Baillie Gifford: why these growth stocks will bounce back

Baillie Gifford Positive Change manager Lee Qian speaks to interactive investor's Sam Benstead about why performance has disappointed this year for the popular growth-style investment fund - but the outlook is still good for these fast-growing companies. Qian reveals his latest portfolio changes, and discusses why some of the fund's worst-performing stocks this year are still worth holding on to. He also gives his view on investing in China and how they define companies that deliver ‘positive change’ to society. Baillie Gifford Positive Change is a member of interactive investor's ACE 40 sustainable funds list.

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Sam Benstead, deputy collectives editor, interactive investor: Our guest today is Lee Qian, manager of the Baillie Gifford Positive Change Fund. Lee, thank you for coming into the studio.

Lee Qian, manager, Baillie Gifford Positive Change: Thank you for having me.

Sam Benstead: So, tell me a bit about the funds. Where do you invest and what makes it positive change? What makes it a sustainable strategy?

Lee Qian: So, positive change is an investment strategy that has two objectives, to generate attractive long-term investment return for our clients, but also to contribute towards a more sustainable and inclusive future.

The way we do it is by identifying and supporting innovative companies whose products and services are addressing a social or environmental challenge. So, the existence of the companies that we invest in directly help to mitigate challenges such as climate change or health challenges. Examples include our investment in Moderna (NASDAQ:MRNA), which everyone will know after the last few years as the company that came up with the Covid vaccination, that has helped us live with the Covid-19 pandemic. So, it's sustainable, in our view, because those businesses are helping to contribute towards a more sustainable future through the products and services they provide.

Sam Benstead: And you work for Baillie Gifford, which is famous for having a growth investment style. Is that true for your portfolio as well?

Lee Qian: Yes, it is. We focus on growth companies, and we have a long-term investment horizon, like most of our equity investment colleagues at Baillie Gifford. When we think about growth, we look for companies that can double over the next five years, for that doubling to come primarily from revenue and profit growth rather than changing price-to-earnings multiple.

Sam Benstead: And performance has been excellent since the fund launched about five years ago, but this year has come off a bit as growth stocks have come under pressure. I think it's down about 20%. So why is it that performance has been less good this year and what drove the growth before this year?

Lee Qian: I think this year we had the very tragic war in Ukraine that has pushed up energy prices [and] led to higher inflation as well. We are also seeing interest rates rising around the world and some geopolitical tensions globally, too.

All that has meant the market is a little bit more risk-averse than previously. And as a result, growth equities have been sold off especially badly relative to the markets. So, there is a kind of a sell-off in growth equities that has contributed to the short-term underperformance.

But over the long term, we are still optimistic about the long-term prospects of the businesses. It's notable that for most of the companies in the portfolio, the underlying operating progress last year has still been very strong in terms of revenue growth and profit growth. So, the businesses are very much performing like expect.

It is just the markets in terms of what multiple they are willing to pay for those companies that have de-rated a bit, but in the long term, the transition towards a sustainable future is a tailwind for many of the companies we invest in. And the situation this year has highlighted in more detail the need for that transition.

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Sam Benstead: So, you’re not going to change the way that you invest, given that investors can now get a 4%, safe, risk-free bond yield from the UK or US government?

Lee Qian: We are not going to change our investment philosophy because of changes in interest rates. Our investment philosophy is based on the hypothesis that the transition towards a sustainable future will occur and that companies providing solutions to our sustainability challenges will prosper over the long term. And that doesn't matter whether the interest rate is at 0% or 4%. Of course, in might matter in terms of the exit multiple and we have seen some of that, but in the long term, we think those businesses will still grow revenue and profits and that is what we focus on.

Sam Benstead: You own some of the big pandemic winners [of] 2020 and 2021. Stocks such as Peloton (NASDAQ:PTON) or Teladoc Health Inc (NYSE:TDOC) or Beyond Meat (NASDAQ:BYND). Do you still hold those in the portfolio, and were you caught up in a bit of a bubble in these names, driven by this short-term boom for people working from home that was only going to play out for a couple of years rather than decades?

