Scottish Mortgage: periods of poor performance are inevitable

Kyle Caldwell runs through Scottish Mortgage’s annual results, highlighting key comments made by the fund managers. 

It has been a painful period for shareholders in Scottish Mortgage (LSE:SMT), which this morning reported a share price loss of 33.5% in its latest annual results (to 31 March 2023).

The performance of its underlying investments – the net asset value (NAV) – was down 19.7%. This notably undershot the benchmark, the FTSE All World Index, which was down 0.9% over the period.

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The underperformance is not down to poor stock selection. Instead, it is being driven by the change in the macroeconomic environment, which has seen interest rates sharply rise in an attempt to cool red-hot inflation.

When interest rates rise, the income returns on low-risk assets – cash and bonds – increases. Due to this, the valuations of more risky assets re-price, causing share prices to fall.

Scottish Mortgage, which appears on interactive investor’s Super 60 list of investment ideas, owns high-risk companies (with around 30% in private companies), whose profits are generally going to come a long way into the future. In industry-speak these assets are long duration, and when interest rates rise the valuations of such investments fall due to the better returns available on lower-risk investments.

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At the same time, investors focus their attention more on companies that are making profits today, which has benefited certain value stocks and sectors of the market.

Views from the board and lead fund manager

Fiona McBain, the outgoing chair of Scottish Mortgage, acknowledged that “notwithstanding the macro-economic headwinds - performance in recent years has been disappointing”.

McBain, who has been chair since 2017 and sat on the board for 14 years, added: “The board shares this disappointment but remains confident that Scottish Mortgage is a strong long-term investment. We firmly believe in the fundamentals of our investment portfolio, which has delivered so much value over many decades.”

Scottish Mortgage, which asks its investors to view its performance over a minimum of five years, has returned less than the average global investment trust over that period, up 25,5% versus 31.2% (as at 16 May 2023, according to Morningstar).

Over 10 years, it is ahead of its average global peer, up 292% against 190%. 

Tom Slater, the lead manager of Scottish Mortgage, pointed out that its investment style is facing into a headwind as “investors have flocked to assets that are already proven and profitable”.

He added: “Predictability can have a deep allure as uncertainty grows and people are fearful. Investing in such assets may be appropriate for others, but we are sceptical that our shareholders will benefit in the long run if we too resort to following the crowd.

“Buying predictability may provide temporary comfort, but it is by embracing discomfort that we can entertain the possibility of outsized returns from exceptional companies.”

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As its shareholders would expect, Slater is sticking to his guns. He notes that “growth and innovation are not dependent on the direction of macroeconomic development” and that “despite recent stock market declines, significant operational progress continues, reflecting the accelerating pace of change throughout the economy”.

He added that over the long run share prices follow company fundamentals, but patience is required.

Commenting on short-term performance, Slater acknowledged that it “has been painful for shareholders, but history shows that periods of poor performance are inevitable”.

He added: “Our approach will never be consistently in favour, and we should not deviate from it to avoid short-term headwinds. If patient ownership of growth companies was easy, there would be far more competition.”

Unlisted stocks

One of the big factors explaining Scottish Mortgage trading on a big discount, currently 22.2%, is due to its holdings in private companies. Many investors are sceptical that the valuations for unlisted companies have fallen far enough in response to higher interest rates. As a result, its discount has widened (from 0.5% to 19.6% over its last financial year to end of March), due to less demand from investors.

The predicament facing retail investors is that, unlike public markets, the valuations of unlisted stocks are set behind closed doors.

Baillie Gifford carries this process out every three months using a “valuations committee”, which takes advice from an independent third party, S&P Global.

Even with regular portfolio valuations, there is a lag between public market and private market share prices.

In its annual results, Lawrence Burns, the deputy fund manager of Scottish Mortgage, pointed out that there are certain “trigger events” that result in a private company being revalued more frequently than every three months. One of those triggers is if there’s a publicly listed comparator company that has seen its share price de-rated by the market.

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In total, Burns points out that over the year 532 revaluations were made, with 84% of the private holdings re-valued five times or more. In aggregate the private company valuations were written down by 28%, which Burns notes compares to the fall in the Nasdaq of 14%. 

Burns added: “The write-downs would have been materially greater if it were not for the upward revaluations of seven companies during the period.”

In addition, Burns stressed that the bulk of the private holdings are “neither small or early stage”.  He added that “the majority of our assets invested in private companies are in businesses which would be large enough in scale to join the FTSE 100 index, if they were based in the UK and listed”,

Overall, 52 private companies are held, with the five largest holdings accounting for nearly half the exposure: Space Exploration Technologies Corp, Northvolt AB, ByteDance Ltd, The Brandtech Group and Tempus Labs Inc.

Portfolio activity

In terms of changes to the portfolio, there was just one sale among its top 30 positions – Alibaba (NYSE:BABA). Other Chinese holdings were reduced and two were sold amid concerns over regulatory risk following interventions over the past couple of years into markets and the economy from China’s communist government.

Elsewhere, sequencing machine companyIllumina (NASDAQ:ILMN) was substantially reduced. Slater explained: “We still believe gene-sequencing is a fundamental building block for advances in healthcare, but the company's execution has been disappointing, which has been reflected in a weak stock price. We have retained positions in other companies where valuation declines have hurt us in the short run.”

New holdings over the period were gaming company Roblox (NYSE:RBLX), cloud networking-provider Cloudflare (NYSE:NET), while more shares were bought in Latin American e-commerce and finance company MercadoLibre (NASDAQ:MELI), which is now a top five holding.

The big three themes Scottish Mortgage seeks to profit from are a digitalised world, decarbonisation, and technology meets healthcare.

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Within those themes there’s various sub-themes, including artificial intelligence (AI). Slater said that advances in AI “could be the start of another computing paradigm akin to the personal computer or smartphone”. Two of its biggest holdings, which are leading players in AI, are NVIDIA (NASDAQ:NVDA) and Tesla (NASDAQ:TSLA). 

Dzmitry Lipski, head of funds research at interactive investor, says: “Scottish Mortgage has clearly struggled over the past year, which has seen a seismic shift in the investment landscape amid runaway inflation and rising interest rates - buffeting many of the growth stocks the portfolio invests in as investors reconsider how much the future earnings of these companies are worth today.

“But our confidence in the trust’s investment strategy remains - including due diligence on the private equity side, and the resources backing it. The approach here is differentiated. The managers seek to identify those companies that will be transformational and will be industry leaders for the very long term. There will inevitably be errors, but the investment trust structure is ideal for this long-term way of investing, not least given the private equity portion.

“The philosophy is such that returns are likely to be driven by a narrow sub-set of securities, within a high-growth style, which brings associated risks. This has been the pattern in the past, but repeatability of this might not be straightforward.

“Scottish Mortgage’s recent underperformance reminds us that while it is an excellent adventurous holding, it needs to be tempered with some lower-risk options. Investors should ensure their portfolios are well diversified and balanced without strong bias to any one style or market cap in order to control risk and limit losses within their portfolio.”

The author owns Scottish Mortgage alongside other funds and investment trusts in a stocks and shares ISA.