Rising global inflation, and rising interest rates to combat them, has taken its toll on many earlier-stage growth stocks in recent years. Fears over higher borrowing costs tend to hit nascent companies harder, and higher inflation reduces the value investors place on future profits. Some share prices also got ahead of themselves in the post-Covid investing frenzy in 2021.
This has led to poor returns from one of the UK’s most popular investment trusts, Scottish Mortgage. The FTSE 100-listed company is one way to gain exposure to fast-growing companies from around the world. But the combination of ebbing investor sentiment, decelerating global growth and some stock-specific disappointments have dented the trust’s admirable longer-term record.
Will Scottish Mortgage recover?
Over the past year the share price has stabilised and partially recovered from its 2023 trough. The performances of Nvidia, Amazon and Latin American online marketplace Mecadolibre have driven much of this revival. The all-conquering AI chip maker Nvidia became more valuable that the entire UK market this year, clearing the $3trn market cap and joining Apple and Microsoft in this feat. Nvidia remains the top holding in the trust at around 7% of the portfolio, although its shares now trade a bit below their summer highs.
In addition, the Board of the Trust has taken steps to rein in a stubborn discount to net asset value. In March 2024, it announced a £1bn share buyback over two-years, culminating in a huge buyback of £311m in one day in May. The appearance of activist investors on the shareholders register may have helped contribute to the size of the move, but whatever the motivation the commitment was well received by the market.
This action followed a strengthening of the balance sheet through the repayment of expensive debt and a reduction in the allocation to private assets from its 30% limit to 26%. As a result, the discount moved from a 10-year wide 22% in May 2023 to around 5%, though it has since moved out to 12% at the time of writing.
What is Scottish Mortgage’s investment approach?
Scottish Mortgage is the flagship investment trust of Scottish fund manager Baillie Gifford. There is an unwavering focus on businesses capable of harnessing the power of technological change across the manager’s range and Scottish Mortgage typifies the approach. Managers Tom Slater and Lawrence Burns aim to invest in companies that create new markets or disrupt existing ones, and in doing so provide substantial growth opportunities.
The Trust invests in private companies as well as those listed on global stock markets. This offers opportunities to investors that are hard to reach any other way. Among the quarter of the portfolio currently dedicated to these unlisted investments are Elon Musk’s SpaceX, TikTok owner Bytedance and payments provider Stripe.
Scottish Mortgage Investment Trust private holdings as a percentage of overall portfolio
Source: Baillie Gifford, 31st March 2024
The Trust has a strong record of backing some of the world’s most innovative and exciting businesses such as Amazon, Facebook and Google at an early stage. Nvidia has also been a major success story, but the Trust has had its fair share of disappointments too.
Exposure to Chinese e-commerce companies acted as a drag on returns, although exposure is now much reduced. Meanwhile, biotech companies Moderna and the now-exited Illumina both languished in recent years. Inevitably, there have been some poor performers among the raft of private companies too, some of which are at an early stage of commercialisation.
Read more: Should you invest in biotech?
What are the prospects?
Despite the Trust’s stuttering performance, the managers point to the strong operational progress of most of the Trust’s holdings. Investee companies are typically valued more expensively on a price to earnings basis – on average almost twice as much. Yet the managers believe their premium rating is more than merited given the growth profile of the underlying businesses.
Shareholders in the Trust may need to be patient, though. There could be further volatility if there are disappointments around the extent to which inflation and interest rates subside. Higher interest rates for longer would likely dampen enthusiasm for growth stocks and private assets in particular.
Yet what is likely to matter more in the longer term is the stock selection generated by the managers. It’s worth recalling the case of Amazon whose shares fell 90% in the aftermath of the dotcom bubble but eventually went onto produce excellent returns, even for those that invested just before the bubble burst at the turn of the millennium. An unshakeable, long-term view can therefore have benefits, provided enough eventual ‘big’ winners can be identified. Therefore, it is the process of identifying these businesses that is most crucial to the longer-term returns of the Trust, and the key criterion by which we should assess prospects.
