Merryn Somerset Webb talks to James Anderson of the Scottish Mortgage Investment Trust about where to find growth, and where the next crop of great companies might come from.
• If you missed any of Merryn’s past interviews, you can see them all here.
Merryn: I’m here today with James Anderson of Baillie Gifford. James is the lead manager of the Scottish Mortgage Investment Trust which I know a lot of MoneyWeek readers will hold because it’s inside our investment trust portfolio. It’s been a stunning performer over the last three years of about 90%, when the benchmark is at more like 35/40%. So it’s done very well for those of us who have had it.
I’m going to start, James, just by asking you what’s the secret of this stunning success?
James: That’s very kind, Merryn, but as you well know it’s the future that matters an awful lot more than what’s happened in the past. I do think there are some distinctive elements to our approach which I would hope remain probably more important for the future than even they have been in the past.
I can probably start by saying that we don’t really believe that the progress of share prices is much to do with the generalised economy. This whole debate about what’s the influence of monetary easing, what’s going to happen in inflation, it leaves me rather cold. What’s critical to me and to our way of investing is that we think there is a process of remarkably rapid change, exponential change that drives the underlying businesses of companies.
Perhaps a reflection on that, I happen to be coming across our original write up of Google when it went public in 2004 just recently. At that time I don’t know whether you remember on adjusted basis what it earned, the answer is 20 cents.
Merryn: I’m afraid I do remember because there was an article in MoneyWeek saying, “You’d be crazy to buy this stock”. I suspect that you thought the opposite.
James: Our own response as a firm was much the same. Now in that time approximately on a split adjusted basis the share prices are up tenfold, the earnings are up a hundredfold, that is real underlying business change.
I think that morphs into a second point that most people think about share prices and picking shares as being roughly analogous to somebody walking into the room, and you’re trying to guess whether they’re going to be above or below average height. It’s not like that. It’s much more about wealth distribution. So in a sense it’s as though we’re sitting in this room and Bill Gates walks in. It’s about trying to capture those outlying stocks which actually are a very major part of the process to stock market attainment. It’s not your 6% per annum yield or whatever people might imagine.
It’s that, and why do we think that might become still more important? I think this is where I get really excited because both Tom, who works with me, and myself would argue pretty strongly that the process of change that we are seeing, though exciting, is now broadening out to areas that are actually much more important to humanity.
Merryn: When you say the process of change, you’re talking about the massive technological change over the last few years.
James: Yes, to us it’s about genuine underlying innovation in some ways, I prefer the word innovation. I was in Long Island recently, so I thought I ought to read the Great Gatsby and there’s one bit at the end when Gatsby’s father is coming to his funeral and he shows the narrator what Gatsby used to spend his day doing. He spent an hour, I think it was at 6:30am in the morning, studying electricity – I think technology is a bit like electricity these days, it’s not really telling you much about what’s changing. A definition of technology is something invented since we were born, it may be okay for you but for me at my age this is problematic – but technology is really innovation to us, now that’s broadening out in two ways. Firstly, geographically, which I’m sure we’ll probably touch on, but also in terms of what it’s addressing.
From having – however wonderful it is to be able to have computing power and information, it was undreamt of even ten years ago, in your pocket on your phone – the importance of that compared to that hitting healthcare, energy, ultimately education and government seems to us minimal.
Bill Gates wouldn’t quite argue this now, given his excellent efforts in human healthcare, but I think he would concede generally speaking that his debates with Steve Jobs – Steve Jobs always used to say that it’s about when data hits biological sciences that it’s going to become really interesting. I think that is absolutely the case. I think we have one area where we’re constantly frustrated, we can’t do more but we think the opportunities might be absolutely enormous. Almost incomprehensible over the coming decade in healthcare.
I think we have great difficulty with that notion, both at the concentration of returns and, if you like, the process of change itself. We don’t realise quite how dramatic – our minds don’t really cope with it. I think that one of the best pieces of investment writing I’ve read recently, you may well have read it yourself, an article by Michael Moritz in Foreign Affairs in which he said the biggest problem is we don’t understand how great a great company can be.
I think we see this in investment, we’re all taught to do analysis, we’re all taught to go back to the figures. We think we’re being serious in doing so, but we can’t grasp that enormous and fabulous process of deep change that’s going on.
