Back to Blue Sky and Base Rates: 10 Years On

As with any investment, your capital is at risk. 

About 10 years ago, exploiting my inner maths geek, I decided to examine the evidence for what really matters in long-term growth investing. I took a break from my usual company-level view of outperformance and looked at the broader stock market. The result was a paper called 'Blue Sky and Base Rates'. 

My goal was to understand how market returns were structured, in the hope of improving how we make investment decisions. Specifically, I wanted to explore how some stocks deliver huge gains over time, while many don't and may even lose value. How did this imbalance or ‘asymmetry’ shape long-term outcomes?

By studying the historical returns of the S&P 500, I looked at how often stocks increased significantly in value over five-year periods, helping me identify patterns and calculate what are called base rates – the likelihood of certain outcomes based on past performance.

The analysis aimed to refine how we imagine possible futures for companies. I explored how a few big winners can drive the overall success of a portfolio, examining what factors like sales growth and sector trends were common to those top-performing stocks. I’ll come back to those findings, but first, some reflections on the wider context. 

A Decade of Perspective

A week, famously a long time in politics, can seem an eternity in financial markets. Valuations can lurch wildly within a matter of days. But if you're trying to build something meaningful, a week is a vanishingly short window through which to view the world.

Rome was not built in a day. Henry Ford's mass production assembly lines at River Rouge took around 15 years to complete. SpaceX's super heavy booster and network of 7,000 Starlink satellites have taken upwards of that. 

These well-known journeys of growth encountered many difficult moments along the way and dreams had to be rebuilt. What mattered was the focus on big future gains.

Considering just how difficult it is to turn a grand vision into something real and valuable, it makes sense that growth should be measured over periods of at least 10 years. That's certainly what our experience tells us.

A Century of Learning

Only one in 10,000 companies survives to be 100 years old. With over 116 years of experience, Scottish Mortgage and of course its manager, Baillie Gifford, are among that small cohort of companies to surpass a century in age. That implies the ability to navigate difficult times.

Our share price chart going back over a century shows that despite inevitable periods of volatility – such as the 1970s oil shock, the great financial crisis, the dotcom bubble and the post-Covid period – Scottish Mortgage has been an extremely successful long-term investment. 

In an industry where everyone has access to the same data and therefore tends to reach  similar conclusions, the characteristics that have helped us include distinctiveness, stability and adaptability.

Distinctiveness comes from perspective. It comes from courage, from hard-won experience, from questioning the prevailing orthodoxy. It comes from accepting that we’ll often look wrong in the moment. It comes from a culture wherein seeming to be ‘wrong’ isn't just tolerated but valued. Stability comes from the deep rootedness of that culture, from long-termism, from prioritising shareholders and being guided by an independent, experienced board.

Adaptability is essential. That means identifying long-term growth themes, investing in companies with the leadership that can exploit them: companies with flexible strategies, resilient financial foundations and innovation at their heart.

Markets Don't Stand Still

One reason we've done a good job for investors over 100 years is by constantly learning and improving. The volatile ride of the past five years has been a chance to reflect and consider the lessons. Has something changed?  Has the return structure of markets moved on? Has the opportunity in growth investing been arbitraged away?

The market's attention span is typically short. Last year, it was elections and inflation. This year, it's tariffs and trade wars. Next year…  who knows? We need to be able to look through that. 

But on the other hand, we rely on following valuable long-term trends such as:

• AI deployment, which has propelled AI-hardware specialist NVIDIA
• the digitisation of the economy, which underpins growth for south-east Asia’s ecommerce giant Sea or Latin America's fintech pioneer Nubank
• electrification in transportation, powering electric and soon to be autonomous vehicles by BYD

Notwithstanding the strength of such forces, we’ve seen a steep drawdown in growth equities. We've seen the emergence of the Magnificent Seven and rising market concentrations. How then should we reconsider that 2014 market analysis in the light of 10 more years of data?

This question led me to recently renew my 2014 analysis. Markets have changed. We wanted to know by how much.

The Persistence of Skew

In Daniel Kahneman's famous book Thinking, Fast and Slow, he looks at probability structures that underlie decision-making. As an investment manager, the key decisions I must make are which stocks to buy and when. In a complex world, I'm trying to support those decisions using concepts such as base rates and scenario analysis.

When I did my original study, looking at data from 1984 to 2013, it revealed that about 20 per cent of companies create half of the return. Furthermore, it showed that only 5 per cent of stocks grew at least five-fold in any five-year period. There was a small number of big winners that drive most of the returns.

One of the most compelling findings from my recent update is the persistence of skew in equity returns. Just as in the 2014 data, a small number of companies has continued to drive most of the market gains. It's interesting that in a much broader index over a completely different time period, we see the same return structure. Again, over the past decade, 20 per cent of the companies drove about half of the return. The top 5 per cent of companies returned at least four and a half fold.

It remains true that, when seeking the best returns, only a few companies actually matter. That skew doesn’t bother us. In fact, it’s the source of our investment edge. It underlies why we continue to back a small number of businesses with the potential for transformative outcomes.

