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Baillie Gifford UK Growth – patience will be rewarded in the long term

Baillie Gifford UK Growth BGUK

Baillie Gifford UK Growth (BGUK) has announced its annual results for the year ended 30 April 2022. During the year, BGUK provided NAV and share price total returns of -16.0% and -27.9% respectively, both significantly underperforming its All-Share benchmark, which it says returned +8.7% during the period. BGUK’s chairman, Carolan Dobson, says that the portfolio’s relative and absolute returns over the year have been impacted by the rotation away from the ‘growth’ businesses that the Company invests in. More defensive names in the oil & gas, banking and also pharmaceutical sectors have been in favour as energy prices and interest rates have risen for a variety of reasons. However, the BGUK’s board and managers say that they continue to believe that those UK growth companies that can exploit their competitive strengths over the long term, and take advantage of the opportunities that follow severe economic dislocation, will reward the patient long term investor in due course.

The largest detractors to relative performance were: Genus, the animal genetics company; Farfetch, an online luxury fashion retailer; and Boohoo, also an online fashion retailer. Of the stocks currently held, Bunzl, the distributor of consumable products, was the notable standout positive contributor to relative performance.

Five new positions were initiated over the year: the pharma-tech company Exscientia; the online wine retailer Naked Wine; the DNA sequencing developer Oxford Nanopore Technologies; the online money transfer platform Wise; and the private company Wayve which is developing software for self-driving vehicles. Three positions were exited: the marine and energy equipment and services provider James Fisher & Sons; the defence business Ultra Electronics; and Jackson Financial following its spin-out from Prudential. Annual turnover was 5.3% and gearing stood at 2% of shareholders’ funds as at the year end.

The net revenue return for the year was 4.39p per share (2021: 2.88p). A final dividend of 3.91p per share is being recommended (2021: 2.42p). The dividend is paid by way of a single final payment.

Over the year, a total of 475,000 shares were re-issued from treasury at a premium to NAV and no shares were repurchased. However, since between the year-end (31 March 2022) and 8 June 2022, 500,000 shares have been bought back into treasury.

Manager’s comments

“Although there is clearly a lot going on in the world, not least the tragic events in Ukraine, in this report we will be focussing on the portfolio as we are acutely aware that we have encountered a run of poor investment performance which was particularly pronounced in the second half of the Company’s financial year. As long-term investment managers, some might imagine we’re impervious to periods of inevitable underperformance. This is not the case. We understand it’s tough, that it has impacted your overall portfolio return and we are suitably chastened in having to report on what must be unwelcome and unsettling news. It also means that whilst we don’t know what lies around the corner, we do know that challenge and support is required during such times of market volatility and uncertainty. Generating a very poor relative return over the financial year leads to the fair and challenging question of ‘what’s gone wrong?’ It’s hard to generalise but part of this can be attributed to the fact that the broad UK index is heavily skewed to a small number of large companies particularly in the oil & gas, banking and pharmaceutical sectors, which we typically don’t own and, which have been outperforming as oil prices hit record highs, interest rates rise (and are expected to rise further), and some investors seek safety in more defensive names. However, we think the main reason is that a material stock market rotation has taken place in which ‘growth’ businesses have fallen out of favour and their share prices have consequently performed poorly. We are aware that this sounds rather pat, but its plausibility is supported by the fact that the worst contributors to our relative underperformance over the financial year were stocks that we own while the list of positive stock contributors to relative performance was dominated by stocks we didn’t own i.e. individual stocks not held that underperformed the benchmark. In other words, as stock pickers of a relatively concentrated portfolio there is no place to hide. However, it also leads to this simple but powerful observation: we have spent a lot of time re-examining the fundamentals of the companies in the portfolio and we believe that they remain strong.

“For example, our largest detractor to relative performance over the year was the animal genetics company, Genus. Its share price halved as a severe cyclical downturn in the Chinese porcine market is affecting Genus’ short-term profitability which is linked to the amount of pigs being reared and royalties received. However, we believe this reinforces the long-term opportunity for Genus as it should provide a further powerful boost to the ongoing consolidation and industrialisation of the pig farming industry and the growth of large-scale producers. We believe the company’s world-leading genetics and its substantial investments into its Chinese supply chain over the last five years has put it in a great position to exploit this favourable industry backdrop. When considering the potential for an excellent investment outcome, our conviction in Genus’ ability to achieve similarly high market share levels in China to the ones it boasts in other large porcine genetics markets, such as North and South America, matters far more than the lack of short-term profit progression or any attempts to predict a cyclical uptick.

“You therefore won’t be surprised that we’re sticking to our process. The boxer Mike Tyson reportedly said, “everyone has a plan until they get punched in the face”. All too often we see underperformance in the investment world leading to style drift. The time-honoured investment process is jettisoned when the punch in the face of (inevitable) poor performance arrives.

