Q and A: Michael MacPhee (Baillie Gifford)

Small funds and investment trusts that fly below the media radar can sometimes offer better returns for discerning investors than many bigger and better known counterparts backed by heavy marketing spend. One example is Mid Wynd International, a £60m investment trust managed since 1998 by Michael MacPhee, a partner at Edinburgh-based Baillie Gifford. The trust targets stocks that are either too small or too specialist to sit comfortably in Baillie Gifford’s two larger investment trusts, Scottish Mortgage and Monks. The trust has returned 75% over ten years, three times the return of the FTSE All-Share index over the same period.

How would you describe your investment strategy?

Returns are asymmetrical in investment. Good portfolios over time are made so by having bought into and held onto a few big winners. One should therefore maximise the chances of owning a few big winners. That is what I try to do. The fund consists of my best bottom up ideas at any one time. It is not constrained by any index or other limits and can invest anywhere in the world.

The portfolio comprises what we hope will prove a good mix of ‘get rich slowly but surely’ businesses, such as Kone or Ocean Wilson (which I have owned as an investor for 21 years), with things that are individually riskier but might make us a great deal of money and are generally off most peoples’ radar. The attraction of the latter category is enhanced if we can find things that are entirely dependent on outcomes which are unlikely to be correlated with stock markets or our other investments.

So, the strategy is to buy great and ideally under-appreciated businesses that churn out cash and deploy it wisely, and look out for ideas, such as Level E or Newbank, where there is a limited downside and a not immaterial chance of a very large upside.

You work closely with Gerald Smith who runs Monks investment trust.  Does your relatively small size determine the different investments these two funds hold?

Yes, though there are some other differences. I’m very fortunate to work in a firm that has a good many smart investors (among whom Gerald is one of the smartest and most fun to work with) and operates a kind of investing neural network. Mid Wynd also has a clear ability to invest in unusual smaller ideas or things that might not work for other client mandates. It is an outlet for interesting ideas and acts as a magnet for some highly rewarding propositions. We can take meaningful positions in quite small ideas.

The holding by the Scott family has been reduced in recent times and a number of Baillie Gifford partners, past and present, have been buying.  You are the largest individual holder of the Trust.  Is it fair to describe Mid Wynd as the “partners’ fund?”

The Scott family are still very significant shareholders in Mid Wynd, and Baillie Gifford partners and staff are present in the register here as they are across all of our trusts. Mid Wynd until recently might be described as something of an acquired taste. The trust has been taking steps to improve liquidity. I take the view that if I’m asking others to invest in it, the least I can do is show willing myself. I also feel comfortable with the manager, despite his many failings!

Given the current macro uncertainties surrounding the global economy, how is this influencing your current positioning? Is this reflected in your current weighting to fixed income, cash and the level of gearing?

The macro uncertainties are significant, with a wide range of possible directions and high probabilities attaching to some of the more extreme outcomes. This has been somewhat the case for a number of years. What’s changing is that everyone is now far more aware of them, and that makes investing to insure against them more expensive.

In terms of asset allocation, the clearest risk and biggest chance of overvaluation looks like government bonds right now. Cash yields next to nothing, although some currencies act like a mirror to those that are in the process of being debauched. CHF (the Swiss franc)/sterling is at an all time high for example and CHF/$ not far behind it.

Corporate spreads are very low by historic standards and returns on corporate bonds will be dominated by the outcome for government bonds. All of which leads one to want to be well invested in equities relative to alternative choices.

Where do you stand in the inflation / deflation debate?

Markets are rightly fairly fixated by this debate. On balance, while we may see a good deal of debt deflationary influence coming out of the West, central banks will tend to err on the side of inflation. The West got itself into debt in large degree by abusing and misunderstanding the disinflation coming out of its trading partners in the East.

Ironically, we may be about to repay the East with a prolonged disinflationary influence of our own that will damp their domestic inflation and may offer them some years of above average stability and falling real interest rates. The world viewed from an Asian perspective may be about to become an even more wonderful place. It is important to avoid being too Western-centric about the investment world.

Would you currently describe yourself as bullish or bearish?

I am somewhat agnostic, having been very spoiled for choice at this point last year when we modestly increased the trust’s gearing. My bullishness test is whether we are coming up with a good number of buy ideas at any point, relative to things in the portfolio that I’d like to reduce or sell.

On that basis, cash is sitting at a low level right now and we are still finding particular things to do that we think will make us money. Some of that derives from the fallout from the crisis. For example, banks are holding investments in illiquid securities, such as life settlements, that they need to offload and which we are in a position to hold. Because of the way that the portfolio is constructed, the fact that I am finding opportunities to buy things however does not imply much about the level of the main market indices.

