The powerful forces that have held back EWIT’s returns for the last three years look set to recede. Our confidence and optimism are grounded in five growth-supporting ‘tailwinds’ we believe will lead to strong returns for investors, justifying your continued patience in the Trust’s investment proposition.
Tailwind 1: Growth re-accelerating
Sales growth slowed during the second half of 2021 and in 2022. Many of the themes to which EWIT has sought exposure have faced operational challenges or reduced demand. These include:
- Online platforms whose sales compare badly to performance in lockdown
- Healthcare companies disrupted by the pandemic
- Financial services adjusting to higher interest rates
Growth, however, is re-accelerating, with projections for revenue and earnings growth notably ahead of the benchmark S&P Global Small Cap index. Many holdings have emerged from pandemic-related disruption operationally strengthened and are now taking market share.
Tailwind 2: Improving financial maturity
Despite the downward direction of travel, central bank interest rates remain materially higher than over the past decade. Markets have reacted to this higher-rate environment by lowering valuations of unprofitable companies. This shift has been indiscriminate, creating an opportunity for valuations to bounce back once companies have proved consistent profitability or an ability to generate extra cash. Recent examples include the market’s revaluation of Xero or American Superconductor.
After a difficult period of adaption in 2021/2022, portfolio companies are focusing on value-enhancing growth while still reinvesting in their business. This is shown by capital expenditure (CAPEX) and research and development (R&D) spending ratios of more than four times the benchmark. Alongside this, we expect 20-25 per cent of the portfolio to display increasingly mature financial returns over the next 18-24 months, potentially lifting performance.
Despite the increasing maturity of our companies, we are clear that pre-profitable firms, with attractive business models and enough cash-generating potential to support their growth plans, will remain an important part of the portfolio. It's often here that our patience and ability to embrace uncertain outcomes creates the clearest opportunity to outperform. This has been the case for several of our most successful investments. Ten of the top 15 contributors to performance over the long term have been unprofitable at the point of purchase, including Tesla, Alnylam Pharmaceutical, Dexcom and Shockwave Medical.
Tailwind 3: Healthcare recovery
Global Small Caps have been resoundingly out of favour over the last three years, but this is even more extreme among small-cap healthcare companies, which were knocked off course by the effects of the pandemic and lowered R&D budgets due to inflationary pressure. We retain our conviction in the potential for long-term novel treatments, and observe that more and more innovation in the sector comes from smaller, nimbler competitors than larger incumbents. This has resulted in healthcare being EWIT’s highest sector exposure, making up around 40 per cent of the total portfolio.
With early signs of a return to healthcare growth, it now seems the negative impact on R&D budgets was temporary, rather than a long-term slowing of growth. However, the most important thing for portfolio companies is the clinical and commercial progress they deliver. Many are showing clear evidence of success, such as Alnylam’s recent trial result in ATTR Amyloidosis with Cardiomyopathy, a rare but serious heart condition, and Twist Bioscience scaling its Express Genes product. Several further positive catalysts lie ahead for these companies in the next two years.
Tailwind 4: Portfolio duration
EWIT’s portfolio is focused on upside and long-term growth, seeking early-stage unique businesses that will deliver substantial and enduring growth. This philosophy leads to exposure to companies with a higher proportion of their potential profits further in the future, ie long-duration equities. While this has undoubtedly been a headwind to recent performance, any downward change in rate expectations should provide a helpful tailwind for the portfolio from here on. We have seen glimmers of this after positive inflation reports in December last year and again in June.
Tailwind 5: Relative valuation
Relative exposure to interest rates and being excluded from the recent trade in the $200bn-plus AI-related ‘mega cap’ stocks that has dominated markets over the last 12 months, have left small caps (valued up to $2bn) at their cheapest compared to large caps ($10bn and more) for a generation.
The last time the relative valuation discount of the two was this large was in 1999. What followed was a decade of small-cap outperformance relative to the benchmark. The gap is most evident in the US market. This discount is also reflected in the low price-to-sales ratio (a company’s market capitalisation divided by its sales) of the EWIT portfolio compared to its historical average.
We think the poor sentiment and a ‘risk-off’, or safety-seeking, approach have caused an exaggerated split in valuations, creating incredible opportunities for stock pickers. The potential rebound could be twofold: a narrowing of the relative discount of small caps to large caps and a re-rating of early-stage companies that deliver on their investment case. This combination could be powerful for portfolio returns.
Conclusion
Improvement in any one of the aspects listed above would be meaningful for EWIT, but we think there’s a good chance of seeing more materialise. These, in addition to the enduring structural trends to which the portfolio is exposed to, such as digitisation, increasing electrification, and an improved understanding of genetics, combine to provide a clear case for improved returns over the long term.
We believe we are nearing the end of this long cycle of underperformance. We are optimistic about multiple drivers of returns on the horizon. Having tolerated extreme drawdowns over the last three years, we urge investors to retain the patience they have shown thus far.
Important information
The value of the trust's shares and any income from them can fall as well as rise. Capital is at risk. Past performance is not a guide to future returns.
This communication was produced and approved in August 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
For a Key Information Document for the Edinburgh Worldwide Investment Trust please visit our website at www.bailliegifford.com
This communication 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 is authorised and regulated by the Financial Conduct Authority (FCA).
The investment trusts managed by Baillie Gifford & Co Limited are listed UK companies and are not authorised or regulated by the Financial Conduct Authority.
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.
Unlisted investments such as private companies, in which the Trust has a significant investment, can increase risk. These assets may be more difficult to sell, so changes in their prices may be greater.
Investment in smaller, immature companies is generally considered higher risk as changes in their share prices may be greater and the shares may be harder to sell. Smaller, immature companies may do less well in periods of unfavourable economic conditions.
All data is source Baillie Gifford & Co unless otherwise stated
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