Review of Scottish Mortgage Investment Trust
Scottish Mortgage Investment Trust is a very successful, very large active equity fund (£7.6 billion in October 2018). Its returns have been very good for the last decade and on the back of its performance it has single-handedly made investment trusts sexy again. In this article we look at how the fund is run, the risks you take by investing in the fund and we consider whether this is a good time to buy the fund.
This is not to be considered a recommendation to buy or sell. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Who Runs The Fund?
The fund is run primarily by James Anderson and Tom Slater. Their skills complement one another in an interesting way. While James Anderson has a background in the arts, having studied History at Oxford as an undergraduate then doing an MA in International Affairs, Tom Slater has a BSc in Computer Science with Mathematics from Edinburgh. James Anderson joined Baillie Gifford in 1983, headed the European Equity team until 2003 when he founded the Long Term Global Growth strategy team and has been joint manager of Scottish Mortgage Investment Trust since 2000. Tom Slater joined Baillie Gifford after graduation and worked in the Developed Asia and UK Equity teams before joining the Long Term Global Growth team at the start of 2009. Slater was appointed deputy manager of Scottish Mortgage Investment Trust in 2010 and in 2015 became joint manager and in the same year was also appointed Head of the US Equities Team.
James Anderson and Tom Slater can draw on the expertise of the Long Term Global Growth team, which has considerable resources. This allows them to identify new opportunities but also to monitor whether the investment thesis that drew them to a company still applies.
Oversight & Expertise From The Board
One of the benefits of an investment trust is the way that it is run, which is as a company. This means that it has a board of directors whose responsibility to ensure that the company is being run for the benefit of its shareholders. The board of Scottish Mortgage Investment Trust bring a great deal of intellectual firepower and relevant experience to the table.
- Chair - Fiona McBain is the former chief executive of Scottish Friendly Assurance, a mutually owned financial services group with over 1,000,000 policyholders. Fiona is a chartered accountant.
- Paola Subacchi is an economist, writer and commentator on the functioning and governance of the international and monetary system. She is the author of "The People’s Money: How China is building a global currency" and a senior fellow at Chatham House (The Royal Institute of International Affairs) in London. Her expertise on China and international affairs is helpful for the fund because it invests heavily in China and the US.
- Patrick Maxwell is the Regius Professor of Physic and Head of the School of Clinical Medicine at Cambridge University. He has extensive knowledge and experience of the biotechnology sector in which the fund invests.
- John Kay has a distinguished record as an economist, academic, author and commentator on business, government and economic issues. He is a fellow of St John’s College, University of Oxford and Investment Officer of the College and he is a director of Value and Income Trust PLC.
- Justin Dowley is a former international investment banker and qualified as a chartered accountant at Price Waterhouse in 1980. He was Head of Investment Banking at Merrill Lynch Europe and brings a wealth of knowledge and experience in the banking industry to the board.
What Is An Investment Trust?
An investment trust is a company that invests in other companies or order to generate a return for its shareholders. An investment trust is listed and traded on the London Stock Exchange. An investment trust differs from other fund types such as an Open Ended Investment Company in various ways:
- Governance: An investment trust has an independent board of directors whose job is to ensure the trust acts in the interests of its shareholders. Often the directors are chosen to bring additional expertise to the trust as well as oversight.
- Size: The shares issued for an investment trust are finite. If you want to buy shares someone else has to sell you theirs. An exchange traded fund or OEIC will expand or contract the number of shares as investors buy and sell, sometimes on a daily basis. An investment trust can issue more shares but this happens infrequently. This means if many people buy or sell shares in the fund, an event that would force open ended funds to buy or sell fund assets, an investment trust does not have to buy or sell any assets. This means the fund has control over the timing of its buying and selling.
- Gearing: As a company investment trusts can borrow money which can then be used to boost the size of their investments. This amplifies profits and losses, so is a double-edged sword. Not all investment trusts choose to use gearing.
- Shareholder Rights: Investors are shareholders and therefore have a vote on investment policy and appointments to the board of directors.
- Discount/Premium: Sometimes the value of an investment trust will be above or below the asset value of the fund. Investment Trusts trade at a premium to asset value if they have performed well as investors are willing to pay a premium to buy into the fund. Conversely poorly performing funds can trade at a discount to the asset value which offers an opportunity to bag some bargains in the event that the fund recovers.