As far as gearing is concerned, I tend to like to operate with fairly small levels of financial leverage. That has certainly been the case for the 12 years I’ve been running the trust. It is dangerous in our business to become too confident; one can easily confuse brains with a brass neck.

What significant changes have you made to the fund in the last few months?

Not so many really. We have been buying into biotech and healthcare shares, an area rich in uncertainty and volatility. We have found an encouraging number of smallish but rapidly growing and high potential businesses in out of the way places. Examples would be Odontoprev, Genomma Labs, MIPs, M3, Mercadolibre, Gruppo Mutuionline, Vodone, Gushan, Totvs and the like. We have reduced holdings in a few things that have done well for us as markets have rebounded from their recent lows. The list includes Falkland Oil and Gas, Ctrip, OGX, Eldorado and ASOS.

What has prompted your interest in the biotech/healthcare sector?

One reason is that healthcare as a sector has been under a massive cloud, which is partly to do with Obama’s reforms and the unsustainable rise in healthcare costs, and partly to do with the accumulating evidence of the poor future faced by large pharmaceutical companies – “falling off the patent cliff” and all that. As far as the biotech sector is concerned, this was an area that attracted a lot of excitement 15 years ago.

Many companies have continued to work on developing interesting new products, but as they are small companies with few products, investors often face binary – all or nothing – outcomes. This is something that institutions and individual investors tend not to like. As a result the shares have become very cheap. Holding a diversified collection of these stocks means the potential upside is huge if any of these things become commercial, which could happen sooner rather than later. The icing on the cake is that as it becomes clearer that big pharma has lots of cash flow, but no future, you are going to see the big companies buying biotech in a big way.

What major themes run through the portfolio at present?  What areas of the market are you avoiding?

Thematically, we remain fairly biased away from debt ridden economies and financially insecure institutions. While we have a fairly large UK listed portfolio, little of what we hold has anything to do with the UK for example. Litigation finance, Brazilian marine operations, algorithmic trading, life settlements and biotech make up a large proportion of what we hold that happens to be listed in the UK.

Successful internet based businesses are a small but important feature. Businesses that have sizeable owner/manager positions are another recurring theme. Seadrill and Marine Harvest, for example, have made investors money in challenging industries because they are controlled by people who demand operational excellence and know how and when to allocate capital.

You own a number of funds such as Level E Maya Fund, Athena Debt Opportunities and Vision Opportunities China which are managed by third parties. Why do you need third parties?

We use third party funds where they offer us something we can’t do ourselves that we believe is worth doing, or which is inappropriately priced for what it is. For example, Athena came about because a number of our investment managers here felt there were great opportunities in distressed securitised debt. Though nobody wants to touch mortgage-backed securities with a bargepole after the credit crisis, the upper tranches of many securitised mortgages potentially offer very good risk-adjusted returns.  However it is an abstruse, closed world and so we commissioned a third party firm of experts in the field to operate a fund for us.

Vision Opportunities provides growth capital to unlisted or locally listed mid caps run by Chinese families. Over a period when the Chinese market has fallen (since late 2007) this strategy and these managers have doubled investors’ money. At the time we bought in, this feat had been rewarded in the stock market with a 40% discount to NAV! The discount is still far too high and the strategy remains differentiated from anything else available to my knowledge in the world of quoted equities.

Level E is a seed investment in a fund that uses artificial intelligence algorithms to trade a range of strategies across major markets. It is being pioneered by a team of academics here in Edinburgh. In return for our initial investment we have received potential part ownership rights over the underlying technologies and asset management firm.

These represent the real upside. They are valued at zero, but may become quite valuable if the strategy pays off and attracts fresh capital from outside investors. This is a Taleb style strategy, the success or failure of which will have little to do with the variables contained in your first question on macro uncertainties!

What do you mean by risk is not volatility and investment is not physics?

Harry Markowitz has a great deal to answer for. Markets are not efficient, nor is the standard deviation of a share price around a stock index any worthwhile reflection of risk (or much else besides). This is true of things that are intrinsically risky, but don’t seem so because they have become large parts of an index. It is even more true of small or mid size companies which oscillate a lot in price, often with little reflection of changes in underlying prospects. Volatility is not risk for a stock picker, therefore, but opportunity.

Investment is not physics because there is much in investment that is innately unknowable. Things which Donald Rumsfeld would have been proud to describe as ‘known unknowns’. Genuinely unknowable things are often valuable because most investors won’t go near them, so they are often cheap. Not only are they often cheap, they are often volatile. Yet if you accumulate a number of them in a portfolio you can enhance your chances of owning a few big winners.