Scottish Mortgage (SMT) aims to generate superior returns from global equities with a highly active, long-term approach. The success of that strategy, particularly over the past decade, has led SMT to grow into the largest investment trust on the FTSE and pass on the benefits of scale in exceptionally low fees.
The NAV growth has largely come through performance. As we discuss in the Performance section, over the past decade the trust has generated annualised NAV total returns of c. 20%, one of the very best results in the investment-trust sector. Growth has also come through regular issuance of shares in the long periods the trust has been on a premium. Despite a wobble during the recent crisis, the trust is now back on a 3.6% premium.
The managers James Anderson (appointed in 2000) and Tom Slater (deputy manager from 2009 and joint-manager since 2015) aim to identify companies which can deliver exceptional returns, then invest in them at an early stage of their development and hold them for the long run. In recent years this has led them to invest heavily in companies developing and benefitting from new technologies, often centred around the internet. This includes those companies operating out of Silicon Valley, but increasingly also their Chinese equivalents and competitors.
The managers believe the new technologies being developed in recent years tend to provide opportunities for increasing returns to scale, meaning that many investors have underestimated the long-term potential in companies exploiting them. This has led to a willingness to hold onto companies at apparently high valuations when the managers believe their long-term potential is still being underestimated.
SMT’s success is highly impressive. James and Tom’s ability to maintain conviction in their long-term expectations for companies despite vicious volatility and shrill concerns about valuation from other investors is not often found, and their patience has been well rewarded. The real question for investors is whether this success is sustainable or has been the result of having had the right strategy at the right time.
In our view there is now a realistic path to high inflation and higher interest rates over the next couple of years, thanks to the likelihood of massive public expenditure in the developed world to attempt a recovery from the current crisis. This could provide a mechanical drag on the valuation of high-growth companies through the discount rate. However, the question is whether this would offset the growth potential in the portfolio. We would not bet on this, as we think there is still huge growth potential in trends evident at the top of the portfolio – for example in online services and electric vehicles, both of whose growth may be accelerated due to the crisis.
However, SMT’s ability to replicate the past ten years will depend on the ability to find new opportunities to revivify the portfolio in time. This will be difficult and require getting numerous calls correct. For this reason, although we think there is huge potential in SMT, we would be wary of putting all our eggs in this basket.
|Highly active approach increases chances of outperformance||Higher interest rates and/or inflation could be a headwind to the strategy|
|Offers rare exposure to unlisted early-stage companies||Can be volatile thanks to large single-stock positions and volatility in some 'story stocks'|
|Fees are extremely low for an active fund||Unlisted holdings could present liquidity problems for the trust if demand for the trust turns|
The managers of Scottish Mortgage (SMT), James Anderson and Tom Slater, aim to identify companies which can grow their earnings above the cost of capital consistently over the very long run. They believe that very few companies can do this, and those that can are able to generate strong outperformance for many years. James and Tom look for companies which have huge addressable markets and a vision for how they can dominate them, with intellectual property, logistics or a technology which gives them the means to do so. They aim to buy companies which can create or dominate whole markets but which are at an early stage of their development, and to hold onto them for the very long term. Increasingly in recent years, this has meant investing before the companies come to the public markets (although companies are doing this later in their development anyway, as we discuss later on).
The managers accept that they cannot always correctly identify these companies: there will be some false positives, so to speak. However, their view is that if they invest in the right type of companies then the asymmetry of returns is so good – i.e. the potential upside outweighs the potential downside by so much – that they can afford to have a few failures as the effect on overall returns will be dwarfed by their successes. The managers believe this style of investing is increasingly appropriate to the current state of markets and society. The current state of technology, particularly with regards to online services and software, means the potential returns to scale grow and grow, rather than diminish. They believe that their success over the past decade (see the Performance section) is due to the fact that many investors have not properly adapted to this new reality.
