Which investment philosophy wins? In the red corner, patient investors James Anderson and Tom Slater of Scottish Mortgage trust, and in the blue corner, Merian’s flexible investor Ian Heslop.
We operate within an impatient industry, which often seems as if it has forgotten its underlying purpose. As managers of Scottish Mortgage investment trust, our job is simply to take capital from those who wish to invest and funnel it towards the businesses that can best use it, in the search of profitable returns for all.
We search for strong, well-run and growing companies, public or private, based on the attractiveness of their fundamental operating economics and competitive advantages. We then try to hold such businesses at sufficient scale over time to make a difference for our own shareholders’ returns. They can be in any industry and from anywhere in the world, as the best opportunities vary in nature over time. This flexibility allows us to adapt to the structural changes occurring in the world and is inherent to our longevity.
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Patience is a virtue
Investment requires patience. Any business owner knows that entrepreneurial progress takes time and is rarely a smooth path. We therefore view it as critical to try to support businesses in their extraordinary endeavours and ambitions, especially when the daily news tumult or the inevitable operational challenges try to blow us off course. Making judgements on managerial excellence or the potential for sustainable competitive advantage is only worthwhile over a suitably long-term timeframe. Anything less is merely speculation.
A long-term investment horizon is crucial, too, if you are to accrue the benefits of compounding returns. Once we find good companies, we anticipate holding them for many years. Our low average portfolio turnover of under 12% per year is the proof that we actually do this. Our longest investment, Swedish industrial company Atlas Copco, has been held continuously since the 1980s, and over 60% of the current portfolio has been held for more than five years.
Scottish Mortgage shareholders need to share this patience; the trust is not suited to impatient investors looking for a quick turnaround or smooth path. The best rewards will only come to those who can endure. We try to maximise Scottish Mortgage’s own competitive advantages, using the investment company structure to invest in private and public businesses, but also by utilising Scottish Mortgage’s scale to keep the cost of accessing these investments as low as possible for our shareholders.
Academic work on the past 90 years of US stock returns shows that the best-performing 90 companies out of a total of around 26,000 accounted for over half of the excess return from equities over that period. A handful of exceptional companies had an outsized impact, consistent with their persistent dominance in the real world. These findings are consistent with our experience of investing globally.
They highlight the fundamental attraction of actual investment in companies: the downside is limited to the capital invested, but when companies compound their growth over the long term it is possible to make many times your investment, skewing the balance of risk and reward in the patient investor’s favour. Our portfolio is therefore relatively concentrated, with around 80 holdings. We are unashamedly trying to uncover just that small number of companies and hold them.
The broad global index and its short-run gyrations therefore merit little attention from us. We have distinct feelings of apathy towards our industry’s constant angst over such volatility, which is often mistakenly conflated with ‘risk’. True investment risk is the permanent destruction of capital value where an industry background or a company’s execution/competitive advantage is not what we had imagined. We acknowledge the uncertainty inherent in investing, accepting that not all will come to pass as we hope. We try to minimise the very human reality that we will make mistakes. But we do not spend time trying to ‘beat’ the market and its mood swings. That is a very different task.
We actively search for stock-specific ‘risk’ and then diversify this, through investing in a wide range of businesses. Scottish Mortgage may be best-known for its investments in Amazon, Alibaba and Tesla, but there are plenty of other exciting businesses in the portfolio addressing specific and large markets such as the genomics revolution in healthcare (Illumina, Grail), the transformation of financial services (Ant International, Transferwise), digital media (Netflix, Spotify), food consumption and production (Meituan, Grub Hub, and Indigo Agriculture); and transportation (NIO, Full Truck Alliance and Lyft).
What all our investments tend to have in common is the fact that they are the companies leading change in their industries, driving progress. Scottish Mortgage aims to help its shareholders share in the benefits of the success of their endeavours.
James Anderson and Tom Slater, fund managers, Scottish Mortgage.
Merian Global Investors
admit that for some private investors, buy and hold, or holding onto stocks for a long time, may be a fairly good strategy. It could reduce their trading costs, because the number of transactions will be relatively small. It could also help them avoid some behavioural or psychological biases which can detract from returns, such as the bias of herding.
This is when investors thoughtlessly chase short-term market movements: it leads investors to panic and sell after market falls, and to become over-confident and buy at the top of rallies. Herding has recently been evident in markets, which over the last year have become more volatile and changeable than they were previously.
However, there are plenty of reasons for not adopting a buy-and-hold strategy, at least not when running a fund. Sometimes buy and hold is presented as if it were a moral virtue: we are told that a long-term investment horizon is good, and that short-termism is an evil. This argument is based on a simple confusion between investment horizon and trading strategy – it is perfectly possible to combine a long-term investment horizon with a shorter-term trading strategy. We all want to optimise our returns over the long term, but that does not necessarily mean we have to hold individual stocks for long periods. More important is to hold the right stocks during the right periods.
Let’s look at some reasons why holding stocks for a long time may not always be a good idea and why adopting a flexible investment strategy can be beneficial. I shall draw on behavioural finance, a discipline that seeks to explain investors’ cognitive and emotional errors.
Behavioural finance is a useful corrective to the ‘efficient market’ hypothesis of traditional economics, which portrays investors as sublimely rational wealth maximisers, and share prices as perfectly and instantaneously reflecting all information.
Recent financial theory has moved beyond the efficient market hypothesis, but you do not need to be a finance expert to see the problems with it, because it flies in the face of common sense. Is anyone you know completely rational all the time? Can they instantaneously process all information? In the real world, investors are driven not only by reason but also by emotion. By studying how investors actually react, and how real (rather than theoretical) markets behave, we can seek to exploit inefficiencies in market pricing.
One behavioural bias is known as conservatism (with a small ‘c’). Under this bias, beliefs are insufficiently revised even when new evidence is presented. What does the buy-and-hold investor do when new evidence emerges against their previous investment case?
A type of conservatism that I believe to be widespread in markets is rigidity of investment style. An example of an investment style is a value style, or buying relatively cheap stocks. Value investing has outperformed over the last 100 years, attracting academic interest and leading some investors to strongly believe in it as a long-term strategy. However, this is of scant comfort to those who have suffered from the value style’s significant underperformance during the last decade, when cheap stocks have got even cheaper.
Another behavioural bias is the endowment effect. People tend to value something they own more highly than something they do not. Buy-and-hold investors are in danger of succumbing to this behavioural bias: it can lead them to hold underperforming stocks for too long and fail to form a fair view of them.
The merits of flexibility
Although stocks are rights to ownership in companies, they can be dominated by market- rather than company-specific factors. In running funds, my team and I see ourselves as temporary holders of stocks, and we seek to use them to take advantage of changes we observe in the market environment.
We favour a dynamic process, which means responding to market changes by flexing our investment style. We use elements of a value style, for example, when we believe the market conditions are right for it; but we use elements of a growth style (buying shares in faster-growing companies) when we believe the market environment has moved on to favour that style instead. By being style-agnostic, and by flexing our style, we aim to earn better returns across different types of market than we could by buying and holding.
Ian Heslop, head of global equities, Merian Global Investors.