Merryn: When you look at companies you’re not looking at valuations at all? We’re talking here about wonderful change, huge innovation, buying Google and what looked like a bizarrely over-high valuation at the time, do you never return and say, “Well hang on this thing is really expensive.” How on earth does that maths add up?
James: I’m sure to an extent you’re teasing me because I’m sure you believe that we do look at this, and we absolutely do look at this, but we try and think about it in different terms. Let’s take up your Google reference, we quite like to call our process ‘growth at an unreasonable price’. There are many ‘growth at a reasonable price’, and I think it captures it because very often if this change doesn’t happen what we’re paying is unreasonable in the sense of being too high. When these changes really do happen, then it’s unreasonably cheap.
For instance, I was mentioning Steve Jobs’ earlier. Returning to Apple, lots of people say, “2008, it was difficult times for you,” etc. Was it? I mean, we were effectively able to buy Apple for under two times peak earnings. That’s unreasonable price for those sorts of returns, so it’s a huge scale. So unreasonable in that sense, but I think it’s also about, as you imply, our first task and our ultimate task.
We think because the great joy of equity is your downside is 100%, and sadly sometimes we explore pretty close to that. Your upside is unlimited, and therefore your first task as an investor is to understand and creatively think about what the upside is.
The discipline that comes with that is being obsessed – and I hope it really is being obsessed – with what are the chances of that happening and what do we think we would pay for that happening. I just don’t think that’s got anything to do with whether a stock is selling on 100 times prospective earnings or whether it’s selling on six times prospective earnings. It is that harvest way out there in the future that is critically important, and your chances of gathering that harvest.
Merryn: Can I have an example of something that’s in the portfolio at the moment that a value investor would look at and go, “Oh my God, the idiots”, but in fact is likely to be your next Google?
James: Funnily enough, it’s one that I think has both gone through some of this process already and is set to do so more. It’s quite a convenient one to talk about because it’s actually our largest holding, which is Illumina, the gene sequencing company.
I find this fascinating because actually we didn’t really have to do that much of the process of prediction and thinking forward we were talking about. By the time we bought Illumina the cost of sequencing a human genome had fallen from $3bn to approximately $100,000. Now, talking to the company and industry experts it was fairly clear that that $100,000 was merely a stopping point, and the process of change was quicker than it is in Moore’s Law, so getting to the level at which this became useful from healthcare outcomes, from medicine wasn’t really a very risky prediction. We thought this was well worth doing and the world would change with it. Indeed it did and the earnings and prospects of Illumina have gone up.
“When did London last create a truly great company? It’s good at circulating wealth, but that’s a very different issue”
But at this moment in time, Illumina is certainly on a very high multiple of earnings, one that a growth investor might tolerate, but a value one certainly wouldn’t. To us, actually, the stock has become more attractive rather than less, because the probability of that serious level of change has gone up. So not just do we know in practical terms the price of sequencing will fall below $1,000 but the chances of Illumina being the beneficiary of that have both got greater in competitive terms and the prize is even greater.
I speak to people now and they will tell you that approximately 90% of all the human genomes that are being sequenced are being done on Illumina equipment. That’s a pretty serious competitive advantage. Secondly, that probably all the coming generation will be sequenced at birth, and if you have serious illnesses – cancer being a very clear early example of this – you will be sequencing in detail many times.
So, from everything from the good of humanity to the likelihood of this happening to the competitive advantage, I think the fact that this is on an extraordinarily high multiple of current earnings it’s not really the issue.
Merryn: We mentioned earlier briefly about how innovation is spreading out geographically as well. Is there a particular – I mean obviously the Trust invests globally –but is there a particular area of the world that you feel is benefiting more than others from this shift?
James: Merryn, the first thing to say is that, and I’m glad you bought it up, because it’s something that Tom and I get very frustrated about. We find it really hard to fit in the standard blocks of asset allocation for this point of view. We don’t really think that countries matter that much. We think that innovation comes from specific cities and regions. Equally and oppositely, there will be many cities and regions that are very wealthy but barely produce a company.
I challenge you with, give me an answer afterwards, when did London last create a truly great company? It’s good at circulating wealth but creation of wealth seems to be a very different issue.
We think about our portfolio in terms of those cities and regions effectively. So we have approximately a bit over 30% of the portfolio that is in west coast America. We have approximately zero or very close to it in east coast America. I think talking about America makes no sense at all. It’s a very different model of capitalism, even in a country like that.