The portfolio is highly concentrated, with 53.5% in the top ten positions. Although there are 89 positions held in total, 80% is in the 30 largest. Of this 89, 47 are unlisted companies which make up 17.1% of total assets (as at the end of May). This reflects the strategy of buying into companies early in their development and letting them grow organically. The managers let their successful positions rise to become substantial parts of the portfolio, reinvesting when appropriate, and don’t trim positions back to preset limits. This approach fits with the managers’ belief that exceptional companies are fairly rare and returns to scale increase for their portfolio holdings if they have chosen correctly. It also reflects their approach of ignoring short-term noise, be that quarterly results or share price-movements, and remaining focussed on their assessment of the long-term potential of each company.
Furthermore, the managers are aware that for active managers to outperform they need to differ from the index, which leads to a high active share (92% vs the FTSE All-World benchmark) and large single-stock positions. The managers consider that as the end investor is unlikely to hold more than 10% to 20% of their investments in SMT, substantial positions are necessary to ‘move the needle’. They view indices as potentially very risky in themselves, and pay no attention to the idea of risk versus the index, but on their assessment of the probability weighted future cashflows. In other words they project out possible growth paths for companies and then discount them back, weighted for the likelihood of occurrence. The indices are full of companies which have a relatively high likelihood of not being around in the future – or at least of being around in a much-diminished form, such as the energy giants in a world aiming for ‘net zero’ – which makes them inherently ‘risky’. It is in this sense that the managers resist being characterised as growth investors rather than value, believing that they have a more appropriate way of valuing companies over the long run, especially given the trend for companies to enjoy increasing returns to scale.
The top ten can therefore see quite volatile movements as shares rise and fall. Currently Tesla is the top holding following its meteoric rise this year, followed by Amazon and gene-sequencing technology manufacturer Illumina.
top ten holdings
||% of total assets
Source: Baillie Gifford, as at 31/05/2020
All of the top three holdings have been boosted by the current pandemic, as have many stocks in the portfolio (see the Performance section). However, James and Tom remain focussed on the long term. A good example of this is the reduction in the positions in Alphabet (Google) and Facebook in recent years. James and Tom believe these companies have struggled more than others with maintaining the pace of progress and expansion. Amazon is a good example of a stock they think has done this well, and James and Tom value company leaders who aim to continually refresh leadership roles, continually trying to expand and develop new areas and broaden the total addressable market. One worry that some investors have about the online giants is the potential for regulation to break them up. However, James and Tom think that if a company is well run and pushing its potential, this could even be a catalyst to unlock further value. Amazon, for example, they believe would likely see the value of both businesses in aggregate rise if it announced it were to split AWS from its online shopping business.
The shift into unlisted companies has been developing over the past few years. In March 2015 unlisted investments made up just 3.9% of the portfolio, growing to 11.8% in March 2016, before growing steadily to the current 17.1% (as at the end of May). As well as growth in the valuation of these companies, there has also been growth in the number of unlisteds held, as James and Tom aim to find companies with the greatest growth potential. Growth is also spurred by their contention that companies are staying private for longer in order to benefit from the longer-term approach taken by private-market investors, and to avoid the restrictions that come with having to report to the market quarterly and manage short-term expectations. In fact, James goes so far as to say that he believes it is probable that all innovation will be done in private, not public, companies in the future.
Some innovations also require huge amounts of capital, which is better accessed in the private markets, James explains. He cites battery-storage technology as an example, as well as synthetic biology and the interface between data and biology, all emerging areas in which Scottish Mortgage is invested.
Sector and country exposure is derivative of stock selection, and there is no attempt made to measure risk relative to an index. The below chart shows how the portfolio is tilted to consumer cyclicals (which includes many online retailers such as Amazon and Alibaba), emerging healthcare, communication services and technology.
