Scottish Mortgage

Wednesday, January 9, 2019 - 15:38

Scottish mortgage

Scottish Mortgage is a global equity portfolio run with a long-term investment time- frame, via a highly-concentrated, growth-orientated stockpicking approach.

It is the largest “conventional” UK-listed investment trust with net assets of close to £7bn. The managers aim to invest in the most promising growth companies across the globe – publicly listed or private.

The trust, which is a member of the FTSE 100, has built on its long-term track record of outperformance over the course of 2018, with NAV total returns to 2nd November of more than 11.8%, well ahead of the 1.6% delivered by the FTSE All World index over the period. Over five years, the trust has delivered NAV total returns of 147.7%.

The managers are not afraid to take punchy bets and the major drivers of performance boil down to the strong returns from their highest conviction investments. However, most recent activity at the portfolio level has focused on investing in private, unlisted companies.

For the first time, in the recent interim results, the managers took the opportunity to review the progress to date of such investments – looking at performance both before and after IPO (if applicable). From June 2010 when the managers made their first unquoted investment to the end of September 2018, the entire Scottish Mortgage portfolio generated a total return of 344%, but the total return from the subset of holdings that had started out as unlisted investments over the same period was 419%. For context the FTSE All-World Index’s total return over the same period was 163%.

Scottish Mortgage remains one of the stand-out higher-risk options for equity investors, yet is among the cheapest in terms of OCF. The trust is likely to generate higher levels of volatility than the index and peers. The trust is currently on a premium of 1.8%.

Portfolio

Scottish Mortgage is the largest investment trust on the market, at nearly £7bn of net assets and has a very distinctive approach. The managers (James Anderson and Tom Slater) emphasise taking a long term view, and employ a concentrated global portfolio of stock picks. They use the closed-ended structure to invest in private companies as well as public, listed ones. Since they adopted this approach in 2002, James and Tom have developed a very impressive network of contacts to help them understand, and invest in, the key growth markets which are transforming the lives we all lead.

They place great emphasis on meeting management teams and Baillie Gifford’s reach and reputation, as well as James and Tom’s track record as long-term shareholders, gives them a high level of access to industry titans such as Jeff Bezos and Jack Ma. In the recently published interim results, the managers comment that they continue to “believe in the benefits of listening to and learning from those who are cleverer than we are”, and use these insights for their own investment research. The managers believe in using their relationships – built over the years by being a loyal, understanding shareholder with “permanent capital”, to develop “insights (that) are not available to purely public equity investors….for example, understanding the business model and growth of Airbnb is crucial to thinking about the future of the hotel and broader travel industry, as well as that particular company”.

This is very much a bottom-up stockpicking approach, with James and Tom deliberately ignoring short-term macroeconomic noise. There are a number of key factors the managers look for in each company they hold, this includes companies that address potentially huge markets at early stages, are run for the long-term by founders or their descendants, and have “flexibility to change direction”. It’s these sorts of companies that they actively hope to identify and invest in.

Scottish Mortgage

The managers like to describe themselves as ‘optimists’, in the sense that they aim to focus unashamedly on the drivers of success, rather than avoiding downside. They believe that equity markets are fundamentally attractive because they offer an asymmetric payoff structure, where you can make more if you’re right about an investment, because upside is unlimited, than you will lose should you be wrong, with downside capped at 100%.

The team has confidence in their convictions and are happy to run winners, which means that Scottish Mortgage’s portfolio is relatively concentrated, with the top ten holdings constituting 51% of total assets (at 30th September). The majority of the trust’s largest holdings are fast growing technology companies such as Amazon, Tencent, Baidu and Alibaba, with other disruptive companies such as Tesla also featuring.

Scottish Mortgage

Source: Baillie Gifford as at 30th September 2018

The managers place a heavy emphasis on the fact that they look to invest for the long term, and have no view on short-term movements in stock markets. This is illustrated by how the team reports on the underlying portfolio, splitting it by holding period, which illustrates their ability to run winners. As we discuss in the performance section, this concentration (and focus on “growth” stocks) has meant Scottish Mortgage has fallen faster than the broader market since the August peak and shareholders should probably expect higher volatility from the shares. However, over the longer term, the team has demonstrated an impressive ability to invest in companies – both public and private – that have considerably outperformed wider markets.

