The testing of Baillie Gifford

If the past couple of years have hardly been a walk in the park for most managers, arguably no investment firm has felt the shift in the environment quite as keenly as Baillie Gifford. A favourite among investors in the era of 'free money’, it is now facing a much less favourable economic environment. Most of its investment funds are underperforming, there is an ongoing debate over its unlisted companies valuations (‘It could be time to buy back into Scottish Mortgage’, IC, 31 May 2023) and earlier this month the firm even managed to get into a spat with climate change activist Greta Thunberg over its fossil fuel investments. 

As interest rate peaks approach, there is hope that the bottom could be near – but it could still be a while before Baillie Gifford funds start to outperform again.

Trying times

The chart below shows how Baillie Gifford’s equity investment trusts have performed against their benchmarks over the past three years on a share price total return basis. The overall picture is quite grim, with seven trusts underperforming their benchmarks by more than 40 percentage points, and just one outperforming it.

Baillie Gifford investment trusts have had to contend with a double whammy of negative sentiment towards investment trusts in general and growth strategies.

Investment trusts are struggling because their structure makes them particularly vulnerable if there is a lack of demand for the assets they invest in. As of 11 August, every global equity investment trust was trading at a discount to net asset value (NAV). And over the three years to July 2023, discounts on Baillie Gifford trusts in particular have widened significantly, explaining some of their underperformance. For example, Scottish Mortgage Investment Trust (SMT) went from trading at a 2.7 per cent premium to a 16.7 per cent discount and Edinburgh Worldwide Investment Trust (EWI) from a 1.7 per cent premium to a 20.2 per cent discount.

The situation with Baillie Gifford's open-ended funds is slightly more nuanced, if not particularly good. The firm's recently published value assessment report on its 36 funds reported that 11 were performing above target, 18 were underperforming their benchmarks and three were outperforming but were below their target, as of 31 March 2023. The time period used for the evaluation was three or five years, depending on each fund’s investment objective. The remaining four funds were too new to be scored. 

The firm has since closed one of the underperforming funds – Baillie Gifford British Smaller Companies – citing its poor performance and a lack of demand for investments in UK smaller companies. But it still rated 11 funds 'green' (above target and index) for performance, including Baillie Gifford Managed (GB0006010168), Baillie Gifford Long Term Global Growth Investment (GB00BD5Z0Z54) and Baillie Gifford Strategic Bond (GB0005947857).

Macro matters

Some investment styles are more resilient than others during a downturn and if ever there was a strategy that is exposed to macroeconomics factors, it is Baillie Gifford’s high-octane pure growth approach.

One of its key principles is that of asymmetric returns. “We know that losses are limited to the size of the original investment,” says Baillie Gifford investment manager Douglas Brodie. "But the maximum upside of a fundamentally successful investment is theoretically unlimited. So to quote Jeff Bezos, ‘If you have a 10 per cent chance of 100x return, you should take that bet every time even if it’s going to feel bad nine out of 10 times’.” Or, as Darius McDermott, managing director of Chelsea Financial Services and FundCalibre, explains: “They could lose all the value on one investment but they could also make 100-times growth on another – so you more than get rewarded.”

High interest rates, the higher cost of capital and risk of a recession change those calculations - at least in the short-term. Businesses that can generate those kinds of sky-high returns become even harder to find while higher discount rates reduce the value of the companies’ future profits. So it is unsurprising that Baillie Gifford should under perform in current market conditions. “You know what you’re going to get with Baillie Gifford in terms of its pure growth philosophy,” says McDermott. “You have to understand what they do as an asset manager, then it is a case of whether you are simply unlucky in terms of the time you invest.”

Baillie Gifford’s strategy was always racy, but the likes of Scottish Mortgage became so popular that perhaps not all investors paid attention to the aggressive approach they were exposing their portfolios to by investing in this trust. Baillie Gifford’s director of marketing and distribution, James Budden, acknowledges that while volatility is part of the strategy, it has been “extreme” in the past few years, both on the upside during the Covid-19 pandemic and now on the downside. But he stresses that the business has kept its long-term approach throughout.

