Long Term Global Growth: investor letter Q3 2024

Your capital is at risk. 

September is always an exciting month at Baillie Gifford. In keeping with academic calendars here in the UK, it is when we welcome our new graduates. The sense of new beginnings is palpable, and with it comes a buzz to our Edinburgh office. Each cohort shares a common peculiarity: little to no background in investments. This grants us the opportunity to revisit, from first principles, what it is we believe while also providing us with valuable fresh perspectives for understanding this ever-changing world.

Little do they know that much of what they will learn throughout their investment careers is how to fend off some of our most dangerous instincts: the near gravitational pull toward pessimism and the consequential push toward risk aversion¹. We instead encourage them to supplement this with a conscious effort to understand the power of exponential growth on returns.

For those who start their training with the Long Term Global Growth (LTGG) team, the task appears simple: look for the world’s best growth companies, regardless of where they may be in the world. And be open-minded to where that growth may come from, it will often surprise.

The arrival of the graduates is also a reminder of another year passing and it is sometimes hard to believe that LTGG has entered its third decade. And while we have already been witness to remarkable levels of technological change and progress over the last twenty years, it feels like we are only just getting started.

We have rarely felt more enthusiastic about the opportunity for outsized returns. Growth rates in LTGG are and have always been ahead of the index² but the gap is widening. This acceleration is being driven by technological unlocks, strengthening of network effects, and shifting industry dynamics. Importantly, valuations have not caught up. We believe these conditions should be fruitful for long-term return generation in the years ahead.

Overlooked growth

LTGG has always been focussed on bottom-up stock picking and we remain steadfast in our view that making top-down portfolio construction decisions is an easy way to miss out on some of the most extreme growth, and therefore returns, on offer.

By way of example, global growth for the “advertising market” is expected to be 8 per cent this year. This is hardly the magnitude that excites us as high growth investors, but it also tells you little if anything about the changes afoot and masks the success of individual companies racing ahead. On the one hand, behemoths like Alphabet (Google’s parent company) are coming under increasing regulatory pressure for cornering all angles of the market - buying, selling and being an exchange. Measures like Apple’s App Tracking Transparency (introduced in 2021) have also been a means to reduce the power of these walled gardens. Portfolio holding The Trade Desk (TTD), a demand-side only platform, on the other hand, is a beneficiary of these changes. 

TTD analyses over 900 million impressions³ per minute to match the advertiser with the opportunities that will generate the highest return on a given budget. The uplift from this technology is twofold. As long as TTD continues to prove its superior ability to pair advertisers with the best available ad spaces, more and more inventory will flow to the platform, creating a mutually reinforcing flywheel. TTD’s revenue grows as a function of increasing volumes, while the marketing budgets of users become more efficient. Over the last twelve months the company has grown revenues 25 per cent year-on-year (three times the rate of the broader advertising market) while nearly doubling its earnings.

The value of TTD’s technology is clear, but we expect to continue seeing improvements now that its latest models are strengthening. Netflix and Spotify have certainly taken notice, and recent partnerships with TTD are a means for these streaming giants to better monetise the hundreds of millions of users on their respective platforms.

We are already seeing the effects at Netflix. In the eighteen months since cracking down on password sharing and simultaneously introducing an advertising tier, 40 million users have opted for a cheaper subscription in exchange for some advertising. Remember the days when you didn’t have a choice whether or not your favourite 40-minute show was sliced by several ad breaks to fill the remainder of the hour? At least now, the adverts you see should be more relevant to you, powered in part by TTD.

Having amassed 288 million subscribers, who tune in for an average viewing of 2.5 hours each evening, Netflix has proved its prowess in streaming. In our meeting with the co-CEOs in July, they attributed their industry-leading engagement and lower churn to their focus and sheer scale⁴. A more benign competitive environment, combined with ramping up advertising efforts, puts Netflix in a strong pricing position and profitability continues to rise, with operating margins having reached 28 per cent. At the current valuation, we see plenty of upside.

