International All Cap: investor letter Q3 2024

Your capital is at risk.

The past three months have certainly been eventful. Weakening US economic data sparked volatility in equity markets over the summer months. September brought the first reduction in the US federal funds rate since the beginning of the Covid pandemic, which was swiftly followed by what was effectively an emergency meeting of the Chinese Politburo announcing meaningful stimulus for the economy. These left markets feeling somewhat more optimistic, with lower interest rates and hope that China was addressing its challenges presenting a brighter outlook for global growth. The portfolio outperformed over the quarter with contributions coming from stocks in a variety of sectors, including MercadoLibre in Latin American ecommerce; DSV, the freight forwarder; and Techtronic, the power tools company.

You’ll have noticed that the portfolio’s annual turnover is higher than average. This simply reflects that we are finding more opportunities to invest in mispriced growth companies than has been the case recently. Over the quarter we added new holdings in private equity firm Partners Group, Chinese media conglomerate Tencent, and the Korean company, Samsung Electronics. A diverse range of companies but each has the potential, we believe, to be a long-term growth machine.

Growth machines

In a recent blogpost, Aswath Damodaran, a Professor at the Stern School of Business at NYU, wrote about the corporate lifecycle. In it, he reminds us just how difficult it is for businesses to durably compound growth: “As companies move through the life cycle, they will hit transition points in operations and in capital raising that have to be navigated, with high failure rates at each transition.” In looking for companies which can grow for a very long time and defy the fade rates ascribed to them by consensus, we’re trying to find companies capable of doing something quite improbable. We’re not always going to be successful in identifying these perpetual growth machines. However, when we do find them, it’s important we understand why so we can apply those mental models to other companies which are navigating different in that cycle.

Atlas Copco, the Swedish air compressor business, is our go-to example for durable success at Baillie Gifford, which is hardly surprising given it has been owned at the firm since before the author of this piece was born. Hopefully you’ll indulge us and allow us to write about it at least once more! When we discuss Atlas Copco, we often talk in terms of its outputs. It has compounded its earnings at 9.5 per cent per annum over the past 20 years, for example, and grown its free cash flow by close to six times over that same period. As Damodaran highlights, though, over that 20-year period, or back even further in the company’s 150-year history, there have been innumerable points in time where decisions have been made which could have could have gone quite differently. In short, it’s the inputs which really matter.

Thinking about those inputs which have made Atlas Copco a durable grower, four stand out. The first is ensuring it has great products. This is a basic point but its focus on engineering high quality machinery has meant that almost every product evolution becomes the gold standard and the product each customer wants to use. Secondly, and related to the first point, is how it delivers exceptional after sales service. Not only does service lead to high margin recurring revenue, it also increases switching costs and promotes customer loyalty. The third input we’d highlight is its decentralised, entrepreneurial culture. When you add this culture to its engineering expertise, you can see how it has taken its domain knowledge in compressing air into related areas like vacuum pumps for semiconductor manufacturing, thereby unlocking further legs of growth. And finally, the fourth input is a long-term approach to capital allocation, set forth by its founding family, the Wallenbergs, which has enabled it to navigate difficult cycles and capture further growth through acquisitions. The company now guides that earnings growth will be roughly eight per cent through the cycle. This is still comfortably higher than the median five-year earnings growth compound average growth rate of 5.9 per cent, observed across a global universe between 1950 and 2015 in a study of base rates by Michael Mauboussin. Atlas Copco continues to beat the fade.

Four inputs for durable growth, then. Great products, great service, great people, and great management. Of course, this is a gross over-simplification, but it does form a reasonable lens through which to look at other companies including those at much earlier stages of growth.