On a country basis, approximately 53% of the portfolio is listed (or based) in the USA, which is actually less than the global market indices. Historically James and Tom have found many of the greatest opportunities on the West Coast in Silicon Valley. They continue to find attractive companies there, but they say they believe more and more opportunities are likely to come from China. Partly this is because the addressable markets there are larger, but they also identify greater opportunity for incumbents to break through, citing TikTok’s parent company ByteDance’s eclipse of Baidu (once a major holding) in contrast to the FAANGs’ increasingly protectionist and anti-competitive ecosystem. Similarly the financial-services sector in China is more dynamic, they believe.
In fact, James and Tom argue that Chinese e-commerce giant Alibaba is arguably the most valuable asset in the world. Although it makes up 5.6% of the portfolio, this rises to c. 8% when the holding in the unlisted spin-out Ant Financial is included. James believes the political clash between the US and China is largely irrelevant to the growth potential of Alibaba and most of his portfolio. In fact, he thinks tensions are likely to grow thanks to the ingrained fear the US establishment has of China’s growing power, which extends far beyond the current President.
In keeping with the long-term approach, the managers have made few changes to their portfolio in the light of the current pandemic. James says he thinks that managers should avoid making decisions when under short-term stress. He believes the most significant change we are seeing in 2020 is actually the steps made towards decarbonisation rather than the fallout from the coronavirus. The Tesla Model 3 became California’s bestselling car in Q1, while in the same period over half of Germany’s energy was provided by renewables. The managers believe this shift of energy source is going to have far-reaching ramifications, and they are therefore seeking to build out assets in the space, including in the battery-storage companies referred to, which are all currently unlisted. The pandemic has also hastened the move to remote healthcare, the managers believe, with SMT holding a number of companies in this area, including Chicago-based Tempus (unlisted). Similarly they think it is likely to spur innovation and growth in the application of big data to healthcare problems, and they hold some companies in this area too.
The board aims to use gearing strategically in order to benefit from the tendency of stock markets to rise over the long term. However, no attempt is made to time short-term market movements through tactical shifts. The board has committed to restricting itself to gearing of 30% as of the time of borrowing (calculated as per the AIC guidelines on net assets). There are also covenants on existing debt which limit it to 35% of net assets. However, in theory, it can gear the trust up to 50% of issued and fully paid share capital and reserves.
In practice the trust has been much more modestly geared. As at the end of May, net gearing stood at 7% of net assets. Of course, the strong growth in the value of the portfolio and growth in the size of the trust through issuance has made fixed debt shrink as a percentage of net assets over time, necessitating new borrowing arrangements to maintain the level of exposure.
In recent years, SMT has been taking out debt by issuing private placement notes, in order to get advantageous rates. These multicurrency loans mature at dates between 2038 and 2050 and sit alongside debentures with maturities in the 2020s. The privately placed debt makes up 78% of the long-term debt. Small proportions of the loans are in euros, while some of SMT’s short-term debt facilities are in dollars. This helps to reduce slightly the exposure of the trust’s NAV to currency moves due to holding non-sterling equities.
Scottish Mortgage has an outstanding track record under the current strategy. Most of the outperformance has come in the past ten years, over which period it is one of the top-performing funds in the entire investment-trust universe. Its annualised returns of 19.7% are fifth, with only Lindsell Train, two technology trusts and a biotechnology trust managing to eke out slightly higher returns. This is almost double the 10.2% returned by the FTSE All-World benchmark each year over the period. Over the past five years the outperformance has accelerated, with cumulative NAV total returns of 199%, compared to just 69% from the FTSE All-World and 63% from the average trust in the AIC Global sector.
The last two periods of underperformance came in 2011 and in 2016. Both were sell-offs, caused in the earlier case by the euro crisis, and in the later case by an oil-price crash before Brexit then spooked markets further. In both cases the high-growth stocks Scottish Mortgage invests in were regarded as being market leaders, expensive and ‘risk on’, and therefore they sold off more than the broader market. To the latter end of 2016 the election of Trump also led to a rally in inflation expectations which saw value outperform growth and Scottish Mortgage underperform.
