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Fund managers are failing British business, says Scottish Mortgage manager

Fund managers are looking in all the wrong places for tomorrow's winners, says James Anderson, manager of Scottish Mortgage Investment Trust
May 5, 2016

British business is "in crisis", "capitalism is failing" and our financial industry is "completely bust" according to James Anderson, manager of IC Top 100 Fund Scottish Mortgage Investment Trust (SMT). He has fallen out of love with the public markets and his solution is to invest in private companies instead.

At the end of June Scottish Mortgage will seek permission from its shareholders to invest up to 25 per cent of its assets in unquoted stocks. The trust currently has about 12 per cent of its assets in private stocks.

"We invest in unquoted companies where we think they have the same attributes in terms of growth prospects, pay-off and competitive advantage as we do elsewhere, and it seems to us that these days those things are more possible for unquoted than quoted companies," he says, despairing of the options on the public markets, particularly in the UK.

"It's been a long time since we had a truly great British company. If we're talking about our ability to create new businesses then British business is in crisis. I think the record of British industry in the past 100 years at creating great new companies is deeply flawed and a lot of the problem is London." And he accuses the financial industry - and his peers - of an obsession with quarterly reporting and profits, which is stifling innovation.

"London is now a city where people come to spend money rather than invest money. The investment scene has really turned itself into investment banks plus hedge funds. I deeply respect Neil Woodford and I think Nick Train does an excellent job, but other than that it's dire. Why is British and European capitalism failing so badly? Because people are scared of [investing in] these things to a great degree.

"Fund management should have as its focus doing rightful investment for the world, but I don't think if you add up all the amounts of money invested by pension funds, sovereign wealth funds, retirement funds and mutual funds, that we're really doing that."

Step in Scottish Mortgage, then, which currently invests in private companies such as software developer Palantir, music streaming site Spotify and peer-to-peer lending club Funding Circle. The trust holds 26 unlisted companies and although Mr Anderson says he expects the percentage to remain "comparatively small", he is planning to increase exposure to unlisted healthcare stocks.

He is looking for companies like Grail, the spin-off from listed DNA sequencing company Illumina (US:ILMN), which focuses on early-stage cancer detection. Many argue that the high risk of failure, high cost of creating new drugs, and high barriers and competition make unlisted biotech and healthcare stocks tricky to back.

Probed on whether this move will increase risk for Scottish Mortgage shareholders Mr Anderson says: "We think that there is a terrible and dangerous confusion between risk and volatility in financial markets. I would challenge anybody to come up with a view as to why most of our big companies today are not much more risky in terms of permanent loss of capital than our unlisted companies. As long as people have a long time frame we think this is not risky, because the fundamental ability of our companies to generate a longevity of cash flow is far greater than the stocks in the index."

The Scottish Mortgage strategy is to pick several names, expecting "most of them to fail", but assuming that "in your crop you have the next Facebook (US:FB) and Alibaba (US:BABA)". This means returns might be volatile, but over the long term potentially far higher than those of other trusts.

And in recent years that has worked. The trust has returned nearly 200 per cent in 10 years against a Global sector average of 69 per cent. This is due to the type of business it invests in, says Mr Anderson, who argues that public versus private is the wrong way to look at the issue.

Mr Anderson gives the impression that he invests in people rather than companies or sectors. He talks of famous chief executive officers (CEOs) and company founders with an evangelical zeal, referring to intimate chats with Tesla (US:TSLA) and SpaceX founder Elon Musk, Amazon's (US:AMZN) Jeff Bezos and the owner of Chinese Internet giant Baidu (US:BIDU), Robin Li. He says that although these are public companies, they "are in some senses not part of the quarterly capitalism game of fund management".

"Frankly these are really private companies in the way they are owned and managed, and thank god for that," he says. The key here is the investment appeal of "founder-driven companies" against "those where the boss has to prove himself in three years or get sacked". He wants those founder-driven stocks to be "very close to being 100 per cent of what we do", over the long term.

But how do stocks such as Rolls-Royce (RR.) fit into this high-tech, unlisted vision of the future? The trust had 1.3 per cent of assets invested in this company at the end of last year and remains invested. Scottish Mortgage has been better at venture-capital-style investing than traditional global growth stocks, acknowledges Mr Anderson, but he feels he has a responsibility to Rolls-Royce. "Rolls-Royce may not be up there with some of the companies I've talked about, but this is one of the few companies where there is a network of excellence so, although it is threatened in many ways, I'd rather not walk away from it. But I will plead guilty to the fact that there are some stocks in our portfolio that do not live up to the aspirations we have for them.

"We don't think we've done as good a job on the bottom half of the portfolio as on the top 20 names, and that's one of the reasons why the venture capital style fits."