International Alpha: investor letter Q3 2024

Your capital is at risk.

All successful organisations make ongoing improvements to their processes and practices, learning from experience to stay ahead of their peers. This continual search for excellence is an important feature of the portfolio holdings whether it be digital platforms like MercadoLibre constantly reducing delivery times for its customers; cycling components business Shimano enabling smoother gear transitions; or semiconductor foundry TSMC exploring novel techniques for manufacturing ever smaller and more powerful transistors.

Baillie Gifford’s long-term success has also come about through continuous learning and steady evolution of our investment approach. It is during particularly challenging periods, such as the past few years, that the most valuable lessons are learned. We deliberately haven't made any wide-reaching changes to portfolio positioning recently, mindful of the dangers associated with kneejerk reactions to short-term market trends. Importantly, we also don't wish to deviate from an investment philosophy which has benefited our clients for more than twenty years.

Following a period of reflection, however, and after listening carefully to our clients, we have made three enhancements to our investment process. We believe these will improve our stock picking and portfolio construction processes, reduce the likelihood of repeating recent errors, and ultimately ensure that we deliver the returns that our clients expect.

First, we acknowledge that our idea generation had become too narrowly focused on higher growth opportunities, and this contributed to the heightened levels of volatility clients experienced in 2021 and 2022 as the market turned. We have therefore encouraged the investors to seek out and put forward different types of growth ideas from their specialist regions. For example, two relatively recent purchases that broaden out the range of growth in the portfolio are Italian holding company Exor and Canadian business Stella-Jones. Although neither of these businesses are likely to grow rapidly, we expect them to deliver dependable and above-market earnings growth for many years to come.

Exor is the owner of luxury car maker, Ferrari, but it also has exposure to healthcare through its investments in Phillips and Institut Merieux. It also has an exceptional track record of capital allocation and trades on a large discount to its net asset value.

Stella-Jones is a company that specialises in the manufacture of pressure-treated wooden utility poles used in electrical and communications infrastructure.  The expansion and much-needed upgrade of transmission networks should underpin mid-single-digit volume growth for many years. At the same time, Stella Jones has consolidated the market, and its dominant position gives it formidable pricing power over its fragmented customer base.

To encourage us to think differently and consider a wider range of ideas, the investment team has introduced regular idea “sprints” These are short, sharp reviews setting parameters that force us out of our comfort zone and challenge our inherent biases. Earlier this year, for example, we reviewed a collection of businesses trading at or below the current year's price-earnings ratio for the market, in the hope that we could undercover an overlooked quality growth stock. We couldn’t get comfortable with any of these on this occasion but will continue to look.

A more recent healthcare idea sprint led to enthusiasm for pharmaceutical giant Roche, which was purchased after conducting our usual, more detailed, analysis. Roche benefits from a rich pipeline of novel therapeutics in growing end markets such as neurology, ophthalmology, obesity, and oncology, whilst its highly profitable and cash-generative diagnostics business provides it with earnings resilience. We also greatly admire the company's science-led culture, supported by a unique organisational structure and the presence of the Roche family as a long-term shareholder.

Secondly, to improve our portfolio construction process our independent risk team has developed a correlations network analysis tool that uses 150 weeks of data to indicate how the shares of each holding move in relation to one another.  This gives us a far more sophisticated insight into what each individual stock adds to the portfolio.

We have already seen the impacts of this. We all admired the merits of Swiss chocolate maker Lindt when it was discussed recently but we acknowledged that it was too similar in profile to some stocks already held in the portfolio. In contrast, part of the enthusiasm for taking a position in Stella-Jones was that it is markedly different from anything else we own for our clients. Another recent holding was in Kaspi, Kazakhstan's leading ecommerce and payments business. Although we already own a number of digital platforms, the correlation analysis indicated that the market views it very differently to the other holdings.

Taking a position in Kaspi, which has the potential to become an outsized winner, is also a reminder that we are not shying away from rapid-growth names; we just want to make sure they bring something different to the portfolio.

Our final area of process improvement has been on valuation discipline. To supplement our bull-bear and base case scenario analysis that looks five years into the future, we have introduced additional valuation lenses to reduce the risk of overpaying for the shares and to provide us with greater confidence in the investment case. This additional input stopped us from taking a holding in an early-stage biotech firm offering treatments for autoimmune diseases. Even though its shares had sold off sharply after a failed trial, this approach indicated a lot still had to go right to justify the price.

Another useful input has been the work conducted by our risk team segmenting the portfolio into growth and valuation quintiles. During the quarter we reviewed the holding in Swedish industrial business Epiroc, which was flagged as being expensive for the level of growth expected. The sponsor was unable to put forward a credible defence during the quarterly portfolio review meeting, so the stock was sold. While we remain comfortable paying above-market multiples for the best businesses, these valuations must be justified by exceptional growth prospects.

Facing up to mistakes, learning lessons and self-improvement are all necessary to remain relevant and meet customer, or in our case client, expectations. However, recognising and continuing to leverage existing strengths is equally important.

With this in mind there are several unique features to Baillie Gifford that are difficult to replicate and are a source of enduring competitive advantage. Our longstanding graduate investment programme, which has been running for 41 years, coupled with low turnover of investment staff, ensures a stable and long-tenured team. The current Portfolio Construction Group boasts over a century of aggregate experience, most of which, has been accumulated within the firm.

This supports the building of deep networks, with colleagues and with investee companies, over an extended period. It creates a culture of sharing, collaboration and robust debate with multiple inputs from a variety of investment teams within the firm, feeding into new holdings and challenging existing ones. 

For example, we recently took a holding in Olympus, the Japanese specialist in endoscopes. When analysing this stock, we benefitted from the strong relationship with and knowledge of the company built up over the 15 years that it has been held within specialist Developed Asian portfolios. Similarly, the research journey for Danish hearing aid manufacturer, Demant, began 23 years ago and has involved multiple meetings with the company, attendance at industry events, meetings with Chinese and European competitors and owning similar firms such as Cochlear. 

We also make the most of an environment that supports giving ideas time to develop, rather than forcing us to make hasty decisions that are not in the best interest of our clients. This has been particularly challenging during the recent performance cycle, but we believe it to be a hallmark of the value we have added for clients over the long-term. The excellent progress made by our rapid growth holdings that have successfully pivoted towards profitability to cater to a changing environment is one recent example. Had we followed other investors and sold these earlier our clients would have missed out on the recent strong rebound in their share prices.

There are several great companies that have made mistakes or suffered a major setback that they have subsequently recovered from, and indeed come back stronger. Among the portfolio holdings Sony's flawed decision to back the Betamax video tape in 1970's and the failure of Nintendo's WIIU console serve as excellent examples. In both cases, lessons were quickly learnt whilst the longstanding competitive strengths of their organisations were maintained, whether it be Sony's history of innovation and product excellence or Nintendo's culture of creativity that have yielded multiple successes in both hardware and software since.

We are confident that our learnings from recent struggles will make us better investors, but we mustn't lose sight of the long term, stock-driven approach that has underpinned our enduring success. Recent research has highlighted a wide range of companies such as those highlighted in this letter, with different and diverse growth profiles and on attractive valuations, that we believe can continue to drive superior investment returns in years to come. We therefore begin the final quarter of the year in an optimistic frame of mind.

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.

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 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.

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

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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.

Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.

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North America

Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.

The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission ('OSC'). Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford International LLC is regulated by the OSC as an exempt market and its licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.

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Singapore

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