To give you a more concrete answer, we think that, regardless of what happens to the Chinese real estate market or Chinese politics, one of the most sensational developments of the last three or five years is that China has proved its ability to create really large scale innovative companies with dominance of areas. I think the fact that Tencent, Ali Baba and Baidu can exist at a scale that outside of America is just not being challenged by any non-west-coast companies is truly remarkable.
Merryn: The Trust has invested in all of it.
James: Yes, the Trust has invested in all of this. I think perhaps most interestingly we bought Ali Baba when it was still an unquoted company, and that’s something else that we feel pretty strongly about. One of the problems with our industry will be that many more companies, partly because they don’t need capital, partly because of all the stress of being quoted, partly because they can invest when they’re like this, will effectively choose not to go public until very late. Ali Baba, on its initial quotation prices rather than what the deal was done at, was worth $200bn. Now that’s a bit of a problem with the first time…
Merryn: Yes, that’s very late float historically speaking.
Are there any regions in the UK that fit your definition? You say London is very bad at creating new companies. Is there anywhere in the UK that you look at and you say, “Well that’s a region that really works.”
“In Berlin, people are beginning to create a set of very, very different companies from what we think are traditional German companies”
James: Pretty wholly and solely I’d say Cambridge is a long way in the lead. They paid me as a graduate of Oxford, but Cambridge is plainly – we own quite a lot of shares in Arm which is plainly a direct instance of that – I think also Cambridge has got the sad side of it because actually I was talking about Illumina earlier that core technologies behind Illumina – and it’s almost a parody, caricature – were invented by people talking in a pub in Cambridge. And of course, they didn’t really manage to commercialise it, to make it into a company to have the development of it, or the efforts involved in that. So I think in a way it really demonstrates both the pluses and the minuses.
I think bringing up Cambridge is in some sense fascinating about Europe as a whole because that’s much more difficult to map than either east China or northwest America.
How is it, one of our largest holdings, Inditex, how is it almost certainly, and I’m really not this moment talking about book, it’s almost certainly the world’s greatest clothing retailer grew up in a village on the Galician coast of Spain. I think at that level you have to come down to a selection of, not particularly one individual, but a selection of individuals that are behind it.
The other place in Europe that I would mention, because I think it’s intriguing and we got to it almost serendipitously by accident, would be Berlin.
Merryn: Where you spent some time recently.
James: One of the things we do is we encourage people to go and spend about three months out in a place. It can be longer if they like and one of my colleagues has just done this in India, for instance. I did last year at Berlin, and that was provoked by something that I think we’ve talked about before, but a very different one from where it ended up. It was provoked by a real frustration with the British media that obsesses about telling us what people in London and New York think are going to happen in Europe, but doesn’t really bother going to ask the Germans. Given that it’s the Germans who make the decisions, it always seemed rather odd to us and I’d literally tear up the Economist and bin the Financial Times and the like for its comments on these.
I went down trying to understand that, and the place and its politics. What instead I learnt is that what Berlin was in either the 1920s or the 1880s seems to me to be recurring. You’ve got an enormous creative, ideologically quite anti-capitalist, hugely young people, hugely immigration, hugely cheap location-driven process of innovation out there, which I think is beginning to create a set of very, very different companies from what we think is traditional German companies. Zalando and Rocket and the like.
Merryn: Have you found some good things to invest in there, where’s the Trust investment in Berlin?
James: The one that’s moved furthest in the completion process would probably be Zalando – and it seems odd even saying that, because it is the Europe’s leading online fashion retailer. They effectively started out as one of these companies starting from scratch … and moved on with this.
I think Rocket which is effectively an internet incubator company is the most fascinating example, because effectively what they’re doing is they’re perhaps in a very Germanic way they’re industrialising the process of innovation. They are deeply unpopular people in Silicon Valley because instead of saying, “You need to be geniuses”, they say, “No, there is a business model here and if we have 20 or 25 companies in, for instance, Nigeria, we know that the odds are in our favour. We know what we’re doing and it will work and you can replicate these business models, you don’t need to be a genius.”
