At just 54, Charles Plowden, chief of investments and one of two senior partners at Baillie Gifford, is almost half as old as his firm, which got its start in Edinburgh in 1908 and which Vanguard hired in 2003 to run a portion of its Vanguard International Growth Fund (MUTF:VWIGX).
In 2008, Baillie Gifford also took over portions of the Vanguard Global Equity Fund (MUTF:VHGEX) and Vanguard Growth Equity Fund (MUTF:VGEQX) (which was merged into the Vanguard U.S. Growth Portfolio Fund (MUTF:VWUSX), of which Baillie Gifford still runs a portion).
Charles Plowden and two of his partners run one-third of Vanguard Global Equity’s assets to mimic Baillie Gifford’s Global Alpha strategy, which has consistently outperformed Global Equity as a whole.
Jeff and I discussed all of this and more with Charles Plowden last month.
Charles, can you explain Baillie Gifford’s perspective on growth investing?
When we think of growth, we really are talking about above-average growth. We are only interested in companies if they have the potential to grow at double-digit rates over the long term. The long-term global average is 7% or 8% nominal earnings growth. And so we are looking for, let’s call it the top quartile of that, so 10% plus. We see different growth styles.
A “growth stalwart” is very steady, predictable growth, but pretty much close to 10%. So, that’s a PepsiCo, Inc. (NYSE:PEP) or The Coca-Cola Co (NYSE:KO), tobacco companies and Colgate-Palmolive Company (NYSE:CL). There’s the high degree of certainty year to year about their performance that risk-averse investors like. Typically they are cash generative, and they do pay dividends, though they don’t have to. That sort of growth can be above average, but tends to fall in and out of fashion in terms of stock markets. At the moment, we see that sort of reliable stock as pretty pricey.
The next category are “classic growth” stocks — the rapid growth stocks whose top lines are growing rapidly — often where demand is very strong. The big U.S. examples would be Facebook Inc (NASDAQ:FB), Amazon.com, Inc. (NASDAQ:AMZN) and Google Inc (NASDAQ:GOOG). These are companies that are capable of 15% to 25% per annum sustained growth rates. Again, with those companies, they go in and out of fashion, and they typically trade for high multiples.
The rapid growth companies’ prospects are higher risk, less certain, particularly than the growth stalwarts. We think in today’s market environment, investors are not fully appreciating those sorts of companies because of the element of uncertainty. The likes of Amazon or Google we consider to be attractively priced at the moment and in both cases have added to over the last few months.
The next growth category is “cyclical growth.” The first two [categories] I talked about typically are regular year-on-year growers — they either have it or they haven’t. It doesn’t tend to go up or down with economic cycles. Whether GDP is 2% or 3% is not really going to have a noticeable difference to Amazon. Whereas if you are a highly geared [leveraged] bank, you are geared into GDP — there is a cyclical element to it. So, these companies don’t grow every year, and they may not be growing at the moment, but we can see through the cycle that they can add value and outperform their peers. Our cyclical exposure is very often in companies that try and benefit by investing at the bottom of a cycle and holding off at the top.
The last is “latent growth” stocks, which are companies that have minimal operational momentum. Their last five years, maybe even 10 years, looks pretty terrible, but we believe there can be a growth stock in there waiting to get out. A change either on the supply side or the industry structure or the demand environment or maybe through a technology means the future is going to be very different from the past. There aren’t so many of these because real dramatic change doesn’t happen to very many industries or companies at any one time, but when we can find them, we are very excited.
Can you give me an example?
Only this morning I had a meeting with [a latent growth company], one of the biggest Japanese non-life insurance companies, MS&AD. That industry has gone from 18 players to three over the last 15 years. These three players have 90% of the market between them. This bodes very well for future pricing, competition and returns because all three are focused on profitable underwriting. No one is fighting for market share — so, it’s all about profits now, and that is very different from the history.
How many stocks do you currently own and in what kinds of weights?
It’s 96 stocks at the moment. There has been [virtually] no change over the last four or five years. I wouldn’t really expect any dramatic change in the number of holdings.
The largest position is just over 4%, which is a U.S. stock, Royal Caribbean Cruises Ltd (NYSE:RCL). The next largest is 3.5%. We have the ability to run the largest positions up to around 6%, but we’ve never gotten there. And Royal Caribbean is only as large as 4% because the stock rose 75% last year. It was one of our most successful investments and we just let it run.
How big is the “incubator” in your portfolio?
