In The Changing Nature of Capital Markets, James Anderson writes about a fundamental part of his investing strategy - investing in private companies. The reason for this is that his team finds more worthwhile new investments in the unquoted world than in public markets.
That shouldn't be a surprise as he notes venture capital investment (at the time of writing) represented three times the amount raised in IPOs in the U.S. It's a similar trend globally too. Anderson believes the increasingly short-term nature of stock market participants is causing founders to stay private.
Many investors in funds, or their advisors, don't like the liquidity mismatch between a fund needing regular liquidity to meet possible redemptions and investing in illiquid private markets. Given Scottish Mortgage is a closed-end fund the size of the fund is controlled by the asset manager which means it has permanent capital, making it well suited for holding illiquid investments. As discussed earlier, risks can be mitigated if the manager's communication is clear and transparent as to a fund's objectives and investment mandate. Scottish Mortgage is clear that it wants to invest in private markets and has the permission of its board to do so and its investors know what they are getting.
In terms of the investment process, equity is equity, regardless of whether it is publicly listed or privately held. Some critics might say that Anderson's investing track record has been helped by the illiquidity premium of investing in private companies. That may be true to some extent, but if you have a long-term horizon then the risk is lower. Also, options always have value, to by having the option of a broader investment opportunity set this should increase your returns and that is a good thing. Anderson calls this acting differently.
The trend in recent years has been for many ambitious, risk taking firms to stay private for longer as then managements are unconstrained by the short-term pressures that come with a stock market listing. Good examples were Airbnb (ABNB, Financial), Spotify (SPOT, Financial) and China's Meituan (HKSE:03690, Financial).
This is a key point for Anderson. While his fund might not have the same ability to offer detailed technological assistance or daily managerial assistance that venture capitalist investors can offer, Anderson believes his team have other strategic advantages for investee companies, such as offering a typically cheaper cost of capital and the ability to write large tickets through the various stages of a young company's growth path, i.e. unlike venture capital they are not looking to exit at IPO, in fact this hybrid investment strategy gives Anderson the opportunity to increase his investments at IPO at a point where he already has a good understanding of the company and a strong relationship with the management team.
What could private investors learn from this? Anderson says he is called a "tourist" by some VCs but in fact he has been able to provide capital in times of difficulty. Ultimately questions of valuation are the same regardless of the nature of the equity. Private investors could expand their opportunity sets by considering angel investing opportunities or by being more open to investing in funds that invest in private holdings. Of course, here the liquidity mismatch is a possible risk, so the fund structure (to avoid redemption risk) is important, and it needs to be carefully thought about.
The key then is to find the right investment opportunities that you can understand and invest in with conviction about the risk-reward payoff. In today's changed capital markets environment by having constraints on the nature or location of the equity you are unnecessarily giving up optionality.
Guru's Focus
Like Warren Buffett (Trades, Portfolio), James Anderson has little time for broker research. As mentioned earlier, he also thinks that focusing on economic data and quarterly earnings is a waste of time. A short-termism approach by the rest of the market gives long-term investors an advantage. What about information itself and how that information is obtained?
Another way Anderson and his team act differently is by their radically different approach to research - actively trying to understand a completely different set of mental models.
First, location, Anderson is based in Edinburgh, not London and he notes that it has often been suggested that it's no coincidence that more top investors are based outside the major fund management centres. Many fund managers like to promote the fact that they go around "kicking the tires" or are doing "on the ground" research by touring various countries. What does this often lead to? Criticism of a country at the macro level isn't helpful in finding the asymmetric upside opportunities. Anderson talks instead of his team burying themselves in the "mentality of a society". How to do this? Anderson and his team have the luxury of being able to live in different cities for months at a time. Most of us can't do that, so he recommends an interesting book called The Geography of Genius: Lessons from the World's Most Creative Places by Eric Weiner. The book features Athens, Hangzhou, Florence, Edinburgh, Calcutta, Vienna and Silicon Valley with the conclusion being that it is at the city level, not the country level where important transformations take place.
How does this help a stock picker find opportunities? For a start, focus your attention away from the traditional finance/business cities like London, New York and Tokyo. As Anderson notes:
"We're better off in Seattle, Shenzhen and Stockholm. I'd go further and suggest that the awful record of most US active fund managers over the last decade and more is primarily the bitter outcome of the unwillingness or inability of the East Coast establishment to understand or empathise with the ethos of the West. It's been better to be an outsider."
Deep Transitions
Most fund managers start with their benchmark and then analyse issues around tracking error and how to make small bets in active share in order to beat the index over the next month, quarter or year. This means the largest companies get the most attention as they have the highest weights in the indexes. But concentrating your portfolio in the largest companies isn't going to give you much if any asymmetric upside. By definition these companies are already very large and likely by now highly bureaucratic. With this short timeframe and this limited opportunity set you are not going to find transformational opportunities.
"What we most need is to be as good as we can be in understanding change."
To find the companies of tomorrow, understanding changes in the world then becomes very important. How does change happen? When, when not? Historical analogies can be useful as well as the mental models to visualise different versions of the future. Anderson spends a lot of time talking to experts. Real experts, not brokers and star analysts. One example he cites is the work by the Santa Fe Institute concerning power laws, exponential progressions and scalability. Another research group Anderson supports is the Deep Transitions Research Project at Sussex University which posits the first deep transition was the industrial revolution that began 250 years ago, and now the second deep transition the Sustainability Revolution which is only just getting started.
The research and development done in engineering, science and technology related centres of excellence from various universities around the world can be highly insightful because these are often the incubators of the entrepreneurs and companies of tomorrow and where so much innovation is created. Just as important is that the market at large is ignoring this type of research, so it is truly differentiated. This type of research strategy reminds me of Michael Steinhardt's "variant perception" but applied over a longer time horizon.
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
