#41 - Roy Leckie: Walter Scott, Long-Term Investing

0:05Welcome to the Insightful Investor Podcast, a weekly series that seeks to share industry, investment, investment, investment, and market insights. We define insights as concepts that are counterintuitive, widely misunderstood, or underappreciated. In other words, unique ideas that you probably won't hear elsewhere. I'm Alex Shahidi, the host of the podcast and co-CIO of Evoke Advisors, a leading investment advisory firm. Learn more about our show at insightfulinvestor.org.

0:38Today's guest is Roy Leckie. Roy is Executive Director and Co-Chair of the Investment Management Committee at Walter Scott, which is based in Scotland and manages about$100 billion. Walter Scott was established in 1983 to manage equity portfolios for institutional clients around the world. Roy joined the firm in 1995. Roy, thank you so much for joining me today. Thanks, Alex. It's a real pleasure. Let's start with your background. I think it's always interesting to dive into how you got to where you are. What would you say originally sparked your interest in stock investing, if we go back a few years?

1:18Look, there's two or three things, I think. I had the great privilege of growing up in Hong Kong, where my dad was posted through his work. He's an actuary in the late 70s. You'll know enough about Hong Kong, I'm sure, Alex, to know that it's a city that has finance and trade, investing, running through its veins. So I was exposed at quite an early age to that central dynamic in Hong Kong. Dad, obviously, being an actuary, had that family exposure as well. And I developed at quite an early age a fascination for the concept of risk, did okay at maths in school. We call it maths. I know Americans like to call it math, Maths plural.

2:04There's more than one, apparently. Of course. Did a degree in statistics. And then I knew during my undergrad years that I really wanted to get into investing. And actually, I was determined to try and get a background, a training in classic Scottish investment management principles with a view to then heading back out to Asia. And 29 years on, haven't quite got around to that part of the planet yet. That's the background. Obviously, being an investor for a long time, you have the opportunity to learn a lot, but you also, unfortunately, make a lot of mistakes. But oftentimes, the mistakes are what teach you the greatest lessons.

2:43What do you feel are the biggest lessons you've learned from mistakes that you've made in the past? Alex, how long have you got? Let me answer it like this. Two really significant things happened earlier in my career. The first one was the Asian financial crisis. and I learned then about leverage, particularly currency mismatch. Companies that were both leveraged and had a mismatch in their liabilities and their assets or their liabilities and their revenues, they hit the skids pretty hard in that period. So I was a great front seat to the fact that with every dollar of debt you have as a business, you kind of lose a degree of freedom.

3:26You lose the ability to cope in challenging times. That was really interesting. And then not long after that, of course, was the TMT boom and bust. And I think, of course, the lesson then was really around valuation discipline, not to get carried away with exuberance, with hype, with the zeitgeist of the era. if there was ever a time where it paid to stick to our classical Scottish risk-averse investment principles, that was then. And I was very lucky that at Walter Scott, we had some real giants of the investment industry to learn from. I would point to those two periods as really, really helpful learning periods quite early in my career.

4:14And you mentioned a few, but you've lived through many significant market downturns, including global financial crisis and COVID and et cetera. What have these experiences taught you about managing risk? I mean, it is interesting. When I look back at my career, there's been so many defining moments. You've mentioned a few. I think there's been at least seven 20 % drawdowns. Some, of course, a lot more severe than that. Over the last 29 years, the Asian financial crisis, TMT, GFC, COVID, there was SARS, one or two other bits and pieces. I think there's always new learnings, but I think probably the most important general learning, if you will, is that downside protection is really very, very highly valued.

5:03So investing in companies that are more resilient, better quality, more predictable. They've got risk attributes that see them protect wealth, protect the restore of value in really challenging times. That's really, really highly valued by clients. And so I think those characteristics of our portfolios have really been the foundation, actually, of our long-term record of wealth creation. So the learnings around understanding risk, being aligned to companies and creating portfolios that have got that downside protection characteristic? Risk is such an interesting concept because unlike returns, which you see every day, oftentimes you don't see risk and it's kind of hidden just beneath the surface until something bad happens and all of a sudden it's front and center.