About 40 stocks make up 20% of the portfolio. Typically these are our higher risk, higher reward stocks where the future does have uncertainty, and they could go very right, or they could go very wrong. But we think you make a lot more money if they go right than you lose if they go wrong — asymmetric returns. You could make 300% return or you could lose 70% of your initial investment, but that is very attractive odds in a portfolio context.
How do you decide when a company is just suffering a temporary setback rather than a permanent change in fortune?
That’s one of the most difficult things to do. You have to do it by looking at each company afresh on a regular basis — not too frequently, but certainly an annual basis and saying, “From here, do we still expect that above-average growth?” Last year, we reviewed the upside for just about every stock in the portfolio over a succession of meetings with a number of colleagues, and those that didn’t meet [our] hurdle typically have been sold or are in the process of being sold. We don’t hold onto things out of loyalty. We hold onto them because we think we are going to make money.
The danger is that if we have held something for 10 years and have a cozy relationship with the [company], we might be a little bit slow to react to a deterioration in management or strategy or market position. But being slow to react is often the right thing to do. We think you make more mistakes by being too quick to react.
Let’s talk about Europe for a bit. Many of the companies you own in Europe don’t rely on local economies for the bulk of demand. But do investors view them with an eye to European trade anyway?
We have very, very few European-listed companies that are exposed to European demand. Most are exporting from Europe or are global companies that just happen to be headquartered there.
In fact, we are beginning to wonder now, six years into an economic downturn, after the European banks have been recapitalized a number of times, after all the efforts that governments have made, whether there may be signs of things getting better at a domestic level, and whether we should actually try and consciously find some exposures to an improved European economy. Within Europe, not only are we not exposed to domestic Europe, we are also not very exposed to the eurozone. Most of our European exposure is to companies based in Scandinavia or in Switzerland, which are not part of the euro. But again, if the euro is going to be a weak currency, that is going to help euro-based exporters, and it may be that there are some euro-based companies that we should be adding to the portfolio.
In terms of Greece and the “Grexit,” as they call it here, I think it is an irrelevance. It may happen and it may not happen. I don’t think the Greeks are helping themselves at all. We have no exposure to the Greek stock market. If anything, it would probably be helpful to the euro to know that the weakest members could be expelled. The issues are political, not economic.
Does the strength of the dollar — and there seems to be a strong consensus it’s going to continue to strengthen — impact your thinking and management of the portfolio?
It has a little. We’ve had a view over the last 18 months that the U.S. was likely to be the strongest of the developed market economies and the first place to see recovery. We have been increasing exposure to the U.S. market, to the dollar and particularly to the domestic U.S. economy. We haven’t gone as far as we could have gone or indeed should have gone. Certainly that was one of the handicaps to performance for us last year.
I think I would agree with the consensus that the dollar looks well underpinned and the fundamentals remain firmly in its favor. That means one would tend to look for new ideas in domestic U.S. companies that are not exposed to import competition. And one would tend to steer away from exporters from the U.S. because they are going to have a rising cost base in dollars and they are going to be competing with cheap yen or cheap Korean won or cheap euros.
Last time we spoke, you were window shopping in the emerging markets. How is your shopping cart looking?
We are still window shopping, and we’ve probably saved ourselves some money by not actually going into the shop. Over the last year, we’ve been net sellers of emerging markets companies. We haven’t really found much to buy in emerging markets. The one market where I wish we’d shown more urgency and done something more was in India. It was just about the strongest-performing major markets last year. We were enthusiastic about everything that was happening, but we were too busy window shopping, and we didn’t go into the shop and come out with something in our bag.
Investors, pundits and even Jack Bogle have been questioning whether U.S. investors need foreign stocks at all. Why own foreign stocks at all?
I haven’t been asked that till now. The big influence in recent years has been currency rather than corporate performance. We made similar nominal returns in some European stocks or Asian stocks, but the currency has gone against them. Maybe the dollar is now getting to heights from which it could in five year’s time be weaker.
Also, U.S. listed corporations are significantly more highly valued than their international peers and competitors. So, you get less bang for your buck if invested in the U.S.
You may say that you get better corporate governance and more transparency and higher quality of company — and I wouldn’t argue with any of those particularly — but there is a premium attached to U.S. corporations. You can put all your money into one of the most expensive currencies and stock markets, but it’s quite easy to envision circumstances where that could work against you. Just because it’s worked for you over the last four years, that might well change at some point.
The other helicopter view is there are twice as many companies outside America as there are inside. There is more choice. And that suggests you can add value through picking the very best international companies.
Well, thank you for your insights, Charles.
Daniel P. Wiener is editor of The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard and the annual FFSA Independent Guide to the Vanguard Funds.