How we unearth the innovative firms of the future

Ian Mortimer, co-manager of the Guinness Global Innovators fund, explains how the equity fund invests, and the team’s focus on a handful of secular growth themes.

He also discusses how the fund differs from a pure-play tech vehicle, the risks that come with investing in innovation stocks, and names lesser-known companies held in the portfolio.

The fund can be found via our new Highly Rated Funds tool, which can only be accessed by ii customers. Information about the tool can be found here.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

Dave Baxter, senior fund content specialist at interactive investor: Hello and welcome back to our Insider Interview series. I’m Dave Baxter, senior fund content specialist here at ii and today, I’m joined by Ian Mortimer, co-manager of the Guinness Global Innovators Z GBP ACC (BQXX3N1) fund. Ian, thanks very much for joining me. 

Ian Mortimer, co-manager of the Guinness Global Innovators fund: Pleasure, thanks for having me. 

Dave Baxter: So Ian, innovation can be quite a subjective term. People interpret it pretty differently. So first of all, tell me, what does the fund do? What kind of companies do you look to buy? 

Ian Mortimer: Yeah, you’re right. So, we’ve been running this strategy as a firm for over 20 years, and I think the word innovation can mean different things for different people. The best way to think about how we run money and what we’re looking for is really, really good growth companies. We’re looking for companies that are exposed to secular growth themes, and within themselves, maybe innovative, but ultimately really good businesses that can compound and grow over time.

So, we’re not looking for the next big thing, very early stage companies, all that kind of speculative end of the market. I think for us, innovation really comes through in terms of that kind of compounding idea and doing interesting things. 

As we can talk about, there’s lots of other characteristics that we’re looking for, because ultimately, it’s also thinking about what makes a good investment. A company might be super interesting and do something very exciting, but is that actually a good investment?  I think that’s a core concept that we want to think about. 

Dave Baxter: So, what kind of metrics are you applying to make sure that you’re not just buying some speculative, unprofitable bet? 

Ian Mortimer: Yeah, so really, if you think about where we’re starting, the idea is if you can find companies that are growing faster in the market, they can outperform. Now, that’s a very simple premise, but it’s quite difficult to achieve. One of the hard things to think about is, there isn’t really any sort of quantitative measure that you can screen for that will tell you a lot about whether that company will grow faster [than] the market in the future. 

A lot of people look at things like historic growth. But actually, that really doesn’t correlate very strongly with future growth. It’s pretty uncertain. So instead, we have to take a slightly more subjective starting point. So, we look for a range of secular growth themes. We’ve got about nine that we typically look at. These look around a variety of different ideas. We then find companies that are exposed to those secular growth themes. So, hopefully, they have a good potential pathway for growth. 

And then to your point on whether they’re a good business, we apply what we describe as a quality cut-off. So, we look for things like companies have a return on capital above the cost of capital, companies with strong balance sheets, companies that actually have earnings. 

So, we’re not looking at that sort of early stage. What does the business model look like? And from that group, we’re then doing bottom-up stock selection. So, we are applying a valuation discipline because we think value is important in the context of growth. 

• Fund Focus: beyond Space X - the next frontier of space stocks
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

Dave Baxter: One accusation that gets levelled at innovation funds is that they’re simply tech funds. How would you defend yourself against that? 

Ian Mortimer: Yeah, I mean, I think we have heard that before. Tech is clearly an area that fits a lot of the criteria we just described. There’s a lot of already good businesses that have good strong pathways for growth. But I would say two things. The first thing is that although we have had a high weighting towards tech historically, it generally has been around 40-45% of the portfolio. Within that there’s different types of industries within the IT sector. So, there’s semiconductors, there’s tech and hardware, and then there’s also software businesses. Each of those have a slightly different business model. 

The second thing though is that clearly over half our portfolio is not in the IT space. We’ve got good exposures to areas such as industrials, financials, and consumer discretionary, for example. I think the pushback I’d have is that [it’s a] slightly broader set that we’re looking at, or they might be. Tech-biased definitely gives us a different exposure and different potential outcomes to a pure tech fund. 

I think if you compare our portfolio to a purely tech fund, it will have slightly different performance and it will potentially have different performance in different market environments, which again, makes it somewhat attractive relative to that tech. 

Dave Baxter: Beyond things like tech, beyond things like AI, what secular growth themes are you investing in?

