Three big questions Scottish Mortgage investors now have answers to

Fund managers Tom Slater and Lawrence Burns address concerns around portfolio performance, Chinese shares and the investment trust’s outlook.

Scottish Mortgage investors are having a difficult year. The shares have fallen 40% as higher interest rates take the gleam off the growth stocks the trust buys, high inflation and economic growth impacts businesses, and concerns about its allocation to Chinese shares mount as the Communist Party sticks with its zero Covid policy.

But rather than hiding from the issues, the trust’s managers Tom Slater and Lawrence Burns have addressed investors’ most common concerns.

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In a recent address to shareholders, they discuss the recent bout of poor performance and why they still back their investment approach, their continued faith in Chinese stocks and what the outlook is for the portfolio. We delved into what they had to say.

Portfolio performance

Slater, who is the lead manager, said that two things were very important right now: doing research on the companies they own to make sure “their engines of growth” that have driven a decade of strong performance are still robust, and looking for new ideas in companies that are “building the foundation for the next decade of growth”.

Burns, the deputy manager, adds that big drops in share prices does not mean companies will not go on to be successful.

“Markets aren’t efficient in that way,” he said. “Consider that Apple has had falls of 70% in the past and Amazon 90%. Markets unfortunately go through these periods but for us we have a responsibility to do two things: an honest reappraisal of our investment cases; and make sure we can take advantage of the volatility for shareholders.”

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Burns says that the tough market today is both a challenge and an opportunity as “innovation is effectively on sale”.

The fund managers have been taking advantage of stock market falls to add companies they have been following that are now at “really attractive valuations”, such as gaming firm Roblox and cybersecurity company Cloudflare.

The stock market sell-off means more new ideas are coming from that area rather than private markets, Slater and Burns argue.

China

Scottish Mortgage has about a fifth invested in China, a similar level to the start of the year, despite actively selling shares.

Chinese companies are facing a clampdown from the government, which has moved to stifle profits and prevent companies from becoming too dominant. The economy is also struggling due to Covid lockdowns, and there is the threat of a trade war with the US, as well as restrictions on key technological exports to China, such as computer chips.

Burns says there are no easy answers when it comes to China. “The China-US relationship is one area to watch, which could end with US sanctions on China. The other risk is the Communist Party’s actions towards its own companies. This has raised questions about the limitations on the scale and profitability for Chinese companies,” he said.

He says that even the Chinese CEOs they speak to are unsure what the future will look like. Nevertheless, he admits that the rule changes from the government would have a cultural impact on Chinese firms by making them less likely to take risks and increase profitability.

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“The risk is that Chinese companies move cautiously and break nothing,” Burns said.

As such, Scottish Mortgage has been selling some smaller Chinese positions, such as digital freight platform Small Truck Alliance, as well as reducing their stakes in internet giants Alibaba (NYSE:BABA) and Tencent (SEHK:700).

Burns says that they still own some very exciting companies in China, such as electric vehicle firm NIO and engineering firm Horizon Robotics. “It would be wrong to cut Scottish Mortgage holders completely off from the world’s second-largest economy,” he said.

Slater adds that although they have been selling Chinese shares, the weighting is roughly the same as at the start of the year (17% versus 16%).

“This doesn’t fit neatly with this narrative that China is a big cause of concern. It’s really important to focus on companies rather than the power struggle between the US and China,” he said.

Outlook

So amid continued pressure on the “growth” stocks that Scottish Mortgage invests in, what is the outlook for its holdings, particularly as high interest rates make raising money more difficult for fledgling companies?

Slater says investors need to be wary of jumping to rapid conclusions and instead do the work on how resilient their portfolio is.

“The vast majority of the portfolio is profitable and generates cash. For those companies the difficult stock market environment has no bearing on the fundamentals of the company.

“We then have a set of companies that run around break-even – but these can be categorised as break-even by choice because they reinvest their profits. I don’t want those companies to stop doing that.

“And then there is a set of companies that are dependent on outside investors for their survival, a single figure percentage of the portfolio, that can drive returns in the long run. It’s periods like this where real long-term competitive advantages are formed,” he said.

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Burns adds that despite the tough macro backdrop there are still key advances in new technologies, and innovation becomes even more important.

He gives the example of MercadoLibre, the Latin American shopping and finance platform, which has grown rapidly despite political and economic upheaval in Brazil.

Slater says that their top 10 positions, which include Tesla, SpaceX, Moderna and MercadoLibre, reflect the sectors they are most excited about.

He said: “Moderna has a technology platform that could fundamentally change healthcare over the next decade. SpaceX could have a monopoly on access to space, which could become a much bigger industry than it is today. There is so much progress to be excited about.”