The shake-up in advertising also provides additional growth vectors for the portfolio’s ecommerce platforms. Amazon is the furthest into this transformation having begun a mere decade ago, its advertising business is now generating over $40 billion in revenue, equivalent to approximately 6 per cent of the $700 billion of gross merchandise value (GMV) flowing through its site. This is further bolstered by more than $1.8 billion in advertising commitments for Prime Video, where nearly 15 million viewers must subscribe if they want to watch Thursday Night (American) Football. And now that they have paid for Prime delivery, why not also buy that new barbeque they’ve been eyeing up from Amazon instead of driving out to the nearest retail park? The flywheel turns faster.

A similar story is playing out at MercadoLibre, now the third-largest digital advertising player in Latin America (behind Alphabet and Meta), but with ample headroom for continued growth. Advertising as a percentage of GMV can triple before it reaches the same level as Amazon. The double-kicker here is that there also remains significant scope for MercadoLibre’s GMV to continue growing. Ecommerce penetration in the region is still only 14 per cent of retail (half the rate of China) and efforts such as the revamped loyalty programme are already showing signs of driving better retention and increasing transaction frequency. This is all promising for MercadoLibre’s upside. Continued operational excellence points to an increased probability of outlier returns and as such we have added to the holding⁵.

Advertising is not the only thing these companies have in common; a more valuable shared trait is that they are all open to change and willing to experiment. It is no coincidence that the portfolio’s R&D spend as a percentage of revenue (14 per cent) is three times that of the index. Nor should it be a surprise that several holdings have reinvented themselves during our holding period, be it Amazon’s book sales dwindling contribution to total revenue or Netflix’s DVD delivery service no longer existing (you may be surprised to learn that this only concluded on 29 September 2023!). Continuing to re-imagine a company’s possible success is essential to avoid interrupting compounding returns.

Increasing returns to scale

Digital platforms in the portfolio are not the only ones that are benefitting from technology-enabled growth spurts. Capabilities that were previously the preserve of the few, such as advanced artificial intelligence and battery technology, are becoming widely distributed in very short order, creating exciting new opportunities for increasing returns to scale.

It is perhaps not overly insightful to suggest that electricity’s discovery revolutionised the economy. However, at the time, few fully appreciated the extent to which its predecessor, steam, had dictated factory layout.

Electricity allowed Henry Ford to be the first to redesign assembly lines to be optimised for workflow requirements, instead of being centred around proximity to the power source. In a similar fashion, the internal combustion engine has influenced the architecture and wiring of traditional vehicles and other modes of transportation. Today’s ever-improving battery technology means there is the opportunity to reimagine this too and optimise further.

CATL, the world’s largest electric vehicle (EV) battery manufacturer, is now looking to deploy its long-range battery technology to aviation, having secured partnerships with Commercial Aircraft Corporation of China (COMAC) and Chinese electric vertical take-off and landing (eVTOL) aircraft manufacturer, AutoFlight. As has been the case with vehicles, electric power allows manufacturers to simplify aircraft design. There is no longer the need for complex fuel storage, pumping, and distribution systems necessary with liquid fuels. The scope for improvement is vast and its pace accelerating. Advances such as CATL’s 500Wh/Kg condensed battery suggest interesting possibilities, like their recently exhibited 19-seat jet with a 500km range in collaboration with COMAC.

CATL’s progress in battery technology has been both non-linear and crucially scalable, rather than limited to laboratory demonstrations. As has been evidenced by the misfortunes of other battery upstarts, matching CATL’s translation from laboratory to product is hard. These capabilities can be likened to semiconductor fabs where barriers to production at the advanced nodes, both in terms of capital and know-how, are high. As the energy density and cost of batteries continue to converge with fossil fuels, an era of universal electrification of sea, land, and air transportation seems closer than many appreciate.

Rivian, on the other hand, is reconfiguring the layout of electric control units (ECUs), essentially a vehicle’s central nervous system. These tiny devices are responsible for functionalities as wide ranging as automatic windows, fuel optimization, climate systems, and more. Rivian has managed to reduce what are ordinarily 60-100 ECUs per vehicle to just seven, by applying what they call “zonal ECU architecture”. Not only does this simplify the vehicle and make computer functions more efficient, but it also results in significantly less wiring⁶. This is a structurally lower-cost architecture and one that puts the tier-1 suppliers in a precarious position if it gains momentum industry-wide. The penny has already dropped for Volkswagen (VW) who like many other traditional auto original equipment manufacturers, have struggled to maintain pace with software innovation. The recently announced joint venture (JV) between these two “automakers” means Rivian potentially gets $5 billion in exchange for helping VW rearchitect its own vehicles. This JV could be the first of potentially several deals to bring incumbents up to speed and could well be Rivian’s “AWS moment”, yet shares are down more than 50 per cent year to date. As such, we took the opportunity to make a modest addition to the holding. 

