Scottish Mortgage is a global equity portfolio run via a highly concentrated, growth- orientated, stockpicking approach and is one of the largest UK-listed investment trusts with assets of close to £7.5bn.
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 to date, with NAV total returns of more than 11%, well ahead of the 1.7% delivered by the FTSE All World index over the period.
Over five years the trust has delivered NAV total returns of 218.8%. The managers are not afraid to take punchy bets and the performance of their major holdings has been a key driver of the trust's success. The largest, Amazon, has delivered total returns of 486.4% over five years which at an average weight of 9.9% equates to an absolute contribution of 30% toward the trust’s performance.
Managers James Anderson and Tom Slater’s approach revolves around investing in innovative companies that the managers believe can revolutionise established industries, usurping incumbents with new technologies and techniques.
Increasingly the managers find companies like this – many of them capital light, technology driven businesses with huge potential ‘reach’ via the internet – are not listed and they have used the advantages of the investment trust structure to increase their exposure to these companies, which at the time of the final results in March 18, numbered 41 holdings valued at around £975m. Airbnb is probably the best known, though not the largest, of its unlisted holdings and is a good example of the type of company described above.
The trust has done very well on the back of its exposure to companies like this. Mounting political and social headwinds – particularly for companies like Facebook – mean it is easy to fear that the trust may be due for a cool bath. The managers disagree, and argue instead that companies like Amazon – far from being close to the end of their ‘growth’ phase – are only beginning to tap the potential revenues they have access to as their ability to analyse data, particularly, increases and new consumer driven markets gather momentum.
Scottish Mortgage remains one of the higher risk options for equity investors, but that risk has been accompanied by strong returns in recent years and the trust’s decisive shift into private companies is an illustration that the managers are not resting on their laurels, and continue to evolve their approach with an aim to generate significant outperformance. The trust is currently on a premium of 2%. It is amongst the cheapest in terms of OCF.
Sixteen years ago, the managers started shifting their methodology from a regionally built global growth trust, towards a concentrated stockpicking portfolio investing for the long term across the globe. 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 even to industry titans such as Jack Ma.
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 they zig-zag to adjust to developing circumstances rather than imposing a spread sheet on reality. It’s these sorts of companies that they actively hope to identify and invest in.
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 (unlimited) than you will lose should you be wrong (max 100%) - though of course the devil is in the detail, and choosing the right investments is the tricky part!
Scottish Mortgage’s portfolio is relatively concentrated, with the top ten holdings constituting 56% of total assets. 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's top 10 holdings
Source: Baillie Gifford
Overall there are 76 holdings in the portfolio currently. At the time of the final results at the end March 2018, the trust held 41 private (unquoted) equities, which tend to be smaller holdings (of which more below). The 30 largest holdings represent roughly 82% of the portfolio. Winners are sometimes ‘run’ for a very long time, and otherwise sized purely according to the managers’ conviction on longer-term opportunities going forward. This long-term approach is highlighted by the fact that 63% of its holdings have been part of the portfolio for more than five years, while overall portfolio turnover is low at 11.3% (five-year average as at 31/03/2018).
The managers take no account of the benchmark (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 (47.4%) though are underweight relative to the index, the Eurozone (19.1%) and a high relative weighting to China at 21.2%. 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.
Source: Baillie Gifford
Unquoted (private) equities
As the trust is centred around the notion of owning the most promising growth companies across the globe, the managers utilise the ability to invest in private markets. They believe that this offers shareholders extra opportunities, as access to the most promising private companies is dependent on relationships and reputation.
The managers are able to use the flexibility afforded by the investment trust structure to invest up to 25% in private companies. The majority of recent purchases have been feathering this part of the nest, which now accounts for around 15% of total assets, 2% greater than last year.
Companies in this bracket of the portfolio are often operating in areas where technology is a powerful influence – either because it is opening up vast audiences to whom these companies can potentially market their products, or because innovation is making new products possible where previously they were not.
A high profile and successful example of the former (now listed) is the trust’s third largest holding, Alibaba (7.5%), which Scottish Mortgage held for two years before it listed. The managers use this company as an example of the reasoning behind their decision to pursue investment into unlisted equities more aggressively; having admired Alibaba from afar – but been unable to invest – for some time before they picked it up in 2012, by which point it had already become a $40bn business.
Uptake Technologies (1%) is an example of the latter. Using the vastly improved capacity of computers to store and interpret data, this US business provides systems which, using a vast array of sensors to collect data, reduce expensive downtime for machines like aircraft, trains and wind turbines by predicting problems before they happen. The theory is that by doing so engineers can ‘fix’ your train before it conks out just outside Beaconsfield, so to speak, which is something we can all agree is a welcome innovation.
Spotify and Dropbox were both unlisted holdings, now listed. Other well-known unquoted holdings include Airbnb, SurveyMonkey, Lyft, and Mobike. Holdings such as GRAIL, Orchard Therapeutics and Unity Biotechnology are examples of the trust’s exposure to disruptive innovation within the healthcare space.
The company has been locking in low interest rates by issuing long term, fixed rate private placement notes. In April 2017 they borrowed £125m at a blended rate of a little over 3%. Gearing has progressively decreased as the trust’s size has increased, reducing by 10% from August 2016, to 3% at the time of writing (July 2018). The board stated in their most recent annual report (March 2018), that they believe the optimum level of gearing is above their current point, and would look to increase the company’s borrowings. This didn’t take long, and in June this year a further £170 million of private placement notes were issued at a cost of just under 3%.
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 September 2017 has been 353% (its share price gains have been even higher at 399.5%), compared to a return of 204% from the FTSE All World index. The graph below shows the performance over the past five years, which is no less impressive.
As the table below shows, some of its largest contributors to performance over the past year have been Kering, Tencent Holdings and Alibaba Group, which all continue to feature prominently in the portfolio today.
Source: Baillie Gifford
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 managers’ growth style and decision not to hold commodity-related stocks hurting relative performance.
Source: Morningstar *2017 figures to end September
Indeed, data shows Scottish Mortgage has been more volatile and delivered a larger maximum drawdown than the sector and index in NAV terms. 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. The graph below shows how strong the performance has been relative to the benchmark since the start of 2017.
Whilst the 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 1.60%) than its average peers (1.27%) and considerably higher levels of alpha (5.87%) than its peers (3.27%) relative to its benchmark (to the end of June).
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 manager’s 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 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. The trust has once again modestly increased the dividend, and earnings per share increased by 12%, having fallen the previous year.
To fund last year’s 2017 dividend of 3p (from earnings per share of 1.07p), the board had to use the majority of its revenue reserves. We understand that the board is very supportive of the managers’ capital growth approach, but is cognisant of the explicit dividend growth component of the trust’s investment objective. The 2018 dividend of 3.07 (2.3% more than in 2017) was paid from a combination of earnings, the remains of the revenue reserve and for the first time, the capital reserve.
Source: Baillie Gifford
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.
Given its longer-term track record of outperformance, the manager’s experience and its large and liquid size, it is not surprising that 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, it did slip to a small discount in February and March due to the global market volatility.
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, issuing more than 50m worth of shares from treasury to the end of 31 March 2018. Nevertheless, the shares trade on a premium of 3.1%.
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%. The current ongoing charge is 0.37%, down 16% from 0.44% for the financial year to 31 March 2018.
Compared to most other funds, particularly in view of the degree of active management employed here, this is significantly toward the cheaper end of the scale. Scottish Mortage is the second cheapest trust in the AIC Global sector, almost half the average OCF of 0.60%.
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