Stuart Dunbar, partner, Baillie Gifford
Transformational growth companies such as Amazon and Tencent are rare. Finding them requires patience, resolve and long-term horizons. Yet many investors cling to mathematical models based on short-term trading and believe decisions can be made on numbers crunched by supercomputers and complex algorithms.
The intellectual underpinning of many such models is the Capital Asset Pricing Model (CAPM). At Baillie Gifford, we are puzzled as to why investors cling to this clearly disproven model as a basis for valuing financial assets. The formula assumes a company’s expected return and risk profile is always reflected in its share price, by 100 per cent rational investors with identical time horizons. It defines risk as historic share price volatility and assumes that how one stock performs relative to another is predictable from their histories. By definition it doesn’t capture what really matters – change and adaptation in the real world. Formulated in the 1960s and only ever intended by its authors as an analytical tool, CAPM has achieved undeserved immortality as a how-to guide for investment practitioners. We think it has no real connection to productive capital deployment – what we like to call Actual investing.
There might be people clever enough to consistently predict fleeting share price fluctuations and second guess the market, but it’s not a skill Baillie Gifford offers. We have no idea what stock markets will do in the next three, six or twelve months. We don’t have strong views on how a company’s share price will perform day-to-day. In a market dominated by short-term speculators, prices are set by investors trying to anticipate what each other will do next. In the short run therefore, the value of a listed company has at best a very loose relationship with the progress of the business it represents. Progress or problems justifying significant share price changes are drowned in the noise. Given that disconnection, measuring risk by reference to share price volatility just captures the wild swings of investor sentiment. In this we can truly agree that ‘past performance is no guide to the future’. Far simpler (but not easy) is to pay it no heed.
We believe that investment is more art than science. The creative part lies in anticipating change at company, industry, societal and human level. It’s trying to understand what drives change and how people adopt new behaviours. It’s imagining what could go right, at least as much as what could go wrong.
The complex projections of CAPM, and related concepts such as ‘reversion to the mean’ – the theory that asset prices always return to the long-run average – are at best red herrings. At worst they obstruct an investment manager’s line of sight to the future, hampering ability to spot long-term investment opportunities.
That vision, if extended over the time-horizons needed for outsized returns, involves getting comfortable with uncertainty. Actual investors know that some companies and technologies we back will not win through. The successes, however, benefit from the asymmetric nature of stock returns: gains can be manyfold, whereas losses are limited to what you invest.
Actual investors think in terms of decades, because it’s only over longer periods that those signals form a clear picture. Companies that most successfully grasp scalable opportunities will eventually have the strongest share prices.
So, the way to mitigate uncertainty is not through the pseudo-science of CAPM and its equivalents, but through a better understanding of the opportunities available to entrepreneurial businesses. These can emerge from accelerating technological progress or new business models. We strive to understand how companies might capture such opportunities and, by dialogue with management, assess whether they can pull the levers to make it happen.
To be clear: Actual investors should be looking for businesses capable of sustaining progress over decades. Points we consider include the size of the opportunity, the adaptability and quality and commitment of management (founder-managers often score highly here). We look at whether or not the firm has a sustainable competitive advantage. If we can see these factors clearly enough we care less about quarter-by-quarter fluctuations and what CAPM might or might not reveal. Understanding the intrinsic qualities of a business and the world in which they will compete in the longer term, make it easier to make predictions over ten years than over a few financial quarters.
For Actual investors, the issue with the short horizon of some stock market analysis is that this reveals nothing about the possibilities for outstanding returns when new technologies coalesce. Baillie Gifford claims no privileged intuition about the future. We do however think it’s easier to spot significant points of change – and to ride the sometimes bumpy road towards them – than to try to second guess other investors quarter-to-quarter.
Important information
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.