Interestingly, the current coronavirus crisis led to very different performance. Technology and internet-related names were considered to be more resilient to the current environment as they in many cases enable other parts of the economy to shut down by facilitating working from home, self-entertainment and online shopping. Furthermore the bias to China has been helpful, as the country exited the medical crisis earliest and before the world’s stock markets bore the full brunt of the panic. Thus the outperformance in 2020 has been extreme, as can be seen from the calendar-year chart below – note that the data for sector and index in 2020 is not missing, but dwarfed by SMT’s absolute returns.
The below chart makes it even clearer that the crisis has galvanised the portfolio as a whole to see another leg up. Not only was it more resilient in the downturn (as we discussed in a strategy note at the time), but it has outperformed in the recovery.
In the early 2000s SMT’s portfolio became more global and reduced its weighting to the UK in search of growth, which has been rewarded given the underperformance of the UK index. Over the past ten years, conviction in the potential in China and in transformative-technology companies has been well rewarded too. The managers’ contention is that the increasing returns to scale of companies operating in software and online ecosystems have been persistently underappreciated by the market. This has led them to hold onto stocks which are often expensive on traditional historical metrics, or expensive based on near-term consensus forecasts, and we would suggest that this thesis has been borne out well by their success.
However, there have been helpful macroeconomic conditions. James and Tom calculate long-term cash-flow forecasts for their companies and discount them by expected long-term bond rates. As these rates have become lower and lower, mechanically the justified valuations of stocks have risen, and this effect has been most pronounced on companies where a greater proportion of the cash flows are further into the future (or in the terminal value, to use the jargon). For much of the period, many commentators have said these yields could not go lower, but they have repeatedly been wrong.
For us it is hard to see a prolonged return to ‘value’ outperforming growth as value has increasingly meant banks and oil and gas or miners. The first two still seem structurally challenged due to the fallout from the current crisis and due to regulation, in the case of oil and gas regulation related to the shift away from carbon fuels. However, we do see a realistic way back to a period of higher inflation and therefore rising bond yields in the coming years. Increased fiscal expenditure funded by central banks seems on the cards. If this money makes its way into the real economy (rather than simply recapitalising the banks as it did post-2008), then inflation could rise and long-bond yields could rise, which would be a headwind for Scottish Mortgage’s portfolio. It would not necessarily offset the alpha generated by the stock-picking of course, but it would suggest lower absolute returns in the future if it came about. James makes the further point that in a rising interest rate environment companies with strong cash generation and easy access to funding would be expected to do well. And he believes SMT’s portfolio would be helped by both factors, with the net cash position of the portfolio as a whole making it less affected by the rising cost of debt.
SMT focusses on long-term capital growth. As such, the dividend is not expected to be a major part of shareholder returns, and the managers do not invest to generate an income. The yield is therefore low, at 0.4%, and the trust is unlikely to interest income-seekers. However, the board can pay a dividend out of capital if it wishes. For the 2020 financial year it raised the dividend by 4%, funding half of the payout from income earned and the other half from reserves. Doing this, the chairman noted that in these trying times, with many companies having to cut their dividends thanks to the pandemic, SMT’s relatively small dividend could be more significant than usual to the end investor.
James Anderson has been the manager of Scottish Mortgage since 2000, while Tom Slater was appointed deputy manager in 2009 and became joint co-manager in 2015. Both are partners at Baillie Gifford, and Tom is head of North American equities. Tom also co-manages the open-ended Baillie Gifford American Fund and Baillie Gifford Long Term Global Growth Fund, the latter of which was previously run by James. James focusses investment research and there is no change to the management of Scottish Mortgage, which at c. £11bn in net assets is the largest fund run by Baillie Gifford.
