Scottish Mortgage: long to reign over us?

Two Kepler analysts go head-to-head over whether the trust will stay king, or if its rule will soon end.

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Scottish Mortgage (LSE:SMT)has been one of the standout performers over the last year, with a NAV return of circa 117.5% over one year (source: JPMorgan Cazenove, as at 21/01/2021), something we discuss further in this week’sresults update.

SMT was well primed to take advantage of the growth rally, which has driven markets throughout 2020, be it the meteoric rally in Tesla (NASDAQ:TSLA) or surge in demand for Amazon (NASDAQ:AMZN)

The question now is whether SMT’s strong performance can continue. In this head-to-head, our two analysts assess whether SMT will remain king, or if its reign will soon come to an end.

Buy with both hands, says David Johnson

While SMT has reigned supreme over the last year, I still believe that there is more to come, with both macroeconomic and sectoral tailwinds supporting growth investing, and SMT’s management team being able to continue to deliver alpha.

The most important factor for growth investing, regardless of where one sees the opportunities, is the prevailing low interest rate environment. Thanks to rock-bottom interest rates, there is currently a low opportunity cost to equity investing, given that the fixed-income alternatives offer little in the way of return.

In my view, this low-rate environment will also likely continue into the future, further supporting the argument behind growth investing. While rising rates were certainly a consideration in early 2020, Covid-19 has nipped that in the bud. Central banks face muted economic growth for at least another year, as companies contend with weakened balance sheets, unemployment that remains frustratingly high, and lockdowns that may potentially persist into Q3 2021. As long-term growth becomes increasingly scarce due to Covid-19, and the opportunity cost remains low, expect investors to continue to flock to the growth names such as those that make up much of SMT’s portfolio.

While SMT offers growth investors a very attractive portfolio of global growth champions, none has as high a profile as Tesla. Although the team has held Tesla for many years, it was only over the past six months that the market saw its true potential (rewarding it with a fourfold increase in its share price), vindicating the team’s investment process.

Not only does Tesla, in my view, demonstrate the foresight of the team as it continues to exceed analyst expectations, but also their faith in their own investment process. Not only had the team held Tesla through years of well-documented volatility, but they saw fit to let Tesla build on its momentum, trimming only when it approached a fifth of the total portfolio.

Although Tesla offers some of the best electric cars and battery technology on the market, I believe that SMT’s holding of SpaceX, another brainchild of Elon Musk, best demonstrates the strategy’s potential. Commercial space exploration would have seemed science fiction even five years ago but, as recent headlines have shown, SpaceX and its competitors are on the cusp of seeing it realised.

Although it makes up only 1% of SMT’s portfolio, it demonstrates the kind of aggressive growth opportunity that is rarely available elsewhere. In fact, SMT’s investment in SpaceX is a result of Ballie Gifford’s reach, given that only a handful of firms can even invest in the company. Access such as this is another highly distinctive aspect of SMT and I believe it will continue to be a positive contributor to its return in the future.

There are also more grounded growth opportunities within SMT, such as their holdings in NVIDIA (NASDAQ:NVDA), Hello Fresh, and Tencent (SEHK:700). While not as exciting as space travel, these companies have been among the (unfortunate) beneficiaries of Covid-19, with their long-term growth stories accelerated due to the sudden changes in consumer behaviours.

Despite the roll-out of vaccines, I do not expect global lockdowns to be lifted in the immediate future, given the enormous logistical hurdles, thus sustaining these new consumer patterns in the near-term. Even in the aftermath of Covid-19, one should not expect consumer behaviour to revert as people have begun to realise the convenience of a work-from-home lifestyle, as well as the efficiencies companies such as Zoom (NASDAQ:ZM) and Amazon can bring.

Covid-19 may end up a once-in-a-lifetime opportunity for many of these growth companies to develop a solid, loyal consumer base; a key step in releasing their long-term potential.

Despite my bullishness, I do concede that concern over the size of SMT is warranted, with its £18 billion market cap dwarfing any other trust. However, I also believe that the growth sector is the one space where a manager can find sufficient opportunities to justify such a size (due to the teams forward-thinking, their access to private markets, and their bullish views on China and broader South-East Asia).

Although there have been past concerns about China’s slowdown in growth, I believe that China will quickly return to its past trajectory, thanks to its successful handling of Covid-19 and a change in foreign policy by the new US government. With this renewed growth will come renewed opportunities, as China will look to dominate the industries of tomorrow to ensure its future growth.

Ultimately for any SMT naysayer, I ask them: would you rather own a tractor or a spaceship?

Ruina Imperii - time to take profits - Callum Stokeld

In 1994, the former members of music duo The KLF literally burned £1 million, sending it up in smoke on video. By then destroying the film of the event, they believed they were essentially leaving no possibility of any pay-off from the act. Fast-forward 17 years, and one would question why they didn’t immediately IPO afterwards.

Making a bear case for SMT has been done many times in the past, and the managers have continued to prove the doubters wrong. It is possibly a foolhardy call to do so at any time. Yet investors should ignore this heuristic bias, and rationally assess the prospects for the current portfolio.

Let us address the elephant in the room and acknowledge that, as with SMT, bears on Tesla have long been proven wrong. Yet the incredible (in every sense of the word) rally in Tesla shares has not been driven by substantial re-evaluations of the operating conditions and prospects of the company, but instead by an army of price-insensitive retail investors brandishing stimulus cheques as betting chips. Free availability of options trading has seen this army/cult hoover up call options on Tesla stock, forcing market makers to delta-hedge their exposure by buying Tesla stock in a relatively illiquid market, and creating a squeeze higher.

