Small-cap funds with a strict size limit on the stocks they are allowed to hold run the risk of selling out of a company at the very point its potential is about to be translated into profits, according to Baillie Gifford’s Douglas Brodie.
Brodie runs the Edinburgh Worldwide IT and Baillie Gifford Global Discovery fund, which invest in small- and mid-caps with extreme growth potential over the long term.
To extract maximum value from his investments, he continues to hold on to them even after they have reached large- or even mega-cap status.
This has led to some criticism. In a recent article in Trustnet Magazine, Fairview’s Ben Yearsley revealed he had sold out of Baillie Gifford Global Discovery, saying “with Tesla as its biggest holding, I am not sure it can really be described as a small-cap fund anymore”.
There is some merit to Yearsley’s point of view, as small caps tend to deliver much higher returns than their larger counterparts over the long term, and it could be argued that holding such a significant position in a $1trn (£760m) mega cap could hinder the fund’s growth potential.
However, Brodie said that experience has taught him the opposite was true.
“When we set up the team, we were adamant about not having a market capitalisation-based trigger as a forced discipline to exit something,” he explained.
“I historically ran regional smaller companies money, where if things did cross a market-cap limit, we’d get a phone call from someone saying, ‘this business is working, you've now got to sell it’. And frankly, there’s nothing more frustrating around the process point than that.
“We've then got to look on as these businesses become genuine global titans of what they do.”
He added: “Size to us is a pretty poor proxy for the maturity of these businesses versus where they could ultimately get to.”
The stock he is most proud of standing by as it has matured is one that could still be considered a small cap: Oxford Nanopore, which has a market cap of less than £3bn.
“We've seen it all the way from scientific publications, postulating that you could sequence DNA and analyse genetic material in a certain way, through to building that up into devices and now deploying those at scale,” he said.
“It is really pushing the application of genomics and genetic insight into areas where it’s not previously been applicable from a form-factor perspective, an ease-of-use perspective, or potentially a cost perspective as well.”
Like most growth-focused funds, Edinburgh Worldwide and Baillie Gifford Global Discovery surged during the coronavirus crisis, making 87.7% and 76.8% respectively in 2020. However, they have both been caught by the market’s rotation from growth to value since then, and have sunk back towards their pre-pandemic levels.
Performance of fund and trust since Jan 2020
Source: FE Analytics
Brodie attributed their poor performance over the past year to the general de-rating of growth stocks, rather than stock-specific reasons. For example, he said many of the ‘lockdown winners’ that have followed a similar trajectory to his portfolios – such as Ocado and Teladoc – have developed their business strongly over the past two years, even though their shares are both down over this time.
Ultimately, he said it will be the fundamental strengths of these businesses that matter, rather than the macroeconomic backdrop, adding that no company has ever had it easy all the way.
Performance of stocks over 5yrs
Source: Google Finance
“A lot of people with rose-tinted spectacles think, ‘isn’t it obvious that Amazon exists’ because we needed an e-commerce champion, or Google because we needed a search engine,” the manager said.
“They often forget about the uncertainties these hugely successful businesses had to navigate to get to where they are today.
“Uncertainty is a key component of investment, as is managing periods of volatility and price instability like we've got at the moment. It tests your temperament.
“But not everything grows in a nice, linear fashion.”
The growth crash is not the first crisis that Brodie has encountered over the course of his career. The manager entered the industry in September 2001 after the attack on the Twin Towers, and began running money in 2006, just before the beginning of the financial crisis. In many ways, he said these shocks tend to follow a similar pattern.
“All of a sudden, uncertainty pops up and people bring their time horizons into how they think about businesses,” he continued.
“If anything, that’s maybe become a little bit more extreme as the years have gone by. For a lot of growth investors, it's been quite a bruising year.
“But that needs to be seen in the longer-term context about how we think about our businesses.
“Investing is a fundamentally long-term task and it's bookended more by the patience that you apply to it than it is by any event.”
Despite their recent large corrections – Edinburgh Worldwide and Baillie Gifford Global Discovery are down by about 50% from their 2021 peaks – both vehicles remain ahead of the MSCI World index and significantly ahead of their sectors over the past 10 years.
Performance of fund and trust vs sectors and index over 10yrs
Source: FE Analytics
Edinburgh Worldwide is currently on a discount of 13.3%. It has ongoing charges of 0.66%.
The £1.3bn Baillie Gifford Global Discovery fund has ongoing charges of 0.78%.