The so-called ‘investment influencers’ that proliferate social media platforms have been blamed for pushing novice investors into riskier stocks and cryptocurrencies, but the incoming deputy manager of Scottish Mortgage Investment Trust has highlighted four more credible thinkers who help shape his view of investing.
Lawrence Burns was named as deputy manager of the giant investment trust earlier this month, when it was announced that manager James Anderson would be stepping down in April 2022. Under Anderson’s leadership, Scottish Mortgage has generated some spectacular returns.
Performance of Scottish Mortgage vs sector under Anderson
Source: FE Analytics
Scottish Mortgage – the flagship investment trust of Baillie Gifford – has somewhat of a unique approach, in that it concentrates on finding companies that can deliver exceptional returns, investing in them at an early stage of their development and holding them over the long term.
In a recent note, Burns highlighted some of the academics and other thinkers that have helped to inform the trust’s worldview – especially why it can be wrong to sell out of a strong company too soon.
“It is a conventional wisdom that pervades much of the financial industry. As the old saying goes ‘it’s never wrong to take a profit’. There is some validity in this approach, hence why it pervades and endures,” he said.
“[But] equity investing is asymmetric, the upside of not selling is near unlimited, while the downside is naturally capped. Surely, for the client it can be very wrong to take a profit? This goes to the heart of why so much of investing is wrong.
“The realities of investment therefore are often very different from the dogma. At Baillie Gifford, we are fortunate to be informed by a range of thinkers from outside our industry that have no incentive to prop-up the myths of investment management. Instead, they deal in observable facts, not the self-serving mantras beloved by professional investment bodies.”
Below, Burns introduces four such thinkers and explains how their work strengthens the case for holding onto companies that have already delivered strong returns.
Professor Hendrik Bessembinder - Where returns actually come from
In his paper Do Stocks Outperform US Treasury Bills?, professor Hendrik Bessembinder of the W. P. Carey School of Business pointed out that almost 60 per cent of global stocks failed to outperform one-month treasury bills over the previous 28 years.
This underperformance by most stocks sits alongside a small number of ‘superstar companies’ – Bessembinder pointed out that all of global net wealth creation is down to just 1 per cent of businesses.
Burns said: “The other 99 per cent of companies were, it turns out, largely a distraction to the task of making money for clients. The capital asset price model (CAPM) so beloved by the financial industry is therefore nonsense because the normal distribution of stock returns that underpins it is imaginary.
“This should shake the very foundations of the investment industry. It provides not an opinion but a collection of facts as to where returns come from and what investors should focus on. The entire active management industry should be trying to identify these superstar companies since nothing else really matters. Investing is a game of extremes.”
Burns added that doing this would require a “vastly different mentality” to the one currently ingrained in the asset management industry.
Firstly, it demands that investors concentrate on the possibility of extreme upside, not the fear of capped downside. “This requires genuine imagination should there be any hope to grasp the potential of superstar companies. After all, it required imagination to see that Amazon could become more than an online bookseller or that Tesla could become more than a premium electric car company,” the manager said.
Secondly, Bessembinder’s research made clear that it is the long-term compounding of superstar companies’ share prices that deliver the results, rather than dipping in and out of them, meaning investing requires patience.
Burns said this means patience when things go wrong (“Even for superstar companies, progress is rarely a straight line”) but also when things are going right.
“After all, the point of superstar companies is that they can go up five-fold and then go up five-fold again,” he explained. “If you sell after the share price merely doubles, crow and take your profits, you undermine the whole point of identifying companies with extreme return potential in the first place.”
Professor Brian Arthur - Increasing returns to scale
The second investment influencer highlighted by Burns is economist and complexity thinker professor Brian Arthur, whose increasing returns theory looks at how positive feedbacks operate in an economy.
Bessembinder’s notion that superstar companies can generate such high returns is contrary to much of economic theory, which believes in reversion to the mean and assumes that companies’ returns tend to stabilise rather quickly.
His research into almost a century of US stock market returns also showed that the concentration of wealth creation is becoming yet more skewed towards a small number of companies. “The superstar companies are becoming more super,” Burns said.
Arthur’s work is helpful in understanding why conventional economic theory’s focus on diminishing returns to scale does not necessarily apply to superstar companies.
“It takes the work of professor Brian Arthur of the Santa Fe Institute to understand that this concept is rooted in observing the returns to scale of the ‘bulk-processing, smokestack’ industrial companies of the 19th century,” the Scottish Mortgage deputy said.
“He notes that western economies have shifted ‘from processing of resources to processing of information, from application of raw energy to application of ideas’. Far from diminishing returns, today’s knowledge-based companies tend to exhibit increasing returns to scale and so, in the digital era, reversion to the mean is even less common. Returns are yet more extreme.”
Professor Ming Zeng - Network companies unleash unimaginable scale
Arthur’s work in the 1980s was a good explanation of the early days of both Silicon Valley and Microsoft, but Burns said professor Ming Zeng – who was appointed Alibaba’s chief strategy officer in 2006 – offers insight in the economic reality of tomorrow.
“For Ming, the greatest superstar companies of the future will be what he calls ‘smart businesses’ harnessing network coordination and data intelligence. These organisations will look less like a company and more like a network,” the manager said.
Ming argues that the traditional conglomerate tends to collapse when it reaches a certain complexity but “the future of business is more biological rather than mechanical”.
Burns pointed to network companies like Amazon, Lyft and MercadoLibre, which are accumulating so much data intelligence in real-time that they can adapt to conditions and evolve in ways that traditional businesses never could.
“The larger these network companies become, the more data they have and thus the more intelligent and effective the network can become,” he added. “If Ming is right, then it is logical to assume the importance of superstar companies will grow even further with the application of machine learning.”
Martin van den Brink - Extending Moore’s Law
For Burns’ final point, he argued that one of the most important determinant of whether companies can continue to be ‘superstars’ is if the pace of change in the world increases or decreases.
He believes that the conditions for change will persist and cited Moore’s Law – which is a projection that for the same price, computing power would double every 24 months. This projection has held true for the past 50 years and is now seen as a ‘law’.
This means that by the early 2030s computing power should be at least some 60x more powerful than today for the same cost. This has massive implications for industries across the board – assuming Moore’s Law continues to hold true.
To give confidence that this law will apply to the future, Burns pointed to the insights of Martin van den Brink, chief technology officer at ASML. Dutch company ASML is the world’s largest supplier of photolithography systems for the semiconductor industry and its products have been instrumental in increasing computing power in recent times.
“Van den Brink makes two points. First, that Moore’s Law is older than we think. It dates back not 50 years but an entire century in all but name to when computing power was vacuum tube rather than transistor based. His second point is even more significant and far reaching, because he believes ASML already has the technology roadmap in place to ensure Moore’s Law extends into the 2030s,” Scottish Mortgage’s new deputy manager said.
“It therefore perplexes me why with the power and predictability of Moore’s Law, our industry decides instead to focus far more on what interest rates or GDP growth rates mean for investing. Frankly, I think we would all be much better investors if we concentrated on the future implications of Moore’s Law. A 60x increase in computing power will profoundly shape our world. The question we must grapple with is what this new world will look like.”