How Scottish Mortgage Finds Growth Stocks

Thank you so much for having me.

Yeah, to make it really simple in the first instance, our aim is to find the world's most exceptional growth companies and own them for long periods of time. It's simple, but it's not easy. Peeling back the layers on that a little bit, we spend our time looking at companies and thinking what might go right, not what might go wrong. In an industry that is full of skeptics and people picking holes in arguments, we think it's important to think critically, but in the context of the upside: how much can we make if we're right about this? We're looking for businesses which can grow to many multiples of their current size. We think the world's greatest businesses are just about always underestimated. We think returns in markets are really concentrated, that it's not about what happens to the average company, but it's about the contribution of a small number of really exceptional companies. Therefore, we should invest our time and effort in trying to identify those companies, trying to understand the leadership, what makes them tick, and trying to learn from those people about what's going on in the world because they are building the future of the economy.

Yeah, you get this, we're all taught that there's this normal distribution of returns. There's the spread around an average and we don't really have much hope as individual investors. But actually, if you extend the time frame, that isn't true. Our average holding period in public markets is around 10 years. When you get to that time horizon, you get a very different distribution of returns. As you say, there's a small number that really, really matter over that time period. Once you take the veil away, once you see that, then I think it changes the nature of what you're trying to do because it becomes much more important to try to find the companies capable of being those big winners. And then where you do find them, the second really difficult task is that you just don't interrupt the compounding. You're not tempted to chip away at them if they become a big part of the portfolio because inevitably, your most successful holding will become a big part of the portfolio, and you will be tempted to chip it away in the name of risk control. But that goes against the structure of returns. It is the small number of big winners that matter.

Yeah, I mean, I think it is difficult. It is, as you say, it's a discipline. What I find quite helpful is, you know, you're tempted to look at reducing stocks that have gone up. But I like to frame it through two questions. The first question is, has the opportunity for that company got bigger or smaller? The second question is, has the likelihood of capitalizing on that opportunity got greater or less? It's only once you've answered those questions that you can come to the issue of valuation, risk: has the stock got riskier, is it more highly valued? Because it may well have got cheaper, even though it's gone up. If I take Amazon, we're just about coming up on our 20th anniversary of owning Amazon stock in Scottish Mortgage. Now, if you think about that original opportunity, it was in the book market, in e-commerce, and selling books and then media. Every time it's gone up, we've been able to come back and answer the question: has the opportunity got bigger? Yes. Has the likelihood of success increased? Yes. And it's enabled us to hold that stock for 20 years.

No, I don't think we're always looking for day one. Amazon is an exceptional company in so many ways, and we've learned so much from it, from Jeff Bezos and his approach to think about investment and about the world more broadly. But I don't think it needs to be day one. Specifically, we're investors in businesses, not investors in technologies. We're thinking about the business model. We think about the ability to grow revenues. We're thinking about how profitable an opportunity might be. We're not trying to predict whether a technology will or won't work. But I think what he's trying to capture with day one is around this idea of mindset, about fighting against all of those things that slow companies down as they get bigger. How do you keep the pace of innovation? How do you stop creeping bureaucracy? How do you stop creeping inefficiency? Not day one in terms of is it early, is it early technology, but yes, you want special companies that can fight against those almost facts of life, those tough realities that are faced with companies as they get larger.

Yeah, I think what this speaks to is that in investing, one of your worst enemies is yourself. Managing your own emotions, managing your own process to deal with that is really important. The starting point for me is just being upfront with people about what you're trying to do. Scottish Mortgage Investment Trust is focused on trying to deliver its shareholders long-run capital appreciation. We're very upfront with people that this will be volatile. Don't judge us over short time frames. I pretty much own all the stocks today that I will own in a year's time. There's not a lot I can do if those stocks are out of favor over the next year. There's a lot of randomness in it, so don't own these shares if you can't stomach volatility, if you have a time horizon that's shorter than that, if capital preservation is your key objective. You get the clients you deserve, you get the investors you deserve. Be upfront with people and be transparent and very clear about what you're doing. The consequence of that is that when you encounter the inevitable volatility, people don't get immediately on your back saying, 'This isn't what I signed up for, this isn't what I expected.' I think that's really important as a starting point.

