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The reason US equity managers have let investors down

20 October 2017

Gary Robinson, co-manager of the four FE Crown-rated Baillie Gifford American fund, explains why the US equity market is nowhere near as efficient as many investors think.

By Lauren Mason,

Senior reporter, FE Trustnet

Most active US equity managers have let their investors down by ignoring the asymmetry of the market, according to Baillie Gifford’s Gary Robinson, who said there are a wealth of underappreciated opportunities in the sector.

This is despite the widely-held view that the US market is already mature and efficient, with many investors opting to use a tracker to gain portfolio exposure.

“The US active management industry has done a pretty bad job of serving its client base, particularly over the last five years,” Robinson, who co-manages the four FE Crown-rated Baillie Gifford American fund, said.

“I think there are some cyclical reasons for that but there are also some structural reasons. The cyclical ones are the strongly rising markets and the cash drag you get in that environment.

“Large caps have done well relative to small caps and a lot of US managers have been holding out-of-index positions. That has hurt funds leading up to the end of 2016.

“But there’s a general trend whereby fewer and fewer active managers are actually delivering for clients. We’re not surprised the client base is disillusioned at this stage.”

According to data from FE Analytics, just 24 out of 95 funds in the IA North America sector have outperformed the S&P 500 index over the last five years. In fact, the sector average has underperformed the index over this time frame by 16 percentage points with a total return of 117.6 per cent.

However, Robinson’s £640m Baillie Gifford American fund has outperformed the index by 15.62 percentage points. It is in the top quartile for its total returns over one, three, five and 10 years as well as over the last three and six months.

Performance of fund vs sector and benchmark over 5yrs

 

Source: FE Analytics

“We strongly believe it is possible to outperform in the US if done right,” the manager said. “The point I’m going to start with is one which I think is underappreciated. That is the role that asymmetry plays in driving stock market returns.”

He referred to a study published by Hendrik Bessembinder of Arizona State University last year, which dissected the total wealth creation for the US stock market between 1926 and the end of 2015.

Out of 26,000 companies and a total wealth creation of $32trn over 90 years, Bessembinder found that the entirety of money made came from just 1,000 stocks.

Moreover, the study showed that half of the overall wealth creation came from just 86 stocks – or 0.3 per cent of US companies – over the time frame in question.


“This is something which is genuinely underappreciated,” Robinson continued. “Back in 2015, everyone was talking about the FANGs [Facebook, Amazon, Netflix and Google] and the proportion of the return of the market that was coming from this small number of companies.

“I kept being asked if this was unusual and it’s not actually. It’s a feature of stock markets. It’s a feature of equities. It reflects capped downside and unbounded upside.

“Contrary to popular economic theory, stock returns are not evenly distributed – they are skewed. What this means is that you don’t outperform by doing a little bit better than average, you don’t outperform by avoiding losers. The route to outperformance is striving to find the winners.”

In order to find these winners, the manager said it is important to remain focused on the upside and block out the media’s focus on short-term headwinds.

“What actually matters in investing is not how often you’re right, but how much money you make when you are right. Because one of these winners can offset losses from lots and lots of losers,” he explained.

“I guess the follow-on question from this is whether it’s possible to identify these companies in advance. We think it is.

“We think these companies that fall into the upper end of wealth distribution share some common factors. We call these companies the exceptional growth companies.”

Prior to the publication of Bessinger’s study, the Baillie Gifford American team ran studies on the asymmetry of the US stock market over rolling five-year periods over 30 years.

On average, it found that 30 per cent of companies lost money over this time and 50 per cent of companies made small gains, which Robinson said tended to cancel each other out.

The remaining 20 per cent, according to the manager, made gains of at least 2.5 times over rolling five-year periods and distributed a disproportionate amount of the market’s return.

It is these 20 per cent of companies that Robinson, alongside co-managers Tom Slater and Helen Xiong, aim to hold in the portfolio. He explained that all these companies have significant revenue growth, as well as profitability and the ability to expand margins.

“We look for three things in these companies. The first is a large market opportunity relative to the current revenue base,” he said.


“The second factor we look for is a competitive advantage moat which is strong and durable. That really comes back to the point around profitability and, more importantly, profitable growth.

“The third aspect we look for is culture. I would go as far to say that culture is one of the most underappreciated and yet important drivers in terms of long-term stock returns.”

The manager therefore has a preference for founder-run companies, as he believes they are focused on delivering more than a monetary gain – which he said should be an output of a process rather than an aim in itself.

Some 70 per cent of Baillie Gifford American is held in companies which have their founders as the CEOs.

“This is a fairly simple process and one of the obvious questions is why most managers don’t go down this route. I think there are a couple of things which actually make what sounds simple quite challenging,” Robinson reasoned.

“The first is that exceptional companies by definition are rare and, when you find them, it’s a mistake to dilute the strength of those companies in the name of diversification. So, the asymmetry of stock markets demands concentrated portfolios.

“You have to be willing to embrace volatility to do that. Our portfolio looks nothing like the index and, over shorter periods, performance can be incredibly volatile. That’s something which requires a degree of patience.”

A second aspect which many managers may find challenging, according to Robinson, is to back these companies over several years in order to reap the benefits.

“The sorts of companies that have the potential to deliver these outsized returns often behave in an unconventional way,” he explained. “They take risk, they’re willing to make big deals and the stock market is not always kind to those decisions in the short term.

“We invest over a five-year time horizon and we hope to hold companies for even longer than that. The turnover for this portfolio is about 15 per cent, which is consistent.”

He added: “We’re not promising to beat the market every quarter, we can’t do that. We don’t believe that anybody can.

“Actually, I think to be successful in investing you have to be willing to look stupid at times. Because what you’re doing won’t always be en vogue. There will be periods where share prices have been driven by things other than fundamental factors.”

 

Baillie Gifford American has a clean ongoing charges figure (OCF) of 0.52 per cent.

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