5:55It's such an interesting concept. And so I feel like you have to keep those painful experiences close to you so that you don't get get complacent and feel like it's not a risky time anymore. Yeah, absolutely. You joined Walter Scott almost 30 years ago. What was it that motivated you to join the firm? And what is it about the culture that has kept you there all this time? Yeah. So as I said earlier, the plan wasn't to stay at the same firm or plan wasn't to stay in Edinburgh for the 29 years that I've been here. As I said, I was very keen to get these Scottish or classical investment training background.

6:34And there weren't that many independent investment firms in Edinburgh at that time that wrote a bunch of letters, had a few interviews and had a couple of opportunities. And actually, it was someone whose opinion I respect very highly said to me, well, look, Walter Scott, it's a great little business. And it was little then. I think we managed under a billion dollars. But it's got a very well-defined investment approach. And they all sit in one room. and that comment stuck with me. I thought, well, if they all sit in one room, what better way is there to learn? And so I jumped straight in. Walter kindly made me an offer.

7:10Actually, my offer was dependent on getting certain grades in my examinations at university. And if I was to pass and get the grades, then I was to turn up on the 5th of September. And that I did. And to this day, no one's ever asked me if I actually got those grades, But there we are. And it was just a brilliant learning environment. You will well understand, Alex, that so much of this industry, this art of investing can't be taught from a textbook. It's listening and experiencing. and having the opportunity to discuss, debate with Walter, with his founding partners, Ian Clark, Ken Lyle, one of two others, was just a magnificent grounding.

7:53And the firm has gone from strength to strength. And hopefully I've played a little part in its growth and its success over the years. It's interesting, the comment that you just made, because we learn a lot with just personal experience, but you can complement that with experiences of others and their path. their learnings. And so you don't necessarily just have to learn it on your own. You can actually learn from a lot of other people. And people look at the world through a different lens. And it's really helpful to try to view things through the perspective that they have. Absolutely. As allocators of other people's capital, one of the great things, one of the great privileges of the job is that we spend time with the management of many of the world's best companies.

8:37And yes, they're not necessarily investors themselves, but they are capital allocators. So there's huge amounts to learn, not just from other investors, but from how other people run successful businesses. So we're really, really privileged in the investment world, particularly in the equity, the stock picking world that I have a seat in. We've kind of got a front row seat to this very dynamic and exciting world that we live in. Walter Scott launched over 40 years ago. How would you say the firm has evolved since its inception? Probably the best way for me to answer is to tell you what's not changed, actually.

9:15And I think there's two key pillars to that, or two key things that have underwritten our success. And one is the investment philosophy. We've been really true to our core investment beliefs since day one of the firm's founding. And then the second thing would be the culture. And I know culture, people will define it in lots of different ways. The culture of Walter Scott, the sense of purpose, the way it's led, the way we all interact with each other, communicate with each other, the kind of alignment we have with our clients. I think those are the two principles that have been constant throughout.

9:49Now, we've grown, as I said, both in terms of assets and client numbers, client types. We're doing a range of different strategies and products for different clients in 23 different countries now. Our back and middle office functions are incredibly sophisticated, using all sorts of fairly high-tech applications and processes. The resources available to our investment research team are just so much greater now. So things have developed and evolved and moved forward. But the crucial thing is what's not changed, I would argue, and that is the philosophy and the corporate culture, which we value very, very highly indeed.

10:27You just mentioned the philosophy, and it's essentially been the same for four decades. One of my prior guests emphasized the importance of being adaptable rather than dogmatically relying on an approach that may no longer work as the market catches up. So how do you think about achieving the balance between being adaptable and sticking to your core approach? Yeah, so Alex, I mean, there's lots of ways to skin the cat in this game. Obviously, plenty of different approaches, many of which work really, really well until they stop working. Of course, we think our approach is really, really well time tested.

