19 Jun 2020
Beyond the pandemic – identifying the true growth companies of the future
Understanding the concept of increasing returns to scale is crucial in identifying the growth companies of the future, argues one of the world’s leading growth investors.
This discussion was recorded on a video conferencing platform. Due to varying Internet speeds, there are some instances where the visuals do not sync with the audio. Please note, you also have the option of listening to the chat on the podcast below.
James Anderson, investment manager and Partner, Baillie Gifford, is well known for being one of the world’s leading growth investors. Through the Scottish Mortgage Investment Trust, which Baillie Gifford manages, he has been an early investor in the likes of Alibaba, Amazon, Tesla and Tencent, examples of so-called exponential technologies. Baillie Gifford also manages money in Investec Wealth & Investment's World Axis portfolios.
Anderson was a guest of Investec Wealth & Investment’s webcast entitled “Paradigm shift acceleration – did we just skip a decade of digitisation?" in the "Markets and investments in the time of Covid-19" webcast series. Anderson was interviewed by Max Richardson, senior investment director, Investec Wealth & Investment, UK.
Given the above investments, Anderson is in a good position to give insights on the growth companies of the future, particularly those that can capitalise on increasing returns to scale (in layman’s terms, this refers to the ability to enjoy higher rates of output without having to increase rates of input). An example is Netflix, a firm that is not bound by traditional physical restraints on inventory, such as a traditional video store.
While the focus currently is on the tech giants noted above, many of them beneficiaries of the global lockdown following the start of the Covid-19 pandemic that has forced people to remain at home, Anderson looks more broadly at the trends shaping our futures. He draws on the work of economists, scientists and historians to build his view.
Prefer to listen on the go?
Listen to the full podcast discussion on digitalisation with James Anderson and Max Richardson here.
I think we will see 2020 as the beginning of the end of carbon.
Understanding exponential change
One of the experts he references is the late Hans Rosling, author of the famous book “Factfulness”. Rosling, Anderson notes, spent a great deal of time studying highly contagious diseases like Ebola, and warned that pandemics were one of the greatest threats to what he called the secret, silent progress of humanity.
One of the lessons of pandemics however, is the way they help us to understand exponential growth.
“It’s the understanding of the dynamics of exponential change that really matters,” says Anderson. “That secret, silent miracle that he talks about is that underlying tick-tock of change that you see and that you mustn't interrupt by putting arbitrary headlines or timeframes about it. It’s cumulative and is critically important in thinking about investment too.”
Anderson believes that the most important developments are often those that you do not see in the news. He notes that humanity has seen thousands of pandemics through history, meaning that the current one may not be the turning point that many people say it will be.
“We may find that when we look back on 2020, the profound turning point, which is much more unusual than a pandemic, will have been an energy transition,” he argues. “I think we will see 2020 as the beginning of the end of carbon.”
Lessons from investing in Tesla
Historically, energy transitions have taken decades, but the current transition could end up being considerably faster. Referring to learning rates (defined as the reduction in cost for each doubling of cumulative production or capacity), he says solar energy currently has a learning rate of about 40% a year and may accelerate further.
He says this compares with the learning rate of between 15% and 25% assumed for the whole gamut of solar, wind, battery storage etc, back when Baillie Gifford invested in Tesla in 2013.
“When we started [with Tesla] we thought if you could do it within a 15 to 25% range, you've got a 75% chance of success at some point.
“Now, given that we've had more years of experience of it, we know it's accelerating, we know the capital availability is there, we know the plans of the companies involved, we are asking: isn't this above a 90% probability of happening?”
He adds on the energy transition: “You know it can change the nature of society - I daren't think we know precisely how it will - but I think the dimensions of this go a long way beyond, you know, BP writing off a few things and the value of Tesla being higher than other car companies.”
Rising tech centres of the world
Anderson also spends time analysing the role of key cities throughout history in driving change, in ways that countries cannot. The obvious modern example is Silicon Valley, with its links to the 1960s counter culture, blossoming into the tech centre that it is today.
But he cites the examples of cities like Amsterdam and Berlin, both with long histories as centres of power, but which are now shaping the future of tech and other industries.
“Berlin is a very interesting example of a city that has been through immense pain and had no corporate sector, but because of its unique history, could invent a new set of companies which, to be frank, show much more sign of hope for the future than much of traditional industry in Germany,” he explains.
“In Scottish Mortgage we have three major, successful investments in Berlin. In all three cases, these are companies that are much less hierarchical, much less formalised, much less incremental forms of business than those practised in Munich, Frankfurt, Hamburg or wherever else.”
Increasing returns to scale
Back to the tech sector, he argues that the concept of increasing returns to scale is perhaps not given the attention it deserves, despite the success of many firms in maximising their returns to scale in this way.
Citing the example of Microsoft, he says: “The cost of replicating one piece of software is very marginal. So while you may have to put this huge effort in at first into research that goes through the income statement – and hence you accept that the company may lose money at the start – what you're left with is an immensely profitable business in terms of the gross margins on any replication of that."
“The challenge now is how much the businesses of the future (or how much of the market capitalisation of the future) will obey the laws of increasing returns to scale, versus how much will follow the traditional model that Henry Ford would have recognised,” he says.