Monks’ musings: sweeter coffee and building scale

As with any investment, your capital is at risk.

We recently updated Monks’ performance and positioning in our interim report (Monks Investment Trust Interim Financial Report - October 2024). The last quarter of 2024 rounded off a strong year for global equity returns. The FTSE World Index delivered +20 per cent over the period. Monks’ share price grew a little less at +19.3 per cent. Our net asset value (NAV) rose by +17.6 per cent.

While the market slightly outpaced the portfolio, it’s the way we obtained growth that matters. Valuation expansion caused most of 2024’s market return. By contrast, earnings growth drove most of our return. That feels inherently more sustainable. We’ve been taking the chance to build positions in companies where the return opportunity looks greatest. And we’ve been moderating positions where the valuation has heated up relative to growth prospects. Some of that repositioning might have come at the cost of immediate returns, but we think it will produce substantial payoffs in the years ahead.

The broad base of growth drivers we have brought into the portfolio has improved our resilience without compromising our long-term growth prospects. Our valuation premium over the stock market on a price-to-earnings basis (ie the amount investors pay for each pound of a company’s profit) has halved from +27 per cent to +13 per cent over the past two years. 

That places the portfolio on solid foundations, which are strengthening relative to the wider market. Our companies are delivering more earnings, have become more cash generative and continue to reinvest at higher rates than the index. We’re excited about the prospects of rewarding our shareholders, whose willingness to stay the course through inevitable ups and downs is central to our ability to take a long-term view.

A differentiated perspective

We focus on much longer time frames in our investment thinking than most: five years and beyond. That’s how long market inefficiencies around growth companies take to show up reliably. However, they are sometimes apparent even on a three-year view, which is the furthest the analyst community is generally willing to look.

The grid below highlights this by showing the returns for groups of large- and mid-cap stocks based on their actual performance versus financial analysts’ initial predictions (quintile 1 represents the highest growth and quintile 5 the lowest).

Companies that deliver the most earnings growth tend to produce the best shareholder returns (the top rows). This holds even when starting expectations are higher (those towards the left), though this eats a little into the returns. People can still underestimate the impact of growth while expecting it to happen. Of course, companies that grow a lot from low expectations (those towards the right) produce the best returns of all.

We aim to capture these enduring market inefficiencies in many ways. Rapidly growing disruptive businesses can outpace high starting valuations to deliver big returns. When given enough time, well-known businesses can compound their way to glory in established markets, with each period’s returns building upon previous gains. And great growth companies can emerge from unfashionable parts of the stock market where expectations have sunk too low.  

Growth in established markets

Technological paradigm shifts drive growth, but companies don’t always need to move the earth to create great returns.

We purchased a position in Dutch Bros. The US coffee chain ‘only’ needs to add $8bn to double its market capitalisation. Dutch Bros’ potential stems from the distinctiveness of its products and the habits it creates. It serves personalised, stronger and sweeter drinks than traditional coffee chains in highly sociable settings. We can see how this format could roll out for years and take share from the incumbents.

We believe the number of Dutch Bros stores could more than double by the decade’s end. Even then, it would still have huge room to expand in its home market. Because its customers tend to be younger, it could fundamentally shift consumption habits. Bitter espresso is, after all, an acquired taste that consumers initially tolerate for its caffeine benefit. What happens if they never develop it?

Growth in unfashionable places

We have also found growth potential in companies where cyclical industry pressures can obscure great businesses. Occasionally, this leads to stocks trading on low multiples of temporarily low profits. Our time horizon gives us a different view. While we can’t predict inflection point timings in industries or stock market sentiment, we do invest when returns look high if a company lives up to its growth promise. Then we wait.

We discussed taking a stake in Builders FirstSource, the US’s biggest builders merchant, in Monks’ musings last edition. We added to this position during the quarter. It currently trades on a low multiple of profits. The company is using its scale to shift towards higher-margin finished products, including preassembled panels, roof trusses, doors and windows. It also provides design services to contractors, essentially delivering a timber kit for assembly to construction sites. That saves time and labour and reduces waste. Smaller merchants can’t make a return on the investments required to compete, and Builders FirstSource’s lead should widen as it grows.

Our new position in Brookfield takes building to a different scale. The alternative investment manager develops and runs physical assets, ranging from commercial properties to power infrastructure. It provides another way to benefit from the need to rebuild and upgrade. It is well-financed, raising funds and poised to compound its earnings at 10-15 per cent for years. Brookfield’s shares trade at a discount to its assets’ intrinsic value. Its complexity may discourage some, but we see opportunity in its compelling growth prospects and a superb record of smart capital allocation.

The outcome

We ended the year with a well-balanced portfolio across our three growth profiles (Stalwart, Rapid and Cyclical, as defined on pages 14 and 15 of our interim report) and a deliberate tilt towards disruptive growth companies with attractive-looking outcomes.

We have adjusted into holdings where upside opportunities appear highly compelling. The composition of our return has been strong in the absolute and differs substantially from the index: much more has come from growth than valuation expansion.

Our premium to the wider stock market has fallen while our portfolio companies’ prospects remain strong. We are widening our range of growth drivers within existing themes (including AI and infrastructure) and adding completely new drivers to the portfolio. Amid continued signs of our companies’ progress, we are confident in the Trust’s ability to deliver attractive returns for shareholders in the years ahead.

Performance source: Morningstar, FTSE, total return in sterling

Past performance is not a guide to future returns.

Important information    

This communication was produced and approved in January 2025 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.  

The Trust invests in overseas securities. Changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up. 

This article does not constitute, and is not subject to the protections afforded to, independent research. Baillie Gifford and its staff may have dealt in the investments concerned. The views expressed are not statements of fact and should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). The investment trusts managed by Baillie Gifford & Co Limited are listed on the London Stock Exchange and are not authorised or regulated by the FCA. 

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