240. Why we’re still investing in Tesla and Netflix

TRANSCRIPT: EPISODE 240
16 February 2023 (pre-recorded 7 February 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Darius McDermott (DM): I’m Darius McDermott from FundCalibre, and this is the ‘Investing on the go’ podcast. Today I’m up Edinburgh with Ben James, investment specialist on the US equity team here at Baillie Gifford. And we’re going to talk a bit about the Baillie Gifford American fund. Ben, thank you for your time.

Ben James (BJ): Darius, thanks for having me. Thanks for coming up.

[INTERVIEW]

DM: So, a busy year 2022 into ‘23. Let’s touch a little bit on the US economy – [a] very well telegraphed recession with a US inverted yield curve [when longer-dated government bonds have a lower yield than shorter dated bonds] – what do you think about inflation?

BJ: Yeah. thanks, Darius. Well, as you know, we’re long-term, bottom-up stock pickers and we don’t really have an edge versus any other investment manager in predicting what’s going to happen in the next year or 18 months. Predicting such things are notoriously difficult and not where we focus. That’s not our strength. But what I can say is that it seems clear that Powell at the Fed [Jerome Powell, Chairman of the Board of Governors at the Federal Reserve] is going to continue to focus on taming inflation, whatever it takes. So, I don’t know whether that’ll lead to a hard or soft landing. But they need to control that, that is the greater evil.

That said, our focus, we think, is more important on a five-to-ten-year view. You know, we don’t know what the economy will do in the next year or 18 months. But we do know that the companies that we are looking at first and foremost are resilient – well, you know, net cash in the portfolio, two-thirds/ 70% roughly are, you know, self-funding – free cash flow positive or profitable – and those that aren’t, are well cashed; we have a small tail of companies which might be more affected by a weaker economy, but that’s why they’re small in the portfolio. But we know that those companies that can grow their revenues or their profits in the top quintile over any five-year period, will deliver the top returns. So, that’s what we are focusing on. And I can’t remember who said it, but that you make your most money in a bear market, you just don’t realize it at the time.

And we are seeing companies with structural advantages and plenty of cash and still self-funding, being able to sort of deepen their competitive advantage, which has parallels to what we saw in 2008 and 2001, where the exceptional companies actually had comparative advantage, [they] were able to deepen their advantages and accelerate out of a recession. So, that’s the area that we are focusing on. We don’t know if it’s going to be a recession or not. And if it is, the companies that we hold are exposed to long-term structural trends and are resilient financially.

DM: So, you know, on the American desk, US equity desk at Baillie Gifford, you are unashamedly growth, structural and high-growth investors. I don’t need to tell you that that was a more challenged environment for that strategy, that investing factor – [a] really tough year [in] 2022 and maybe just the last bit of ‘21. How do you keep going? What drives you to keep going and investing consistently in that style, in the face of a very challenging headwind in the last 12 months?

BJ: Yeah, so first and foremost, I’d like to thank anyone listening who is invested in the American fund or some of our other products that … we don’t take what’s happened over the last year lightly and appreciate how challenging it’s been for you as our clients and investors in our funds. It’s been very challenging … I think there’s a number of factors that you can look at here: first of all, there’s a shift in environment. So, rising inflation means rising interest rates, which hits the discount rate that people use to value stocks in the short term, and therefore higher growth stocks, like ones we invest in, whose profits are further into the future than average will be discounted and their share price comes down.

We also think there was a general sentiment shift which is hard to manage for, if that’s the right way to describe it [DM: Probably hard to quantify as well.] Yeah. And I think, given we were chatting about this beforehand, I think, given our long term approach and trying to find companies that will grow at least two and a half times over the next five years, with a better than average chance, when stock prices are moving so quickly and so violently in both directions – bear in mind this is a sort of three year story we’re talking about from the beginning of the pandemic and the first and second and third order effects from that – we’ve been constantly revaluing the upside. So, on the way up you revalue: can it still do two and a half times? And if it can, then we’re likely to let it run because, it’s not that the share price has peaked, it’s actually the opportunity may have increased faster than the share price.

