Baillie Gifford European Growth 15 December 2022

Baillie Gifford European Growth Trust (LON:BGEU) is managed by Stephen Paice and Chris Davies, who start with a blank piece of paper and aim to identify the companies with the best long-term growth prospects in the European market.

The portfolio is highly active and differentiated from the benchmark. Positions in unlisted companies contribute to this, the weighting being currently at 10.6% of the portfolio, as does the significant mid-cap tilt. Overall, the trust is highly sensitive to the growth factor, which helps explain the swings in recent absolute and relative returns.

The last year has seen a significant fall in both the NAV and share price, following an equally extreme rise. As we discuss under Performance, this has been driven by macroeconomic conditions which we believe are unlikely to repeat and, in our view, long-term alpha is more likely to come from the managers’ success in identifying companies which can deliver exceptional long-term earnings’ growth.

The managers report an “extreme mismatch between the potential of our companies and their valuations” and that operational performance has largely been good, even as prices fall. In fact, some companies have performed extraordinarily well, yet been punished (see Portfolio).

BGEU’s shares have moved onto a discount over the course of 2022 as risk aversion has risen and growth-investing has fallen out of favour. At the time of writing, the discount is 13.8% compared to an average of 9.8% for the AIC Europe sector.

The trust has structural Gearing which contributes to NAV volatility and amounted to 15% of NAV at last month end, following falls in the portfolio’s value over the year. Helpfully, this debt has been locked in for the long term at very low rates.

The approach taken by Stephen and Chris is refreshingly optimistic. While the immediate outlook for the economy in the UK, in Europe and globally is poor, and the cost-of-living crisis bites, it is important to remember that there are still new markets and products being developed. Human ingenuity has a good track record of improving our standard of life and generating wealth. Stephen and Chris are looking for the outliers which will deliver the greatest returns, often by delivering the greatest change. This highly-active approach has the potential to generate high levels of outperformance, as it has done in the past, although active approaches also bring the potential for underperformance if the stock picks are wrong.

In our view, BGEU looks increasingly interesting after a period of underperformance. The longer record of the strategy has had a tendency to deliver alpha in cycles (see Performance). We would not, however, expect the extreme outperformance of 2020 and early 2021 or the extreme underperformance since, to repeat. This is because these seem reflective of extreme swings in economic conditions and valuations. In short, we would not expect growth stocks to be so indiscriminately bid up or down, but rather earnings’ performance to be more crucial to performance.

After significant falls in the portfolio’s value and with the trust on a discount of 13.8%, we think this looks potentially attractive as an entry point. It is particularly important for investors to take a long-term view though. This is due to the managers’ own focus on the long-term, the immediate outlook being poor for short-term earnings, which often drives short-term share price performance and the potential for volatility, thanks to the high active share and structural debt.