Small-cap biotech stocks are among the most exciting opportunities in the world, or so says Douglas Brodie, manager of Edinburgh Worldwide Investment Trust (EWI) and Baillie Gifford Global Discovery fund (GB0006059116).
Biotech is the area Mr Brodie is most positive about and around 20 per cent of Edinburgh Worldwide's assets are in this area. This includes companies that are not yet profitable and whose fortunes hinge on the outcome of single drugs - around one-third of the trust's assets are in pre-profit companies.
Mr Brodie argues that despite the apparently high-risk nature of biotech investing scientific advances have made it easier to spot the winners.
"There has been a sea change in the healthcare area and that will run for decades," he explains. "Healthcare investing has changed a lot. If you go back 10 or 20 years, small biotech used to have a terrible reputation. It would be one company asking for $400m (£302.68m) to put one drug through clinical trials and it would be the only drug they had. As an investor you were faced with a binary decision around which it was very hard to add any value.
"Healthcare innovation takes decades to come through – it isn't just about the transition from the eureka moment to a product becoming commercially relevant, but also the years of putting it through clinical trials. But science at the front end is making me hugely optimistic about where healthcare could get to in the coming decade."
Overall, around 30 per cent of Edinburgh Worldwide's assets are in healthcare-related stocks. These include its second-largest holding, Alnylam Pharmaceuticals (US:ALNY), a company working on gene-focused therapies for genetic diseases which accounts for 5.7 per cent of assets.
Mr Brodie tries to spot the winners but accepts that early-stage investing means there will be losers too. "We get things wrong," he says. "We are dabbling in the part of the market where you are sometimes investing in binary cases, which can be raw unpolished businesses that do not work. You want to invest in businesses where you can make multiple times your money so you have to accept that sometimes this won't work. The earlier you go in, the more pure technology risk you take. And the further along you go, the more it becomes a transition from technology risk to commercialisation risk to execution risk."
Early-stage companies in the trust's portfolio include Oxford Nanopore Technologies, which works on DNA sequencing technology. At the end of the trust's last financial year in April this accounted for 1.3 per cent of assets.
Mr Brodie also looks for companies that use technology to displace old companies and industries, so he is prepared to pay higher multiples for ones that have the potential to grow much faster than the broader market.
"There is a clear disruptive element to our businesses," he says. "We are in a golden age of innovation where that tool-kit of different technologies that businesses now have access to is enabling them to do things radically differently and better than the way it was done before."
But disruption alone is not enough. "Scalability is key," he adds. "Any idea on paper can sound really interesting – I can identify a Facebook mark 2 company – but getting it to work and making it scalable is a huge challenge, and that's the difference between winners and losers."
Examples of winners include Edinburgh Worldwide's largest holding, electronic bond trading platform MarketAxess Holdings (US:MKTX), which has a market cap of $6.5bn (£4.92bn). Mr Brodie says trading platforms are "natural monopolies because everyone wants to meet at one venue – they don't want a complex trading landscape".
The fund looks for businesses with a market cap as low as $100m (£75.67m) and can invest in stocks with a market cap below $5bn (£3.78bn) at the time of investment. But that doesn't mean Mr Brodie is forced to sell holdings as they grow.
"The thing that used to drive me mad in my old days of regional small-cap investing was when you would buy something based on a hypothesis, it would start to work and the share price would go up, and then someone would tell you to sell it because you'd tripped a limit," he says.
"We keep to the ideas generation of what we do. We are looking below $5bn, but we desperately want to own big, successful businesses – we just want to buy them when they're small. The businesses that we've always liked are small, but they want to be big and global. Why define companies by what they don't want to be? We are looking for unpolished gems – young raw businesses that won't be perfect and will have flaws, but have the potential to be much bigger."
The discovery team, which Mr Brodie heads, acts as an incubator for ideas that other Baillie Gifford funds use – about 50 per cent of the stocks in Edinburgh Worldwide are also held by other Ballie Gifford funds. For example, Tesla (US:TSLA), one of the biggest holdings held by the Baillie Gifford funds in aggregate, was uncovered by Mr Brodie's team. He invested in Tesla when it was $3bn in size – now it has a market cap of over $53bn.
More than 50 per cent of the trust's portfolio is invested in the United States. "The US is our happiest hunting ground," he says. "We thought we would find a lot more interesting businesses in emerging markets. But we're seeking to invest in innovative, globally relevant entrepreneurial businesses, and you find less of that in emerging markets. You find a lot of entrepreneurial people, but the innovation tends to be more inwardly pointed and about solving local problems so we have struggled with idea generation there.
"We've been naturally skewed to parts of the world where the funding cycle of young businesses is more developed. In the US you've got a very active early-stage and growth investing climate with venture capital and angel investors, and the chain of incubating is more developed."