Time to buy heavily discounted Baillie Gifford investment trusts?

Once the hottest fund manager in town, Edinburgh-based Baillie Gifford is out of favour with investors.

Its growth-focused approach to investing, which sees it take large stakes in exciting but expensively valued companies, is under pressure as higher interest rates increase the appeal of lower-risk options available to investors.

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This has caused investors to sell its investment trusts, leading to wide discounts, meaning investors buying today pay less than the underlying investments are worth, the net asset value (NAV).

In contrast, during the 2020 and 2021 boom period for growth shares premiums were far more common. As a rule of thumb, investors should be wary of premiums of over 5%, as over time high premiums do not tend to be sustainable. 

As of early January, most Baillie Gifford trusts traded on double-digit discounts, including Scottish Mortgage at 10%, Edinburgh Worldwide at 14% and Baillie Gifford China Growth Trust at 10%.

This is linked to poor performance since interest rates began to rise at the end of 2021. However, longer-term Baillie Gifford funds have generally beaten their peers and rewarded patient investors.

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We ask whether now is the time to pounce on a bargain, or whether Baillie Gifford is battling more fundamental challenges as an investment manager.

Source: Morningstar. Total return figures to 31 December 2023. Past performance is not a guide to future performance.

Why are discounts so wide?

Two factors are working against Baillie Gifford trusts: the poor recent performance of their investments, which has turned investors off the shares, and doubts over the valuations of private companies, which in some cases make up 30% of portfolios.  

Baillie Gifford trusts generally share a similar investment style. They buy companies that are big on innovation and the promise of future profits, but are often less mature and do not return a lot of cash to shareholders. Companies held across a number of portfolios include Tesla, Amazon, Moderna and ASML, the Dutch semiconductor machinery firm.

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This growth style struggles during periods of rising interest rates, as bond yields and cash returns rise, which deters investors from taking risk.

The impact on Baillie Gifford was that some of its largest investments crashed in value as market sentiment turned. Scottish Mortgage shares trade at around half their late 2021 value, while shares for Edinburgh Worldwide, which is a global smaller companies trust and consequently even riskier, trade at 65% below their 2021 peak.

Baillie Gifford trusts have also been in the firing line more than most due to their investments in unlisted shares, where the valuation depends on the views of investment consultants instead of market prices.

The valuations of private companies have stayed relatively resilient compared with public companies, and therefore shareholders have reacted by selling trust shares to create a discount between the share price and the net asset value (NAV).

Gearing is also a factor behind the recent underperformance of investment trusts managed by Baillie Gifford. Borrowing money to buy shares means that trusts are more exposed to stock market swings than their open-ended peers.

For example, Scottish Mortgage is 13% geared and Edinburgh Worldwide is 11% geared, meaning that their investments are 13% and 11% larger than they would be without leverage.

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Is Baillie Gifford or market conditions to blame?

Market conditions have not helped Baillie Gifford, but has the fund group also managed its portfolios poorly?

Scottish Mortgage managers have admitted some mistakes, such as being too slow to withdraw from China following geopolitical tensions. The trust had long backed China, but reduced its exposure last year.

Manager Tom Slater said the changes were driven by concerns about the growth of big online platform companies after several regulatory interventions, as well as reflecting concerns about deteriorating relations between China and the US.

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The trust also substantially reduced its holding in Illumina, the DNA sequencing machine company, which was a regular feature in the top 10. Shares have fallen more than 50% over the past five years.

Slater said: “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.”

Despite some stock picking errors, and macroeconomic headwinds, Slater says that Scottish Mortgage is not changing its investment approach.

Speaking in January 2024, he said: “We don't expect to outperform every year. No investment approach works in all markets. It has been a particularly difficult environment for growth investors since the end of the pandemic. We aren’t changing what we are doing based on market conditions. It is not easy to stick to your guns when the market is against you.

“We believe it is our ability to stick to our approach that differentiates us and allows us to build a long-term track record.

“We have, of course, made mistakes but for the vast majority of our holdings the opportunities remain substantial and the likelihood of success has increased.”

Slater calculates that average revenue growth rate of top 10 public and private holdings is nearly 40% a year.

Ewan Lovett Turner, head of investment trust research at Numis, says now could be a good entry point for Scottish Mortgage shares.

He said: “It has clearly been a tough period for performance in recent years but for managers with a strong long-term record and clear investment style, which Baillie Gifford have stuck to, the point after a period of underperformance can often be an attractive time to buy.”

Winterflood, another broker, also continues to back Baillie Gifford’s investment approach and credibility when it comes to growth investing.

On Scottish Mortgage, it said: “We remain confident that Scottish Mortgage is well-placed to outperform over the long term, and should be a key beneficiary of any re-opening of the IPO market, as it is exposed to several anticipated IPO candidates.”

Will the discounts narrow?

The economic picture is beginning to work in favour of Baillie Gifford’s growth-focused investment trusts.

Central banks are close to declaring victory on inflation, and have paused interest rate rises, with investors now expecting rate cuts in 2024, potentially starting as soon as springtime.

This change in messaging– a so-called pivot – sparked a big rally in interest-rate sensitive stocks since the beginning of November 2023, with a number of Baillie Gifford trusts seeing big share price jumps.

For example, Baillie Gifford US Growth is up around 30% since then, and Edinburgh Worldwide shares have risen 20%.

Lovett Turner says that headline discounts on Baillie Gifford have come in a bit over the last couple of months as sentiment has improved towards growth stocks.

He said: “Generally there are double-digit discounts on Baillie Gifford trusts which has potential to be a good tailwind to returns.

“There are some really exciting holdings in some of the Baillie Gifford portfolios that have potential to deliver attractive returns regardless of the interest rate environment.”

One of those is Elon Musk’s private firm Space X, which is in Scottish Mortgage (4.1% of portfolio), Edinburgh Worldwide (10.1%) and Baillie Gifford US Growth (7.2%). SpaceX launches satellites into space and has a communications network called Starlink, which beams high-speed internet to Earth.

According to media reports, SpaceX could sell shares at a price which values it at $175 (£140 billion).

“A $175 billion valuation is a premium to the $150 billion valuation the company obtained through a tender offer this summer. The increase would make SpaceX one of the world’s 75 biggest companies by market cap, on par with T-Mobile US Inc (NASDAQ:TMUS) ($179 billion) and Nike Inc Class B (NYSE:NKE) ($177 billion),” Lovett Turner said.

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Pressure from outside investors could also spark a narrowing of discounts for Baillie Gifford trusts. American activist investors Saba Capital, a $10 billion New York-based hedge fund, has been building positions in UK investment trusts, including those run by Baillie Gifford, to profit from discount moves.

Trusts he has invested in include Edinburgh Worldwide, Baillie Gifford US Growth Trust and Keystone Positive Change. Financial publisher Citywire report that Saba also made a 30% gain by buying into Scottish Mortgage shares last April and selling them at the end of 2023.

Saba could begin to deploy an “activist” approach, where it pressures the board of the trust to close the discount, such as by buying back their own shares.

The hedge fund could also deploy “arbitrage” trades, according to Citywire, where it buys shares in a trust and shorts the stocks (to make money if they fall) in the portfolio in order to profit if a trust’s share price and the shares of its portfolio companies move in different directions.