Value investors perplexed by their continued underperformance over the past decade are likely to become even more bewildered following a statement from James Anderson, manager of the Scottish Mortgage Investment Trust.
For so long regarded as the epitome of growth investing, which has proved dominant since the end of the financial crisis, Anderson appears to have trivialised the growth versus value debate by saying “oddly enough, we believe that we are value investors in a certain way”.
Performance of indices over 10yrs
Source: FE Analytics
However, he pointed out one crucial difference between him and fund managers who follow a more widely accepted definition of value investing is that he avoids what he refers to as the “short cuts” of price-to-earnings and price-to-book ratios.
“The only correct definition of value is the value of the long-term free cash flows or earnings of the companies involved,” he explained.
“Now, we believe that it's very hard to be properly long term and have only one hypothesis about what long-term prospects are.
“So even in our largest and favourite holdings over the years, we will have versions of [our hypothesis] which suggests we will lose money – in some cases, all of the money. But the upside is so great.”
Anderson (pictured) believes much of the reason for the underperformance of value investing lies in the rigid way this method is taught, with a failure to account for a wholesale transformation in the economy and society since the term was first coined in the mid-1900s.
In particular, he said value investors have failed to heed the “extraordinarily prescient work” of professor Brian Arthur of the Santa Fe Institute, who wrote more than 20 years ago about how technological advances meant an ever-greater percentage of businesses would be characterised by increasing returns to scale rather than decreasing ones.
“About a year ago, to the irritation of my wife, I spent quite a long time at Christmas and New Year ploughing through Ben Graham's books,” Anderson continued.
“And, you know, he just did not envisage this situation being possible. But I think this is getting more and more serious because investors are taught both through their admiration of people like Warren Buffett – which is surely deserved in a very long run – but also by the CFA, nothing that has to do with these increasing returns to scale which have enabled companies to grow for far, far longer and to far higher levels.
“The easiest example remains Microsoft – it costs it nothing to print a new software device for all of us to use after the initial research, and so profitability goes up rather than down.
“Sometime in the next few years, it's highly likely that Microsoft will overtake that original capitalist company, the Dutch East India Company, as the company that has enjoyed returns substantially above the cost of capital for the longest time in history.”
It sounds a lot like Anderson is implying “this time it is different”, often referred to as one of the most dangerous phrases in investment. Yet when this was put to him, he replied: “I'm not sure at one level that it is wholly different”.
Anderson has previously highlighted research by professor Hank Bessembinder of Arizona State University which showed that half of the wealth created by the US market from 1926 to 2016 came from just 0.4 per cent of companies, while the majority of other stocks underperformed bonds.
And the manager said parallels could be drawn between this small group of successful companies of the past and the giant tech and growth names of today that are routinely referred to as being overpriced.
“Bessembinder’s examples started out as revolutionary. The oil industry was once a positive revolution,” Anderson explained.
“The people operating those companies in their early days never wanted to define what the opportunity was, which is just as much true of the Rockefellers as it is of Jeff Bezos. More recently, they believe in open-ended addressable markets.
“And by implication they don't try to think about those in quarterly terms.
“[So my process is] much more about judging in a qualitative manner the management teams and the business cultures than it is about analysing either profit & loss or balance sheets.”
Anderson said investors need to revolutionise the way they think about what creates growth in companies, economies and societies. He claimed most fund managers have got stuck in a heavily complicated way of thinking about growth that is “both provably wrong and very damaging”. And he said the proof of this can be found in the trust’s outperformance.
“I think we're only at the beginning of this and unless people face up to this economic reality, they will struggle to invest appropriately,” Anderson continued.
“I might turn that around and say, although I think it's very sad from a societal point of view, that's why our advantage has lasted a long time. Normally, I would have expected investors to adjust and take advantage of that. Why has it taken so much longer now, when for instance in the late 1990s people embraced change and new metrics far too quickly?
“But now we've had 15 years at least of this being the dominant ethos of markets and the dominant driver and yet we see very few people adapting.”
Data from FE Analytics shows Scottish Mortgage has made 666 per cent over the past decade, compared with gains of 182.27 per cent from the IT Global sector and 170.28 per cent from the FTSE All World index.
The trust is on a premium of 3.14 per cent compared with a discount of 0.42 per cent from its one-year average and a premium of 1.35 per cent from its three-year average.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
It is 8 per cent geared and has ongoing charges of 0.36 per cent.