11:06It doesn't work every year. In fact, there could be quite long periods where it doesn't add or obviously add value. But over pretty much the vast majority of rolling three and five-year periods, it's worked in that we've generated good alpha. I think in every rolling 10-year period, if you look at it monthly, it has done the job. So it does take time, requires patience. But sticking to our core philosophical beliefs, our philosophical principles has worked well for us. Now, as I say, lots of ways to skin the cat, lots of different investment approaches, some of which are the complete antithesis of our research-driven, bottom-up, fundamental, stock-picky approach.

11:48And that's great. We have our way. We have no intentions of changing. And so let me ask you about those stretches of underperformance. So how do you conceptually know what attributes of your philosophy are timeless, particularly when you're going through those periods? Are there questions of, okay, maybe things have changed now, and obviously you have some history to give you a longer timeline, but how do you think about that? The core belief, if you like, within our philosophy is that the external return, the return you get as a shareholder in a company, in any company, is ultimately driven by the internal return, i.e.

12:26the return that the company makes, the wealth created by that company. So as companies, through time, compound their earnings and cash flows and dividends and book value and so on and so forth, given enough time, the return to shareholder accurately reflects that very, very similar. So that's our core philosophy. So that sees you investing in companies with certain attributes. Obviously, the key attribute is that they deliver superior rates of internal wealth creation through time. Now, in order to find those companies, we look for certain characteristics around balance sheet, cash generation, certain qualitative and quantitative characteristics.

13:02And the market recognizes those different characteristics in different ways at different times. So thinking back over the last few years, there was a period going into COVID where it was all about growth and then companies that had a kind of exciting ESG story to tell were performing really well. And then we went into a period where it was value was the key focus of investors. And then profitability has been rewarded over certain periods. My kind of best guess is that as we look forward from here, probably the characteristic that's going to be rewarded most is balance sheet resilience. So our core philosophical identity stays the same.

13:45How that's played out in the stock market can vary through time, can be pretty difficult to predict in all honesty. So we don't really try it. That's why we adopt the buy and hold approach that we're devoid of having to try and second guess what themes investors are going to focus on. We just stick with these high quality businesses through time, knowing that ultimately external return will equal. So we can tolerate, as long as our clients understand what they bought and will be patient with us, we can tolerate those periods of underperformance. So you've been a professional investor for three decades.

14:23Do you feel that the stock market has become more efficient over time and therefore more difficult to outperform a passive index or not? I think it appears to be the case in the US, Alex, particularly where returns have become so concentrated of late. Many investors, many active investors haven't really felt covered, don't really feel comfortable running such concentrated portfolios as concentrated as the US market has become. So it looks like active isn't doing all that well, particularly in the US. I think that will turn at some point, in all honesty. I think the next bear market will expose quite a lot of weakness in some of those stocks, some of those companies that have been driving that concentration, driving the overall performance.

15:11So yes, in bull markets, as we're experiencing right now, particularly in the US, active management is struggling. But active management isn't just for bull markets. Long-term savers, long-term asset owners have to understand that markets go in cycles. And it's likely, in my opinion, that active managers, not all, but many more than have been active managers will earn their crust as market conditions become more challenging. I'd say the US, though, is the market that has and will probably likely continue to be the hardest one to outperform. We're very happy to be global investors in that regard.

15:52One of your core tenets is that superior long-term returns are generated through ownership of great businesses, which you talked about, with high levels of profitability, strong balance sheet, enduring growth. All this obviously sounds intuitive, but how do you assess how much of these attractive attributes for a company are already reflected in the prices you have to pay to invest? Look, when it comes to valuations, we seek to be very conservative around valuation risk. We just don't want to overpay for stuff. So we do a huge amount of work, look at a range of different valuation metrics. This is where the experience and actually our team-based dynamic really comes to the fore.

16:34But I would also say that real wealth creation isn't necessarily in the buying. For us, it's more in the owning over the long term. So we are very patient. We understand that a great company can be a bad investment if we overpay. But paying a fair price for a brilliant business that compounds over a long period of time, it tends not to matter whether the initial starting valuation was 20 times or 18 times earnings. So we're pretty good at valuing the opportunity set. looking at companies, trying to figure out what they're worth today and what the future prospects are. And we're very patient, so we'll wait till opportunities arise.