How Much Does It Cost?
The ongoing fee for Scottish Mortgage Investment Trust is 0.37%. Compared to its global equity fund competitors this is very cheap. For example Lindsell Train charges 0.74% (or 0.54% if you hold it on the otherwise pricey Hargreaves Lansdown platform), and Terry Smith's Fundsmith Global Equity fund is 0.95%.
What Is Their Investment Approach?
The fund's stated goal is:
"Scottish Mortgage is an actively managed, low-cost investment trust, investing in a high conviction global portfolio of companies with the aim of maximising its total return over the long term. The managers look for strong businesses with above-average returns and aim to achieve a greater return than the FTSE All-World Index (in sterling terms) over a five year rolling period."
Like other popular and successful active funds in the UK Scottish Mortgage Investment Trust concentrates its portfolio in a small number of companies. Rather than tweak the benchmark the fund goes all-in once it identifies a company that it likes. The largest 30 holdings accounted for 80% of total assets, with Amazon alone accounting for more than 10% of the assets, and the total number of holdings was 79 as of October 2018. The fund holds more stocks than Fundsmith, which usually holds around 30, but is still a highly concentrated portfolio. This increases the risk of the fund as well as its potential return.
As well as concentration within a small number of stocks the fund is concentrated in certain regions, with the US making up over half the portfolio with about a fifth in China and about a fifth in the eurozone. The fund is also concentrated in certain sectors dominated by consumer services (38%), Technology (24%) and Health Care (17%), and these three sectors make up 80% of the portfolio.
When funds buy and sell shares they have to pay a fee to their broker. The more they trade the greater this fee, and this detracts from the return of the fund. One of the common attributes of Scottish Mortgage Investment Trust, Fundsmith Equity and Lindsell Train is that they try to keep their broker fees low by buying and holding their investments as long as possible. Over 60% of the portfolio has been held for more than five years, and many stocks have been held for more than a decade, such as Amazon, Tencent, Baidu, Kering and Alphabet. In the year preceding March 2018 portfolio turnover was just 13%.
Another source of increased risk is that the fund buys unlisted companies. This is risky because unlisted companies tend to be smaller and more difficult to sell than companies listed on a stock exchange. A listed company is obliged to publish regular accounts that are in line with accepted accounting standards and these accounts have to be audited by an independent accountant. Unlisted companies have less transparency and require more research. An example of an unlisted company owned by the fund is Flipkart, which is India's answer to Amazon. Another is Airbnb, the online marketplace for booking homestays and tourism experiences.
The benefit is that unlisted companies, being small, have potentially greater upside if they are successful. Also, by not being accountable to shareholder scrutiny of quarterly accounts the management of the company can focus on long-term growth. If unlisted companies grow they may become listed, as happened with Alibaba, the cloud storage company Dropbox and several other of the funds holdings. A public listing may boost the price of a company, as shown in this graph from the fund's 2018 interim report. Alibaba's share growth was so large from initial investment to 2018 that the graph has to have a break inserted to show the more than 1000% increase. Spotify, too, was a great success for the fund, growing by almost 300% from the time of the initial investment. There are also some relatively disappointing results, for example Home24 (online furniture sales), HelloFresh (meal kits) and Unity Biotechnology (develops medicines that potentially halt, slow or reverse age-associated diseases).
Scottish Mortgage Investment Trust invested had 35 unlisted investments in 2018, which means unlisted investments accounted for 17% of the fund's total assets. The fund states that it will never invest more than 25% of its capital in unlisted companies.
Growth at an Unreasonable Price
Some active share funds are aimed at finding companies that are undervalued. This is done by building several models of the future cash flows for a company, then working out the present value of those cash flows and comparing it with the share price of the company. This allows a fund manager to gauge whether a company is overvalued (share price greater than theoretical price) or undervalued (share price less than the theoretical price). Value funds would restrict their purchases to companies that look cheap.
Other active share funds, including Scottish Mortgage Investment Trust, target growth. This means they try to identify companies which can grow their earnings rapidly. This could be because they have some technological edge or are entering and pioneering an entirely new market. A good example is the electric car manufacturer Tesla.