Well, I'll just expand because you talked a little bit about how we deal with that internally. What I would say on that is, we all know the behavioral economics stuff about disliking losses much more than we enjoy gains. What I think is so important as an institutional fund manager is that you don't amplify. You always get asked questions about the stocks that are going wrong. That's what people want to push you on. If a stock has a profit warning, you can guarantee there'll be people in the firm that'll ask me about it. There'll be shareholders, there'll be clients, there'll be consultants. The list is endless. But what we do, and I'll take a specific example: there was a stock that had a profit warning two or three years ago. I had a relatively new colleague, and he was at his desk saying, 'Well, oh, thinking, Christ, it's going to be terrible. The atmosphere is going to be poisonous. What's going to happen? Is it an emergency meeting?' This stock was down more than 50%. The analyst who picked it was sitting at the desk, and nobody mentioned it. I didn't ask that person, 'What's going on at this company?' Somebody from the client side came up to talk about it, I sent them away. Inevitably, the person who's picked that stock is going to be feeling dreadful. Of course, they're going to be focused on it. Of course, they're going to be trying to work through it in their own terms. We can get to that eventually, but not at the moment. The worst possible message that that analyst could take away from that experience is, 'My God, that was dreadful. I was in so much trouble. I'm never going to stick my neck out and pick a stock like that again because the consequences of taking risk are too bad.' It's getting behind that person, rally around, don't put immediate pressure on them, help them think it through, and help them get back to taking that calculated risk the next time. I think that's so important because it's cultural. It's how you train people, it's how you bring people through.

Yeah, I completely agree. I guess what I would add to that is, if you go back to the small number of big winners that we talked about, if I look at every single one of the big winners that I've owned over the past 20 years, they've had periods where they've been extremely difficult to own, where it's a feature, not a bug. Amazon, we bought in 2004, it had fallen by a third by 2006. That was the time that they were introducing Prime free shipping. Suddenly, their most profitable customers were becoming loss-making. The market earnings estimates were going down. The market didn't like it. For the first two years, we looked stupid. In 2008, 2009, it fell by half. Again, it's an intrinsic characteristic of big winners that they will be volatile. If you can't endure it, NVIDIA, everybody thinks we own NVIDIA today. We bought it in 2016. 'Aren't you clever?' The peak-to-trough decline in NVIDIA three years ago was 73%. We looked incredibly stupid for owning that stock. If you can't deal with that, you won't enjoy the subsequent gains.

Yeah, inevitably, there are some that won't recover, and I wouldn't try to hide that at all, but it's back to payoffs. If you think there is a small number of exceptional companies that drive returns, then anything that you do that interrupts that compounding will be very damaging to the overall outcome. If there are some that you hang onto, you ride that share price down and they don't recover, it's better to do that and still own the ones that do recover. You've got to have that bias because if you sell your Amazon or your Tencent or your NVIDIA, it's so damaging to the subsequent returns. It's so hard to get back in.

Yeah, and it relies on you getting two decisions right. You have to make the right decision about selling and then the right decision about buying. If that wasn't hard enough, then as you describe, it's the mental dexterity, the actually being able to deal with your own emotions to allow you to do that.

Well, maybe I'll start by telling you what it isn't. It isn't the technology. We don't think we have a deeper insight into the technology that these companies have than anybody else. When we bought Tesla in 2013, it was not because we knew something about batteries or self-driving software that nobody else did. So instead, where our focus is, is first of all on the culture of the organization. Why do the people turn up to work? What is it that they're trying to achieve? Why should they have a sustainable edge in what they're trying to do versus other people? Go back to the Amazon example: it was that relentless drive on the long term. It was the '96 shareholder letter you talked about, about how they were going to make trade-offs, how they were going to make decisions. I think that was so much more important in the outcome over the subsequent 20 years than any of the products and services that were available when you analyzed the company back in 2004. There are quantifiable aspects of that. You know, how much skin in the game do they have? How much of their own wealth is tied up in the stock? How are they compensated? How are they incentivized? Then there's a lot of other factors that are much more intangible, but they are worth looking for because the time horizon of most participants in markets is so short that they don't care about these things. So you might pick up insights that other people are not even bothering to look for. If I extend that, because your question was touching on IPOs and companies coming to the market, I think your chances of evaluating that in the time between an S-1 IPO document is filed and that company coming to market are almost zero. You just can't do it in that time frame. So we put our time and effort into trying to meet and understand these companies when they're private, building up some understanding of the track record, building up some understanding of the way those companies operate, and then trying to put ourselves in a position to actually make a judgment when you get to an IPO, but not doing it from a standing start in 30 days.