The managers also see huge opportunity in the transition to renewable energy through holdings such as Northvolt, the privately-owned Swedish battery developer that specialises in lithium-ion technology for electric vehicles.
Yet it must be accepted that the risks are high. Amazon was something of an exception among the many early internet companies that failed to grow significantly or, even worse, went bust. Investing in companies at an early stage of development, and more mature ones where lots of market or product growth is priced in, tends to involve a broad range of possible outcomes compared with backing more established, predictable businesses.
Some of these businesses will fall short of expectations, some will surpass them, but either way the magnitude of changes in perceived valuation and share price is likely to be considerable. Scottish Mortgage contains dozens of underlying businesses for diversification. However, they are all selected for their rapid potential growth and are concentrated in sectors where innovation is most prevalent such as technology and healthcare. Even among the ‘blue chip’ companies in the current portfolio such as Amazon, Meta, Tesla and Nvidia there is risk growth aspirations won’t be met.
Characteristics of the Trust
Acknowledging these key risks, what are the attributes that makes Scottish Mortgage worth considering?
Firstly, the culture and philosophy at Baillie Gifford is distinctive. Their managers think over the very long term (at least a decade) and act as patient providers of capital to disruptive growth companies. They believe a very narrow set of stocks drive most equity market returns and embrace this in their portfolios by concentrating on what they see as the defining growth engines ahead.
Secondly, Ballie Gifford’s reputation for being supportive long-term shareholders has led to superior access to company management and entrepreneurs. They are one of the few investors that speak directly, one-on-one with the likes of Elon Musk. They believe their access to great thinkers gives them an important advantage in identifying the areas in which the next wave of innovation will occur, how industries might develop, and the companies well placed to capitalise.
Thirdly, the Trust can invest where others can’t. Private investments have contributed significantly to returns and represent, perhaps, the biggest ‘edge’ the managers possess. Just over a third of the current portfolio started off in the unquoted arena and increasingly the managers see non-listed investments as offering some of the best potential. That’s because some of the most innovative companies in the world today are private, often because they are technology-based and can grow quickly without the need to access capital from a stock market listing.
Finally, and very importantly, the Trust has exceptionally competitive charges for such a differentiated actively managed investment.
Although inflation and higher interest rates have dampened investor enthusiasm, the long-term structural trends the Trust is seeking to harness such as digitalisation and intersection of biology and information technology continue. The managers also see huge opportunity in the transition to renewable energy.
It remains inevitable that the approach taken by the managers will lead to some disappointments among portfolio holdings and extensive volatility. Yet they would argue that ideas drive growth, and that trying too hard to be ‘right’ on every investment leads to being too conservative in the pursuit of opportunities that provide the largest returns over the longer term.
Read more: How to build a growth portfolio
Should you buy Scottish Mortgage?
Scottish Mortgage has a clearly defined identity of backing fast-growing and potentially world-changing businesses. It is capable of outsized returns but is also susceptible to very poor periods where market sentiment is at odds with the managers’ strategy and characteristically extreme growth bias. The concentrated nature of the portfolio, as well as the significant stakes in immature businesses whose success or otherwise can be binary in nature, adds to the risk.
The Trust also employs some gearing (borrowing to invest), which exacerbates the movements in the underlying portfolio and leads to greater gains in rising markets and larger losses in falling ones. The fact that the share price can trade at either a discount or premium to the value implied by the price of the underlying investments also adds to the short-term volatility.
It should therefore be considered a particularly adventurous global equity option within a diversified portfolio. It will most appeal to those who share the managers’ long-term perspective – as well as their assertion that a small band of companies will dominate market returns – and are happy to ride out significant short-term volatility. In this context, it remains part of our Preferred List, which is designed to provide a helpful shortlist of investment options for the consideration of investors who wish to make new investments.
Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.
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