Now, I may think the founder is actually a genius for spotting this, but that’s in a somewhat ironic sense. I think it is a profoundly different model and we think you need those profoundly different models. It’s like Interteks, reverse the model of, instead of importing goods from China, they export from northern Spain to China which seems completely counter intuitive. So we think genuinely different business models are the proof of these countrywide differences.
Merryn: I need to ask, I know what your answer will be but I need to ask anyway. You have no concerns about the macro environment at all, with an eye on your portfolio and the worries about very high levels of evaluation in the US, worries about the credit bubble, worries about the potential failure of monetary policy in the developed world. All these things that I worry about and that I think our readers worry about, and you don’t appear to worry about at all. I accept what you say about how the state of economy very rarely has an impact on stock markets, that’s not the way it works. Nonetheless, we do live in rather unusual times.
“We’re going to be facing more change in the next 30 years than in accumulated history put together”
James: The first thing, Merryn, to say about – and I hope you would acknowledge that this is the genuine thought, it’s not just saying for your audience – I think it’s really important that there are people like you both talking about these issues and advising people to construct portfolios and incorporate them. Really, my argument is that I think it is incredibly important that people, whether through us or anything else, have some exposure to these great things that are happening out there.
It’s not saying the entire portfolio ought to be in it. I believe what I’m saying, there’s no pretence about it, but I think having the exposure is the important thing. If I worry about anything at the macro level it’s what I’m talking about, it’s too powerful, too important and the process of change will be so dramatic that we can’t cope with it.
Merryn: What will happen?
James: You encapsulated in the sort of worries that even someone like Elon Musk talks about, he’s probably done more in this field than anybody else that artificial intelligence will take over the world and we won’t be able to cope with it. I think on a slightly less dramatic level, one of the people we paid a lot of attention to in recent years is Ian Morris, whose books you may have come across. He makes following people like Ray Kurzweil, the case that this exponential change is quickening all the time and we’re going to be facing more change in the next 30 years than already in accumulated history put together. Can we all cope with that? I don’t know, how long do companies’ real competitive advantage periods last against that, just the chaos it may induce, the bad things that may happen.
If anything, I worry that if you were to extend my ideas to their extreme they become worrying in that fashion. The traditional worries, no, I don’t really concern greatly with those. You’d be bored if I went through each specific case.
Merryn: It’s not just the industry business, life is going through phenomenal change. The fund management industry has also been seeing a period of change and will continue to do so as pension freedoms come on etc. I know Bailey Gifford has been in the forefront of trying to create a better business, is there anything you wanted to say on that regarding fee structures and investing sales etc?
James: I absolutely agree with your implications, Merryn. I think in some ways fund managers have been very lucky because we’ve had investment bankers out there to attract the blame, by God if they do that we’d start off. I think many of the ultimate decisions about how our companies naturally run, how they recruit their people, what their values are, are set by fund managers and we have to take responsibility for that.
To my mind I know what you concentrate on and I think this is absolutely right is on the ultimate value to savers, but I think it’s much as anything it’s also important for us to focus on how can we make companies better. I think it’s not us interfering day to day, it’s a very strategic level. What are your competitive advantages? How do you make your competitive mode better? All the things that the Buffet would approve of and Charlie Munger would be out there talking about.
I think that’s not just critical from point of view of the economic health that we’re dealing with. I think this is what’s so sad, it’s far more satisfying as a fund manager to say you might have helped on this. I mentioned Illumina a couple of times, actually it wasn’t the analysis that was the most satisfying, by far the most satisfying facet of our involvement with Illumina is that we stopped them being taken over by Roche. I think that would have done huge damage, not just in shareholder terms, but in terms of human health and the prospects of it.
I think that level of involvement is really critical. I think it’s shattering, even being a small conservative Edinburgh firm, how much companies, even some of the great companies, largest companies in the world, want to have shareholders doing this and been deprived of having shareholders do this.
To be blunt, does it translate into lower fees? Yes, for sure, but if you can get the structure right. If you can get fund managers who are not concerned about whether they’re going to be sacked at the end of a year, but have the ability to think what’s good for the corporate environment, what’s good for savers over ten years, 15 years because they’ll still be taking responsibility. I think we get a better world as an output from that and as a fund manager, heck you can cut our fees quite a lot and still have that security, you’re much better off. So we will continue trying to get fees lower rather than higher.
Merryn: Thank you James, it’s cheered me up no end talking to you.
James: My pleasure. Thank you very much.