James and Tom have full and final responsibility for all buy and sell decisions. However, the collegiate approach taken by Baillie Gifford means that they are constantly exposed to the ideas and analysis of the managers working across the markets in which they invest. James and Tom are both partners of Baillie Gifford, the firm which manages the Trust. Given the partners are the sole owners, they share directly in the profits. Additional both have personal wealth invested in Scottish Mortgage meaning that their economic interests are aligned with those of long-term shareholders of the trust.
Issuing new shares while at a premium is one factor that has helped SMT grow to become the largest UK-listed investment trust. That said, performance has had the largest effect. The 2019 financial year (ending in March) saw the largest net issuance of £400m, 5.4% of the NAV at the start of the year. For the 2020 financial year this fell to net issuance of just over 1%, ,with the trust spending some time trading on a discount, which is rare over a five-year view, as the graph below shows. In the summer of 2019, the market began to worry about the valuation of high-growth internet-related stocks, in which SMT is heavily invested. This was sparked by the failed IPO of WeWork (which SMT doesn’t hold). In 2020, all stocks sold off when the current pandemic spread to the West, and SMT briefly fell into a double-digit discount. This evaporated as SMT’s portfolio outperformed in the crisis, and the trust now trades on a premium once more, with the board issuing shares regularly. At the time of writing the premium is 3.6%.
Events of the last year have reminded investors of the danger of buying a trust on a premium. However, we think that over the long run the alpha-generation potential of the strategy is enough to be able to offset any ‘amortisation’ of the premium. However, it should probably be considered by investors alongside the trust’s charges. The OCF (as we discuss in the Charges section) is very low, but if we imagine a ten-year investment in SMT bought at a premium of 2% and sold at par, then an extra 0.2% of drag would be added to investment returns. (Of course there is no reason to think one will be able to sell at par, and there is a huge variance in possible impact depending on the course of the discount, but this illustrates the issues that have to be considered.) Rather than being a reason not to invest, in our view this just underlines that in the case of SMT in particular, investors need to take a long-term view. The board also has the ability to buy back shares to control the discount and reduce shares, and has used this readily in the brief periods when the shares have been trading below par.
Scottish Mortgage’s rapid growth has brought the added benefit of falling costs for shareholders, which reduces the drag on returns that these cause. The OCF is only 0.36%, which is by some way the lowest in the AIC Global peer group, where the average OCF is 0.82%. This is partly aided by the growing irrelevance of fixed costs on such a large portfolio (£11bn in net assets as at 31 May 2020). However, the trust’s management company Baillie Gifford has also cut its ad valorem fee a number of times as the trust has grown. Currently, the management fee is 0.3% on the first £4bn of net assets, and 0.25% thereafter. There is no performance fee. The KID RIY is 0.81% compared to a sector average of 1.07%, according to JPMorgan Cazenove, although methodologies may vary. The difference is attributable in large part to the cost (per share) of the Scottish Mortgage’s borrowings which are invested in the portfolio (the gearing).
James and Tom view ESG matters within the framework of the sustainability and longevity of a business. Baillie Gifford’s approach as a house is to look for management teams whose economic interests are aligned with those of shareholders and wider stakeholders. This is essential for a company to have true longevity, they believe. Furthermore, Baillie Gifford takes the attitude that it is its responsibility to promote responsible capitalism so that it maintains the support of citizens. This flexible approach allows for the fact that attitudes at the company and societal level can evolve, and that the same ends can be achieved in different ways.
This means that James and Tom do not exclude companies from their investment universe purely on the grounds of ESG factors, but adopt a positive engagement approach whereby matters are discussed with companies’ management teams. The aim of this is to improve the relevant policies and management systems and enable the managers to consider how ESG factors could impact long-term investment returns. Furthermore, as the mandate is global, candidate companies could be working within corporate and societal cultures with very different ethical assumptions.
For many ESG-conscious investors, we think the commitment by James and Tom to invest in new sources of energy, as well as in companies which are facilitating and prospering from the switch away from fossil fuels, will appeal. However, this is fundamentally an investment proposition – the managers believe this is how society is developing, and so this is where the best long-term returns lie.