Investment process: Growth but not at any price
Baillie Gifford has been investing in innovative US companies for over 100 years and across the company has significant funds invested in US equities. Within a broad investment universe of about 1,700 sufficiently liquid listed stocks, the managers believe about 350 companies offer the potential to meet their investment criteria. In addition, their search for exceptional growth companies extends into the realm of private companies and the managers have increased their focus on unlisted companies. This shift has been motivated by the view that US companies are choosing to remain private for longer and, as such, the public equity markets no longer offer the full spectrum of growth investment opportunities. The managers will consider private companies with pre-money valuations of US$500m or more and they usually invest in the late stages of a company’s venture capital funding process. The trust has scope to invest up to 50% of its NAV in unlisted companies and the managers are largely indifferent as to whether a company is publicly or privately owned. They will conduct due diligence and allocate capital wherever they see the highest returns.
Robinson and Gibson are active, bottom-up investors who do not look at the index or target a specific tracking error. They seek to identify a small number of new investment ideas each year. Robinson and Gibson are part of Baillie Gifford’s seven-strong US equities research team and their work benefits directly from their colleagues’ insights and challenges. They also draw on ideas and perspectives from across Baillie Gifford’s global investment teams, including its specialist healthcare/biomedical team, and they seek to foster links with external sources of ideas and information, including academics and visionary thinkers, inquisitive journalists and industry experts. In normal times, the managers also conduct in-depth research trips to technology innovation hubs and healthcare clusters. However, they do not use broker research, as the time frame of such reports tends to be too short to be useful, given that USA targets returns over a five-year time horizon.
The trust’s research process casts a wide net over many disparate sources of information, so the team has constructed a framework for analysis and valuation that distils this information into a consistent format that facilitates comparison across potential investments. Capital is allocated according to its potential to generate the managers’ target 2.5x investment return. Each potential and existing investment is assessed via the same eight questions intended to determine:
what the world might look like if the company is successful.
what aspects of the company’s culture increase the likelihood that it will achieve long-term success.
the company’s enduring sources of ‘edge’, such as deep competitive advantages or ‘moats’.
what is exciting about the market opportunity.
the company’s important forward-looking financial characteristics and whether the long-run incremental returns are attractive.
how the company might meet the trust’s target of 2.5x investment returns over the next five years and the probability of this outcome.
the potential for the company to be a real outlier.
what to do next – buy, hold, sell, watch or conduct further research.
The managers use this same research framework to assess private companies, but they apply a higher valuation hurdle. Instead of seeking an investment return of 2.5x, the target return for private companies is 5x. This higher target is intended to compensate for the lack of liquidity in private company holdings and also reflects the earlier-stage nature of such investments. Private company valuations are updated every three months by Baillie Gifford in accordance with International Private Equity Valuation (IPEV) guidelines. In addition, USA’s board conducts detailed biannual reviews and can challenge Baillie Gifford’s valuations.
Meetings with the management, staff, customers and suppliers of target companies are very important to USA’s investment process. These interactions also allow the team to understand the company’s culture and its remuneration and incentive structures, factors that are particularly relevant given the trust’s long-term investment time frame.
This fundamental analysis is discussed at weekly research meetings. The managers do not seek consensus between all team members. Rather, they focus on the potential upside of an investment and back the conviction of individual analysts. Robinson and Gibson manage the trust as a team, backing each other’s convictions, so if one wants to own a stock, it will be held in the portfolio.
This process leads to a relatively concentrated portfolio, as the managers believe it is important not to dilute its exposure exceptional businesses. The portfolio typically holds 30–50 listed holdings, with a maximum of 90, including privately owned companies. Initial investments usually represent 1–2% of portfolio value, as the managers want any holding to be significant, although some investments in new biotech companies may be smaller. The maximum direct investment in any one company is limited to 10% of the trust’s total assets at the time of the investment, although the holding is permitted to grow beyond this level due to subsequent performance. There is no maximum holding size, to give each portfolio holding the space and time to realise its full potential. The managers refer to this as their ‘hold discipline’. For example, the trust’s position in Tesla reached almost 15% before it was reduced in January 2021.
In general, the managers will assess each holding when its share performance hits their 2.5x target return on investment threshold. Depending on the outcome of this process, the stock may be held or sold. The managers will also dispose of positions if some fundamental change threatens the investment hypothesis, or if performance is muted and no longer looks likely to meet the 2.5x hurdle rate. Positions may also be trimmed or closed if the managers have better ideas or greater conviction elsewhere.
