Investors struggling to make sense of the transformation in the stock market over the past few years should look to the biological theory of ‘punctuated equilibrium’, in which enormous leaps forward in evolution also tend to be made in relatively short periods of time.
This is according to Kirsty Gibson, manager of the Baillie Gifford US Growth Trust.
Like all managers at Baillie Gifford, Gibson’s philosophy is based on the asymmetry of stock market returns, saying investing is not about “how often you are right, but how much you can make for clients when you are”.
“Your downside is capped at 100 per cent of the money that you invest, but your upside can be many multiples of your clients’ money,” she said.
“As a consequence of this, being long term for us is not about looking at the base case for a given company. We are looking to back ambition, those businesses that we believe could be outliers, and if they succeed, deliver significantly greater returns than the average firm.”
This method of investing paid off spectacularly last year, when the Baillie Gifford US Growth Trust made 133.45 per cent, more than 9x as much as the S&P 500, as the coronavirus-related lockdowns worked in favour of the forward-looking growth stocks Gibson is biased towards.
Performance of trust vs sector and index in 2020
Source: FE Analytics
Yet while the manager said she cannot promise a year like 2020 in performance terms “well, ever”, she pointed out the kind of quick overhaul of existing industries seen during the pandemic is not as rare as conventional investment wisdom suggests.
“Like nature, the stock market and private companies are complex systems,” she explained.
“There are many players with different motivations, time horizons and styles, with people buying and selling, and that’s even before we talk about the different asset classes and the different underlying characteristics driving the assets themselves.
“Complexity in nature reflects the tendency of very large systems with many components to evolve into what we would call a critical state, a sort of teetering calm which is way out of balance, where minor changes or disturbances can lead to avalanche effects in all different sizes. I think this applies to the stock market, too.”
Gibson (pictured) said the best way to think about this is a pile of sand. If it is on a flat table, the addition of a single grain of sand will have little impact on the other grains: the sandpile is stable, and the grains don't interact, so this is not a complex system.
In a mounted pile of sand with steep sides, however, the addition of a single grain causes local disturbances.
“As more grains are added – or thinking from a stock market perspective, more events occur, whether that be company results, M&A, new product launches or IPOs – the steepness of that side of the sandpile begins to increase,” she continued.
“And as more events occur, or as we add more grains of sand, avalanches of all sizes begin to appear. The addition of one more grain of sand increases the likelihood the other grains will topple: they influence each other. Some of the avalanches will be very large, as what starts with a small avalanche gains momentum and has broad-ranging implications for many of the other grains.”
The manager said that in this way, Covid represented a grain of sand added to the already complex system of the stock market, which set in motion an avalanche.
In biology, this is called punctuated equilibrium: the idea that evolution occurs in spurts, with long periods of relative inactivity interrupted by rapid disruptions and a large ‘avalanche’, instead of following the slow and steady path outlined by classical Darwinism.
Gibson said that if you were to draw this on a graph, it would look like a consistent curve, with steps representing periods of relative stability, followed by radical disruptions and then new periods of stability, where a new equilibrium is formed.
However, the manager pointed out that this new equilibrium is not completely stable either.
“A sandpile is not a flat beach: the sides of the pile are less steep than they were prior to the punctuated equilibrium event, but disruptions and avalanches can still occur,” she added.
“And so just like in nature where species evolve or mutate rapidly during periods of punctuated equilibrium, the same can be said of companies in both public and private markets during the pandemic.
“Many had to adopt new business practices, marketing strategies, adapt to massive surges in demand and handle the consequent challenges with supply. And just as happens in nature, some thrived, others evolved to survive and no doubt some will become extinct.”
One of the companies that thrived last year was Moderna, which most people know as a supplier of one of the Covid vaccines.
However, Gibson said that Moderna is much more than this single vaccine, adding that the pandemic has helped to de-risk its foundational technology for broader use.
“Moderna uses mRNA to create therapeutics,” Gibson explained. “If, on the one hand, you have DNA which is the code for life, and on the other end you have proteins, the functional unit in the middle is mRNA, and that's what gets the code out of the nucleus. If DNA is the hardware and proteins are the output, then mRNA is the software code, and it's a digital code made up of four letters.
“You can change the code to produce any protein you want inside the cell and the pandemic has allowed Moderna to show what mRNA is capable of far faster than had it not occurred.
“But the opportunity from Moderna is far greater than Covid: it is looking to build a platform of therapeutics, with mRNA at its core.”
Data from FE Analytics shows the Baillie Gifford US Growth Trust has made 244.28 per cent since launch in March 2018, compared with gains of 75.47 per cent from the S&P 500 index and 74.47 per cent from the IT North America sector.
Performance of trust vs sector and index since launch
Source: FE Analytics
The trust is on a premium of 3.31 per cent, compared with 4.51 and 3.41 per cent from its one- and three-year averages.
It has ongoing charges of 0.75 per cent.