In an interview with Citywire's Gavin Lumsden James Anderson said the following about Tesla:
So we certainly believe the position is that there is still a good possibility that Tesla will prove entirely and highly successful and the returns we make to that would outweigh the downside involved in all these complex tasks not working out. But I think one should always try to phrase things in terms of probabilities and payoffs rather than certainty. You know I don’t like it when people try to push the position and say “Tesla will be at X”. It may be at X and we think there is a chance that we can make a lot of money for our clients in exercising this vision, which is surely good for the world, but are we certain about it? No of course not.
The interesting twist about Scottish Mortgage Investment Trust's approach and other fund managers is that they place less emphasis on valuation and more on identifying companies that can rapidly and sustainably grow their earnings. Unlike many growth investors that look for Growth At an Reasonable Price (GARP) they are happy to buy Growth At an Unreasonable Price (GURP).
The approach of the Long Term Global Growth team is to look at probability adjusted long-term cash flows. Not only do the team estimate future cash flows they also associate probabilities with different potential future cash flows. Sometimes a low-probability payoff may be worthwhile if the upside is sufficiently large thanks to technological trends and competitive advantage, as they have judged is the case for Tesla.
Not a ‘FANG’ fund
Anderson and Slater are at pains to point out that they are not a technology fund. These are sometimes called FANG funds after the large and successful US technology stocks Facebook Apple Netflix and Google. Tom Slater said in a YouTube interview that the technology focus of their fund is simply a consequence of long-term growth trends being currently lying in the technology sector:
People often try to characterize us as technology investors. I don't really believe that we are technology investors. And instead, it's trying to think through the implications of some of these well-established trends and say, well where does that take us? As James says, we're in the hundred oddth year of Moore's Law, but it's just saying well what does the doubling of price performance in semiconductors mean if you look out five or ten years. What would be the implications of being able to process data on that scale? And I think that takes you to some quite interesting places. Whether it's cars that can drive themselves, because actually you've just reached the data processing capability that you need to do that. Or take the healthcare example. We've seen the growth of affordable high-throughput sequencing. That exists today. You can see a clear trajectory of the prices coming down from this point.
One of the companies that Scottish Mortgage Investment Trust has owned for a while is Illumina. This company sells DNA sequencing machines that can currently sequence 48 human genomes in two and a half days. The company claims that it will bring down the price of sequencing a person's entire genome to $100. Slater goes on to say how the next step after identifying a trend is to find the companies that are surfing the crest of the technological wave:
Again, link it to a special company. That isn't just happening because of a technological revolution, it's happening because you have a special company that's driving that process forward. But if you can see that trend, you can see it's clearly established then you can think, well, where does that take you? And, for example, all those companies that have interesting intellectual property based around understanding genomic basis of disease suddenly look to be in a stronger position both to capitalize on that opportunity but also to address a much larger opportunity. And so we've bought a variety of therapeutic healthcare companies if you look over the last two or three years not based on some hypothesis about the technology but just simply looking at the well-established trend lines in this and thinking about what the consequences might be.
Trends Beat Macroeconomic Factors
James Anderson said in an interview on YouTube:
"We are very dubious in the common assumption in stock markets that there is something called top-down macroeconomics and bottom-up companies. They meet and meld together, and what we're looking for is just as distinctive, we hope, in terms of thinking about macroeconomics as it is for thinking about corporate advantages that Tom's been talking about there. Because what we're looking for is the type of economic trends that are high probability, of high importance and will last for decade after decade. We think that is so much more significant than wondering what the Fed's going to do next quarter. We're not even sure one would know whether to buy stocks or sell stocks after that."
The implication is that investors should ignore things such as monetary policy or inflation and simply focus on technological trends. For example, Moore's Law states that the number of transistors in an integrated circuit doubles every two years. In the graph below the y axis is logarithmic which means growth in the number of transistors has been exponential.
As the number of transistors on a chip increase the speed of the chip increases, allowing new applications to be developed that harness this increasing processing power. Anderson goes on to say:
"We're much more interested in the 117th year of Moore's Law, effectively, or of the underlying rates of improvement in the technologies that power both data and batteries, if you like, and I think if you put those on top of what we're seeing in companies they do interact with each other. And that's the point of real significance for us and that's why we think you can afford to put aside so much the noise that preoccupies people at those levels."
The trends that the fund has identified and which, if they continue, will buoy up the fund returns are:
- The continual rise and development of China, in particular of its world leading digital economy.
