Rising global inflation, and rising interest rates to combat them, have seen the technology sector, and ‘growth’ stocks more broadly, at the eye of the storm in the recent share market sell-off.
There are good reasons for this. Higher borrowing costs reduce the value investors place on future profits. This particularly hits companies where the valuation today depends on longer-term growth and future cashflows. In addition, some technology-enabled businesses thrived during Covid lockdowns but could not sustain rapid growth in earnings as more ‘normal’ conditions returned. Shares in companies where investor expectations got ahead of themselves have been more severely punished in the downturn.
One fund group where previous strong performance has turned around very sharply in the past year or so is Baillie Gifford. There is an unwavering focus on businesses capable of harnessing the power of technological change across the fund range. The fund group’s flagship investment trust, Scottish Mortgage, typifies the approach, with managers Tom Slater and Lawrence Burns aiming to invest in companies that create new markets or disrupt existing ones, and in doing so provide substantial growth opportunities.
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. With exposure to electric car makers Tesla and Nio, Chinese e-commerce giants Tencent and Alibaba and biotech companies Moderna and Illumina (companies at the forefront of finding a solution to the Covid crisis), the Trust also had a particularly spectacular year following the March 2020 pandemic-induced market lows.
Yet those outsized gains have dissipated as investors grappled with estimating how far central banks will go with interest rates, how companies will respond to potentially slower growth and higher input costs, and whether the economy will experience a ‘soft landing’ in terms of growth or something more severe.
The value of investments can fall as well as rise. Investors may get back less than invested. Past performance is not a reliable guide to future returns.
It also seems a fair amount of speculative activity helped drive many tech and growth stocks to excessively high valuations in late 2020 and early 2021. Subsequently, the prevailing mood has changed and the focus among investors is much more on immediate fundamentals such as balance sheet strength and earnings generation than on future potential.
What are the prospects?
With fear and scepticism uppermost in investors’ sentiment, the short term could be difficult for growth stocks. There could be further volatility as expectations change about how far and how fast interest rates have to rise to curb inflation. The month-on-month inflation numbers across major economies will be keenly watched and are likely to dominate day-to-day stock market moves. This is likely to be exaggerated in the share price of Scottish Mortgage, as it will the tech sector and growth stocks more generally.
What is likely to matter more in the longer term, though, 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 on to 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.
Yet it must be accepted that the risks are high here too. 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 a high level of market or product growth is priced intends to involve a broad range of possible outcomes compared with backing more established predictable businesses.
Some of these businesses will fall short of expectations, and 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, but 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, Tesla and chip maker Nvidia, there is a risk that growth aspirations won’t be met. In addition, there is some exposure to Chinese stocks where the opportunity in terms of innovation has to be balanced with the limitations and risks associated with investing in a jurisdiction where there can be an uncertain stance from authorities in terms of company profitability and shareholder rights.
Characteristics of the Trust
Acknowledging these key risks, what are the attributes that make Scottish Mortgage worth considering?
Firstly, the culture and philosophy at Baillie Gifford are 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 the vast majority of 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 a supportive long-term shareholder of businesses 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 and, previously, Jeff Bezos. 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 that are well placed to capitalise.
Thirdly, the Trust has the ability to invest where others can’t. Private investments (not listed on any stock exchange) 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 in the future. 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 gain access to 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.
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 opportunities 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.
The managers report strong operating performance and revenue growth from the businesses in the portfolio. They also believe these companies are generally well capitalised to weather the storm of higher interest rates, even though this is a real headwind to investor sentiment. It remains inevitable that the approach taken by the managers will lead to disappointments among portfolio holdings and a high level of 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.
Scottish Mortgage has a clearly defined identity of backing fast-growing and potentially world-changing businesses. It is capable of outsized returns but 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. It is also worth noting that as an investment trust its share price can trade at either a discount or premium to the value implied by the price of the underlying investments. Presently, shares trade at around a 15% discount to net asset value, having traded at a small premium as recently as April 2022.
Scottish Mortgage has a clearly defined identity of backing fast-growing and potentially world-changing businesses.
The Trust 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.
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