Stuart Dunbar, partner, Baillie Gifford
What counts as a mistake in investment? For Actual investors there’s usually only one big cause for regret: looking at a company and failing to imagine how it could grow into a world-beating enterprise.
One such error occurred in 2009 when Baillie Gifford considered investing in Netflix but passed up on the grounds that it probably wasn’t a very exciting business. Thankfully, by 2015 we had realised our mistake and did invest. But the success of Netflix shouldn’t have been beyond our imagination. Gains foregone by delayed action can be far costlier than the traditional ‘mistake’ of simply losing money on an initial investment.
As for the many times when hopes and expectations about a company we’ve invested in come to nothing, we don’t see them as ‘wrong’ decisions. We certainly don’t fret over them. Doing so wastes time and energy better spent looking for potential winners. Anyway, a poor outcome doesn’t mean the investor was ‘wrong’ to back the company. The share price of many of our biggest outperforming holdings has halved at some point along the journey.
Investment managers can only ever make decisions based on the information available at the time. All we can do is ask the right questions about a company, consider the market context, and come to a view.
Disappointment usually has one of two causes. Sometimes events just don’t go as hoped and planned. It happens. Never being caught out that way can be a sign of habitual lateness to grasp new growth opportunities. Waiting for absolute certainty is no way to achieve exponential growth.
Alternatively, sometimes an investment doesn’t turn out well because something has happened that was foreseeable, but which we failed to understand. That really does count as a mistake, but one we can learn from, and avoid making more than once.
But whether through bad foresight or bad fortune, the inevitability of things going wrong should never make us, or our clients, risk averse. It makes sense to focus on finding investments that could go spectacularly right.
Actual investors know that losses are limited to the size of the original investment, while gains have no such cap. Over time the effect of a portfolio’s big winners can vastly outweigh the large rump of relative underperformers. A need to excuse holdings ‘going wrong’ can inhibit investors from taking risks on those with the potential to return large multiples of an original investment over a long time horizon.
This house style of ‘running our winners’ – ignoring short-term price moves, resisting profit taking and keeping faith in long-term growth – is not unique to Baillie Gifford, but it’s one we embed in our research process. In a study we commissioned of global stock market returns between 1990 and 2018, University of Arizona scholar Hendrik Bessembinder established that, when combined, the top 1 per cent of all listed equities gained an amount equal to the total gain in the whole of the market (relative to US treasury bills).
Or to put it another way, 61 per cent of companies lost value for shareholders during their listed lifetime, 38 per cent collectively made up for these losses, while the remaining 1 per cent accounted for the entire net gain.
This work has clarified in theory what we’ve long known in practice about the wildly asymmetrical impact of winners over losers. Professor Bessembinder’s dataset of US and global stock indexes and his analysis revealed the order of magnitude of the difference, teaching us that almost nothing matters more than spotting the winners of the future.
Bessembinder’s more recent work helps us identify the common characteristics that result in good outcomes for investors: the flexibility of the original business plan, the management’s culture of long-termism, and the breadth of opportunity for the technology they are exploiting.
If a company with what we think are the right qualities takes a dip, we look again at whether its business case still holds. If it doesn’t, we should sell and move on. If it does, we might invest further.
Inevitably some investments turn out wrong. Sometimes the unforeseen is just unforeseeable. But only by embracing uncertainty can we hope to find the 1 per cent of outperforming companies that ultimately matter.
This update is solely for the use of professional investors and should not be relied upon by any other person. It is not intended for use by retail clients.
Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018. Baillie Gifford Investment Management (Europe) Limited is authorised by the Central Bank of Ireland as an AIFM under the AIFM Regulations and as a UCITS management company under the UCITS Regulation. Baillie Gifford Investment Management (Europe) Limited is also authorised in accordance with Regulation 7 of the AIFM Regulations, to provide management of portfolios of investments, including Individual Portfolio Management (‘IPM’) and Non-Core Services. Baillie Gifford Investment Management (Europe) Limited has been appointed as UCITS management company to the following UCITS umbrella company; Baillie Gifford Worldwide Funds plc. Similarly, It has established Baillie Gifford Investment Management (Europe) Limited (Amsterdam Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in The Netherlands. The representative office does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co. Baillie Gifford Overseas Limited and Baillie Gifford & Co are authorised and regulated in the UK by the Financial Conduct Authority.