And so we saw that with the likes of Moderna [, Inc.] and we thought – which is the vaccine maker – and with the likes of Shopify [Inc.] – which is the e-commerce platform that helps merchants get online – you know, Shopify saw its merchants more than doubled to north of 2 million, saw its gross merchandise volume grow 3x, and saw its profits grow by 14,000% over the two year period. But it just so happened that it then also decided to reinvest all those profits as it hit an air pocket after the pandemic. And then rising the interest rates sort of was a double whammy.

So, back to your question, it’s hard, but you stick to your philosophy and process, and you stick to the upside, and you try to avoid making knee-jerk reactions to the noise and the sentiment in the market and focus on the company fundamentals and the long-term opportunity. So, are the companies resilient? Yes. Is the opportunity still intact? Yes. Then our edge is in holding on and riding out the volatility of these companies, and it is painful, but we think it’s the right thing to do for the next five to 10 years.

DM: Okay. And any sort of question at a market level is always relevant for the likes of yourselves, but you are invested in US equities – why should our listeners either hold or potentially even add to US large cap equities, given the difficult year that they had in 2022, but also they were coming at an index level from high valuations versus its own history, still too reasonable high valuations, whereas if we wanted to look at other markets, we can actually see markets trading at discounts to their long-term average?

BJ: I don’t want to tell anyone how to build their portfolio, but there’s a difference between the way we invest and [how] a passive S&P 500 [index] tracker, how that will behave. Essentially, I think there’s a role for both active and passive investing in the US in people’s portfolios, but it just depends on your risk tolerance and what you’re trying to get. I do think in general, that the US as a country generates the most and best growth companies out there. It’s the most competitive, it’s the most innovative, it’s the deepest market in the world. So, personally speaking, and this is not advice <laugh>, I would hope that everyone has a small exposure, at least to some of the most innovative US large-cap growth companies.

But what we do, is try and find 30 to 50 of the best growth companies – we call them the exceptional growth companies in the US – for the next five to ten years. And a lot of them aren’t in the index. So, we are very different to the index. So, if you take the S&P 500 as a sort of an example or as a representation of the wider market, we have an overlap of about 8%. So, our portfolio will behave very differently. And the reason we do that is because we are focused on the next five to ten years of structural change and those companies driving that and exploiting that, whether that be in healthcare – the increased personalisation of healthcare and the speed with which we can sequence genomes and make targeted personalised medicines – and, you know, Moderna is a prime example in that. There are other companies in the portfolio like Alnylam Pharmaceuticals [Inc.] which switches off genes that make genetic diseases or create genetic diseases. Or whether it’s in the electrification of transport through, you know, like Tesla [Inc.] or Rivian [Rivian Automotive, Inc.] or whether it’s the continued shift of most of our commerce or economy online, whether that’s advertising, buying or selling secondhand cars or whatever.

So, that’s the areas that we are focused on, and things are happening in those spaces with disruption and the speed of technological innovation creating exponential change. And the thing with exponential change, whether that be the exponential reduction in the cost of solar [power], or the exponential reduction in the cost of sequencing a human genome, or the exponential increase in speed of how you sequence a human genome, means that softly, softly – along comes a winner that disrupts a big US large capital within the broader index. So, that’s the role that we play, is like having a sort of hedge against a world that’s changing too quickly, than most sort of conventional risk metrics can cope with.

DM: So, they say a year is a long time in markets, and we are here today, four weeks into 2023. It does appear that sentiment broadly feels a little bit better from all parts of markets, not just US equities, but just the bond market and everything else. How does it feel, as we are sort of gently into 2023? Are you hearing good things from your companies or is it just those standard long-term fundamentals and maybe some compressed valuations which get you excited about the year ahead?

BJ: Yeah, so I mean, a month is far too short a time to tell what’s going to happen in the next five years. But, you know, given what’s happened over the last year to 18 months, a positive start to the year is welcome, but I would say that it’s not a strong indicator of long-term, five-year-plus performance.

What we are seeing when we are out meeting with the companies – which we’ve been doing a lot over the last year – is, for the vast majority, strong operating fundamental performance in the face of challenging headwinds, which is fine, which is what we want to see. You know, we’re not saying that we’ll see the supernormal growth that we saw in 2020 or early 2021, but the companies are still growing.