Running our Winners

How has that skewness come through in our portfolio? Stock ranking has been an important differentiator. We've ‘run our winners’. To invest in high growth is to believe that the world will change for the better. That belief, tempered by judgement but undimmed by cynicism, is what underpins all our investments. We think critically, but about what might go right, not what could go wrong.

The blue circles representing our largest holdings over the past decade show they've returned several times their value. Along the bottom, you can see all of our worst investments. We pick stocks that have gone to zero – trucking company Convoy and battery-maker Northvolt most recently. But what is crucial is the payoffs: what you make when you win versus what you lose when you get it wrong.

That's the skew that's driven returns. The likes of NVIDIA, Spotify, home delivery leader Meituan and space logistics and satellited internet company SpaceX have created substantial upside. Meanwhile, the impact of the losers does not exceed the size of the investment and has therefore been much more limited.

Fundamentals Drive Returns

Another of our core beliefs was reinforced by the new analysis: that long-term returns are fundamentally driven by factors such as revenue growth. Piercing through the cacophony of market noise are the companies that deliver real business progress. That ultimately reward patient investors.

When we bought NVIDIA back in 2016, many considered it just a gaming hardware company. We saw the potential for its chips in autonomous cars, in cryptocurrency, in AI, and it's gone on to deliver trillions of dollars of upside thanks to those AI chips. We took substantial profit from the holding last year.

Since we bought a holding in the Chinese food delivery company Meituan as a small private company, it's grown to the point where it's often delivering as many meals each day in China as there are people in the UK. It's now expanding rapidly into new categories and new countries.

The Power of Time

One of the most under-exploited assets in investing is time. Many of the top-performing companies only emerge as such over five to 10 years. We humans are naturally not very patient. We often prefer immediate gratification – the legacy perhaps of our evolutionary origins, when we used to lack full control of our food supply. Share prices are heavily influenced by short-term noise. Turnover data indicates that the market's time horizon extends to one-to-two years at best.

With our 10-year horizon, we aim to already own growing businesses by the time the market is ready to recognise them. By resisting the temptation for short-term trading, we allow compounding to work its quiet magic.

This approach is especially powerful in backing businesses that are creating an industry rather than competing with existing players, because the market struggles to value such opportunities. Artificial intelligence, autonomous driving, reusable space rockets: these things don't happen overnight. They take years to build, and there'll be mistakes along the way.

Global Opportunities and Sectoral Evolution

Our updated analysis also considered sectors and geographies. 

In terms of sectors, information technology and consumer discretionary companies have continued to dominate the top outcomes. Whereas healthcare has dropped out of the top spots, perhaps reflecting the challenge of rising interest rates and drug pricing concerns. Industrials saw a renaissance, perhaps reflecting strong demand for goods through the Covid period and substantial infrastructure investment.

On geography, the highest concentration of top-performing companies was in the US and China,. This helps explain our persistence in investing in China when so many other investors have given up on it. Furthermore, and crucially, outliers do exist across regions. The world is rich with investment opportunities – from AI in the US to precision engineering and luxury goods in Europe, tech giants in Asia and Latin America. Hence our unconstrained approach and Baillie Gifford’s global body of research.

What are the Implications for our Strategy?

Revisiting my original research, and reconsidering it in the light a decade’s further experience of the highs and lows of investing, has reinforced some core beliefs about what’s needed to survive and thrive in this business. I’d summarise the lessons as follows:    

• Maintain a long-term investment horizon, in companies whose transformative potential might take 10 years to be realised
• Remember the power law in market returns and back only a few exceptional companies that can deliver substantial returns
• It’s robust fundamentals, such as rapid sales growth and increasing probability that determine top performers
• Keep a global perspective: an unconstrained approach can best capture exceptional growth companies worldwide
• Embrace the non-obvious: distinctive investment demands the ability to cut out market noise

The Foundation of Long-term Success

On that last point on the above list: being distinctive is essential, but it’s also difficult. Everything around us encourages convergence. It takes deliberate, sustained effort to stand apart, to resist being enveloped by the surrounding environment. Yet for high-growth investors, distinctiveness is non-negotiable. It isn't a style or preference. It's the foundation of long-term success.

Scottish Mortgage is not in the business of chasing consensus. We're in the business of allocating capital to outcomes that haven't yet been proven, and to companies that don't just seek to compete, but to create. That kind of investing is inherently uncomfortable. It demands imagination, patience and a tolerance for being misunderstood.

Focusing on what matters and constantly trying to learn and improve has stood us well for 100 years. I think it continues to prepare us well for the future. In the ever-evolving investment landscape, patience and a focus on growth remain guiding principles. As history has shown, meaningful growth is not achieved overnight, but through steadfast commitment to a long-term vision.

Annual Past Performance To 31 March each year (net %)

Source: Morningstar, total return, sterling. *FTSE All World Index (GBP).

Past performance is not a guide to future returns.

Risk Warnings

The trust invests in overseas securities. Changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up.

Unlisted investments such as private companies, in which the Trust has a significant investment, can increase risk. These assets may be more difficult to sell, so changes in their prices may be greater.

The Trust invests in emerging markets, which includes China, where difficulties with market volatility, political and economic instability including the risk of market shutdown, trading, liquidity, settlement, corporate governance, regulation, legislation and taxation could arise, resulting in a negative impact on the value of your investment.