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The A.G.E of European equities

 Robert BaltzerTom Coutts explains how he goes about identifying and building a collection of world-class businesses that just happen to be based in Europe Investors are facing a challenging financial environment with ultra-low interest rates, quantitative easing, competitive devaluations, and equity market volatility that lurches from fear to greed and back again. We have built our investment process on three foundation stones: Alignment, Growth and Edge 

Investors are facing a challenging financial environment with ultra-low interest rates, quantitative easing, competitive devaluations, and equity market volatility that lurches from fear to greed and back again. 

  • We have built our investment process on three foundation stones: Alignment, Growth and Edge

  • We believe that part-ownership of listed companies provides you with an opportunity to benefit from human entrepreneurship and imagination

  • In the long run, stock markets should rise – albeit not smoothly 

“I’m talkin’ about friendship. I’m talkin’ about character. I’m talkin’ about – Hell, Leo, I ain’t embarrassed to use the word. I’m talkin’ about ethics … It’s a wrong situation. It’s gettin’ so a businessman can’t expect no return from a fixed fight. Now if you can’t trust a fix, what can you trust?”

Spoken by gangster boss Johnny Caspar, these are the opening lines from the Coen brothers’ film Miller’s Crossing. When we look around and survey the financial environment, with near-zero interest rates, quantitative easing, competitive devaluations and equity markets lurching from fear to greed and back again we are reminded of Caspar’s pleading words. Parts of the financial market today feel to us like a fixed fight – or perhaps a fight that central bankers and other authorities are trying to fix.

How then to answer Caspar’s question – what can you trust? Well, we believe you can trust in human ingenuity and creativity and that owning equities offers the chance to share in the financial fruits of these characteristics. There will, of course, be share price declines as well as share prices rises, but those declines only become actual losses if people sell – because, provided you do not sell, the precipitous, headline-grabbing market falls such as we have been seeing are little more than noise.

In the long run, stockmarkets should rise – albeit not smoothly. And in the long run, the stock prices of growing companies with a competitive advantage that are run by honest people who are aligned with their customers, their employees and their shareholders should, we believe, rise by more. In order to give ourselves the best chance of finding such companies in the European market, we build our investment process on three foundation stones: Alignment, Growth and Edge.

Alignment Alignment matters in several ways, but perhaps the most critical is what is known as the principal-agent problem. This arises from the differing objectives of the principals – in other words, the owners of the firm – and the agents – the people responsible for managing it. One of the best studies of this problem was a 2005 paper by John Graham and others studying the decision-making preferences of chief financial officers of publicly-listed firms.

This concluded in a rather depressing manner: “The majority of managers would avoid initiating a positive NPV [net present value] project if it meant falling short of the current quarter’s consensus earnings. Similarly, more than three-fourths of the surveyed executives would give up economic value in exchange for smooth earnings … Managers are willing to sacrifice economic value to manage financial reporting perceptions.”

This distortion of behaviour caused directly by the stockmarket is one of the key challenges faced by listed companies and it means we need to be very clear about the motivations and the character of the people who manage the companies in which we invest our clients’ money. The risk is less that of actual embezzlement – though that does of course occur – and more to do with a steady drip-drip of decisions taken with half an eye on the executive’s own interests over the next quarter or two, rather than the interests of the company and its shareholders over the next decade or two.

“The prices of financial assets rise and fall but high-quality growth companies endure.”

One way to mitigate the challenge is by asking, when we research a company – is there an inside owner? Such owners come in many forms in Europe: a founder, a family, a holding company or perhaps a foundation. Not all exert positive influence. But we have found over the years that investing alongside such influential long-term owners has brought real benefits to our clients. Typically around 60% to 70% of our portfolio is invested in companies with this type of ownership and governance structure. Incentives matter. Alignment matters.

Growth We are growth investors. What this means in practice is that we expect to make money for our clients through growth in the underlying profits and cashflows of the businesses in which we invest, not through changes in the value placed on those profits by the stockmarket. This is not to suggest our way of going about the task of investing clients’ money is better than any other, it is merely that this is how we have chosen to do it. As London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton have shown, the annualised real return since 1900 for a (retrospectively constructed) global stockmarket index is 5.2%.

Acknowledging the risk of extrapolation, and assuming long-run inflation of 2% or so, this suggests to us that we need to be aiming for growth in intrinsic value of 10% or more from the companies in which we invest. We fully expect to be measured by our clients by our long-term record against a representative European index but, as countless people have observed down the years, relative returns do not pay the bills.

We therefore consider it both a useful discipline for us, and a useful way of framing our clients’ expectations, to think in terms of an absolute level of return. To put it simply, we may be judged by the strength of our returns relative to the benchmark, but we serve no useful purpose as investors unless, over the long run, we deliver attractive absolute results for our clients and absolute growth in the value of their financial assets.

Edge The last element of our three-letter acronym is Edge, the competitive advantage a company has – or, in many cases, does not have. It is in the search for enduring corporate excellence that we spend our time, analysing companies in order to learn more about them and deepen our understanding of the elusive elements that combine to make up a company’s competitive advantage.

There is no magic recipe – no secret sauce. There may be patterns that repeat themselves within an industry – in branded consumer goods, niche industrials, financial services and so on – but the only really unifying factor is an absolute focus on serving the customer well. That is as true of Ryanair, whose customer proposition of value, efficiency and choice is absolutely clear, as it is of more obvious examples, such as L’Oréal or Nestlé.

As business management expert Peter Drucker wrote 30 years ago: “‘Quality’ in a product or service is not what the supplier puts in. It is what the customer gets out and is willing to pay for. A product is not ‘quality’ because it is hard to make and costs a lot of money, as manufacturers typically believe. That is incompetence. Customers only pay for what is of use to them and gives them value.” Simple as they may be, these words explain perfectly the difference in long-run business performance and share price returns between Ryanair and, say, British Airways.

Conclusion Returning then to our initial question, what can you trust? Well, we think you can trust that part-ownership of listed companies gives you an opportunity to benefit from human entrepreneurship and imagination. We further believe that owning a subset of those companies that exhibit certain enduring characteristics – a growth opportunity, a competitive edge and a far-sighted management team – will lead to outperformance of that index in relative terms and to good absolute returns too. Volatility comes and goes.

The prices of financial assets rise and fall but high-quality growth companies endure. Baillie Gifford’s European Fund is not a play on the European economy or on the European markets, it is a collection of world-class businesses that happen to be based in Europe. It is our belief that owning them over the coming years and decades will deliver good long-term returns to our clients.

Tom Coutts is head of European equities at Baillie Gifford and investment manager for the firm’s European Fund. For more articles, white papers and fund presentations from Baillie Gifford’s investment experts, please visit the Intellectual Capital website

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