Budden says: “One or two people wrote in and said, ‘Why on earth didn’t you sell at the top [of the Covid rally] and buy Shell (SHEL) and BP (BP.)?’ [But] that's not what we do. We're not going to change our long-term growth proposition to invest in the next short-term fad.”

The long-term picture is more mixed. Even after the battering it took, Scottish Mortgage’s share price total return over the past decade is 297.4 per cent against 167.6 per cent for the FTSE All World index. And Pacific Horizon Investment Trust (PHI) is up 271.5 per cent over 10 years while the MSCI AC Asia ex Japan index returned 89.4 per cent. But other trusts that had slower growth in the previous years saw much of their performance wiped away by this downturn. For example, Baillie Gifford China Growth Trust (BGCG) delivered 19.2 per cent over 10 years against the MSCI China All Share index’s 84.4 per cent.

McDermott is cautiously optimistic about the firm’s prospects. “If you think we are staying in a world of 5 per cent interest rates where rates do not rise any further, Baillie Gifford should do well from this point,” he says. “If rates were to go down to a ‘new normal’ of 2-3 per cent, that climate could see Baillie Gifford outperform once again.”

But even if interest rates have peaked, some of the economic consequences, including a potential recession, are still a risk and it is uncertain how growth companies would cope with this.

“We're pretty positive that the companies we own can function well in an environment where interest rates are higher and capital is more expensive,” argues Budden, pointing at their strong balance sheets, positive cash flows, ability to raise prices and competitive advantages. But with contrasting data on inflation and a potential recession constantly coming in, it is hard to tell when those fundamentals will be recognised in share price terms." Baillie Gifford funds have sold some companies whose business model was “under pressure” such as Peloton Interactive (US:PTON), Teladoc (US:TDOC) and Carvana (US:CVNA). 

Trust outliers

Topping the chart of underperformers on a three-year basis are three trusts that truly reflect the manager’s reputation for a pure growth strategy. Scottish Mortgage, Baillie Gifford US Growth Trust (USA) and Edinburgh Worldwide also have significant exposure to unlisted companies – 28.2 per cent, 32.9 per cent and 20.7 per cent of their assets at the end of June, respectively. 

The concerns over unquoted companies have to do with valuations and how well the companies will hold up in an environment of high interest rates. “Late-stage venture capital is enduring a painful valuation reset, following an exceptional period when a tsunami of liquidity drove valuations to unsustainable levels,” Investec analysts wrote recently. “We continue to believe that it is incredibly difficult to establish a fair value for these ultra-long-duration assets.”

The negative sentiment towards Baillie Gifford’s portfolios is in many ways justified, and there is an argument that discounts are not so much a bargain as they are a fair ‘risk premium’ for the headwinds faced by growth assets. Still, not all Baillie Gifford trusts are created equal. Kyle Caldwell, collectives specialist at investment platform interactive investor, says that Monks Investment Trust (MNKS) has taken action in response to the macroeconomic headwinds, reducing its exposure to highest-risk stocks – the so-called ‘rapid growth’ portion of its portfolio. The trust has less than 4 per cent of its assets in unlisted companies, and in the past year has significantly outperformed Scottish Mortgage both on a NAV and a share price basis. “There could be a potential turnaround in performance on the cards,” says Caldwell.

Pacific Horizon has had a difficult 12 months, but its NAV performance is holding up comparatively well on a three-year basis. Much of its outperformance was generated during the Covid pandemic, but its comedown has not been quite as steep as that of other Baillie Gifford trusts. This is partly thanks to what Numis analysts describe as a flexible investment approach, “with exposure to cyclical sectors such as materials increased [via] companies which would perhaps not initially be typically associated with a Baillie Gifford portfolio”.

Scottish American Investment Company (SAIN), an equity trust with a 150-year history whose income mandate “fits awkwardly with Baillie Gifford’s focus on disruptive growth stocks”, as Numis analysts put it, has also held up pretty well. The trust targets dividend growth rather than just high yields, so has some affinity with Baillie Gifford’s philosophy. Its shares were trading at only a small discount to NAV as at 11 August, so it is not especially cheap.