However, the managers will not sell a position simply because of short-term share price volatility. They will remain focused on the stock’s long-term prospects and do not shy away from larger, less predictable risks, if they believe the potential pay-off is worthwhile. They point to the asymmetry of equity market returns to justify this approach: an investor can only ever lose 100% of capital due to a poor investment decision, but over time, can make many multiples of an initial investment from a successful investment. This asymmetry rewards optimistic investors with far greater gains from being right, than losses if they are wrong. It also means the costliest investment mistake can be excessive risk aversion.
Inevitably, risk-taking and the pursuit of long-term outperformance will be accompanied by some volatility and performance may be lumpy over the short term. But this is not something the managers discuss or analyse. They maintain that creating narratives around short-term performance distracts from the trust’s long-term investment objective and therefore does not serve its shareholders well. The managers ask to be judged instead on their performance over longer time frames.
One of the strengths of Baillie Gifford as an investment house is the degree to which the various investment personnel interact both within their teams (aided through stock coverage rotation) and with other teams at Baillie Gifford. This is helped by the trainee analyst rotation policy, through various investment committees and by the firm’s shared outlook on investment. Indeed, Robinson has spent time on the Japanese, UK and European equity teams and Gibson has previous experience of the small- and large-cap global equities teams. This really does make the output greater than the sum of the parts and makes the company stand out from others. Another key advantage it has is the ownership structure, which is an unlimited liability partnership, the ultimate in alignment of interests between fund managers and investors.
USA unlisted valuation policy
Baillie Gifford’s holds the unlisted investments at fair value. There is a disciplined approach to ensuring that the unquoted element of the portfolio reflects as far as possible the level of an open market transaction. Valuations are based on a regular rolling three-month valuation cycle and on an ad hoc basis when an event justifies it. The valuation group at Baillie Gifford, which is independent of the investment teams at Baillie Gifford, receives independent advice from S&P Global. A final valuation is then applied to portfolio holdings at which time portfolio managers are advised. When market volatility is high, the valuations committee will check the valuations of the unlisted portfolio on a daily basis versus listed alternatives. Over the 12 months to the end of May 2022, the valuation committee has valued 51 securities within the USA portfolio, 169 revaluations have occurred, with 56% of the portfolio revalued twice and 24% of the portfolio revalued five times. While most revaluations have been negative, there have been some write ups where fresh capital had been raised at higher valuations. While market volatility in growth companies has been high, the unlisted investments are largely held via preference stock, limiting the downside participation.
Baillie Gifford US Growth Trust’s approach to ESG
The trust’s board believes it is in shareholders’ interests to consider environmental, social and governance (ESG) factors when selecting and retaining investments and has asked the managers to take these issues into account, provided the investment objectives are not compromised. The trust’s managers share the board’s view on the importance of ESG factors, viewing them as integral to their success as long-term investors. At a fundamental level, investee companies can only be financially sustainable in the long run if their approach to business aligns with changing societal values and meets the expectations not only of the company and management, but also of its customers, shareholders, suppliers and employees. The managers’ disposal of the position in Meta in November 2020, due to the lack of management responsiveness to various concerns voiced by users, regulators and employees, is one illustration of the managers’ application of this principle. Baillie Gifford has also been engaging closely with Tesla on some of its governance issues recently, and with The Trade Desk on its approach to climate change and emissions.
The managers’ ESG criteria go beyond a company’s financial sustainability. They are seeking ‘game changers’ – companies with the potential to change society for the better, directly, through the products they sell, and indirectly, via the industries that supply them. To assess a company’s potential to be a game changer, the managers create a societal contribution hypothesis as part of each investment proposition. This is a highly subjective, unquantified assessment of the benefit the company might deliver to society if it grows according to its forecast potential.
USA’s managers believe in active ownership and they use the leverage provided by their steady and often sizable stakes to encourage companies to improve where necessary and realise their full potential, as both businesses and positive contributors to society. They expect their investee companies to operate in accordance with the principles set out in the United Nation’s Global Compact on human rights, the environment, corruption and the treatment of workers. The managers will engage with a company’s management if these standards are breached, with the aim of improving the firm’s behaviour. If these efforts fail, the stock will be sold.
The trust’s managers, Ballie Gifford & Co Ltd as AIFM and Baillie Gifford as portfolio manager, are signatories to the United Nations Principles of Responsible Investment and the Carbon Disclosure Project and members of the International Corporate Governance Network. Baillie Gifford became a supporter of the Taskforce on Climate-related Financial Disclosures (TCFD) in May 2020 and published its first firm-wide TCFD-aligned report in March 2021.