QD view – In defence of growth

Edinburgh Worldwide recently published its annual results – covering the 12-month period to 31 October 2022 – and the figures are not great, by James Carthew

 
Over the period, the NAV fell by 40.3% and the share price by 46.0%. The fund benchmarks its performance against the S&P Global Small Cap Index and this returned -6.8% over the period.

The reasons for this are obvious – the selloff in growth stocks that has occurred since interest rates started rising to choke off inflation. The big question though is: as inflation eases (which it clearly is), will growth-focused trusts like Edinburgh Worldwide recapture the ground that they lost in 2022 and move on to new highs?
 

EWI is yet to recover

 
To some extent, you might suppose that this would already be happening. After all, funds such as Chrysalis are already well off the bottom. Its share price is 73% higher than it was on 12 October 2022. That has not happened yet for Edinburgh Worldwide, however. Over the same period, its share price is up just 10.3%.

The introduction to the managers’ report in Edinburgh Worldwide’s results statement takes a big picture view. It raises some interesting points which might be worth unpacking here.
 

Four observations

 
The first is to resist the temptation to believe that investing “can be distilled down to a simple equation with neat outputs and defined probabilities”… “such an algebraic approach is a fallacy – the path of equity markets over the past ten years is testament to this”.

That might seem obvious, but there is a tendency amongst investors to seek patterns where there are none and seek comfort in forecasts – for economic growth, earnings, election outcomes and the like – which may be wildly inaccurate.

Markets have been volatile in recent years because unexpected events have caught investors off guard. The managers make the point that the two main ones – COVID and Ukraine – have second-order effects that have created economic instability elsewhere with rippling out effects, many of which are yet to fully play out. This has highlighted the futility of attempting to time markets.

These ‘black swan events’ highlight vulnerabilities that can be factored into models of economic forecasts – the degree to which an invasion of Ukraine makes a Chinese attack on Taiwan more or less likely, for example. However, other things will come along to knock markets sideways. Downside/volatility insurance is expensive and eats into returns. There is not much that investors can do to protect themselves beyond ensuring that their portfolios are adequately diversified, but this is not bulletproof as assets tend to become more highly correlated during periods of market distress.

Second, Edinburgh Worldwide’s managers feel that “the current instability in markets is sculpting a new investment backdrop, one where capital is less freely available, the hurdle rate for returns is higher and the tolerance of uncertainty is lower.”

I’d concur with this, put simply when investors’ perception of risk is heightened, they demand higher returns. For decades now, governments/central banks appear to have been fearful of weak/volatile markets and have gone out of their way to smooth out the bumps in their economies. The best example of this has been the idea of the ‘Fed put’ – interest rate cuts designed to bolster confidence in the US economy – but it has taken other forms too such as quantitative easing. This sticking plaster approach has distorted returns and companies’ balance sheets, and created an environment where risk taking and speculation reached excessive levels – fuelling bubbles like Crypto and meme stock-investing. We talk to a lot of ordinary investors in the course of our business, and nothing is as depressing as the investor who thinks that every investment should go up 10x and it is easy to make a fast buck. As David Johnson here points out – FOMO is not a viable investment strategy.

Last year investors’ attitude to risk swung a long way against growth to the benefit of value-style funds. We understand the attractions of near-term cash flows (in the form of dividends) in a period of higher interest rates – this has been a big factor in the resurgence of value strategies over 2022. The median UK equity income trust returned 2% over the past 12 months versus –7% for the median UK all companies trust.

What is harder to fathom is the recent vitriol directed at growth managers by some investors. They were transparent about their investment approach, and it is unreasonable to suppose that they should have seen the degree of the shift in the economy coming (or even, given what we said about market timing above, repositioned their funds accordingly).

Third, the managers believe that “the whims of a stock market can come and go but the legacy of innovation remains and is all around us.”

After a period of underperformance, it might seem an easy defence to say – we are long term investors, you need to judge us in terms of five- or 10-year periods. However, Edinburgh Worldwide has always stressed that it is seeking to identify and back tomorrow’s leading companies. These businesses take time to mature and may often lose money/consume cash for many years before coming good. Not everything will make it, but the aim is that the rewards for the ones that succeed are a multiple of the money lost on those that fail.

As the managers stress, there is no shortage of innovation to get behind. Technological and medical advancements appear to be accelerating. Many of these spell real trouble for incumbent large and currently profitable businesses – tomorrow’s value traps. It is possible to pick holes in individual stock selection decisions, but if the managers are correct, the future for the portfolio as a whole is still bright.

Finally, the managers conclude that “The decade long era of abundant and overly cheap capital has run its course. The premium placed on stable long-term capital will be higher”… With “the supply of capital restricted, we see greater opportunity for our analysis to actively focus on companies that are in a capital consumptive phase of growth.”

That is an acknowledgement that ultra-low interest rates and a laissez-faire attitude to risk are a thing of the past, for a few years yet anyway. We talked about Ruffer’s views on markets in last week’s show (click here to view). Its idea that inflation may be harder to eradicate than many think rings true to us.

We think that the managers’ job has got harder in the current environment because even companies with great potential might find that they run out of money. Edinburgh Worldwide’s closed-end structure will help a great deal in this environment, writing cheques where open-ended investors cannot, and so dictating terms. Companies may find it easier to tap private sources of capital instead, and the trust’s ability to back unlisted companies might become increasingly useful. It may be a hard slog, but there is an opportunity here for the managers to lay the groundwork for the next phase of the trust’s outperformance.
 
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