Focusing on price-to-earnings (P/E) ratios when analysing a business is a “lazy” way to invest and risks missing out on the small number of companies responsible for the majority of growth in markets over the long term.
This is according to Stephen Paice (pictured), manager of the Baillie Gifford European fund and European Growth Trust.
Paice’s approach relies on taking advantage of the asymmetry of returns in equity markets – with the majority of companies either losing money or treading water over the long term, he focuses his efforts on the handful of stocks that are capable of at least doubling in value over five years and delivering gains of 10- or 20-fold when held over long periods.
While many investors struggle to get their head around this concept, often taking profits from their winners and recycling the cash into underperformers in the hope of benefiting from mean reversion, Paice pointed out this asymmetry is entirely logical and can be seen in most other walks of life.
“There are outliers in pretty much all distributions,” he said. “If you think about the number of books published in the US every year, it is about 1.5 million, but fewer than 500 of those actually go on to be bestsellers that sell more than half a dozen copies.
“Similarly, there are several hundred thousand words in the dictionary, but again the majority of communications use just 500 words.
“And it’s the same in stock markets: the vast majority of wealth is generated by a relatively small number of companies, so you get a distribution curve with a long tail of big winners that drive equity returns and performance.”
He added: “We’re not trying to build a portfolio of better-than-average companies that are of good quality and have decent prospects; we just want the absolute best.”
One of the problems with focusing on the “absolute best” companies is that they are often in high demand among investors and, as a result, tend to come with lofty valuations. For example, Paice said one company he is optimistic about, Dutch payment processing firm Adyen, is on a P/E ratio of about 110x for next year’s earnings, which most investors would write off as overvalued.
However, the manager warned that if they want any chance of accessing the market’s big winners, they need to look past such conventional valuation metrics.
“The P/E, which is what most people look at, is far too short term and pretty lazy,” he continued.
“It is not thinking about ‘what does the market think it’s worth and therefore I will have a stab at whether I think that is high or low’. What you need to do with these companies is look over a much longer period of time.
“We think about what needs to happen to this company to double or go up five-fold. Then we think of the probability of that happening, and if we think that probability is greater than the base rate, then we will invest.”
Europe isn’t known for its entrepreneurial dynamism in the same way as somewhere like the US, which raises the question of whether investors would be better off in another region if they are looking for companies capable of delivering outsized returns.
While Paice pointed out Europe is home to many world-class engineering companies that may have flown under investors’ radar, he accepted it hasn’t produced a household mega-cap name to rival the FAANGs – Facebook, Amazon, Apple, Netflix, and Google-parent Alphabet – in the recent past. Yet the manager said this could be about to change.
“When we’re looking for companies for the next 10 years, we talk about Adyen, Spotify and Zalando,” he added.
“These are some of Europe’s relatively new young companies that have these asset-light forms that produce so many big winners in the US.
“I think the biggest change in Europe is that companies are now starting to realise how important scaling up is and the huge benefits of scale and positive feedback loops.
“Any kind of network business – like Facebook, Amazon, Adyen and Spotify – because of their network effects, as they get bigger, they get more powerful, they get stronger, their business economics improve and the margins go up.”
Many of these European tech companies have been beneficiaries of the coronavirus-related economic lockdown, which helps to explain the outstanding performance of Baillie Gifford European this year – the fund is up 22.51 per cent in 2020 while its sector and benchmark are both flat.
Performance of fund vs sector and index in 2020
Source: FE Analytics
However, Paice said this doesn’t mean someone investing now has missed the boat.
“I think it is the first innings for some of these companies. If you look at Spotify’s monthly active users, you’re talking about 100 million. Most investors think about what is going to be the increase in the monthly active users next year and the year after, whether it is going to grow at 20 to 25 per cent. Where we’ll get to is, is it going to go to 350 million?
“We look at 3 billion people who listen to music now and we’re trying to assess whether Spotify gets to 1.5 billion monthly active users.”
He added: “In terms of changing human behaviour, these penetration rates are not just going to slowly increase over time; they are becoming tipping points where you can have a rapid change that is exponential.
“But you have to extend your timeframe: if you’re not willing to look out five or 10 years, then you are going to miss this.”
Data from FE Analytics shows Baillie Gifford European has made 226.7 per cent since Paice joined in April 2011, compared with 91.35 per cent from its IA Europe ex UK sector and 80.3 per cent from its MSCI Europe ex UK benchmark.
Performance of fund vs sector and index under manager
Source: FE Analytics
The £1.53bn fund has ongoing charges of 0.58 per cent.