Baillie Gifford sticks to a script it concedes is out of fashion just now

Baillie Gifford’s focus on disruptive companies capable of adding value over a five-year market cycle is out of fashion at present, potentially challenging the growth equity manager’s ability to deliver benchmark-beating returns for the current cycle.

“We can’t recall when our approach was so out of step with the prevailing market narrative,” the Edinburgh-based firm wrote in a recent fund commentary, contrasting Baillie Gifford’s relatively long-term approach to investing with the market’s “current near sightedness.”

In a recent interview, Stuart Dunbar, a Baillie Gifford partner who works with the firm’s clients, said the current moment is marked by “a peculiar mismatch,” with a tidal wave of change and disruption coming down the pike in sectors such as energy, healthcare and financials even as market players appear singularly focused on near-term cash flows.

By way of example, Dunbar pointed to Moderna — a Cambridge, Mass.-based drugmaker included in some of Baillie Gifford’s biggest portfolios — which he noted can see its share price fall dramatically if somebody says the company’s COVID-19 vaccine sales look set to decline.

“Moderna is not a COVID company. Moderna is an innovative mRNA platform drug company with a pipeline of 40 or so drugs … based on deep sequencing and analysis,” Dunbar said. That the company’s share price goes up and down depending on talk about its COVID-19-related sales “tells me the market is completely focused on the wrong thing,” he said.

Other factors weighing on growth stocks include, of course, the surge in interest rates over the past 20 months, with higher discount rates weighing on net present value — even though good companies with pricing power should be able to continue to grow, Dunbar said.

The result: a “tremendous roller-coaster” ride this cycle, with an initial COVID-driven leg of stellar outperformance in 2020 followed by a painful stretch of underperformance, he said. By way of example, Baillie Gifford’s $44.8 billion international growth equity strategy beat its benchmark by a whopping 54.4 percentage points in 2020, followed by underperformance of 17.9 points in 2021, 20.4 points in 2022 and 3.2 points for the first nine months of 2023.

Baillie Gifford reported $264.4 billion in total assets under management as of Sept. 30. That is relatively flat from the $268.7 billion in AUM it reported as of Dec. 31, 2022, but is down 42% from $454.9 billion at the end of 2021, according to Pensions & Investments data.

Institutional clients have largely stuck with the firm in the face of its current rough patch — testimony to Baillie Gifford’s efforts to ensure clients understand and embrace its approach of “trying to find great businesses with aligned management and long growth runways,” with no regard for short-term market pyrotechnics, Dunbar said.

For U.S. institutional clients this year, “I think we might be … flat-ish,” a hopeful sign that those investors are taking a longer view, he said.

Still, the whiplash investors have experienced could deprive Baillie Gifford of a central argument for convincing institutional clients to hire active equity managers: that while a manager can trail the client’s risk benchmark in any given year, it can top the benchmark over a market cycle.

“Over five years plus, we think there’s a high probability that we can outperform … (but) we will deviate from the index in the short run dramatically, positively and negatively … because we don’t (hold any companies just) for the sake of managing our tracking error,” Dunbar said.

“We ask our clients to focus on the underlying fundamental progress of the companies we invest in (and that) over a five-year plus period it is probable that their share prices will move to reflect that fundamental progress.” That holds true 80% or 90% of the time but sometimes the peak-to -rough fall in market valuations is so steep that it takes more than five years for the market to recognize the value being created — and this may be one of those moments, he said.

Clients, meanwhile, typically hire Baillie Gifford to play a specific role in their portfolios, alongside other equity managers, so its imperative that the firm refrain from “style drift” by, for example, trimming its market exposures when growth stocks surge across the board, as was the case in 2020, Dunbar said.

Instead, “because we’re not market timing, we haven’t done anything and our clients have taken the pain on the derating of growth companies,” he noted.

Even if most clients are holding tight, there have been some signs of discomfort with the firm’s recent performance.

At a Nov. 15 meeting of the Arkansas Public Employees Retirement System, Daryl Bassett, a member of the $10.3 billion fund’s board, suggested APERS should hammer out a “path forward” for the fund’s $480 million international equity mandate with Baillie Gifford, with consideration of how much longer underperformance can be tolerated.

Bassett couldn’t be reached immediately for further comment.

Dunbar said clients are right to demand Baillie Gifford explain its underperformance.

Just saying “wait longer” is not sufficient to allow worried clients to continue to have confidence in what we do, he said.

Instead, it’s necessary to show the work the firm’s investment team is doing on the companies in the portfolio, and reiterate that “these companies are on track fundamentally and at some point the share price will catch up,” he said.

For the moment, Dunbar said, the share prices of the companies Baillie Gifford holds in its portfolios are as far from reflecting that fundamental progress as he can remember.

Moderna’s share price is back to where it was in late 2020 even though it has “grown its top line over 300%” in the interim, Dunbar noted in an email. Moderna is a top five holding in Baillie Gifford’s $15.2 billion Scottish Mortgage Investment Trust.

Contemporary Amperex Technology Co., the Shenzhen, China-based maker of electric car batteries, likewise isn’t being rewarded now for its growth momentum, with its share price down more than 50% over the past two years. “If it continues to grow as we expect, it will be on a P/E of less than 1.0” within five to 10 years, he said.

“There has never been a bigger difference … between our analysis of where the companies we own can be in five years and the prices that are currently being attached to those companies,” he said. “Some of these companies, if they grow in the way that we think that they will, will be on earnings multiples of three times in five years’ time.”

“Bear in mind, we’re not trying to invest in companies that have 20% upside because they’re a bit cheaper than their competitors. We’re trying to find companies that at minimum can double on a five-year view and very often do very much more than that,” he said.

Baillie Gifford isn’t an asset-gathering machine, Dunbar said, noting that the billions of dollars of net flows the company garnered from U.K.-based retail investors in the wake of Baillie Gifford’s stellar performance in 2020 had left him concerned that those clients could be overly focused on the short term.

With outperformance giving way to underperformance that year, some of that retail money flowed out, Dunbar said.