Baillie Gifford European Growth (BGEU) has published its annual results for the year ended 30 September 2023, during which it provided NAV and share price total returns of 8.3% and 8.6% respectively, but these were significantly behind its benchmark, the FTSE Europe ex UK Index, which it says returned 20.5% (all figures in sterling terms). As its chairman, Michael MacPhee, points out, an environment of higher interest rates continues to make it a challenging time for growth investors, although he also believes that BGEU’s currently out-of-favour growth style will be vindicated in the longer term. The following are key highlights from the results:
- Positive contributors in the period included: Ryanair, which continued to take market share from weaker airlines and invest in new capacity; and online classified companies Adevinta and its major shareholder Schibsted which showed that they can offset temporarily weaker volumes with price increases.
- Negative contributors in the period included: battery startup Northvolt which was written down to reflect moves in public benchmarks, though operational progress remains good; and payments processing company Adyen which fell after announcing some market share losses in the US.
- Annual turnover was 9% and gearing stood at 15.6% of shareholders’ funds as at the year end.
- The portfolio now contains five unlisted companies accounting for 10.9% of total assets as at 30 September 2023 (2022: 11.0% in four companies).
- The net revenue for the year was 2.68p per share (2022: 0.79p). A special interim dividend of 2.20p was paid on 15 September 2023. A final dividend of 0.40p per share is being recommended (2022: 0.70p).
- Over the year a total of 538,471 shares were bought back into treasury.
Manager’s commentary – overview
“We took over management of the Company four years ago with the aim of investing in Europe’s most dynamic growth companies. Since then, the share price has experienced a spectacular rise and equally spectacular fall. Adjusted for the share split, we started at just over 80p, peaked at around 170p, and ended the current period almost where we started. While we continually ask ourselves what we could have done differently, Baillie Gifford has been managing European portfolios since 1985 and has experienced poor performance before. Many of our most successful companies have been through similarly difficult bouts. Just as those companies did, we emerged from each one in a stronger position. We do not wish to downplay the recent period of poor performance. We think about it every day. Disappointing as this is, however, it is more important to consider where the share price will be five years from now.
“Over short periods there are many variables that help dictate what a company is worth. These include interest rates, risk appetite, social media, and many of the behavioural shortcomings from which we humans regularly suffer. Companies make mistakes too – operational hiccups happen. These are businesses run by real people trying to navigate complex issues and unpredictable events. Over longer periods of time, however, these variables play a far less significant part. What is more important for value creation is a strong, durable corporate culture, and the ability to grow profitably over time. We will make mistakes, but if we build and maintain a portfolio of high-quality growing businesses run by people we trust, we believe that we can deliver for our shareholders.”
Manager’s commentary – performance
“Over the last financial year, the Company’s NAV delivered a total return of 8.3% while the FTSE Europe ex UK index returned 20.5% in sterling terms. The Company’s share price total return was 8.6%, ending the period at 83.6p, representing a discount of 13.6% to the NAV. This compares to a discount of 13.5% at the beginning of the period.
“Despite these relative returns, we are increasingly optimistic about the future. Operational progress has been at least in line with our expectations, and we are seeing many affirming signals that our companies are taking advantage of this environment, investing while peers retrench, carrying out acquisitions, and buying back shares. We are not the only ones who think the selloff is overdone.
“Positive contributors in the period include Ryanair, which continued to take market share from weaker airlines and invest in new capacity. Online classified companies Adevinta and its major shareholder Schibsted showed that they can offset temporarily weaker volumes with price increases. Both companies’ share prices have also been boosted by news that a private equity consortium is looking to acquire Adevinta. Freight forwarder DSV and building materials manufacturer Kingspan continue to execute well, and both have been linked with potential large-scale acquisitions made feasible by their strong balance sheets. Spotify continues to grow healthily and now boasts over 550m monthly active users. After much investment, its recent focus has shifted to profitability using cost reductions and price increases as levers. This shift is underway at many technology companies, although Spotify is the first to be rewarded by the market.
“Some companies performed less well. Battery startup Northvolt was written down to reflect moves in public benchmarks, though operational progress remains good. Elsewhere, payments processing company Adyen fell almost 50% in the week after announcing some market share losses in the US. This looks temporary to us, though we continue to monitor progress and debate the attractiveness of the new, lower valuation. Sartorius Stedim Biotech, which manufactures bioprocessing equipment for the biologics industry, also reported negative news, noting a slowdown in demand and higher inventories. Again, these issues feel temporary, and we have made a modest addition. Swedish gaming company Embracer has been more disappointing. The investment case centred on the founder’s strategy of acquiring media content and gaming studios and letting their founders flourish in a decentralised organisation. Unfortunately, this was a case of overpromising and underdelivering, and management is now being forced to sell assets to pay down debt. We have some sympathy for the idea that the company is now undervalued, but we have lost faith in the management team and the board. Trust in management and alignment are non-negotiable for us so we have sold our entire position.”
Manager’s commentary – improving performance
“We genuinely believe that the future looks brighter than the past. Cynics may argue that this is what all underperforming fund managers say, so the onus is on us to explain the underpinnings of our optimism. So, what are the catalysts to drive improving performance?
“Cognitive psychologist Gary Klein, in his book ‘Seeing What Others Don’t’, suggests that performance is improved by ‘reducing errors and increasing insights’. As we have written before, our main error has been misjudging the impact of rapidly shifting monetary policy on the valuations of growth companies. Because the companies in the portfolio tend to be smaller and grow much faster than average, most of their lifetime cashflows are in the future, and these are now being discounted at a much higher rate than they were. We have therefore felt the impact of rising rates much more acutely. When panic sweeps the market, it is the more nascent, higher growth companies that get hit hardest.