“However, we believe that changing our investment approach would result in poor long-term outcomes; it would incur costs and ultimately mean shareholders would hold a different type of portfolio to that which they bought into. That’s before we even get to the question of whether we have the skill to time shifts in market sentiment (which we don’t). What it boils down to, on our part, is a commitment that we won’t change our long-established and successful long term investment approach although we acknowledge that it is one that will come with its ups and downs along the way. Having a supportive long-term corporate culture is another invaluable asset in these times: we don’t have management breathing down our necks demanding we fix things as doing so would make things worse rather than better.

“Rather than being obsessed by short-term share price gyrations, however dramatic those may appear to be, we remain focused on what we can control – methodically and calmly re-examining the fundamentals of the companies in the portfolio and assessing whether from today’s starting point, they can meet our return hurdles over the next five years. It’s about ensuring companies can demonstrate pricing power and resilience in the face of higher inflation, and, ultimately, significantly increasing earnings. If this comes together then share price outperformance should follow. Evidence of the healthy fundamentals of the portfolio was highlighted during the recent reporting season when many of the companies highlighted that they were now financially in a better position than they were pre-pandemic. Given the terrible shock to the global and domestic economy caused by Covid, this is astounding. It is on this basis we can be optimistic about the long-term prospects for the portfolio.

“This is not to say that we aren’t considering developments in the portfolio: the large investment programme announced by the platform Hargreaves Lansdown (a position we reduced in the second half of our financial year), the competition in the food delivery markets that Just Eat Takeaway.com operates in and the tricky trading issues for Boohoo.com are all giving us pause for thought. While it is tempting to magnify these challenges to something systemic, there are always matters in a portfolio that require assessment and we don’t see anything unusual in that respect. Equally, when we look at stocks that have been subject to a market sell-off, such as Games Workshop, Farfetch, Wise, Lancashire, Integrafin and Just Group, it’s hard for us to square this with their compelling long term growth opportunities and, in some cases, their stronger fundamentals coming out of the pandemic. Some do have some near-term issues to bear which the market has fixated on, but if as a long-term investor, we deem them manageable, then we believe that we’d be daft to throw in the towel on them. Put another way, the last year illustrates the difference between volatility and the permanent loss of capital. As owners of a portfolio of businesses, we are suffering from Mr Market currently offering us lower, and in some cases, derisory prices for many of our holdings. We see our job as stewards of shareholders’ capital to not grumble or protest about the prices being offered but to simply have the discipline and patience not to accept them. In doing so we would crystalise the loss of capital and make it real. The benefit of the investment trust structure and the permanent nature of the Company’s capital structure means that we have the ability to be patient and wait for the fundamentals of our companies to be better appreciated.

“This in part explains why the overall portfolio turnover remained relatively low over the year at 5.3% with three names exited and five new investments made; with the exception of Wayve (see below) and the sale of Jackson Financial, which was a holding received as a consequence of a demerger from Prudential, these transactions were commented on in the Company’s Interim Report to 31 October 2021. That said, we are assessing more potentially attractive ideas than we’ve seen for some years which is another sign that paradoxically, despite recent performance, as growth investors we are excited by the growing pool of potential investment opportunities. That’s not a prediction of when our style may return to favour, merely that we are assuredly not beset by doom and gloom. While our level of invested borrowings remains modest at 2% as at 30 April 2022, this could potentially increase when the right opportunities present themselves.

“The one new position initiated in the second half of the Company’s financial year was our first investment in a private business, Wayve, which is developing software for self-driving vehicles in London using end-to-end deep learning (or in popular parlance artificial intelligence). This is a very difficult problem, but the pay-offs to making a system work and obtaining regulatory approval are extremely large. Wayve appears to be well placed with its differentiated approach of training a single neural net on the whole problem, allowing AI to develop solutions without the imposition of human-coded rules. The AI is developed using just a few cameras placed on vehicles operated by high-traffic fleet partners such as Ocado. In theory, its approach is much cheaper and better able to adapt to new environments than more ‘traditional’ approaches to autonomous driving, which are yet to be deployed beyond limited pilots despite the many billions invested. We also believe Wayve has a high-quality management team who have attracted some of the best machine learning experts as investors, advisors and employees.

ESG engagement and consideration is an important component of what we do as portfolio managers. We have highlighted some examples of our ESG engagement over the last year below. However please note that these are examples of our overall approach and are only some of the conversations that we have with management teams and boards. We also try to adopt a respectful rather than grandstanding approach when reporting engagement. The result is possibly a drier read than possibly expected but in that we are unrepentant. That’s because it is key for us as shareholders that we build relationships with our businesses and that means engaging in honest, frank and open dialogue. We believe that this is valued by companies who in turn rightly expect us to behave responsibly when we report on our engagement with them. It’s a delicate line to tread but it certainly doesn’t mean that we pull our punches. For example, we opposed Rio Tinto’s vote on climate change at its recent AGM as being insufficiently ambitious despite the company making the case to us and us acknowledging the undoubted progress made on a crucial issue that will impact the business. Our approach here is to continue the dialogue. With more debate and encouragement, we will see if Rio Tinto can move to an even better position that we can support. It illustrates that patient long term engagement is sometimes not neat, simple, or even potentially rewarding in the short term. Yet it’s an incredibly important thing to do well as thoughtful decisions by the board and management could impact a business positively for many years to come (or vice versa).”

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