You know, AWS, Amazon Web Services – which is the cloud-based business of Amazon – it’s not growing at 30% per annum anymore, it’s in the high teens. This is a roughly a hundred-billion-dollar revenue run rate company. And if you put that on five-time sales, that’s a half a billion-dollar market cap company in its own right. Which means that the market is only ascribing another, you know $800 billion to the rest of Amazon. That includes its advertising business and Prime and media, and then e-commerce in general.

So, actually, I think what we’ve seen specifically at the close of the year is compressed valuations in some stocks and some of the key big companies; Tesla’s valuation was depressed – it’s come back quite a bit in January – but others like The Trade Desk [Inc.] and Shopify – the Trade Desk is a programmatic advertising platform [and] Shopify being the e-commerce platform – they were compressed and may have come back a bit.

But then you’ve got other companies which are unrelated to the cycle, unrelated to the conventional business cycle, and healthcare really falls into that. It doesn’t really matter what the interest rate is for Moderna. You know, what matters is can they continue to bring about their innovative mRNA-based vaccines [a vaccine that triggers an immune response] quicker than others? Can they combine them quicker than others and have say, a combined flu / covid / RSV [a respiratory virus that affects the lungs] vaccine that is as, if not more, effective than the conventional practice of conventional vaccines. And can they continue to do that faster than everyone else? If they can do that, it doesn’t matter what the interest rate is. It’ll continue to make money. And so … [DM: They have demand.] Exactly [DM: Must have demand for [their] products.] Yeah, exactly. And so, there’s 20 odd – 25% of the portfolio within innovative healthcare companies that are exposed to a completely different cycle and funding source.

And then you’ve got those disruptors who … Dave Bujnowski, one of the investment managers on the team, released a really interesting paper – and there’s a podcast of it actually on our website – about the engines of growth. And we don’t need the economy to be expanding for these companies, the majority of these companies in the portfolio, to expand. What we’re focusing on is what’s changing. Because when there’s change in an economy, there’s an opportunity, someone, an entrepreneur or a company to come in and do something better, whether that be supply, latent demand in a better way, or there’s new demand coming, so you meet it with new supply. And so, there are companies in those spaces that we’re looking at that we think will, you know, continue to grow whatever the weather.

DM: Perfect. Well, that’s a nice segue then into a couple of final questions. We always like to finish with a couple of stock examples, but let’s do, if we can, maybe a minute on Tesla and a minute on Netflix. Two interesting stocks from an investment point of view, but at least High Street brand names that listeners to the ‘Investing on the go’ podcast will have heard of. So, do you want to have a go with Tesla first?

BJ: Yeah. I mean when we were chatting before and you were talking about Tesla being a Marmite stock, and it is a divisive stock. I think it’s because of a number of reasons, not simply because people get very passionate about cars and they think they know cars. But look, Tesla’s share price was weak in 2022 on the back of some outstanding share price performance in the years running up to that. Part of that is highly likely to do with Elon Musk completing his takeover of Twitter and associated negative news flow about that.

But if you look at the company and its fundamentals and its operating position, it’s never been stronger. So, it’s reached a battery surplus in September. [DM: That’s car batteries?] Car batteries, yeah, in September, and it’s designed a tablet, a Cobalt-free battery that will enable a further step up in vehicle capacity. Car production’s ramping around 50% per annum, and we think it can do that for a long time. The main constraint to selling more cars is securing delivery capacity. The Tesla semi-truck is rolling off production lines – the cyber truck’s coming; stationary storage – its battery storage business – is ramping in earnest. And, you know, [it] had over USD21 billion in cash at the end of the last quarter.

But what we’ve been doing with the company in terms of engagement has been speaking to the company management and the board in detail, particularly when there was the press attention on what Musk was doing at Twitter. And you know, we’ve only been able to do that because of our 10-year plus relationship with the company. So, we sat down with chairperson Robin Denham to have a long discussion about, you know, whether Mr. Musk is distracted, and we’ve been reassured that he is as committed to Tesla as ever, and that he remains actively involved in key day-to-day decisions, but remotely, which is our experience when he was heavily involved in the ramping up of some of the SpaceX work. And it’s a pattern that he has. He tends to, when he goes into these projects, whatever they are, he tends to go in deep and hard and fast, and it takes up a lot of his time and attention, but then he steps back and brings people in that can, you know, once it’s in the position that he wants it to be, to sort of let it run itself. But look, focus on the fundamentals. We can see it having 60 billion of EBIT – earnings before income interest and tax – in five years’ time. We only need a teen sort of multiple on that EBIT number to make a two and a half times return even from here. So, we still remain very confident in the long-term picture for Tesla.