A company a bit further behind Atlas Copco in its journey would be FEMSA, a Mexican bottling business. FEMSA traces its roots back to 1890, making it a similar age to Atlas Copco. However, the nature of its operations provides it with a significant amount of optionality as to its future direction. The core of the business has historically been Coca-Cola bottling. It has become the largest and most profitable Coca-Cola bottler in the world, bringing it close to customers and giving it significant logistical know-how. It is reinvesting the profits from the bottling business into the rapid rollout of its OXXO convenience stores across Latin America and now into Texas. It opened seven of these stores every day in 2023 and the company suggests store level return on invested capital is an impressive 40 per cent. Each store unlocks more growth by building closer relationships with customers. Customer trust is high. Many pay their bills and make bank transfers in OXXO stores, bringing FEMSA into financial services and turning it into a growth octopus of sorts. Its tentacles can expand further. Its financial services portfolio could expand to working capital loans for its bottling customers, while its store roll-out expertise is now being applied to drug retail. Like Atlas Copco, it has long-term oriented management and a culture, embodied by its “Cuauhtemoc Ideology”, which emphasises the highest standards. Having proved its excellence in several related business areas, having grown closer to customers, having established an exceptional management track record and a high-performance culture, FEMSA has many of the characteristics of a perpetual growth machine.

If we go back even further on the S-curve, you’ll find Spotify. The past twelve months at the audio streaming giant represent a terrific example of a company navigating a very tricky transition: moving from investing purely for growth at the expense of profits, to rapidly growing both revenues and earnings. At the core of this is the product itself. Spotify has developed a service which customers love. It has continually increased its share of net premium audio streaming subscriber growth, from 30 per cent in 2020 to 40 per cent in 2023, while its competitors YouTube, Amazon and Apple combined accounted for roughly 29 per cent of net adds in 2023. It has recently pushed through premium subscription price increases in its more mature markets without causing notable user attrition. There are likely price increases to come given that music content is under-monetised with global recorded music revenues 47 per cent below where they were in 1999 on an inflation-adjusted per capita basis.

CEO Daniel Ek and his team at Spotify have constantly looked at different ways to increase the value of the service it provides, bringing audiobooks and podcasts on to the platform. It even highlights when your favourite artists are playing at venues near you and access to their merchandise store. Meanwhile, its investments in higher margin business lines, such as its advertising network, have paid dividends. The proof is how the gross margin, which had been stubbornly stuck around 25 per cent for years, has now reached 29 per cent. This, along with greater cost control, has seen it generate positive earnings per share in 2024 and it is becoming the lean, mean, cash generation machine we always believed it could be.

Spotify will have many more transition points to navigate in the future, successfully monetising its growing user base in emerging markets being one example. However, going back to the lens we established with Atlas Copco, the strength of the product and the service it provides appears to be there. Management has undoubtedly been iconoclastic, and its culture is becoming increasingly entrepreneurial. Only one in five companies observed in that base rates study were able to compound annual earnings growth between 10 and 20 per cent over a 10-year period. Given the hallmarks of a growth machine are there for Spotify, it looks in a position to do the improbable.

Investing in these businesses as they navigate different transition points in their lifecycles requires patience. It requires an appreciation of many aspects of an investment case which do not show up in financial statements. Whether that is understanding what customers think of them or taking time to understand how a management team approaches decision making and capital allocation, finding companies which can defy convention requires more qualitative than quantitative inputs.

Many investors do not appreciate the durability of their growth opportunities because investment orthodoxy tells you that growth fades and traditional discounted cash flow models assume a fairly abrupt decline to a terminal, GDP-like, growth rate. While growth does fade, some companies, like Atlas Copco, FEMSA and Spotify, can extend their growth period far beyond consensus expectations. Having a clear picture of the requirements for long-term compounding and the behaviours to benefit from it can be a source of edge. Baillie Gifford’s experience of remaining invested in Atlas Copco continuously for 39 years and our own patient culture, might just put us in the position to own and benefit from these durable winners.

This is an International All Cap commentary based on ACWI ex US All Cap. Not all stocks may be held, but themes of this commentary are representative of: EAFE Plus All Cap and Developed EAFE All Cap. 

The International All Cap Strategy comprises three distinct variants. Overall, the variants are broadly similar, with the key difference being the degree of exposure to emerging markets listed holdings. 

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.

Legal notice: 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.

Risk factors

This communication was produced and approved in October 2024 and has not been updated subsequently. It represents views held at the time and may not reflect current thinking.

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