17:18But we're also very cognizant of the fact that compound growth and time tend to be the main determinants of investment success rather than starting valuation. Is another way of saying what you just described, that you're much less focused on the timing, and in some cases, even the valuation, as long as you're not grossly overpaying and much more focused on just identifying the great companies that you want to partner with, that you want to hold for a long time. Really, it can be simplified down to those core components. Yeah, our favorite holding period is forever. It's trying to create wealth for clients through the ownership of great businesses as they compound year after year after year.

18:01Share prices might not reflect that compound of wealth creation year after year, But ultimately, they will. Ownership rather than the buying and selling of share prices, it's the ownership of great businesses, wealth-creating businesses. That's the approach, always has been. You can tell that by our turnover rates. So average turnover in portfolios of 10 % to 15 % per annum. That tells you we're buying and holding for an average of seven, eight, nine years. And indeed, there's probably half a dozen companies, Alex, in the portfolio today that we've held for well over 20 years. There's three or four in the portfolio we've held for 30 years that were in the portfolio the day I started at the firm.

18:41And the cool thing is one of them recently, the dividend they paid us was greater than the share price we initially paid. That is compound growth investing. Is your sense that the market doesn't fully price the quality? If you're buying a really high quality business and the market recognizes that it's high quality, it may not be easy to get in at a price that actually allows you to generate a good investment return. I'd rather not concur with that and answer the question like this. We just look longer ahead than most people. If you look at the average holding period that most investors own stocks for, it was short when I started my career and it's got a huge amount shorter.

19:26So are we better at valuing a business for the next month, the next six months, the next year? Don't know. Do we have a skill set in identifying companies that have the ability to compound for many years into the future and figure out what a reasonable price is? I think we do. So it's not so much a comparative advantage on valuation, rather the skill set of thinking about investing as a long-term undertaking, which is increasingly rare, much to my surprise. I mean, one of the many things I've got wrong in my career, when I got to grips with what it is that we're trying to do, I said, well, surely, surely the rest of the market is going to start thinking more long-term.

20:15And the exact opposite has happened. And you see that. You see it not just in investor behavior, you see it in corporate behavior as well. I mean, I find it quite bizarre. Many companies seem to manage their business on a quarter by quarter basis. They talk about earnings over the next quarter as if this is the defining criteria on success, which of course is not. So it's our ability to frame the investment challenge as a multi-year undertaking rather than a quarter by quarter or even shorter in some instances. That's how I would answer that, Alex. It's actually very insightful what you just said in that in some ways, the market has become less efficient.

20:53If you're approaching the market from a long-term investment standpoint, 30 years ago, you had more people like that than you do today. Yeah. I shouldn't complain. I don't think that others are not adopting because at the end of the day, we have the ability or the opportunity to capitalize on the impatience of others. Many ways that kind of summarizes what Walter Scott does, how we add value. The short-termist bias in the market provides opportunity for long-term investors such as ourselves. One of your core focuses is on companies that are not only built to survive the downturn, but can potentially prosper when others are challenged.

21:35Would you talk about that? Well, look, it comes back to what I said earlier about understanding risk, downside, protection. We like to invest in companies that have got quite a high degree of resilience, quite a high degree of reliability, predictability. That means they need to have certain characteristics. around cash generation, around balance sheet, around management quality, management teams who are honest and properly incentivized, aligned to the long-term wealth creation objective, and so on and so forth. So these companies, both in a business and a stock market sense, tend to provide that downside protection that helps build or helps to underwrite a long-term successful track record of alpha generation.

22:24Clients tend to be pretty happy if in a roaring bull market, we are there or thereabouts. We wouldn't expect to add huge amounts of alpha in a roaring bull market. But what clients really highly value when market is down 20 % or 25%, and they happen, I've had seven, as I think I said, or seven or eight over the course of my career. If you're down a whole lot less. You've preserved value. It means you don't need to rise nearly as much to get back to the high watermark. And clients sleep better at night. So we think we can deliver that pretty well, that downside protection. It's not because we're doing anything fancy financial engineering, protecting the portfolios, because we're investing in companies that firstly we know are going to be around when they come through the other side.

