Heading up a trust that has more than trebled investors’ cash over the past decade – and comfortably doubled the gains of its sector and “notoriously difficult-to-beat benchmark” along the way – gives a fund manager a certain amount of leeway.
But does it give them enough to tell a roomful of existing and prospective shareholders “you shouldn’t try to make money through investing”?
James Anderson (pictured) certainly thinks so. The manager of the Scottish Mortgage Investment Trust believes that focusing on “extraordinary people trying to solve quite extraordinary problems” rather than more objective metrics such as balance-sheet strength or cash-flow generation will fulfil a responsibility of fund managers to aid the progress of society and the economy. More importantly, however, he said it will also drive “extreme” returns over the long term.
Anderson highlighted research by professor Hank Bessembinder of Arizona State University showing that half of the wealth created by the US market from 1926 to 2016 came from just 0.4 per cent of companies – and that the majority of the other stocks underperformed bonds.
“Everyone in stock markets who takes the CFA is brought up to believe there is something called an equity risk premium where you can take as much risk as you like and trade that for reward,” he said. “That is not how the stock market works at all.
“Stock market investing is not about buying a little of everything and thinking somehow it is less risky if you do that. It is about giving yourself the best possible chance of owning a small number of outliers.”
Scottish Mortgage has signed a contract with Bessembinder which will allow him to expand his research: first internationally, and second, to find out what the 0.4 per cent of companies have in common.
Anderson said the latter point has already thrown up some clear patterns, the first couple of which are fairly predictable – these companies were addressing markets with the potential to become enormous from an early stage, and the management teams were accountable to long-term shareholders.
However, while Anderson suspected these first two factors would come up, the third one took him by surprise.
“What interested us more was that most of these companies when they started did not have a clue as to how their business would develop,” he said.
“They are all run on a completely pragmatic basis and wouldn’t dream of using a spreadsheet to project their earnings, wouldn’t dream of saying at the start they knew what was going to happen in the future.
“And all this culminates in an intense feeling that what the stock market needs to do is actually think creatively and think about the quality of people rather than anything you can read factually. So, it needs us to change our thought process.”
So how then can investors spot a company that could find itself in the 0.4 per cent bracket? Anderson said this is best summed up in the term “constructive support”, which means remaining “incredibly loyal” to the companies he invests in, refraining from selling out even if he expects a significant share price correction in the short term.
The manager said this approach and the reputation he now has in the industry of sticking by investments through thick and thin means he is given access to companies with world-changing technology at an early – and often unlisted – stage. And, if one of these early-stage companies becomes a world leader, its management team often shows the same loyalty back.
For example, Anderson is one of a handful of investors that Amazon founder Jeff Bezos has a one-to-one meeting with each year and, when Elon Musk made headlines in May after accusing analysts of asking “boring, bonehead questions”, Scottish Mortgage was one of three major shareholders who received a phone call from the Tesla founder the next day.
“Tom [Slater, co-manager] took the call because I was away,” Anderson continued, “and Mr Musk started by saying, ‘look we’re terribly sorry if we gave the impression we don’t like our long-term investors and if somehow calling the analysts boneheads was contributing to that’.
“To which Tom quite rightly said, ‘we completely agree with you – they are boneheads and they are damaging to the task’.”
Anderson admits that the downside to his approach is volatility and points to the enormous maximum drawdown figures of some of his biggest winners over the years.
Source: Baillie Gifford
However, even though Scottish Mortgage itself has the highest maximum drawdown in the IT Global sector over the past decade – 57.85 per cent compared with 33.14 per cent from its peer group composite – Anderson said the perception that the trust is in some way risky is misguided. He believes the biggest risk for investors is that they miss out on the 0.4 per cent of truly great companies. This is not, he explained, because he has a reasonable degree of confidence in his holdings, but because he is “90 to 95 per cent certain they will destroy most companies that people think of as safe and secure”.
Anderson claimed many investors are burying their heads in the sand about this process, even though it has been happening for much of the past 20 years. For example, he pointed out that much of the talk at the turn of the century was about how Amazon was overvalued, especially compared with the likes of Barnes & Noble and Borders – yet of these two physical book stores, one has already gone out of business and the other one appears to be going the same way.
“If you look at the prices of the consumer staples companies, oil companies, pharmaceuticals companies, you can already see this is starting to happen,” he added.
“And I would really plead with people that they don’t fall for this notion so assiduously put about by the financial community that somehow there is going to be a set of stocks that is dull and reliable with huge cash-flows which won’t have risk.”
The manager said the first piece of work related to the stock market that he ever undertook – a history of Procter & Gamble, dating back to the aftermath of the American Civil War – helps to highlight why consumer staples could be entering the same sort of long-term decline as newspapers and book stores. The paper showed that the sales of Procter & Gamble at least doubled in every decade from the 1860s onwards – until the present decade, when they went negative.
“Now what is happening here is that there are two great weapons that Procter & Gamble had – one was a respected brand, principally built by advertising, most recently of course by TV advertising, and the other was absolute control of shelf space. And of course, those two are interactive,” Anderson explained.
“We are probably surprised just how good an investment Netflix has been. But more important is that it shows there is not much point in Procter & Gamble trying to advertise on TV any longer.
“Now some of this has collateral damage. Somebody pointed out to me recently that Procter & Gamble obviously owns Gillette and what is happening in advertising is completely destroying it. Its competition these days is from the likes of Dollar Shave Club and various other companies which don’t want to have their goods in shops.
“So where does all this go?” Anderson asked. “Every time I have been speaking recently, someone has said, ‘where is safe?’ And I think everyone is overestimating their own portfolio’s solidity in the next bear market.
“If there is a panic, it will probably show up in all of these companies people have come to rely on in the value creation post-Second World War western capitalism. And we feel more strongly about that than we do in our own companies.”
Data from FE Analytics shows Scottish Mortgage has made 383.31 per cent over the past decade compared with gains of 176.37 per cent for the FTSE All World benchmark and 167.84 per cent from the IT Global sector.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
The trust is trading at a premium of 3.5 per cent to net asset value (NAV) compared with 1.7 per cent and 1.86 per cent from its one- and three-year averages. It is 1 per cent geared and has ongoing charges of 0.37 per cent.