DM: And maybe then just a briefer word on Netflix.

BJ: Okay. Briefer word on Netflix. I got the hint. Look we had some questions on Netflix from earlier in the year when it seemed that it was actually more saturated, particularly in the US, than we had estimated; [there was] a lot of password sharing, and there was a decline in subscriber growth for the first time, [DM: Which is the headline thing that …] That’s the headline. Yeah. [DM: More users, less users!] Yeah.

Now, we’re not too worried about that in the short term. What worried us a bit more was this pivot towards advertising, and we needed to work that out, but also the churn in some of its less mature markets internationally. So, a big part of our forward-looking hypothesis for Netflix is its international expansion, becoming a global TV channel essentially. We were seeing turnover and sort of a drop in subscription numbers in its some of its less mature international markets, so they weren’t saturated. And that told us that there might not be the stickiness in customers when the cost-of-living increases. It’s very easy to turn on Netflix, well, guess what? If your price is increasing, it’s quite easy to turn off.

So, we reduced the position size to sort of reflect the reduction in conviction in the two and a half times case. We still think it could do it, but it was less likely. But we wanted the time to work through the implications of the cost-of-living increasing, potential recessions and its advertising tier. And as we’ve worked through that, and spoken with management, it’s becoming clearer that actually it could … it’s the second, well, it’s not even the second act, the fourth act for Netflix, if you think about where it started in sending DVDs through your letterbox. But anyway, the point being is, it’s actually we think potentially another accelerant or supportive leg for growth for the company to move into becoming one of the two or three or four global dominant streaming TV channels. And the advertising aspect of its business can actually help people stay online and save money. So, stay as members and save money. So, it plays into that cost-of-living reduction /cost-of-living increases, and people tightening their belts a bit. So actually, it’s one of our top 10 holdings still. So, we remain confident in the long-term upside there too.

DM: And then maybe if we could just have one other name, a new stock, that’s exciting the team that maybe is less of a household name.

BJ: Sure. So, well there are a number of companies within the portfolio that we’ve been adding to over the last couple of months. So, one of the companies that we’ve held for seven or eight years Abiomed [Inc.], which makes heart pumps, was acquired by Johnson & Johnson at a 50% premium, which was, you know, was a shame to see it go, but obviously the company, Johnson & Johnson saw the value in that. And we reinvested the proceeds of that into several of the companies in the portfolio that we think have been beaten up. And that includes Tesla, includes Shopify, includes The Trade Desk. But I think, the areas of real excitement for us are quite broad, but one I would focus on is the ongoing digitisation of our economy and the shift to the cloud.

So, companies like Snowflake [Inc.] and HashiCorp [Inc.] and Datadog [Inc.] these are companies which you know, in layperson’s terms provide the infrastructure and help companies run their business from the cloud. So essentially, instead of having computers in your office which is your database, you outsource it all and you pay a subscription to a company, and you host it on the cloud.

Now, it’s a very different environment to in the past where, you know, you’ve been buying stuff to make projects, whereas actually you can do all this through a subscription on the cloud, and it actually helps you save money, makes you more efficient. And in an era where, you know, money is less free than it has been and where chief investment officers and so on are being asked to do more with less, the flexibility that the cloud computing companies give you to be able to continue to compete and adapt to rapidly changing environments at a relatively low cost to having all your hardware on-prem [onsite, in your premises] is really exciting. And so, we think that there’s a sort of anti-fragile quality to these companies and they’re providing a sort of disruptive engine of growth or replacement engine of growth, rather than needing the economy to expand. So, I’d say those companies are really quite exciting.

DM: Ben, thank you very much for your time this afternoon, and thanks for taking us through Baillie Gifford’s approach to US equities and, you know, talking openly about a number of interesting stocks.

If you’d like more information on the Baillie Gifford American fund, please do visit FundCalibre.com and please do like and subscribe to the ‘Investing on the go’ podcast.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening, elite ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.