Scottish Mortgage: discount plan succeeds as share price soars over 30%

Investors in the Super 60 Scottish Mortgage (LSE:SMT) investment trust will be pleased that short-term performance has markedly improved, with a share price total return of 33% over its latest financial year (to 31 March 2024).  

However, the performance of the underlying investments – the net asset value (NAV) – lagged the share price, up 11.5%.

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Alex Watts, fund analyst at interactive investor, explains why there is a gap between the two, discusses portfolio changes over the past year, and shares the ii View on the outlook for the FTSE 100-listed investment trust.

Performance

The discrepancy between the substantial price return of nearly 33% and the lesser NAV uplift of circa 12% is accounted for by a narrowing of the discount from -19.6% to -4.5%. This marks a reversal from the prior two years of negative returns for the trust.

The reported year’s impressive share price performance recouped some of the losses of the first half of 2022, when SMT returned -46%, and restored the trust’s track record over five years.

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While distributions are far from a predominant objective of the trust, it’s notable that despite a fall in income across the portfolio from an abnormal level in the prior year, a proposed total dividend of 4.24p represents growth of 3.4%, retaining SMT’s “dividend hero” status. The trust has now increased income payouts for 42 consecutive years. Its dividend yield, however, is a very low 0.5%.

The numbers in detail (for full year to 31 March 2024)

Net Asset Value (NAV) Return: +11.5%
Share Price Return: +32.5%
Benchmark Return (FTSE All World): +21%
Discount: -4.5% (stood at -19.6% a year ago)
Gearing: 11% (stood at 14% a year ago)
Dividend: 4.24p (+3.4% vs last year)

Outlook

The disruptive effects of widespread artificial intelligence (AI) adoption is cited as a continuing driver of change, with Scottish Mortgage reiterating its belief that it will be a small number of exceptional companies that will drive and benefit from this sea change.  

Discount

The discount narrowing throughout the period was a strong driver of returns, although the trust continued to trade at a discount throughout the entire year. Over the period, £592 million of shares were bought back by SMT, representing 4.9% of issued share capital.

In mid-March, SMT’s board announced that it would make at least £1 billion available to buy back its own shares over the next two years. Prior to this announcement, the discount stood at -15%.

Portfolio

Commensurate with the manager and the chair’s conviction in AI as this generation’s transformative theme, NVIDIA Corp (NASDAQ:NVDA) – for many, the face of AI – has grown to be the trust’s largest holding (8%). But the managers have built up exposure across the supply chain of AI hardware, recently adding a position in Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM), a fabricator of chips for Nvidia.

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Further up the supply chain still is the long-held ASML Holding NV (EURONEXT:ASML) (7.6% of the portfolio), which in turn builds the lithography machines for TSMC. There are also companies providing AI infrastructure, such as Amazon.com Inc (NASDAQ:AMZN) and Snowflake (NYSE:SNOW), and firms facilitating real-world AI application, including Tesla Inc (NASDAQ:TSLA) and Recursion Pharmaceuticals (NASDAQ:RXRX).

A notable change is SMT’s disposal of Tencent Holdings Ltd (SEHK:700), on the basis of political and regulatory risks in China. Late in 2023, Scottish Mortgage’s fund managers, Tom Slater and Lawrence Burns, made clear that caution was necessary when investing in the region. Accordingly, SMT has continued to selectively reduce its Chinese holdings, despite recognition of opportunities in the region.

Also noteworthy is that the long-held Illumina Inc (NASDAQ:ILMN), whose share price has disappointed over the past five years, was cut late in 2023 owing to poor managerial execution.

Unlisted exposure

There has been minimal change in the private portfolio of SMT (now 27% and 53 holdings), with SpaceX remaining the largest unlisted holding. While operational performance is noted as being positive across the unlisted investments, management note minimal interest for these firms to enter public markets.

Gearing

Gearing levels ended the period at 11%, down from 14% at the prior year end. This is financed at a low cost of capital of 3.18%.

ii View

It is encouraging to see a turnaround in short-term performance for SMT, following two prior periods of both NAV and (more so) share price decline that had tainted a previously stellar track record. The year’s NAV returns were buoyed by high-conviction positions in AI-related companies Nvidia and ASML, and exaggerated by a narrowing of the discount.

Long-term returns for the trust are very much intact, outperforming the benchmark by roughly 4% (annualised) over 10 years.

SMT invests in a range of exciting themes, of course, not just AI. The reported year also saw strong performance from luxury goods, including Ferrari NV (MTA:RACE), and payments, such as Wise Class A (LSE:WISE) and Adyen NV (EURONEXT:ADYEN), among other areas.

However, the managers’ commentary focuses heavily on their conviction that AI increasingly will be an elemental theme underpinning and fuelling global innovation and thus driving market returns, with SMT’s portfolio positioned accordingly.

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While this has proven successful this year, and is an exciting prospect, investors should be cognisant that such high commitment to one particular theme can make for a volatile ride. Technical constraints in AI models or a down cycle of demand could create short-term stress for SMT’s zealous allocation to companies involved in the hardware, infrastructure and application businesses behind AI. But, in keeping with Slater’s own view, smooth returns and exceptional performance are often mutually exclusive.

The year to end of March 2024 was eventful for Scottish Mortgage, perhaps most tangible for investors is the materialisation of some progress in addressing the material discount, which is so unusual for the trust. The discount touched nearly -23% in May 2023, and narrowed to a more palatable -4.5% at period end (versus a 10-year average nearer -2%). A range of factors have affected repricing for the trust’s shares relative to its NAV.

At a corporate level, shareholders benefited from the board’s substantial buyback of nearly 5% of issued share capital during the period, and commitment to an historic £1 billion to buying back shares over the next two years. It is a decision that shows conviction in the portfolio and rewards shareholders, which include activist investor Elliott Advisors, and brought about an ensuing response in the share price.

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In addition, the re-rating also speaks to market participants’ recognition of SMT’s strong positioning in the context of the AI bull market and also hints at a dissipation of uneasiness regarding valuations of unlisted holdings in the portfolio.

Scottish Mortgage is an adventurous option on ii’s Super 60 list of investment ideas.