It has been a turbulent start to 2022 with concerns surrounding inflation depressing investor sentiment. Recent comments from the Federal Reserve suggest interest rate increases are likely in the all-important US economy, which has prompted rising bond yields and a sell-off in the technology sector and growth stocks more generally.
Why are these areas most affected? In short, it’s because businesses investing to secure big future profits, as opposed to near term ones, are more impacted by changes in the ‘discount rate’, which is generally a by-product of the current interest rate. Higher inflation and interest rates have the effect of making the value of future profits – and therefore the shares in businesses – worth less in ‘today’s’ terms.
This is reflected in the weakest performing trusts and funds in 2022 to date comprising many technology-orientated strategies. This includes several Baillie Gifford managed investments such as Scottish Mortgage, a highly popular investment trust and constituent of the FTSE 100. Managers, Tom Slater, Lawrence Burns and James Anderson aim to invest in companies that harness the power of technological change, create new markets or disrupt existing ones, and in doing so provide investors with substantial growth opportunities.
Table: Performance of Scottish Mortgage Investment Trust versus global benchmark over discrete calendar years and year to date 2022
Past performance is not a reliable indicator of future returns. Figures are shown on a share price % total return basis, bid to bid price with net income reinvested; Source: FE Analytics, data for 2022: 31/12/2021 to 12/01/2022.
Riding a growth wave
With exposure to electric car makers Tesla and Nio, Chinese and US e-commerce giants and biotech companies Moderna and Illumina (both at the forefront of finding a solution to the Covid crisis), Scottish Mortgage has fully harnessed the strong performing areas of global stock markets over the past decade. The fund has ridden a wave of technology and healthcare innovation, reflecting the managers’ success in backing the disruptive business models.
The managers are passionate investors and free thinkers. They place little emphasis on traditional valuation metrics for stocks and reject the idea that ‘cheap’ companies will ‘mean revert’ in any meaningful way. With no limits regarding geographical or sectoral exposure, they are able to invest in what they consider to be the world’s most exciting companies. That’s whether they are listed on a stock market or are private companies accessed through their network of contacts.
It is a long term, high-conviction approach capable of outsized returns but also susceptible to poor periods where market sentiment is at odds with the managers’ strategy and characteristically extreme growth bias. The recent pronounced market sentiment shift away from ‘growth’ into ‘value’ stocks is typical of this. Recent investor favourites in ‘re-opening plays’ such as travel and leisure and ‘old economy’ areas such as shipping and resources, are simply not aligned with the Trust’s philosophy. The concentrated nature of the portfolio and significant stakes in immature businesses whose success can be binary in nature also adds to the risk.
It is a long term, high-conviction approach capable of outsized returns but also susceptible to poor periods where market sentiment is at odds with the managers’ strategy and characteristically extreme growth bias.
Volatility in key holdings
Recently, there has been some volatility in key holdings in the fund on top of a general swing in sentiment against the growth investing style. Tesla, whose share price ballooned over the course of 2020 and 2021, has pulled back from recent highs. The managers have trimmed their holding significantly over the past year or so, locking in profits, but at over 6% it still represents the second largest stock in the portfolio.
Moderna, meanwhile, whose share price has exploded upwards last summer, has been on a decline since then. The biotech company shot to fame as the first company to start trialling a Covid-19 vaccine, which ignited sales while it continued to build a large pipeline of drugs to tackle infectious diseases, autoimmune disorders and cancer treatments. As the largest position, the managers continue to back it owing to its unique platform that develops medicines based on messenger RNA (mRNA) technology, which tiggers immune responses through teaching cells how to make proteins.
The Trust’s Chinese stocks such as Tencent, Meituan and Alibaba have also had a tough time as authorities moved to clamp down on regulatory concerns and certain business activities. Over the course of last year the Chinese government became more interventionalist towards listed companies, looking closely at issues such as competition, data protection, consumer rights, employee’s rights, and wellbeing.
It is also notable that following the recent share price decline the Trust’s shares have moved from a 6% premium to net asset value at the start of December to a small discount. There’s an explanation of how investment trust discounts and premiums work in this article 'How investment trusts can enhance your portfolio'.
Sticking to the process
The managers pay little attention to short-term valuation fluctuations and aren’t overly concerned with quarter-on-quarter reporting numbers. Instead, they try to take at least a five to ten-year view with the intention that any company invested in has the potential to at least double in value.
Given the unpredictable and ‘noisy’ nature of markets, they make no attempt to manage fund performance over periods shorter than five years, and the investment theses formed for underlying holdings are framed in suitably long time periods. Instead, the focus is on the opportunities presented by the ‘super-cycle’ of technological innovation, which they believe over the longer term overwhelms the commodity or economic cycles investors often focus on.
The managers have a strong record in identifying winning companies and as large, patient investors tend to be able to access new and privately owned opportunities that others can’t. Indeed, Private investments have contributed significantly to the Trust’s 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 – ones to which regular investors cannot gain access – as offering the best potential in the future. That’s because some of the most innovative companies in the world today are private businesses, often because they are technology-based and have lower costs meaning there is little need to raise capital via the stock market to grow.
Scottish Mortgage backs some of the world’s most innovative and exciting businesses and the managers have demonstrated great insight and stock picking over the years. However, the areas the managers invest in are prone to rapid changes in sentiment. A good deal of optimism can already be factored into the share prices of high-growth companies, meaning any disappointing news can be severely punished if they don't keep delivering.
A cooling towards the technology sector and high-growth stocks is a difficult backdrop for the Trust, but we believe investors should look to back favoured managers in a range of strategies for the long-term, rather than reacting to every market move. There is a paradox at the heart of active management. In order to justify paying active management fees, we demand high conviction approaches that look very different to the benchmark. However, the more genuinely active a strategy is the greater the likelihood it will experience spells of pronounced and sometimes prolonged underperformance. Scottish Mortgage does adopt a very different strategy to most funds available meaning that periods of poor relative performance are to be expected and indeed must be embraced over the long term.
We continue to believe the Trust should be considered a higher risk global equity option for 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. The growth potential of the collection of companies making up the portfolio should, ultimately, be a more important variable than where interest rates end up, even though this factor can be hugely influential on short term sentiment and share price action.
We continue to believe the Trust should be considered a higher risk global equity option for those who share the managers’ long-term perspective.
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