Portfolio breakdown

Scottish Mortgage

Source: Baillie Gifford, Kepler Partners

Winners are sometimes ‘run’ for a very long time, and otherwise sized purely according to the managers’ conviction on longer-term opportunities going forward. Portfolio turnover is low at 13.7% according to Morningstar. The managers take no account of the benchmark with an “active share” of over c.95%; indeed they argue risks lie within many indices as certain established incumbents face challenges in the form of disruptive technologies and environmental concerns.

Currently, the managers have a high weighting in absolute terms to North America (52.8%), though are underweight relative to the index, the Eurozone (16.9%) and a high relative weighting to China at 22.2%. Despite their large weighting towards the US, the managers stress that they invest wherever any companies demonstrate the characteristics that offer the potential for greatness at scale. They feel over the next 20 years that China has the potential to do this, and that the most value will be found in the Eastern hubs like Shenzhen, Hangzhou (not Shanghai) and Beijing.

Unquoted (private) equities

As the trust is centred around the notion of owning the most promising growth companies across the globe, the managers believe they need to increasingly utilise their structural ability to invest in private companies. They believe that this offers shareholders extra opportunities, as access to the most promising private companies is dependent on relationships and reputation as an investor as much as anything. As the portfolio stands at 30th September 2018, 50 of the 80 companies that the trust owns a stake in are either unlisted, or were unlisted at the point of the trust’s first investment. As such, the great majority of recent purchases have been in private companies, and together unlisted equities now account for around 15% of total assets.

For the first time, in the recent interim results, the managers took the opportunity to review the progress to date from such investments – looking at performance both before and after IPO (if applicable). From June 2010 when the Managers made their first unquoted investment to the end of September 2018, the entire Scottish Mortgage portfolio generated a total return of 344%, but the total return from just the subset of holdings that had started out as unlisted investments over the same period was 419%. For context, the FTSE All-World Index’s total return over the same period was 163%. The team provide an example which shows the strength of the model, and being able to be invested both before and after IPO. The team first invested in Alibaba in 2012 as a private company. The return from holding this as a private company in the portfolio until its IPO in September 2014 was over 270%. As at the end of September, the sterling based return from the investment since the IPO was roughly 200%. The total holding period return, however, was over 1,000%.

The board and managers note that they are keen to set realistic expectations for Scottish Mortgage’s shareholders, observing that so far the results from
investing in private, unlisted companies have been unduly good. They point out that just as with the publicly-listed holdings, some investments will not work and a number may fail outright. Baillie Gifford’s approach is that, by design, only a handful will really drive the returns – as a result of the asymmetry of returns that comes with equity investing.

Whilst much of the new investment has been in unlisted companies, over the six months to 30th September, the team has also been attending to the listed part of the portfolio. They made significant additional purchases following IPOs in their holdings in Spotify, Funding Circle, Rubius Theraputics, Chinese electric car maker NIO, Unity Biotechnology, Survey Monkey, and Meituan Dianping. The team has also adding to positions in Delivery Hero, Tableau Software, and Gubhub. On the other hand the team has made significant reductions in their existing holdings in Inditex and Facebook.

Gearing

The company has been locking in low interest rates by issuing long term, fixed rate private placement notes. As the graph below illustrates, gearing had progressively decreased as the trust’s size increased and markets continued to rally. In June 2018, reflecting the board’s view that the gearing level was below the optimum level, the board secured a further £170m of 20-30 year borrowing at a cost of just under 3%. This, and the market falling has meant that gearing has once again crept up to the current level of 8%.

Gearing

Source: Morningstar

Returns

Scottish Mortgage has one of the strongest long-term track records in the world of investment trusts.

Its NAV total return over 10 years to the end of October 2018 has been 604% (its share price gains have been even higher as the discount has narrowed), compared to a return of 241% from the FTSE All World index. The graph below shows the performance over the past five years, which is no less impressive.

Portfolio breakdown

Scottish Mortgage

Source: Morningstar

However, the graph below, which shows discrete calendar year performance, illustrates the risks (as well as the positives) of investing in Scottish Mortgage. While it has beaten its benchmark in seven out of the past 10 years, it has tended to fall further during more turbulent conditions (as was the case in 2008 and 2011). An exception was in 2016 when the trust underperformed the index, which made 28.9%, with the managers’ growth style and decision not to hold commodity-related stocks hurting relative performance.