Commercial vehicles are also getting a long-overdue overhaul thanks to portfolio holding Samsara. As a reminder, Samsara looks to turn all physical assets, ranging from commercial vehicles, trailers, industrial equipment, and warehouses into smart assets. This is not a small opportunity to go after (as businesses with some form of physical assets make up as much as 40 per cent of global GDP) but it is a surprisingly greenfield one. Commercial vehicles are the golden thread that runs through this disparate category, so the majority of its customers begin with video-based safety or vehicle telematics products. Once in an organisation, Samsara is able to prove the staggering value it creates for its customers with a return on investment (ROI) of 8x. This is an important lever for growth as it drives both upsell (adoption across more assets) and cross-sell. The network effects at play stem from scale advantages and a growing data set. The more a customer embeds Samsara, the greater the visibility across assets, translating to a higher ROI and a shorter payback period. This provides Samsara with ample scope to raise prices in the future were it necessary.

We expect Samsara will continue to compound revenues more than 25 per cent over the next eight years while also benefitting from increasing operational leverage. Execution to date has been impeccable, so we recently increased our position to reflect our growing conviction in the upside.

These companies are collectively rearchitecting the infrastructure of the future. In a time of scarcity, all help to remove cost and introduce efficiencies for their customers. This degree of progress won’t happen overnight. But our investment time horizons afford us the patience to capture more of the upside that is potentially on offer from these multi-decade opportunities.

Competition for capital

We are currently undertaking an upside review for NVIDIA. Hundreds of billions of dollars are being put toward AI-powered data centre buildouts, fuelling the astonishing growth the company has experienced over the last two years. Its latest set of results, however, were met with disappointment and the ripple effect vast. Despite revenues continuing to climb 122 per cent year-on-year and earnings outpacing at 152 per cent, volatility ensued. Market participants now want to see concrete evidence that these investments will generate returns. 

We continue to challenge ourselves to truly interrogate how great an investment opportunity this may be and how differentiated our view remains. If artificial general intelligence comes to pass, could computing rise to a share of the global economy that begins to parallel physical manufacturing? If so, that could infer trillions of spend and allow headroom for NVIDIA revenues to grow 2x, 5x, even 10x or more in theory - and with sufficient likelihood to continue to warrant such a significant position size in the LTGG portfolio.

Our conviction in the upside potential of longstanding luxury brand Kering, however, has waned, leading to a complete sale of the holding. When we first invested in Kering in 2008, our central investment thesis was that the group would evolve from a motley collection of disparate brands into pure luxury. Sure enough, it did become synonymous with the likes of Gucci, YSL, Bottega Veneta, and Balenciaga. However, the multi-brand approach did not result in long-lasting diversification, where the ebbing of one brand’s success in any particular period would be offset by the rise of another. Gucci’s standout success instead meant it grew to become approximately half of Kering’s total sales. And while the brand successfully leaned into the new generation of younger consumers, its styles veered more toward fashion than luxury, more cyclical than timeless. Gucci’s high net worth customers appeared increasingly alienated. Support from Kering’s other brands hasn’t come to bear, as they remain sub-scale and face headwinds of their own. Taking this together with the potential retirement of Chairman and CEO François-Henri Pinault, who has architected the group’s success over the past twenty years, we took the decision to sell our holding in August 2024 in favour of higher conviction names elsewhere.

Despite ‘only’ a approximately 4x return during our 16-year holding period, Kering features among the top ten contributors to LTGG performance since inception in 2004. This phenomenon is a function not just of its longevity in the portfolio, but also its position size. This serves as a reminder that our task in LTGG is threefold: (i) identify the outliers, (ii) hold onto them over time, and (iii) hold onto them at scale.