So the way that we try to handle that is thinking about what return might we earn over the next five years. If things go right, what are the payoffs, and can we make enough money? That framing, I think there's a couple of things in that. The first is the time frame. I'm not telling you is the price-earnings ratio today 20, and is that cheap or expensive? What has to happen for us to make a lot of money over the next five years, and how likely is that? So we accept that there's not one answer. We extend the time frame to five years, and then we try and think about scenarios. Is the opportunity big enough, and is that captured in the stock price today?

I guess the short answer is that we don't spend a lot of time thinking about it. The global economy is a complex system, and trying to predict the outputs of a complex system is just about impossible. But I also think one of the things that bottom-up investors are guilty of is saying, 'Well, I just look at the stocks, and that's it.' I think you always invest in a context, but I just would be wary of defining that context by macroeconomic variables, because I think there are trends that are actually much more predictable and are much more likely to be useful. I take Moore's law, which predicts the price performance of computers. That has marched on steadily for most of the past 20 years, and it has been a really important driver of what's happened in the economy. Wright's law, which says that there's a predictable decline in the cost of producing something the higher the volumes that you produce. If you want to bring it right up to date, the scaling laws in AI systems. There are these identifiable trends, and thinking through their consequences and what it might mean for a business is much more useful. Again, making it tangible: Amazon has benefited over the past 20 years because the technology that powers its storefront gets better and cheaper every year, and physical retail, rents go up, the cost of employees goes up, the cost to serve goes up. For Amazon, the technology that powers its challenges has got cheaper and cheaper, and so understanding that was much more important than saying, 'What's the GDP growth in the US going to be for the next 20 years?'

Yeah, I agree, and I also think it comes back to another Buffett concept, which is circle of competence. Why should you have an edge in making money by predicting these macroeconomic variables? There's so many people looking at it. I don't have an economics degree. Why should I have an edge in outperforming a professional economist in predicting this, if indeed it can be predicted? Try to stick to the things that you actually might credibly be able to do differently, or think differently about, or have an edge in doing.

So we talk endlessly about frameworks is the short answer to your question, and thinking about mental models, about frameworks that you can apply that might generate insight. With a shout-out to my colleague Dave Bouchkoski, who really pushed this one on us, I'll pick one, which is Stewart Brand's pace layering model. In that, he's thinking about the way society changes, and the idea is that the top layers of society... so if you have fashion at the very top, fashion moves quickly, but it can't affect a great deal of change. But then as you work down the stack, again, he's thinking about it through the lens of society. I'm thinking about it more through the lens of companies. You have the impact from industry. You have the impact from infrastructure. You have the impact from regulation, all the way down to nature. Every time you move down a layer on the stack, things move more slowly, but the power to effect change increases. So again, if I bring it to a specific: if a company goes from being... it has a hip product, that's just fashion. It moves quickly, but it's probably not lasting. But then maybe it gains traction and becomes useful in people's lives. But then if others start building on top of it, if it starts to become infrastructure, then you can have greater and greater conviction in its longevity and its ability to influence. And so as we think about big tech today, they've become an infrastructure layer, and what becomes critically important is how they interface with the governance layer, because the governance layer ultimately is even more powerful. So that's a model we use frequently.

Yeah, I think Stewart Brand had some amazing ideas. I'd recommend his books, worth a read. I do think, as you say, it applies in all sorts of different contexts, just as a way to try and think through longevity, which is so important when you're investing.