Ian Mortimer: I think in terms of that starting point, it’s fairly broad. We’re not saying we are going to be better than the next person at finding the next big thing. Because as we just described, that’s really difficult to do on a consistent basis. So, yes, within our themes we do, as you rightly say, have things like AI, cloud computing and so forth. Tangential to that would be things like robotics, for example. 

But also we have things like advanced healthcare. More areas like the kind of consumer orientated-type businesses within that as well. I think by having that slightly broader thematic approach, one of the things we’re avoiding is that idea that you get these bubbles - it’s kind of a hype cycle, I think Gartner described it as - and we’ve seen that time and time again over the years that we’ve been running the strategy. 

It’d be things like biotech, or it could be 3D printing, for example. People tend to get very excited, it gets a bit hyped up, and then maybe the reality doesn’t match that hype, and then you suffer potentially the drawdown, which is often a derating, as opposed to necessarily the company’s doing really terribly. 

So, by having that multi-thematic approach and being slightly broader in our opportunity set, we then hope we can find good businesses exposed to good growth areas, and really it’s the valuation part that’s driving a lot of where our allocations are going from.

We’re not trying to fill buckets, we’re not saying this is a good theme, we should have 10% in that, that’s a good theme, 10% on this. It could be, if all robotics companies were extremely expensive, there would be none of those in our portfolio, because that doesn’t make a good investment. 

• How ISA tax rules are changing from April 2027
• How the experts would invest a SIPP at every life stage

Dave Baxter: These themes, things like AI, can come with a lot of hype, they can come with a lot of froth. How do you navigate that when you’re investing in these companies? 

Ian Mortimer: A way of thinking about it is a little bit of extremes, so probability distribution. We’re not looking at the extreme tails. So, if you think about things like in the pandemic when we had Peloton Interactive Inc (NASDAQ:PTON) as the extreme example, a huge rally, but it did not reflect at all ultimately what that company could achieve going forward. Valuations were very, very stretched. We’re clearly avoiding those.

As you then come more towards the middle, what we’re trying to do is balance that idea of…we want to let our winners run, we want to have companies where that pathway for growth is relatively long, and we want to keep supporting those companies and benefiting from that growth. However, there’s clearly a limit to that.  

So, we are valuation disciplined and the first thing we’re doing is we run a portfolio of 30 positions and they’re approximately equally weighted. So, all our positions start life at about 3.3% and we’re happy for them to run up. But if we start getting towards 5% or above, we may step in and reduce that weight down. So, within the mechanism of the portfolio construction, we’re actively taking profits if companies rally too far. And that’s often associated with an increase in valuation. 

Not always. You mentioned some of the Mag 7 stocks, things like NVIDIA Corp (NASDAQ:NVDA). As that’s rallied, actually, the valuation of that’s come down because the earnings growth has outpaced some of that price growth and therefore the valuation has compressed. So, we’re taking all that into consideration.

And, ultimately, part of our sell discipline would be if we felt the valuation got too rich, we would potentially sell that company. I think a good way to think about valuation in the sense of growth investing is a little bit more, not necessarily the absolute valuation, but what are you paying today for the expected future growth? 

If you think about a simple analysis of a company, if you can understand the current cash flows, and you imagine they’re just flat, so just maintenance capex, so they’re re-investing to kind of keep going. If you discount that back, you could get an approximate valuation for those cash flows.

If you compare that to the current market cap, the difference is what you’re paying today for the future growth, and how expensive is that option? Because what we know is, as we mentioned at the beginning, future growth is very difficult to predict. The market isn’t brilliant at it. It’s very hard to do quantitatively. So, therefore, if you’re paying a big price for that option today, it could easily disappoint and that’s where you tend to get those valuation pullbacks or the deratings of these growth companies. 

It’s not that they necessarily have to do terribly. They just have to not meet the high expectations. And so therefore it’s the rate of change-type argument. So, a lot of the work we’re doing is thinking about what are we paying today for the future growth, and how expensive is that option?

Because what we’d ideally love to find is companies where you’ve got a great business today, you can understand it, maybe the market isn’t necessarily pricing that future growth very highly. If it doesn’t come through, you should hopefully limit some of your downside. But if it does come through, you can potentially get the strong benefits of that re-rating story and that growth coming through. 

