Jon Henry, client service manager at Baillie Gifford, which manages the Monks investment trust explains how a long-term patient approach can produce compound returns from a diversified portfolio of global equities.
Jon Henry outlines long-term investment opportunities and why taking a positive approach is key.
Sound investing is all about finding businesses that are trying to do fantastic things and taking a long-term view. If you take the last 90 years, the average per capita income globally has trebled; the average life expectancy has gone from 31 to 67; child mortality has fallen by a factor of 10 and global literacy rates have risen significantly from 25% to 80%.
So despite the short term challenges we currently face, there’s a lot of good happening in the world and being positively calibrated should lead to good outcomes for investors who are looking to invest in the growth companies of tomorrow.
A small number of companies responsible for value creation
Ultimately, the ability to seek reward is guided by our belief that it’s a small number of companies that drive the value creation in equity markets over the long run. Research by Professor Hank Bessembinder of Arizona State University looks at both US equity returns and global equity returns. Professor Bessembinder’s central message is that of the $45 trillion created by 62,000 listed companies between 1990 and 2018; only 800 are responsible for value creation. That is to say that the 61,200 others effectively cancelled each other out and they failed to generate in aggregate more than the return on a treasury bill, the risk-free rate of return. Even more staggering is that 121 companies in the research created half of the $45 trillion. Hence, an even smaller subset of companies is responsible for a vast amount of wealth creation.
Stalwart companies and rapid growth stocks
However, we recognise that companies grow in different ways. So if we take the example of companies we call stalwarts. These are companies which can continually produce consistent levels of earnings growth. They’re entrenched in their industries, they’re usually market leaders with strong brands and a low level of customer churn. If you take the example of ResMed, a US company that makes equipment for sufferers of sleep apnoea. ResMed makes equipment which prevents that from happening, which has a profound effect both on patient healthcare – as people sleep more, their health increases significantly; but also in terms of reducing cost, both for the patient and the healthcare system. Such companies are looking to grow their earnings at about 10% per annum over the very long term.
In contrast with the companies we identify as stalwarts, there are rapid growth stocks. These are very different types of companies that are growing their revenue and their top line very quickly, usually investing heavily to disrupt existing industries or indeed create new ones in themselves. Take the example of Spotify, which is considered the pre-eminent online music streaming platform in terms of democratising access to music and content but also disrupting the existing music industry.
We expect these types of companies to produce much higher levels of growth, around about 25% in earnings growth in the long run or even higher in some cases.
Investing heavily for future growth
Going forward, we believe companies that operate on highly scalable platforms will continue to thrive. These are generally online or tech-enabled companies that are investing heavily for future growth. The unifying theme amongst these companies is they can change the way that we consume products and services. These include the likes of Amazon and Alibaba but also smaller, nimbler, earlier-stage companies like Chegg, which is a US education portal that brings together students and on-campus universities with tutors and materials to study for their course. Lending Tree is another example, an online financial platform allowing people access to mortgages and bank accounts.
Emerging middle classes is another positive investment theme. We continue to see massive numbers of people in emerging economies moving into the middle class, with a level of disposable income which is a powerful force in terms of what’s happening in terms of consumption and in financial developments. Beneficiaries include companies like Ping An and AIA which are operating insurance sales in Asia, or HDFC Bank in India where more people are looking to buy their first home.
There are also companies we call compounding machines, which are mostly made up of stalwart businesses. Good examples are Visa and Mastercard, which are the rails upon which the payments system operates. The move towards digital payments in the last decade or so has been hugely beneficial for both companies, and they have consistently compounded their earnings between 12% and 15% over the previous decade.
Finally, there’s the growth in transformational healthcare, which is an innovative collection of healthcare businesses that are attempting to treat challenging diseases or lower cost in the healthcare system.
Stewards of capital and embracing asymmetry
Ultimately, the navigation of a wide range of different factors in the environmental, social and governance spheres are hugely important in terms of companies growing earnings sustainably over a long period of time.
As providers of long-term risk capital to companies, it’s important to engage actively and challenge companies on how they’re dealing with a wide range of issues. Good examples of how we engage significantly with companies include speaking with Ryanair in terms of unions, staff relations and treating customers fairly, or talking to a number of our energy holdings in terms of their carbon footprint and their green practices.
Finally, there’s the importance of embracing asymmetry. Equity markets give us the opportunity to make many times our clients’ capital. Stocks in theory have unlimited upside where your downside is capped at 100% of your initial investment. So it’s vital that a portfolio allows the opportunity to take advantage of the skewed returns in equity markets.
Analysing the contribution of the top and bottom ten performers and how that impacts a portfolio is a good example of embracing the asymmetry of returns and how it manifests in the underlying investment strategy. The key message is that the best contributors should more than outweigh all of the poor performers in the bottom 10.
Diversification in practice
In terms of Monks Investment Trust, there is a broad correlation between our level of conviction and the position sizing in the portfolio. If we start at the bottom, there’s a large number of names that makes up 26% of the portfolio. Effectively a lot of the portfolio is down in this incubator, round about 0.5%, 0.6% position. These companies embrace the asymmetries of equity investing in the purest sense. They are the high risk, high reward investments that we’ve made in the Trust where we accept that a number of these might not work. What we do look for is a number of them to move up through the portfolio into mid and large-sized holdings, to generate significant returns for the Trust in the long run.
Conversely, the most significant positions at around about 2% to 3% of the portfolio are ones in which we have the highest level of conviction in terms of the probability of those companies meeting our return hurdles on a longer-term view.
So while the equity landscape is facing some difficult challenges with the global spread of COVID-19, ultimately we remain positive in our ability to structure a portfolio which captures a wide array of opportunities and gives us that chance to deliver returns over the long term.
Jon Henry is Client Service Manager at Monks Investment Trust, Baillie Gifford.