Calendar year NAV performance

Scottish Mortgage

Source: Morningstar

Indeed, data shows Scottish Mortgage has been more volatile (18.8%) and delivered a larger maximum drawdown (-20.6%) than the sector and index in NAV terms (median averages of -16% and 13% respectively). Nonetheless, this is to be expected from a concentrated portfolio with a clear growth focus, not to mention being heavily ‘overweight’ relative to the benchmark in technology and emerging markets. These characteristics have meant that in the recent equity market falls, the trust has fallen further than the benchmark, as the graph below shows, where an upward sloping line shows relative outperformance, and downward, underperformance. Year to date, Scottish Mortgage remains ahead in NAV performance terms.

Relative performance YTD

Scottish Mortgage

Source: Morningstar

Whilst volatility has been higher than peers and the benchmark, the managers are adding value. The trust has delivered better risk-adjusted returns over five years with a Sharpe ratio of 0.8% than the median average of peers (0.42%) and considerably higher levels of alpha (5.29%) than its peers relative to its benchmark (to the end of October). On the other hand, as one might anticipate, the trust has much higher volatility than the sector average at 15% vs 9.7% average.

Dividend

The trust’s managers pursue a purely ‘growth’ investment approach, and so the level of dividends that a company pays does not feature in the managers’ investment process. They are not worried about companies meeting quarterly earnings forecasts – it is very much the long term they are looking at, trying to understand how companies re-invest capital themselves.

This notwithstanding, Scottish Mortgage does pay a dividend (though the yield on the current share price is 0.6%) and the board aims to deliver progressive nominal increases over time. Indeed, the company has paid a rising dividend for 35 consecutive years.

In the recent interim results, the board was able to announce a slight increase in the like-for-like revenues per share. All costs are set against capital – a change first enacted last year - which means that earnings per share were 1.35p over the six months and an interim dividend of 1.39p. This compares to the dividend for the entire year last year of 3.07p. The board aims to continue with its dividend policy of maintaining a modest year-on-year increase, which is likely to be paid from a combination of earnings and capital reserves (the revenue reserves having been largely exhausted in previous years). We understand that the board is very supportive of the managers’ capital growth approach, and puts the team under no pressure to deliver income.

Dividend

Source: Morningstar

Management

James Anderson has been the manager of Scottish Mortgage since 2000, and he has been a senior figure at Baillie Gifford for a considerably longer period. Tom Slater was appointed deputy manager in 2009 and became joint co-manager in 2015. They take a five to ten-year view of investments and do their best to insulate themselves from what they view as noise, preferring to look past short-term earnings and take a view on prospects further down the line than many other managers.

Baillie Gifford is one of the UK’s largest and most successful private investment management partnerships with great stability and depth of resource. James Anderson and Tom Slater are able to draw on the expertise of around 100 investors across the firm, and often take unorthodox research avenues.

Discount

Given its longer-term track record of outperformance, the manager’s experience and its large and liquid size, Scottish Mortgage has traded at a small premium for most of the past five years.

Membership of the FTSE 100 means it is now an option for a greater number of passive strategies (such as tracker funds, ETFs and quasi-trackers), which has meant demand for shares has been strong. However, the trust did slip to a small discount in February and March due to global market volatility – at which point the board did repurchase shares.

The board has no formal discount control mechanism, but it has a stated intent to “aid the efficient functioning of the market” in its shares – issuing and buying shares back in “normal market conditions”. As such, it has been active in issuing shares over the past 12 months to keep the trust’s shares trading close to NAV. The shares currently trade on a premium of 1.8%.

Discount

Source: Morningstar

Charges

Baillie Gifford charges a very low management fee. However, upon entering the FTSE 100, the trust has changed its charging structure. While the existing 0.3% management fee will be charged up to the first £4bn of assets, after that the fee falls to 0.25%. Last financial year’s (to 31 March 2018) ongoing charge was 0.37%, down 16% from 0.44% for the financial year. Compared to most other funds, particularly in view of the degree of active management employed here, this is very much toward the cheaper end of the scale. Scottish Mortgage is the second- cheapest trust in the AIC Global sector, with just over half the average OCF of 0.55%.

Charges

December 2018

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