One of the things we talked about for clients is, if you’re not going for those big winners, are you going to be missing out? There’s some interesting research that we’ve seen looking at 10-baggers in the US equity market. So, stocks where the price performance had gone up 10 times. They analysed it back and you look at all those types of examples over the last 50 years, I think, in the US equity market. What did those companies look like at the beginning of that journey? 

You generally found there were slightly larger companies. So, market caps tend to be $5 billion-plus. The companies tend to have earnings, and the multiple tend to be about the same as the market, so you weren’t paying these big premiums. Why did those companies go up 10 times? The revenue grew faster than the market expected, margins expanded alongside, therefore the earnings compounded up faster, and then you had the re-rating story on top. 

So, one of the things we would say is we think you can apply that valuation discipline. You don’t have to stretch for those extremes. We think that gives you a better chance of a good return on average. But it doesn’t preclude you, by the way, from owning some companies that do extremely well. And we’ve had plenty of examples of that through the life of the fund. 

Things like Netflix Inc (NASDAQ:NFLX) went up 10 times in 2007. We’ve owned Nvidia for more than 20 years in the strategy. More recently, it’s things like Lam Research Corp (NASDAQ:LRCX) or KLA Corp (NASDAQ:KLAC), applied materials and the semiconductor equipment manufacturers. These are all types of those sorts of examples where at the starting point, they weren’t really richly valued. They weren’t at these extremes, but they came through and did extremely well. 

Dave Baxter: On the theme of innovation, what are some of the big risks people should be aware of? One I think of is perhaps that it’s more sensitive to interest rates, and the fund, like many others, did take a bit of a clobbering back in 2022. 

• The smaller company funds offering big yields
• Fund Focus: where Baillie Gifford has - and hasn’t - recovered

Ian Mortimer: I think that’s more the style, I guess, of growth, right? I think the example you’re seeing there is there’s quite a big difference in terms of what shifted in the narrative in the market. So, if you think about post-financial crisis, up to the pandemic, we had a zero interest rate environment. It was a really good time to be investing in growth. A lot of funds or stocks that did well were those higher growth, the better, right? Really rallying a lot.

Whereas as you rightly say, that started to change. First, you have this speculative sell-off post-pandemic in 2021, and then in 2022, you had the interest rate regime change.

I would say, if you think about that spectrum of growth investing again, if you’re at the more extreme end with the very, very high valuations, a lot of the value today is in the future. That’s what you might argue is a higher duration growth investment strategy. I think that was more affected.

I think we were on that spectrum and we recognise that. We have quite a clear focus on the types of companies we are going to be investing in, the kind of factors we’re exposed to. But I think it was less extreme. If you look at our track record, maybe compared to different types of growth investing, I think we did very well leading up to the pandemic, but we didn’t capture all that upside in that frothy-type market.

But I think we did better, particularly in the speculative sell-off in 2021. And we were maybe relatively less affected by some of those changes that maybe we had seen. Yet, we’ve still kept up very well with things like Mag 7 and the AI story. 

Dave Baxter: And what are a couple of lesser-known stocks currently in the fund? 

Ian Mortimer: So, thinking about things outside tech, we own a company called ANTA Sports Products Ltd (SEHK:2020) for example. So, that’s in the consumer discretionary space. You can think of it like the Chinese Nike or the Chinese Adidas, for example. This is a company that’s making apparel and footwear. It’s a multi-brand product and it’s done really well out of bringing in Western brands like Fila into China and then selling it domestically. It has done quite well making acquisitions like Amer Sports. More recently, it’s taken a stake in Puma, for example. 

If you look at the financial characteristics, it’s got better gross margins, they manage their business to be more profitable than maybe some of those Western brands. That’s a good example of a company that might not necessarily be associated from that growth perspective, but is in a very different area to something like tech, but has a lot of the things we would like to see, whether it’s barriers to entry or sustainable competitive advantages versus their peers, and also that pathway for growth.

They’re doing that in multiple different ways, whether that’s direct to consumer, whether that’s through building out selling to more childrenswear, for example, whether that’s building out Western brands into China. That’s definitely a stock that would be different to maybe some of those typical tech-type stocks that you might expect to see in a growth portfolio. 

Dave Baxter: Ian, many thanks for your time. 

Ian Mortimer: Thank you. 

Dave Baxter: And thank you for watching. Do let us know as always what you think in the comments. And if you’re a fan of this series, hit the like button and hit the subscribe button. Thanks and take care.