The current portfolio

A trade-off to our appetite for such high growth companies is the accompanying share price volatility. Even LTGG’s top five returning holdings have collectively had twenty-five individual instances of drawdowns greater than 30 per cent during our holding period. In the short run, multiple volatility can completely dominate share price returns. Indeed, this continues to dominate LTGG’s three-year rolling performance, an overhang from the severe 2021-22 drawdown that followed the exceptional portfolio outperformance during the pandemic. And this latest quarter is no different with Symbotic, Dexcom, Moderna and e.l.f Beauty all experiencing drawdowns in excess of 30 per cent.

But more than a century of stock market history attests to the fact that companies with the highest rates of earnings growth reap the highest share price returns over five-year periods. We therefore remain laser-focused on finding the most extreme earnings growth prospects that we can, because we believe that if we succeed, it is likely to be the single best predictor of our performance for clients over the long run.

In that respect, the current portfolio is in a strong position. On a five-year basis, delivered earnings growth has been 3.5 times greater than the index. But also, on a forward-looking basis, even consensus numbers, which we take with a large pinch of salt and which tend to be extremely timid relative to our own upside estimates, place nearly 80 per cent of the LTGG portfolio today in the top two quintiles of earnings growth over the next three years. That figure has doubled over the past three years. Moreover, it is twice as much as the index. This attests to the fact that we haven't lost our focus on extreme growth prospects during this period where growth investing has been out of favour.

The premium for LTGG’s growth is lower than it has been for many years relative to its own history and relative to the index. This is because LTGG’s price-to-earnings-growth (PEG) ratio is currently 1x, which is about half of its five-year historic average, and less than the index which is on 1.5 times. Unpacking this further, 55 per cent of the portfolio companies (by weight) are trading below the midpoint of their 10-year PEG valuation range. It appears that slower, steadier growth is being favoured by the market. In our experience, outlier returns are achieved by embracing uncertainty. 

LTGG continues to find a number of largely overlooked growth opportunities and it is only a matter of time before these exceptional companies with excellent fundamentals are rewarded.

Conclusion

To us it is always an exciting time to be joining LTGG, but the current conditions feel particularly rich in opportunities for long term growth investors.

One of the first lessons we endeavour to pass on to new graduates is just how inconceivable exponential growth may sometimes seem. We can’t help but ask the same questions year after year:

“How many grains of rice would you need to fill a chessboard if you place one grain on each square?”

A resounding “64!” can be heard. Clearly too easy.

“Now how about if you start by placing one grain on the first square, and double with each new square? 1,2,4,8… How many grains of rice would you need then?”

Few, if anyone, will answer 18 quintillion grains of rice⁷.

To save you from looking it up, that is an 18 followed by 18 zeros!

Getting a handle of this eighth wonder in action is quintessential to understanding what drives returns in LTGG. Being openminded to grasp the changes that occur on a very large scale and over long periods of time, regardless of whether or not they happen to be in favour in the short term, is one of the most important traits we seek to preserve. Our experience teaches us that the payoffs of doing so, for those who are patient, are nothing short of extreme.

¹ We should specify, the most dangerous instincts for the long-term investor.

² 12-month historic growth rates: revenue 15 per cent (4x the index) and earnings 55 per cent (20x the index). 5-year historic growth rates: revenue 28 per cent p.a. (5x the index) and earnings 26 per cent p.a. (4x the index).

³ Essentially the options available for placing your advert across various digital channels including display, video, audio, social media, and connected television.

⁴ Unlike most of its meaningful competitors, Netflix does not have any legacy businesses proving to be a distraction.

⁵ MercadoLibre has grown revenues over the last 5-years at a CAGR of 55% p.a., only to be exceeded by free cash flow growth of 67% p.a.

⁶ A whole 1.6 miles of less wiring!

⁷  Unless already familiar with the puzzle.

The LTGG Euler Diagram 

The diagram below represents our current view of stock concentrations in the LTGG model portfolio. We have identified what we believe to be the key driver(s) of each stock and have grouped stocks as appropriate. Circle sizes are based on the aggregate stock holding weights in the portfolio and some stocks are represented in more than one circle. The font size is indicative of the size of the holding in the portfolio – the larger the font the larger the position within the portfolio. We use this diagram as an input to our consideration of risk and diversification in the portfolio and we review it on an ongoing basis. The classifications are subject to change over time as our views evolve.

Source: Revolution, MSCI. US dollars. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 

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.

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