The 2020 performance of Scottish Mortgage Trust (managed by James Anderson) was truly exceptional. 110% is by some distance the biggest 12-month appreciation any portfolio holding has achieved.
A question now for most investors being have certain investment themes done too well? Have prices risen so far there’s danger of significant declines from excessive highs?
Indeed, James Anderson has at times been called a momentum manager, which really means trend follower. This implies he has ridden a wave which possibly lacks substance and longevity. A number of seasoned market commentators doubting the sustainability in technology stocks believing valuations excessive. There are growing predictions of a pivot back to a more classic value orientated market; the value index having had a dire 2020. In fact, a pretty lacklustre last decade.
So, with the above in mind, we have written a ‘short history of a few things’ piece to compare and contrast the ‘value’ investing style of Warren Buffett, the old king and the ‘growth’ strategy of James Anderson; the new ‘great pretender’?
To think differently
The human brain is an information processor designed to pattern match successful outcomes, prioritising personal safety. It is not in the wiring of most to be significantly creative.
Hyper ‘creative’ people are rare, they can imagine what does not exist and make it reality. From their ranks, the best become our legends.
Da Vinci, Mozart, Shakespeare, Newton, Marie Curie, Einstein, Lennon, Jobs, Bezos and Musk as well-known examples.
One of, if not the most successful investor of all time, is Warren Buffett.
Anyone serious about the discipline has studied his career and pored over his shareholder letters.
Warren is a disciple of Ben Graham who wrote the book on value investing ‘The Intelligent Investor’ in 1949.
He understood that the true value of a company is a function of a company’s ability to generate cash flow in the future for its shareholders. This conceptualises owning shares as buying a fractional right to all future profits of that company.
His genius was synthesising a model for Berkshire Hathaway (his investment company) using upgraded value investing principles allied to a novel way of financial engineering, to create a wealth compounding machine.
I first attended a talk by James about 12 years ago, right before LWM was starting. I had researched the fund but to hear him was to know he was exceptional. We have invested in Scottish Mortgage since day 1.
The last time I saw him was mid-2019, giving the keynote address at the Frostrow conference. In his presentation he questioned the relevance today of Ben Graham and ‘value investing’ but more of that later.
James Anderson could not initially appear less like Warren Buffett as an investor.
He has built Scottish Mortgage as a vehicle to explore and invest in a world of accelerating technological change. Possibly he is best understood not so much as a fund manager but a highly intelligent, inquisitive and passionate seeker of outstanding creative minds. In essence the investing Renaissance Man.
His core investment insights are:
- The outperformance of general indexes compared to fixed interest securities is from the outsized growth of a small number of companies. The goal has been to identify and invest in these.
- Growth can be greater for longer than most intuitively believe.
- He invests in companies and people changing the world in positive ways, believing financial reward will probably follow.
- He looks to identify business leaders of vision, integrity and ability.
- He is comfortable that some investments will perform poorly or fail. Losses are limited to one times’ capital, but gains can be many multiples.
In addition, he is a strong critic of excessive charging. The Scottish Mortgage AMC being 50-70% lower than comparable funds with no performance fee.
Industrial revolutions: a changing world
1st – 1780s Steam power, industrial mechanisation
2nd – 1900 Oil, Electricity, Automobile, Plane
3rd – 1950s Nuclear, Telecoms, Television, Microchip.
4th – 1980s Personal Computer
5th – 1990s Internet
6th – 2000s Human Genome mapped
7th -2010s Artificial Intelligence
Between revolutions 1 and 2, over a century.
2-3 50 years
3-4 30 years
4, 5, 6, and 7 inside decades. All related to the microchip.
Buffett’s peak investing years were 1975 to 1995, his performance was stellar in a period ideally suited to his model.
- Investing in companies growing consistently above the average in a time of global expansion, but in a period of no significant disruptions to business models.
- Employing cost-free leverage (Insurance premium float) in a time of high interest rates, high but decreasing inflation and strongly increasing stock multiples.
To understand the success of Buffett is to realise he is a mathematician. His algorithm designed to compound value based on a set of predictable inputs.
Essentially, he calculated the odds, investing only into knowable, highly favourable outcomes. What makes him appear magical is the compounding effects created are initially invisible. Taking time to gather momentum but increasingly powerful.
This is the same phenomenon occurring with technology which has been building for half a century.
Predictably predictable / all empires fall
The core belief for a value investor in the Buffett mould is that whilst the performance of a company or economy will undoubtedly fluctuate, sometimes deeply depressing prices, the upward trajectory of growth and earnings for elite businesses stay predictably positive over time.
This stays true though only if fluctuations are transitory. The flaw to the model is fundamental or permanent change, then the rules of the game are no longer the same.
In 1995 the top 5 holdings in Berkshire were:
Coca Cola – carbonated sugar drinks
Headwinds – increasing awareness of general health and weight control. Huge increase in diabetes.
So, the future post ‘95 was negative.
Cap Cities ABC – Owner of US TV stations
Headwinds – Terrestrial TV suffered as subscription channels such as HBO grew and then more recently has been marginalised by streaming. Advertising also moved increasingly away from TV and onto digital platforms which allowed precision targeting of consumer groups based on content consumption.
Future post ‘95 was negative.