More stimulus cheques are on the way, so I concede that this story may not be over yet, but as a car company alone the Tesla case seems absurd. The stock is too volatile to pinpoint any one example of its absurdity as static, but in recent weeks Tesla has been worth more than the next eight largest car companies in the world combined.

This is despite the fact it is already losing market share in the electric car market in Europe, and that Volkswagen (XETRA:VOW), for example, announcing they will produce over 1m electric cars in 2023. Renowned stockpicker Michael Burry (of ‘The Big Short’ fame) has joined in the Tesla bears and disclosed that he was short towards the end of 2020. He joins long-standing bears which include David Einhorn, and renowned short-sellers Jim Chanos and Carson Block (though the latter has declined to bet against the stock).

Maybe the Tesla bull case isn’t, however, to do solely with cars, but with some future pivot elsewhere (tunnel infrastructure in Florida? Try not to laugh at the back please…)? Well maybe, but the electric car market elsewhere in the world shows similar signs of what would politely be called ebullience (but which some may regard as more akin to insanity). Chinese electric car maker Nio, which in 2020 produced approximately 43,000 cars (admittedly a seismic jump from 2019 production figures), has a market cap of c. $92bn (having topped $100bn in recent weeks). This, you will have noticed, amounts to over $2m of market cap for every car produced in 2020. Again, it is of course fair to accept that growth is in this price. But at what point do we accept that there are already some fairly exceptional growth expectations attached (and that therefore exceeding these to drive share price returns becomes more challenging)? Bear in mind that former Premier Li Keqiang last year noted that China has over 600 million citizens earning less than c. $140 a month.

Of course, the recent travails of Alibaba founder Jack Ma have shone a light on potential challenges to the very sizeable Chinese holdings beyond just Alibaba and Ant Financial. There have been suggestions that the Chinese government is looking into potential nationalisations of both Alibaba and Ant Financial, while Tencent and Meituan Dianping have both also been mentioned as potential targets of anti-trust activity.

In general, antitrust activity does indeed seem to me to be likely, as the managers of SMT suggest, a good thing for Chinese growth long-term. However, it does not seem likely to be good for shareholders, and furthermore should also introduce to the market the concept that your future growth ceiling may have to be adjusted somewhat lower. You will never be allowed to grow to a truly dominant stage, and persistently weak consumption growth on a massively extended capital stock suggests the ‘growth of the Chinese consumer’ as a massive tide that lifts all boats may yet prove as elusive as Mr Ma. Even where quasi-dominant positions are tolerated, I would suggest that this will only be when it is done in conjunction with the interests of the state; expect more activity in line with the recent ‘decision’ by Kweichow Moutai’s management to donate 10% of the company’s stock to their, heavily indebted, home province of Guizhou. China is still a Communist state, and when push comes to shove it is the interests of the Communist party, not the Chinese people and certainly not foreign shareholders, that will be judged paramount. Like Moutai’s flagship product, this will leave a bad taste in the mouth.

Still, antitrust remains tentative in the US, right? For sure, some of the tech giants likely face some tokenistic challenges, but there remains a wide universe of mega-growth opportunities, no? Well, in the near-term pressures do seem somewhat more tokenistic and specific than structural, but if the cases against the tech giants are successful I would suggest that it would represent a repudiation of the Bork doctrine. Over the long-term, this sets the direction of travel certainly towards a stricter interpretation of antitrust that focuses on monopsony as well as monopolistic pricing pressure, and where market share is likely to be the key consideration.

If so, does your effectively zero cost of capital now in the promise of future cash extraction from a position of dominance still look attractive? Maybe at a price, on the possibility that efficiency gains mean the dominant share isn’t necessary to make the business cash generative. Let me suggest this will never sustainably happen for food delivery businesses (as it eviscerates the already slender margins of the underlying producers), amongst others. If you cannot ultimately expect this position to emerge, or even if you have to adjust your probabilities lower of such a situation, you must reasonably revise your fair value estimate of present value downwards. This will be a severe headwind.

Ultimately, I would suggest that so too will be the unwind of a very frothy IPO and SPAC market, to value realisation of the increasingly significant private equity book. Of course, these businesses, without needing to go public to access capital, may simply choose to remain private instead. Yet their valuation on SMT’s book will reflect market level valuation multiples for comparable peers. A decline in public company valuations will be met pari passu.

Much of these trends reflect a divergence in longer-term trends from the world of the past 30 years. The secular trends of ageing demographics and declining bond yields may or may not yet be played out, but the political trends have been in reverse and are reflecting the necessity for social stability of a seismic shift in returns accruing to labour instead of capital. Separately, yield curve control will likely be enforced by the Fed in my opinion (and the ECB has indirectly announced they will effectively do so already), whilst Strauss-Howe generational theory would perhaps suggest we remain amidst a pushback against the established centres of political and economic power. California remains the only true technological ecosystem globally (China still can’t produce a semiconductor worth a damn), yet residents are fleeing ruinous costs of living and rising taxes. We are likely entering the slowdown phase of a Kondratieff cycle, and blue-sky growth will lose its lustre.

I expect one last blow-off top in the coming months for pre-earnings technology stocks and related themes, and then the long miserable denouement. In my view, SMT investors who wish to remain aligned with the stylistic approach should focus instead on Japan, and growth focused trusts in this region such as JPMorgan Japanese (JFJ).