The three types of growth shares we’re backing to beat the market

In this Insider Interview, Kyle Caldwell speaks to Mike Taylor, co-manager of Monks Ord (LSE:MNKS), about how the investment trust is positioned very differently from the global stock market and why he believes stock selection matters more than ever. Taylor runs through the three growth categories in the portfolio and names a number of stocks. 

The fund manager also explains how lessons learnt in 2021 and 2022 led to Monks becoming more balanced in its growth-focused approach.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio, I have with me Mike Taylor, one of the fund managers on the Baillie Gifford-managed Monks Investment Trust. Mike, thanks for coming in today.

Mike Taylor, fund manager of Monks Investment Trust: It’s great to be here.

Kyle Caldwell: Monks invests very differently from the global stock market, therefore investors should expect the performance to vary over time. However, the past five years has been a very tricky period of performance. If you compare performance against a global index fund or a global exchange-traded fund (ETF), you have considerably underperformed. Could you explain why? 

Mike Taylor: There’s probably two parts to this answer. First of all, in the 2021-22 period, we got our positioning wrong, so we had too much money invested in the most rapidly growing businesses with the highest valuations. If you recall, we were coming out of the Covid period at the time, and many businesses that were involved in the digital world were on very high valuations, and we were optimistic about those companies. 

But a couple of things happened. First, the world emerged from Covid, and some companies that had had a particularly strong demand environment suffered demand weakness. And second, and perhaps most painfully, interest rates rose very sharply. If that happens, that tends to impact the valuation of companies where their profits are far into the future. And at the time, Monks was on a price-to-earnings multiple basis at a premium to the index of somewhere in the region of 40%. So, as that came back in, that was very painful for us. 

But we learned the lessons from that period, and we’ve ensured since then that the portfolio [is] much more balanced. So, Monks will invest in three different types of growth. Yes, the most rapidly growing businesses, but also those steadier, more mature companies growing for a long time, and companies operating in more cyclical industries. We’ve been keen and we’ve made a deliberate effort to be more balanced between the types of growth. 

The irony, of course, is that as we were focusing on that, the market has become very, very narrow. More recently, it has been driven almost entirely by artificial intelligence-related businesses and within the AI world by some of the more marginal AI models and the least profitable lower-quality companies that have almost been bailed out by that source demand. 

Now, we think while that’s been painful in the short term, us being broad in a market that’s narrow, that diversification will pay off in the long run. The drivers of our growth, we think, are more diverse than the market, and we think we are positioned in the highest-quality businesses that have a right to earn profits over the very long term. And, as I look at the positioning of the portfolio as a whole, we’re forecast to grow more quickly than the index. 

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Kyle Caldwell: As you mentioned, 2022 was a tough year. In that year, the shares lost around 30%. The current backdrop is that we’re in a potential higher-for-longer environment for interest rates. If UK interest rates were to change, the expectation is that they would go up rather than down. Inflation remains much higher than central bankers would like to see. So, how will Monks fare given that macro backdrop, and how does it compare to 2022? 

Mike Taylor: Yeah, who knows where interest rates will go over the longer term. But I think your assessment is correct. We could well be in a higher-for-longer environment. And there are a couple of things to point out. 

First, it’s a contrast to where we were five years ago. In that environment, we went from 0% effectively to over 4% very, very quickly. That is a pretty unique environment and a uniquely bad environment for high-growth investing. 

Then, if we fast forward to today, will you get the same sort of level of going from 4% to add another four? You know, debate and discuss. But within that picture, we have to look at [how Monks has changed]. So, as I mentioned, what was very painful five years ago was that step down in the valuation of the portfolio. Today, we are not at a premium to the index. Then, as I look at the growth drivers within the portfolio, they are broader than five years ago.

So, in this higher-for-longer environment, what I think is really going to matter is having earnings growth. If you can’t rely on a valuation re-rating, and we think we’ve got that in Monks, not just in artificial intelligence, but in areas that actually might benefit from a higher inflation environment. 

So, we have banks, or we have energy companies, and if there’s inflation out there, there’s a high chance that it might be coming from energy businesses, and Monks has several in the portfolio. So, I feel confident from a valuation point of view and from an earnings drivers point of view.

Kyle Caldwell: Going forwards, what would your elevator pitch be to try and convince someone to back an active fund manager like yourself versus just simply owning the market through an index fund or an ETF? Particularly when investors can see that over the past five or 10 years, there have been some very compelling returns just owning the market. 

Mike Taylor: Now is the moment to be a selective investor. It’s not always sensible, or rarely sensible, I think, to look in the rear-view mirror and extrapolate that forward. We’ve had an extremely narrow market driven by one theme that is well analysed and understood at a high level. 

