What are the risks to Scottish Mortgage?

Scottish Mortgage Investment Trust backs some of the world’s most innovative and exciting businesses and is a popular holding among private investors.

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  1. Rob Morgan

A handful of funds have remained part of our Foundation Fundlist (our list of preferred funds for new investment) since the outset in 2013.  One such stalwart is Scottish Mortgage investment trust, a favourite holding of many private investors.

For those unfamiliar with the Trust, its managers, James Anderson and Tom Slater of Baillie Gifford, 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.

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 free 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.

A truly long term approach

The managers’ long history of investing in Amazon typifies their approach of ‘running winners’. It has been a holding since 2005, but just in the five years to March 2020, Amazon has added a remarkable 35% to the Trust’s net asset value. Other companies the managers have backed from an early stage include other tech successes Google (now Alphabet) and Facebook, as well as China’s internet giants Alibaba, Baidu and Tencent.

Private investments have also contributed significantly to returns. 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. These are not small or nascent companies. On the contrary. Ant Financial (an affiliate of Alibaba, the worlds highest valued fintech company and the Trust's largest unlisted stock) has a valuation that eclipses any company in the FTSE 100.

Long term performance of the Trust has been nothing short of spectacular and has been boosted by a remarkable period so far this year. Since the inauguration of the Foundation Fundlist at the start of January 2013 the Trust has turned an investment of £1,000 into over £6,000 (data to 30.07.20, total return basis with net income reinvested, source: FE Analytics), though past performance is not an indication of future returns.

Table: Year to date and discrete annual performance of Scottish Mortgage versus its benchmark

Past performance is not a reliable indicator of future returns. Figures are shown on a % total return basis, bid to bid price with net income reinvested; Source: FE Analytics, 2020 YTD data: 31/12/2019 to 30/07/2020.

Concentration

Clearly, investing in the technology sector and having the conviction to hold onto winners has paid off handsomely for Scottish Mortgage. Recently the acceleration of digitalisation brought about by Covid-19 has provided an added boost. We are certainly pleased with the returns generated since 2013, but in fact, our Collectives Research Team have been keen on it longer still, attaching a positive rating to the fund from 2011 during the throes of the European Sovereign Debt crisis when shares in the Trust had fallen by a precipitous 63%.

Shares quickly recovered, but this episode illustrates the extent of the potential volatility. A ‘concentrated portfolio’, as well as other factors unique to investment trusts such as gearing (borrowing to invest) and changing investor sentiment towards shares, means it should be considered particularly high risk. Investors should be prepared to commit for the long term – ideally 10 years plus.

A concentrated portfolio means that a fund has a smaller number of positions or that a relatively small number of stocks make up a large proportion. With Scottish Mortgage the latter applies, with several strong-performing stocks dominating and a tail of others that are hoped to be future successes. The top 10 stocks account for a punchy 55% of the portfolio and around 20% is in just two stocks – Amazon and Tesla. Meanwhile, China’s Tencent and Alibaba make up 12% of the portfolio.

At a sector level there is obviously a strong bias to technology, perhaps better defined as changing tech and media habits, and to a lesser degree to transformational healthcare through stocks such as gene sequencing business Illumina.

These characteristics give the Trust exceptional performance potential, and they are the factors behind the strong returns to date, but also mean that very large short-term ups and downs are inevitable.

Possible headwinds

What could derail performance for investors over a more sustained period? A cooling in investor sentiment towards the technology sector and high-growth stocks more broadly would certainly be a difficult backdrop for the Trust. For instance, with investor expectations high and valuations across the sector elevated, any disappointing company earnings announcements could send share prices lower. In certain cases, increased taxation and regulation might ultimately impact earnings too.

A changing economic environment also poses a threat. Monetary stimulus through ultra-low interest rates means investors currently see less difference between the value of money today and the value of money in the future, which essentially serves to make future profits more valuable than they would be if more inflation and higher interest rates were expected. This is particularly important for the technology sector where tomorrow’s profits for many companies are expected to be a lot greater than today. A scenario where inflation rises and interest rates creep upwards would likely be detrimental.

Finally, the unlisted element of the portfolio (which could be as much as 30% in coming years as the limit the managers have is raised) provides great opportunities, but also could prove a hindrance if investors have reason to doubt the managers’ selection process. So far, they have shown outstanding insight in both listed and unlisted holdings, but a high-profile flop might mean greater scepticism towards other positions in the unquoted portfolio.

Presently, the shares trade on a small premium to the net asset value of around 1% but a waning of investor sentiment could see that erode.

Our view

Scottish Mortgage has a clearly defined identity of backing fast-growing and potentially world-changing businesses, a high-conviction approach and very competitive annual charges. It’s a great advertisement for active fund management and we remain positive on longer term prospects, not least due to the outstanding record of the managers in identifying long term winners in their respective industries.

The drawback is a risk to capital in the shorter term. 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.

We, therefore, 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.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. 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. If you are unsure of the suitability of your investment please seek professional advice.

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