Graham or Growth? Part 5 - Governance and Concluding Thoughts

May 2019
James Anderson
JOINT MANAGER, SCOTTISH MORTGAGE INVESTMENT TRUST

When we first attempted to explore and explain our enthusiasm for Growth Investing 15 years ago it was natural to try to learn from our predecessors. The problem was that there was very little literature to guide us. The only text in the canon of investment that espoused Growth Investing was Phillip Fisher’s ‘Common Stocks and Uncommon Profits’. It dates from 1958. What follows is James’s musings after he reread Ben Graham’s value bible, ‘The Intelligent Investor’.

GOVERNANCE

Ben Graham covered this current preoccupation in The Intelligent Investor:

“Ever since 1934 we have argued in our writings for a more intelligent and energetic attitude by shareholders toward their management...But the idea that public shareholders could really help themselves by supporting moves for improving management and management policies has proved too quixotic to warrant further space in this book”.

As Jason Zweig points out these words were far from mere rhetorical flourish. They were the bitter fruits of real disillusion. Over the editions the relevant section shrank by 75 per cent. The only hope that Graham saw was the rise of hostile takeovers.

But where are we now? Hasn’t this picture changed substantially even if it superficially seems that shareholders are as ineffective as Graham complained? I think it has changed utterly. There are three reasons that this is so. The first is that the rise of the institutional investment industry has exerted untold, and often invisible, influence on the corporate mentality. The impatience to see quarterly results, the demand for regular outperformance, the longing for stable and growing dividends all exert pressure on the boards and executives through an endless parade of meetings, appointments requirements and votes as well as the direct sanctions of buying and selling. This often appears to be the opposite of the careless negligence that Graham bemoaned. As in his time it usually avoids direct engagement but the systemic pressures to short-termism have risen inexorably.

This is underwritten by the rise of the aggressive activist hedge funds. This has been displayed in case after case from JC Penney to Sears to Sony to Nestlé to Barclays. Seldom is inaction an option whatever the situation. The first half of 2018 saw a record 145 new campaigns against 136 companies. Elliott alone launched 17 campaigns. As short-sellers similar individuals and funds have been equally fearsome – and with tactics and targets that seem to exceed the utility that short-selling could once claim. This isn’t the world Graham observed. All too often the enemy isn’t a company squandering cash flow on inane ventures to satisfy managerial ego as he feared but rather a race of companies scared to invest adequately in an uncertain future.

The third factor is the remorseless rise of Corporate Governance teams at asset managers, asset owners and advisory services. As with the rise of professional investment management this theoretically beneficial development is deeply concerning in the wrong hands. If the besetting sin of professional asset management is preoccupation with short-term performance then that of governance teams is their tendency to believe in a set of policies – at best guidelines, at worst rules – that are applied to all companies. Generally these policies are about detailed prescription rather than broad principles. That seems to us to be the polar opposite of a thoughtful and constructive approach to corporate stewardship. It’s strange indeed to believe that all companies at all stages of their evolution in vastly different industries, geographies and with markedly different capabilities, characteristics and leadership should be governed by prescriptive diktats. This isn’t just a rant. It’s a response to the challenges of our era. It’s less a complaint than a justification for a different approach. I’ve tried to set out the case that we live in a complex, chaotic and initially path dependant world. In such an environment a small number of simple principles tend to work far better than detailed prescription. Indeed this seems to us to be in turn a reflection of the nature of competitive advantage. As John Kay wrote 25 years ago “the strategy of the firm is the match between its internal capabilities and its external relationships”. Or as he followed on more recently:

“There is a role for carrots and sticks, but to rely on carrots and sticks alone is effective only when we employ donkeys and when we are sure exactly what we want the donkeys to do.’

This is acutely the case in our style of hyper-growth investing: we’re usually dealing with sensitive but brilliant racehorses, not donkeys, and we do not think it wise to issue instructions in a world full of great but unpredictable opportunities.

What can we do therefore? There seems to be one overriding principle and three associated attitudes of mind. The principle is that we should encourage companies to focus all their efforts not on metrics but the overarching and qualitative goal of building long-term competitive advantage. If this is the focus and the approach is thoughtful then we will be enthusiastic supporters. By definition this requires the ability to find and build unique characteristics – not the meeting of the same attributes as required by all. Competitive advantage cannot be adhering to a predefined generalised notion of best practice. The associated mentalities are suggested by the nature of our own investment philosophy. We are long term. Therefore we need a culture that is long term. Often this is greatly helped by leaders confident in their long-term mission and secure in their role. We believe that even in the greatest firm hard times are inevitable. Therefore our instinctive, but not inevitable, reaction is sympathy not condemnation when 13 nasty weeks come along. They will.

Lastly, and similarly, if we understand the potential opportunity and we think the pay-offs justify the inevitable risks we will applaud the effort to create great new opportunities even if the attempt fails. In short: what we are aiming to do is reclaim activism for high-growth investors. Activism shouldn’t be confined and owned by all too often negative and destructive hedge funds – nor by the detailed and overly generalised rule book of Governance departments.