Lee Qian: Yes, so I think there was a thesis that the pandemic has led to a structural shift to how we live and how we work. We still see some of that playing out. Most people are working hybrid still and with the elements of working from home, they still do Zoom calls or Teams calls. So, we do think that there’s been some behavioural changes because of the pandemic for some of those companies [and] that will continue to be the case. So, we have held on to Teladoc, for example, because we believe the transition towards telemedicine is a structural growth opportunity over the long term. There will be bumps along the way [and] there might be a few years where the growth might be very high and a few years where growth might be a bit lower. But over the long term, we think that the move towards telemedicine is going to be a tailwind for Teladoc. So, we continue to hope that.

We are still holding on to Peloton and that has much more operating challenges. But we have met the companies and we have metrics that we want the companies to achieve for [them] to continue to be in the portfolio. And we have sold some as well. We sold Beyond Meat because that one just hasn't worked out as we expected. So, we feel that there are more exciting opportunity to deploy our clients’ capital.

Sam Benstead: And what made you sell Beyond Meat? What didn’t go to your expectations?

Lee Qian: The execution of the company has fallen short of our expectations. I think they have over expanded into too many markets with too many restaurant partners at the same time, and they were not in a position where they have the internal manufacturing capability to satisfy their requirements. We have seen them struggling to ramp up production in a way that is attractive at a unit-economics level. We have seen gross margins collapse as a result and therefore we felt that it was time to move on from that company.

Sam Benstead: And what other big purchases or sales have you made this year?

Lee Qian: So, we have added to a few companies where we felt the recent market volatility has presented a much more attractive valuation than before. So, we added to MercadoLibre Inc (NASDAQ:MELI), which is a leading e-commerce and fintech business in Brazil and Latin America. The company has been performing very strongly, gaining market share, but the share price has more than halved from its peak, and we think that is a very good opportunity to add to that company.

We have also added to Shopify (NYSE:SHOP) as well. That company continued to perform well. We have done our independent research where we ask someone to speak to 10 to 20 small businesses that use Shopify, or use the Shopify alternative, and the overwhelming feedback is that customers/merchants really like using Shopify and the transition to e-commerce will continue. The share price has been off 80% from its peak and we think it is at a very attractive valuation, so, we added to that.

And then one company that we sold is Alibaba (NYSE:BABA), the Chinese e-commerce business, where we felt a combination of regulatory actions and some questions around culture and their ability to continue to innovate and grow, has led us to be more pessimistic about its outlook, and we have since sold that investment as well.

Sam Benstead: Do you own other Chinese companies? Is this a broad play that you don't like China as much anymore, or is it specific to Alibaba?

Lee Qian: We don't own any Chinese companies in Positive Change. But that is not to say that we will never invest in China. There is no top-down exclusion on China. We haven't found a company that satisfies both our investment and impact objective in China.

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Sam Benstead: So, some of those companies you mentioned, so Shopify and MercadoLibre, their shares have fallen quite dramatically this year because of rising interest rates. But maybe they went up too much over the past couple of years. What do you think will be the catalyst for these growth stocks bouncing back?

Lee Qian: I think there is a market tendency to overreact on the way up, on the way down, frankly. And I think that people now are a bit too pessimistic about the prospects of some of those online businesses. And they think that an opening up of the economy would mean that people will shop a lot less online and go to physical stores. Some of that will happen, but we do think that the move towards online commerce is a structural opportunity around the world. E-commerce penetration is still around 10% to 15%. And in places such as China, that is up at above 30%.

So, there's still a long way for e-commerce penetration to grow and it's a matter of time. And we want to pick the companies that have the strongest competitive advantage that give us confidence that they will grow over the long run. So, I think it will just take some time for the growth to continue and for the market to realise that the growth story here is not over. And I think we will see a benefit from the increase in revenue and profit from those businesses, and potentially a higher multiple that the market is willing to attach.

Sam Benstead: There are five managers on the Positive Change team. How do you make decisions with so many people?

Lee Qian: We have three investment managers and two impact analysts in the decision-making group, and that is to ensure that when we make an investment, both the investment prospect of the business and its impact on society are considered. We have a general preference to back enthusiasm of sponsors and people who have done the research on the company. So, as long as we have at least one investment sponsor and one impact sponsor for each stock, then that company can go into the portfolio.

Sam Benstead: Lee, thank you very much.

Lee Qian: Thank you very much for having me today.

Sam Benstead: And that's all we have time for. You can check out more Insider Interviews on our YouTube channel, where you can like, comment, and subscribe. See you next time.