But I think what’s really going to matter is to be selective within that and to have sufficient growth drivers without it. That’s what we’re trying to do on Monks. So, can you find the businesses that will still be able to earn outsized profits in five years, and won’t have them competed away by new competition? And can you combine that with growth drivers in areas like energy or healthcare that are unrelated to AI? 

Fundamentally for me, what I think drives returns in the long run in the equity world is earnings growth. And I’m much surer of the stability, the durability of the earnings growth in Monks than I am from a narrow and somewhat fragile global market. 

Kyle Caldwell: As you touched on earlier, holdings in the portfolio fall into one of three categories. There’s the growth stalwarts, rapid growth and cyclical growth. Could you explain what the split is between the three, and is one of those areas more of a focus than the others at the moment? 

Mike Taylor: Rapid growth and growth stalwarts are around 30% each, and cyclicals are around 40%. It’s worth noting that within that cyclical area, there are several different cyclical industries. So, there are a number of semiconductor industries within that space, but there are also financials and energy companies, and they’re operating on different cycles. 

What we’re trying to do at the moment is look for the most advantaged opportunities within each bucket. It’s an interesting time in that I think you’re getting opportunities in each of them. So, in the rapid growth space, you’ve had a pronounced sell-off this year in a number of digital businesses. It’s almost the flip side of the AI trade. There are a number of software or e-commerce or digital companies that have sold off unfairly. So, we’re going through those companies and saying: OK, that is an opportunity. 

A quick example is that this year we added to Shopify Inc Registered Shs -A- Subord Vtg (NASDAQ:SHOP), the Canadian enabler of smaller e-commerce businesses, and that sold off significantly on AI-related threats. We don’t think anyone is going to spin up, using AI code, a rival to Shopify. It’s intrinsic to those companies. So, we took advantage there. 

On the growth stalwart side, these steadier businesses, often those companies at the moment have been left in the shade, again by AI. We don’t think the market appreciates some of the unique drivers there. We invest, for example, in companies that make ball bearings that go into factories or heavy industry, and so on. There’s one business in Monks called RBC Bearings Inc (NYSE:RBC), which dominates that space. It’s a wonderful unique business and as America re-industrialises, its opportunity’s getting bigger. 

Then, in the cyclical space, there are a number of industries that aren’t booming at the moment that we think there is, from a valuation point of view, an opportunity to get involved at attractive points in their own particular cycle. At the moment we are interested in aerospace, for example. That’s a cycle that has been messed around post-Covid by the inability to produce enough planes and so on. That’s produced distortions within that market that we’ve been able to take advantage of. 

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Kyle Caldwell: Monks has over 100 holdings. How often are you making changes to the portfolio in a typical year? 

Mike Taylor: Typically, we would change 15% to 20% of the portfolio each year, and that’s consistent with our long-term time horizon, which is about five years, that’s how far we’re looking out. But, of course, it varies. Some years it might be a little lower than that, some years it might be a little higher. 

This year, particularly towards the start of the year, it was a little bit higher, and that is because we perceive the opportunity set to be changing. Part of that, yes, is artificial intelligence. Part of it is that we are seeing growth at the moment in industries that for years prior didn’t really see it. These tended to be particularly capital-intensive industries. 

So, we made investments in, as mentioned, the energy space or in the financial space or the resources space, which has added up to the picture that we have today of the Monks Investment Trust’s forecast to grow more quickly than the index, to do it with superior quality metrics in terms balance sheet margins and so on, and all available at a similar multiple to the index. 

Kyle Caldwell: You mentioned Shopify. Are there any UK companies that piqued your interest when we had the software sell-off earlier in the year? 

Mike Taylor: Yeah, so there are a couple of UK investments in the trust. One that was probably associated with the sell-off is Autotrader Group (LSE:AUTO). This is the website you go to to look for cars, typically secondhand cars. 

The fear that the market had there was that: couldn’t artificial intelligence scour all the individual dealer websites and replicate what Autotrader does? We don’t think that’s credible. Autotrader has a pretty unique competitive position and it is essentially plugged into all dealerships in the country, and it has access to their data in a fashion that makes it very easy for the users to use. 

If you think about the used car market, no two used cars are the same. There’s different mileages, models, makes, ownerships, dents, so getting the right data is critically important. Artificial intelligence is only as good as the data that it’s fed and Autotrader has the advantage there. So, we’re happy current holders of that company. 

Kyle Caldwell: Finally, Mike, a question we ask all fund managers we interview: do you have skin in the game? 

Mike Taylor: Absolutely. Monks is my largest individual position and we have been buying through the year including this month. 

Kyle Caldwell: Mike, thanks for coming in today. That’s it for our latest Insider Interview. For more videos in the series, do hit the subscribe button and I’ll hopefully see you again next time.