CONCLUDING THOUGHTS

At the end of these explorations I’m left with conflicting views. But in aggregate I think that the world so brilliantly described by Ben Graham is unlikely to return. That’s partly because he and his exceptional followers have been so influential. As Charlie Munger (aged 95) remarked about ‘groupie’ fund managers who follow Berkshire principles they are “like a bunch of cod fishermen after all the cod’s been overfished. They don’t catch a lot of cod, but they keep on fishing in the same waters. That’s what happened to all these value investors. Maybe they should move to where the fish are”.

But it’s not just that Value has been overfished. It’s a simple statement of fact that there have been great growth companies that have defied the scepticism of Graham and the mantra of mean reversion. They have endured for decades even at massive scale. I don’t see this as a contention but as an observation. Ironically they’ve altered the patterns of stock market return sufficiently that the very utility of the ‘mean’ has been undermined. The mean is now so far above the median stock that our entire notion of the distribution of returns has to be reviewed. The first chance to reassess came with Microsoft over 30 years ago. The investment community has been slow indeed. We can react to economic data or quarterly earnings in seconds but adjusting our world view has proven far harder.

But the observation of Black Swans of Growth can surely be put in a much more structured context of thinking about our corporate and economic world. If you live in a technology and knowledge driven universe of great complexity and initial path dependence, why wouldn’t you expect the lucky emergent few to buck the notions of the fallibility of growth stocks? Given these features of our time then Brian Arthur’s Increasing Returns to Scale becomes the canonical description of at least a very large – and probably expanding – portion of the investment universe. Put more bluntly it’s surely time for those whose mental models are locked in Modern Portfolio Theory and Equilibrium Economics to cease viewing themselves as the essence of intellectual modernity and sophistication. A little modesty and much more reading might be in order. It’s possible that the Graham world may still operate in sectors supposedly immune to the Arthur rules but the area insulated from its operation has shrunk year by year.

What of the future? It seems reasonably probable that the percentage of our economy sparked by knowledge, technology and networks will continue to expand. A major contributor to this prospective pattern is that the access to data is becoming ever more important. As technology executive and artificial intelligence (AI) expert Kai-Fu Lee points out, brilliant data scientists can and will be beaten by mediocre colleagues with more data. That’s the extreme essence of increasing return markets. But in stock markets it is right to express several cautions. Although the perception of most market participants and asset allocators is, as we know to our cost, strongly disbelieving of the justifications for growth investing the fact is that in markets it has been the dominant force for a prolonged period. It’s not mean reversion we should fear but market prescience. Our waters may become as overfished as those of Newfoundland. Yet that would appear to be a topic to remind ourselves of as a potential Ides of March when and if Growth Investing becomes accepted by the investment industry at large. That appears still far off.

The second caution would be that it’s a serious possibility that public equity markets have become so hostile to companies investing substantial capital in genuinely risky businesses that the next generation of founders has no appetite for the rigours of quoted life. With the amount and comparative patience of venture finance so increased why would you bother? This matters still more as in the early stages the workings of chance may propel a venture forwards so far and so fast that it may be established as a platform of increasing returns without the pause to go public – let alone the delay of returns until after an eventual IPO. Even passive funds would inevitably miss out in this context.

The venture capital alternative is equally relevant in thinking about returns. Recent research demonstrates clearly that the return distribution in quoted equity is much more akin to venture principles than has been imagined. One consequence is that one success matters more than one failure. The value tradition finds this challenging: we’re back to Rule 1 being not to lose money and Rule 2 being not to forget Rule 1. At a portfolio level that may not be wise.

Lastly there’s an ugly parallel to the self-reinforcing, path dependant but then unstoppable growth trends that we’ve discussed. That’s the methodology of climate change. The consequences for the global economy are potentially so hard to fathom that debates between Growth and Value may be equivalent to medieval debates about the number of angels that could dance on a pin-head.

Yet beneath all the sound and fury of Growth versus Value there is much to be admired and learnt from the best disciplines of the latter. There is far better articulation of ideas and of the moral and practical purposes of investment. There’s a wonderful focus on patience too. As long as it’s possible to steer clear of the questionable focus on dubious metrics such as ‘low PE’ or ‘low book value’ and the factually unfair denigration of terrific company records with mean reversion defying decade after decade then isn’t there much in common? I’d love to be capable of equalling Munger’s tale of Coca-Cola as imagined in 1884. But wasn’t it in direction, if higher in quality, a quintessential long-term Growth formulation? It required creativity not analysis, it described why returns wouldn’t revert for 150 years and why they would not be constrained by physical asset multiples, it discussed what founders and management needed to do and not do to mould the prospects. It acknowledged doubt but embraced the contemplation of the enormous addressable market. Perhaps we’re not so far apart when all is said and done.

The views expressed in this article are those of the author. Its express purpose is to highlight areas of intellectual thought and debate which inform the investment philosophy that underpins Scottish Mortgage, in the hope that they may be of wider interest. The author(s) therefore make(s) no suggestion that this article constitutes independent investment research and it is not subject to the protections afforded to such.

Further, it is not intended to be considered as advice or a recommendation to buy, sell or hold any particular investment. Those considering investing in any of the areas highlighted in the article should undertake their own research, seek advice if unsure, and be aware that the value of any investment and any related income, can fall as well as rise, meaning that investors may not get back the amount invested. For those looking for information on Scottish Mortgage specifically, please visit www.scottishmortgageit.com for a Key Information Document.