Investors should be careful not to fall for the media narrative that they should be trying to outsmart their peers, as this risks distracting them from what should be their core aim: buying and holding businesses capable of delivering the highest growth over the long term.
This is according to Douglas Brodie, manager of the Edinburgh Worldwide Investment Trust.
Brodie said that if you engage with the media in any format today, you are likely to be bombarded with a never-ending stream of news telling you that something important, and often negative, is currently taking place. He noted that this is likely to reinforce any biases you may have, creating casualties of “patience, perspective and positivity”.
Yet Brodie said the financial world had a similar problem long before the roll-out of online and 24-hour news.
“For the best part of 40 years, you've had armies of analysts and investment banks micro-analysing tiny trends in businesses and feeding guidance to their audience,” he claimed.
“[This has been] with the notion of beating consensus over ever-tighter periods and a whole exercise that's really shifted right of the decimal point.
“It's ended up with something that's become increasingly short term and increasingly reactionary. And it's arguably pushed finance down a route that's probably served its own needs more than it has its clients’.”
He added: “Much like what we've seen recently in media and politics, it has meant that investment has become ever more distorted, somewhat abstract and actually quite removed from its core purpose.”
The core purpose of equity investing, according to Brodie, is “beautifully simple”. The manager pointed to a chart showing earnings growth versus share price performance over 25 years, split into rolling five-year periods. He noted that if you separate companies by earnings growth into quintiles, the fastest growing performed by far the best for investors, while the slowest growing performed by far the worst. This relationship goes beyond investment cycles, with Brodie saying he couldn’t find a single five-year period where this pattern didn't hold.
“In the short term, I get it,” he continued. “There are multiple things that drive share prices: news, technical factors and so on.
“But in the long term, it is actually simple – arguably beautifully simple. Your job as an investor is to try to get ahead of that, predict where that growth is going to come and position yourself accordingly.”
The problem with accepting this as your investment objective is that it means you then have to take on the task of predicting the long-term direction of societal and economic trends, and the industries and companies that will shape and benefit from them.
Brodie said this can be a daunting task as it takes you into a “sphere of uncertainty and projection”. However, he said that regardless of how uncomfortable this process can be, it is an unavoidable part of long-term investing, with no shortcut.
“At the end of the day, it's not a game of trying to outsmart other investors,” he explained. “It's not a game of you versus the index. It's not calling cycles. It's not faddish valuation methodologies that come and go.
“It's recognising that industries and societies undergo profound change over decades, if not multiple decades. And while some of the [investment headlines] do feed into that, they don't ultimately define that human ingenuity, entrepreneurial flair, technology, progress and innovation which are key contributors.
“You need an investment process and philosophy that embeds that stance, one that emphasises the long term, one that emphasises patience. And if you do that, then growth and the compounding effect of growth can really come to the fore.”
Brodie said there are other problems that have arisen due to the short-termism in the industry. One of the most problematic is that it doesn’t allow analysts to accurately gauge the importance of asymmetry to returns.
Performance of trust's stocks under manager
Baillie Gifford’s managers often refer to the work of professor Hendrik Bessembinder from Arizona State University, which shows that half of the wealth created by the US market from 1926 to 2016 came from just 0.4 per cent of companies – and that the majority of the other stocks underperformed bonds.
And Brodie said that is not the only way in which asymmetry of returns is overlooked.
“Investors tend to think of percentage of returns, not dollar value created,” he explained. “But if you do that [as well], the ability of smaller businesses to drive returns becomes very real.
“Think of the example that you create the same dollar value in a company growing from $1bn in size to $50bn in one going from $50bn to $100bn. But one is a 50x return and one is a 2x return.
“So if you get into these businesses early, it tends to be terrifically powerful. To draw that together, growth matters, picking great companies matters, attaining those companies matters, and everything else is largely noise. And you have to filter it accordingly.”
Although Edinburgh Worldwide looks for companies of less than $5bn in size, it is not a conventional small-cap investment trust. Brodie aims to run his winners to harness the sort of upside potential mentioned above, meaning the trust will eventually become a multi-cap vehicle.
However, this is not just a case of investing in small companies that are growing – in a previous article on Trustnet, deputy manager Svetlana Viteva pointed out that most smaller companies are destined to stay small.
Instead, Brodie and his team looks for businesses with a particular set of characteristics.
“To keep it simple, we love businesses that are out there trying to solve very large problems,” the manager continued. “These are companies using a technology toolkit to innovate and disrupt, to be pioneers of new ways of addressing what are often decades-old problems. These are mission-led businesses, they are not your typical small businesses which are trying to plot away with a commoditised product and a generic offering, with lots of companies doing the same thing.
“The bigger that problem, the more ambitious the company, the more likely we are to sink time and resource into understanding it. These are the companies that can make a difference both in terms of how the world will look in five-, 10- or 20-years’ time. But they are also the ones that, if I get it right, will reward the patient long-term investor.”
Data from FE Analytics shows Edinburgh Worldwide Investment Trust has made 326.68 per cent since Brodie took charge in January 2014, compared with 140.54 per cent from the MSCI World index and 80.66 per cent from the IT Global Smaller Companies sector.
Performance of trust vs sector and index under manager
Source: FE Analytics
The trust is on a premium of 0.56 per cent compared with 2.19 and 1.72 per cent from its one- and three-year averages.
It has ongoing charges of 0.72 per cent.