Not everything in Baillie Gifford’s garden is blooming

Not everything in Baillie Gifford’s garden is blooming – Baillie Gifford Japan has struggled to match its benchmark and its peers in recent years

Amid the uncertainty that COVID-19 has created, investors have been looking to technology stocks and companies with strong defensible business models, reasoning that these can persevere even in a recession. That has done wonders for the likes of Polar Capital Technology, Herald, Edinburgh Worldwide and, notably, Scottish Mortgage. Baillie Gifford’s (and the investment companies sector’s) flagship trust is booming. At the start of this year, it had a market capitalisation of £8.4bn. By yesterday, helped by a 50% increase in the share price, that had grown to £13.3bn.

Given that Baillie Gifford applies a similar investment ethos to all of its funds, you might have thought that they would all be flourishing. However, Baillie Gifford Japan is a notable exception in this regard. Its share price return over the past six months is -5.3% and its NAV return over that period has lagged that of JPMorgan Japanese by 18%. [NB. I should say that this particularly bothers me because I hold Baillie Gifford Japan.]

Six months is too short a period to evaluate performance, but Baillie Gifford Japan has been struggling relative to its peer group and its benchmark for a couple of years now. Sifting through the various reports from the manager, it is not easy to work out what the problem might be. All managers get some stock selection decisions wrong and we are still talking about a relatively short period of problematic performance (the literature urges us to look at returns over five-year periods).

The largest holding is Softbank, which I think may be yesterday’s hero, but as the manager points out, its market cap is underpinned by its holding in Alibaba. Also, its share price is hitting new (post tech boom) highs.

In Baillie Gifford Japan’s annual report covering the year to the end of March 2019, a couple of stocks, Outsourcing and ZOZO, were highlighted as detractors from returns over that period. Outsourcing is a staffing business, whose shares weakened on fears that a slowing economy would hold back the company. The manager decided to add to this position but the share price has continued to fall. ZOZO is an online fashion retailer. The manager reduced this position on corporate governance grounds but the stock was later taken over.

More recently, the share price of conglomerate Itochu, which was the fifth-largest holding at the end of February, was hit hard by COVID-19. The seventh-largest position ahead of the COVID-related market falls was Inpex, an oil and gas producer. Unsurprisingly, its share price cratered when the oil price collapsed and is yet to recover. I am surprised that Inpex was in the portfolio, let alone the top 10, given Baillie Gifford’s public statements about the end of the fossil fuel market.

Baillie Gifford Japan divides its investments between ‘secular growth’, ‘growth stalwarts’, ‘special situations’ and ‘cyclical growth’. Itochu, Inpex and Outsourcing all sit within the cyclical growth bucket, which was about 20% of the portfolio at the end of February.

Cyclical stocks were always going to do badly faced with the prospect of a significant global recession. However, the theory behind having some exposure to cyclical stocks is that, if you can pick the ones that can survive a downturn and have the wherewithal to build their business as others are struggling, you can reap the rewards when the cycle turns in their favour. Baillie Gifford Japan’s manager will be hoping that the stocks in this bucket will be an engine of outperformance at this time. For now though, they are dragging on returns.