“In order to minimise future valuation risk, we monitor interest rate and duration risk in the portfolio and construct a reverse discounted cashflow model for every company we look at. These process tweaks will help us test our assumptions on valuation, but also to take advantage of opportunities in a volatile market. This is crucial – the potential upside is much greater than the potential downside, so while minimising errors is important, it is less important than identifying insights to help us invest today in tomorrow’s winners.”
Manager’s commentary – portfolio
“Portfolio turnover for the year was 9%, implying an average holding period of just over 10 years. During the second half of our financial year, we made six new investments in public companies: EQT, one of the world’s largest and most reputable private equity firms; LVMH and Moncler, two luxury goods companies that are getting better as they get bigger; Soitec, an innovative French semiconductor company exposed to rapidly growing markets; Royal Unibrew, a multi-beverage company with serial acquirer characteristics; and Eurofins, a global lab testing business we’ve been waiting patiently to buy for many years. We also made a new investment in an unlisted Italian software company called Bending Spoons, which has a unique approach to monetising consumer mobile apps. This is a diverse, high-quality, highly profitable collection of companies growing much faster than the market, with meaningful inside ownership and attractive valuations.
“During the same period, to make way for these new holdings, we completely sold five investments. We have already mentioned Embracer, but food delivery firm Just Eat Takeaway.com and green holding company Aker Horizons didn’t work out either. Just Eat Takeaway.com suffered from an ill-timed acquisition in the highly competitive US market. Legislators also introduced fee caps which effectively turned a profitable business into a loss making one. With Aker Horizons we underestimated how difficult it would be for its portfolio of clean tech businesses to generate profits. MedTech distributor Addlife, and heat pump manufacturer NIBE, have been more successful. During the Covid pandemic, Addlife benefitted from increased demand for diagnostics and hospital equipment, while demand for NIBE’s energy efficient heat pumps far exceeded supply during the energy crisis. In both cases we determined that valuations had risen too much, and that the capital would be best redirected into better ideas.”
Manager’s commentary – private companies
“While the Company can invest up to 20% of total assets in private companies, we currently have five investments accounting for around 11%: Northvolt (4.9%), McMakler (1.8%), sennder (1.8%), Flix (1.5%) and Bending Spoons (0.9%). Overall operational progress has been good and both Northvolt and Flix are rumoured to be considering an initial public offering (‘IPO’) in 2024.
“We think giving investors low-cost access to private companies that would otherwise be unavailable is an attractive proposition. Companies are staying private for longer, as many of them are relatively asset light and therefore require little capital to grow. As a result, many are in the fortunate position to be able to choose their investors. We think our reputation as long-term growth investors and our ability to invest in both private and public markets mean we are advantaged when it comes to deal flow. We absolutely believe that investing in Europe’s increasingly dynamic private companies can generate significant value and provide insights into a level of disruption not normally seen in public markets.”
Manager’s commentary – Northvolt
“Our very first private investment is becoming increasingly important to us and the broader European economy. Northvolt was founded in 2016 by two former Tesla executives backed by two Swedish entrepreneurs who wanted to accelerate decarbonisation. Their mission was to produce the world’s greenest batteries with the lowest carbon footprint. In just seven years, the company has taken on over 4,000 employees, secured more than $8bn in funding, and received more than $55bn in orders from customers like BMW, VW, Scania, Siemens and ABB. This is truly remarkable.
“At 4.9% it is the largest position in the portfolio, so its success will help underpin any rebound in performance. The rumoured IPO in 2024 is just a milestone for us if it happens as we can continue holding the shares if there remains sufficient upside. Either way it should be very high profile particularly given its strategic importance to Europe’s automotive industry, politicians, and financial institutions who all want to see it succeed. Europe cannot afford to rely on Asian battery manufacturers. It needs to build its own supply chain and Northvolt is the best chance we have.
“Northvolt’s opportunity is large and growing. In Europe alone, battery demand is expected to increase from around 150GWh in 2022 to 1,370GWh in 2030. This is likely to be revised upwards as new markets and applications emerge. We suspect this will be a commoditised market, but Northvolt’s strategy seems well-suited. Important aspects of this strategy include:
- An ambition to lower the carbon footprint of a battery to 10kg of carbon dioxide equivalent per kilowatt hour, a 90% reduction from the current industry benchmark. This will be driven by access to very cheap renewable hydroelectric power, using responsibly sourced raw materials, and using at least 50% recycled material.
- Its unique vertical integration. Everything from cathode production to cell assembly to recycling will be done in-house. This not only lowers carbon emissions but also helps capture more recycled materials and improves quality.
- A European supply chain. A local champion needs local supply, and Northvolt’s aim is to source 90% of components from within Europe. This creates a lot of alignment with those customers and politicians responsible for orders and subsidies.
- A focus on talent. Northvolt has assembled one of the best R&D teams in the world. Battery chemistries and technological roadmaps will evolve so it is important that the company can adapt and compete with its Asian competitors.
“During an investment trip to Sweden with the Board, we recently visited Northvolt’s first factory, Northvolt Ett, in the small town of Skellefteå. The 200-hectare site near the Arctic Circle is equivalent to around 300 football pitches, so is a highly ambitious project. The current plan is to produce 150GWh of batteries by 2030, but there is upside potential to this figure. To put this into context, if the average electric car has a 70kWh battery, this would be enough to power more than 2 million of the 11 million cars sold in Europe in 2022. Using public estimates for battery prices in 2030, this could result in $10-15bn in sales. Engineering and manufacturing at this scale poses tremendous challenges, and there will no doubt be delays and setbacks. If Northvolt succeeds, however, the payoff for investors could be huge.”