Wells Fargo – One of the big US banks
Headwinds – absolutely hammered in the 2008 Financial Crisis and then more recently embroiled in a major scandal involving fake accounts.
Future post ‘95 was negative.
Washington Post – newspaper group
Headwind -The internet has profoundly impacted newspapers with reduced advertising and lower circulation.
Future post ‘95 Very negative
This is a classic Buffett investment as most men shave and Gillette provides the razor blades. So, recurring predictable demand.
It was a fine investment, bought by Proctor and Gamble in 2005.
Future post ‘95, predictably consistent.
The catalyst for the 1st, 2nd and part of the 3rd Industrial revolutions were new sources of energy.
In 1958 Texas Instruments created the first microprocessor or chip (to replace vacuum tubes and transistors). The microchip would profoundly alter the future for mostly everything and bring into being a literal science fiction future. This though by no means was immediately apparent, taking decades to become visible as the momentum of advancement compounded.
“If a Rolls Royce had advanced in design at the speed of the microchip it would now get 500,000 miles to a gallon and be cheaper to throw away than park”G Moore
Gordon Moore was a co-founder of Intel and predicted in the mid-1960s that the computing power of microchips would double every two years. From then to now, it has.
As James Anderson pointed out in a recent article related to exponential growth rates of infection (the ‘R’ rate) humans find the magnitude of gain created by recurring doubling of value extremely difficult to grasp.
As an example, how many times does a normal piece of paper need to be folded for its height to reach the moon?
The answer is 42. Sounds ridiculous but it is true.
The concept is easier to grasp when realising that 75% of the distance is covered by the final two folds.
If this same concept is applied to the computing power available today compared to 20 years ago, then by Moore’s Law it’s 512 times greater.
The ‘mind bender’ is that in the next two years, the increase from today will be equal to the total achieved in those previous 20 years.
The times they are a-changin’
At the beginning of the 20th Century (1900) Rail Company stocks were over 50% of total US market value.
By 1960, the biggest US companies by market capitalisation included Exxon, Ford, US Steel, Gulf Oil and General Motors.
In 1975, Tangible Asset value (physical assets such as plant, machinery, land, inventory, cash etc) accounted for 83% of the average S&P company balance sheet value.
In 2000, the biggest companies included Microsoft, GE, Cisco, Exxon and Walmart
In 2020, the biggest companies are Apple, Amazon, Microsoft, Alphabet and Facebook.
In 2020 Tangible assets total 10%. Intangible assets make up 90% of total market value (patents, copyright, software and brand value).
The journey from value to growth
As referenced earlier, at the Frostrow conference James called into question the relevance today of classic value investing. Graham wrote extensively as an example on buying shares in a business where its tangible assets were greater in value than the market capitalisation of the company. This certainly now seems quaint and from another time.
The Buffett version of value investing used the valuation bias of Graham but applied it to the price of a share related to the ability to compound profits reliably into the future. Graham’s ‘margin of safety’ was to buy at less than book value. Buffett’s margin was to buy at a price which significantly undervalued the future compounding growth of free cash flows (‘GAARP’ growth at a reasonable price)
So, Buffett was and is a growth investor of a type.
The difference that makes all the difference
Any human will share about 99% of the same DNA as the person standing next to them.
96% of the same DNA as a chimpanzee
90% with a cat, 85% with a mouse, 61% with a fruit fly, 60% of a chicken.
And more than 50% with a banana. So, we are more like a banana than not.
If something generally is only 10% different then the assumption would be a smallish change, but that percentage of changed DNA turns you into a cat!
So although James Anderson and Warren Buffett appear very different, their investing DNA is in fact very similar.
- They seek out great businesses
- Run by great management, preferably with financial stakes
- They are deeply shareholder friendly
- Highly moral
- They both understand and so invest to harness the power of compounding growth.
The difference in DNA however and it makes a huge difference, is that the latter understood and embraced the unknowable. So Scottish Mortgage is a complete inversion of Buffett’s model of predictability of outcome.
Investments in Amazon, Tesla, Illumina, Alibaba, Tencent, Spotify or ASML were made long before they became what they are. There was absolutely no attempt to identify certainty. In fact, the opposite approach was taken.
Where Buffett had mined for unappreciated consistency, Anderson embraced the enormity of unappreciated potential. The future was unknown and in any detail unknowable. With this certainty of uncertainty, the known unknown, he identified companies and individuals he believed would successfully imagine it into being.
He invested in the best ‘technology creatives’.
Mark Andreessen, a tech investing legend of 25 plus years involvement recently wrote of the Millennium tech bubble that he could not think of one idea around then that has not been successful since, literally not one.
The tech crash of 2000 haunts investors and is continually referenced by commentators with 2020 being likened to it.
But Andreessen’s observation of 2000 is critical. The potential then was staggeringly real, and it has since actualised. The potential in 2021 is arguably even more staggeringly real.
This is not to say that stock valuations in 1999 did not get hideously silly because they did. And, more than likely, for some stocks the same is true today.
The final word goes to another of our favourite investors, Howard Marks, who recently wrote:
“The basic equations of finance were not built to handle high double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter”.
We absolutely agree this is true for the investor community at large.
But Scottish Mortgage, built by James Anderson, absolutely handled it.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog, and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.