23:13Actually, there's a reasonable chance they're being predatorial. Companies we invest in quite enjoy tougher times. It's when things are too easy, rates are too low, liquidity is too abundant. Economic growth is so robust that everyone's doing well. We don't fear the challenging economic or stock market times when they come. It tends to shine a light on the qualities of the stocks we've picked for clients. Right. Another way to think about it is if you're a highly skilled pilot and you're flying with your peers and the skies are clear, everybody looks like they're equally skilled. So in some ways, you tend to thrive when a storm approaches because your skills are better showcased in that environment.

23:57Yeah, it's a great analogy, which I'm going to use at some point, Alex. Thank you. Sure. I completely understand being a long-term investor in equities and thinking with the long-term in mind, which is largely related to just survive. Don't go down with others, survive in order to compound over time. How do you deal with investors or clients who may not have the same time horizon as you? And is it just a challenge to try to help them zoom out and appreciate the time horizon? Generally, how do you deal with those considerations? Part of that job should be done or most of that job should be done at the initial client take on.

24:36Well, we seek to be very, very diligent around who we work for, in all honesty. Clients must want a manager who does what we do. So we actually think we should be bought rather than us going out and selling to people. We don't have a business development for a year. You don't see us doing much advertising or selling, if you like. The culture of the firm is very much being an asset manager rather than an asset gatherer. And if an asset owner likes our approach the way we think, the way we slice the dice, we'd be delighted to throw a hat into the ring. But we're probably not for everyone. So the first thing is to ensure clients understand what they're buying.

25:16We work very hard at that. But then it's around client service. So we've always sought to accompany an excellent performance profile with first class or best in class client service. So we have a group of colleagues who go out and engage with our clients, tell them what we're doing, tell them what we're thinking, how we're positioning the portfolio, the sorts of companies we're investing in, explaining why performance is in line or behind their expectations over whatever period, and ensure that they feel comfortable and confident with what it is we're doing. Our main management KPI, Alex, most important metric for Walter Scott's management, it's not our AUM or our profits.

25:59Our most important KPI is client longevity, how long our client relationships last. And we're very proud to have a growing group of clients that we've been working with for 30 years. They've been through a number of performance cycles with us. In order to ensure our underwrite client longevity, we've obviously got to deliver the performance. that has to be accompanied by great client service. And also we've got to get the operational stuff right. So the administration. Longevity is a very persistent or prevalent theme throughout everything to do with Walsh Scott. Long-term how we invest, long-term with a team, 30 years, 29 years, and long-term with clients.

26:38The investment management service should really be considered as a long-term undertaking in our opinion. Yeah, just like the stocks that you're picking, you're looking to invest for the long run. You want your clients to invest with you for the long run. Yeah, clients get the best out of us when they are with us for a long time. And of course, that can require patience. We don't deliver every year. We all know investor psychology is difficult. Many asset owners, the temptation is to buy on the back of a great performance spurt and then sell when things don't look so good. Thankfully, many of our longer standing clients understand actually certainly don't fire us when the performance doesn't look good.

27:21If anything, add to Walter Scott and the knowledge that the philosophy and the process of the team haven't changed, so the performance will come through. You have something called the seven sisters analysis. Would you walk us through that at a high level? To use your analogy, Alex, this is like a pre-flight safety check. It was the US Air Force, wasn't it? The pilots, accident rates, fatality rates plummeted when they introduced just a 20-question pre-flight safety check. In many ways, our seven sisters is a bit like that. We ask a series of questions around management quality, market positioning, barriers to entry, pricing integrity, whether the company's got comparative advantages that are difficult to replicate, and so on and so forth in order such that we kind of expose ourselves, hopefully, to a clear understanding of all the risks that a company's business model might face in different phases of the economic cycle.