix. He is keen to grow reliance on the US for chip manufacturing, but Asia has a huge lead and it will take time, capital and talent to unpick that.

Don’t you think state interventionism in countries such as China could be a huge issue?

Understanding that China has a very different social and economic governance system is essential in evaluating its companies, in our view. In China, both the state and the private sector play an important role. The latter is perhaps less well understood, but the private sector does contribute the majority of the country’s tax revenue, employment, and technology innovation. Therefore it is vital that the state keeps the private sector vibrant. China’s state-led industry policy has led to success in certain sectors (electric vehicles for example) while also causing dilemmas for investors. On one hand, it creates intensive competition that squeezes producers’ profit margins – only one in seven Chinese EV brands is expected to turn a profit by 2030.

On the other hand, these policies spur innovation, accelerate the green transition, and benefit consumers with lower prices and better products. As long-term stock pickers, it is important to be active and selective in China. Our bar to investing in Chinese companies needs to be high. Given the intensity of the competition and the competing incentives of the state, vigilance is required in terms of the entry point.

We still believe that finding companies that stand to benefit from policy support and profit motive can still be potentially rewarding.

In your Indian holdings, there is a concentration on banks (HDFC, ICICI, Axis) and life insurance (HDFC Life and ICICI Pru Life). Why is that, given your focus on growth stocks?

Our goal is to find companies that could grow faster, longer, or stronger than the market average. We want to be open-minded about where growth is coming from hence we don’t tend to pre-exclude certain sectors. Our India allocation is deliberately balanced between different growth types:

• ‘Old India’: growth compounders such as HDFC which has grown its loan book consistently for decades and is a long-term beneficiary of the structural growth and rising middle class of the country.
• ‘New India’: rapid growth companies such as Delhivery, whose ecommerce logistics were mentioned in the webinar.

It’s worth mentioning we are cautious in the small- and medium-cap and consumer space where valuation is stretched.

Do you see some novel geopolitical risks and opportunities in key strategic supply chains such as semiconductors and graphics processing units in future?

Yes. Clearly, this is most evident in the ongoing technology competition between the US and China. Tightening export controls on advanced chips and manufacturing equipment to China is both a threat to China’s development but also an incentive for China’s government and private companies to deepen their investments in these areas to support a move towards greater self-sufficiency over time. This may potentially lead to a fragmentation of global semiconductor supply chains, and greater opportunities for domestic Chinese players alongside the growth of alternative hubs in countries such as India and Vietnam.
Additionally, Taiwan’s dominant position in advanced semiconductors creates a unique geopolitical dynamic, with TSMC in particular critical to global supply chains.

Are you not worried about China’s clash with the West and [political] drivers that will override any micro or single-stock-related capital returns for investors?

You’re right, despite the attractiveness at stock level for selective Chinese companies, we need to consider the overall country risk at a portfolio level – this is reflected in our moderate underweight to neutral position in China versus the index. Macro and non-economic decision drivers (such as sanctions) can sometimes derail an individual investment case and we must carefully assess and avoid them. However, we try not to make broad generalisations about China. These tend to be unhelpful: there are a lot of nuances, and risks should be looked at case-by-case. The sanction risks for telecom and energy companies in China have a very different impact from the potential tariff risks on Chinese consumer electronics exporters.
A domestic regulatory crackdown on antitrust issues within ecommerce is very different from political scrutiny in the financial sector which may impact profitability more structurally. Our key job is to work out if the growth potential of our holdings is high enough to bear the related macro risks to these businesses.

Which emerging markets are you most positive about over the medium term, based on both the fundamental outlook and valuations?

We’re positive about the broader secular trends that support a continued shift in the economic balance of the world towards emerging markets as a whole.

These include particular strengths across EM in renewable energy and having the commodities and materials to support the climate transition, countries with strong and sizeable domestic demand, the ‘picks-and-shovels’ manufacturers that dominate semiconductor supply chains, and countries set to benefit from shifting supply chains as businesses seek to add resilience to their existing China exposure.

Our current portfolio is most overweight in Brazil at the country level, which mostly reflects the attractions of two companies offering different growth opportunities – Petrobras and MercadoLibre. While the macro picture is very supportive of India being one of the best structural growth stories in emerging markets, the current valuation premium for Indian stocks is a challenge and detracts from the investment case.
China is perhaps the opposite here, given that it has some exceptional companies which are trading on very low multiples, but where the macro picture and geopolitical risk premium puts a limit on our enthusiasm.

How much attention does your team allocate to macro v micro in your company selection process?

We do not think you can be purely bottom-up In emerging markets. As a rough rule of thumb around 20 per cent of our process is devoted to macro consideration. We consider macro factors when assessing companies but also more holistically as part of our portfolio construction group meetings. We’re ultimately aiming to deliver hard currency returns and therefore cannot overlook macro factors, as currencies can be volatile in EM and will be directly impacted by macroeconomic strength or weakness. One of the common pitfalls for EM investors is to think about their investment cases only in local currency terms.

Risk Factors   

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 November 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. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.

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

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