- The spread across all industries of the gathering and computer-facilitated use of data.
- The structural shifts in the global healthcare industry and the industrialisation of biology.
- The long run shift in much of the transportation infrastructure to electric and autonomous vehicles.
- Shifts in energy generation to renewable sources and the proliferation of energy storage solutions for domestic and commercial use.
- Greater social, political and regulatory scrutiny of large corporations.
This is a high risk fund and so investors should be willing to hold it for a very long period of time, preferably decades, to get the maximum benefit from its investment approach. Scottish Mortgage Investment Trust focuses on growth stocks. These stocks are extremely sensitive to global growth and trade. Consequently, a recession in the US or China could significantly reduce the returns of the fund.
Many of the technology companies owned by the fund depend on trade between the US and China. Trade may be affected by the US America First policy and any trade war between the US and China, and this poses a political risk to performance. For example, as trade tensions rose toward the end of 2018 Alibaba, Tencent and Baidu suffered sharp falls in their stock prices.
Gearing, also called leverage, amplifies positive and negative returns by borrowing money on top of investor funds effectively increasing the size of the fund. Scottish Mortgage Investment Trust uses gearing but limits it to a maximum of 50%. For example, in October 2018 the total assets of the fund before deduction of borrowings was £7,609,926,379.56, but shareholders' funds were just £6,857,301,429. The difference of 11% was due to borrowing of £753 million. The fund usually keeps the level of borrowing between 10% and 20%.
We can see the result of gearing, and the high risk nature of Scottish Mortgage Investment Trust's investments if we plot the fund daily returns versus those of its benchmark which is the FTSE All World Index in sterling. The dashed line shows the returns one would expect if the returns varied an average of one-to-one with the benchmark. The red line shows the actual way returns typically vary against the benchmark. Returns for the fund tend to be 34% higher than those of the benchmark.
- FTSE All World +4%: Scottish Mortgage Investment Trust +5.4%
- FTSE All World -4%: Scottish Mortgage Investment Trust -5.3%
This gearing return boost of 34% helps lift returns during global stock market rallies, but the downside is that it also boosts losses during global stock market falls.
Another manifestation of the increased risk of the fund is its high typical daily percentage price movement, or volatility. This is about 19% for the fund which is higher than MSCI World (14%), the FTSE All World index (13%), or either of its main competitors Lindsell Train (12%) or Fundsmith Global Equity (12%).
The fund depends heavily on the expertise of James Anderson, who has been at the helm since 2000. His age is not given on the Baillie Gifford website but he got his MA in 1982, so assuming he was then 23 he is probably at the tail end of his fifties. Tom Slater has been co-manager or manager of the fund since 2010 and is about a decade younger, around 40, so his career has longer to run. If James Anderson could no longer run the fund due to ill health Slater could take over running the fund. The difficulty for investors is judging how much the success of the fund depends on the skills of each manager.
Another manager risk is "loss of mojo". Sometimes, and often inexplicably, managers simply lose their edge and never recover. For example Bill Miller, a fund manager based in the US, beat the S&P 500 for 15 years in succession from 1991 to 2005. Then his winning streak came to an end and his returns never had anything close to such a winning streak again. The answer to the question "can you be lucky for 15 years in a row?" is: "yes".
Scottish Mortgage Investment Trust is popular because it has performed extremely well for the last decade. In the plot below are the annual returns of the fund, aligned with those of its benchmark (the FTSE All World Index in sterling) and two of its competitors Fundsmith Equity and Lindsell Train. This illustrates both the strength and weakness of the fund.
The fund's strength is that during "good" years when equity markets are rallying it tends to outperform. For example, in 2017 its benchmark, which is a global share index, rose 11.1% and the fund had a spectacular return of 40% which was far higher than most other global active share funds such as Fundsmith (22%) and Lindsell Train (25%). The fund's weakness is that during "bad" years it can crash more heavily than other funds. For example, in 2008 when its benchmark fell by -22% the fund fell twice as much, by -45%.
Is Now A Good Time To Buy The Fund?
There are many reasons why the fund is popular beyond the usual stampede into funds that have performed well:
- Good governance given the oversight by a highly skilled board of directors
- Low fees and low turnover
- Transparency, with excellent videos and regular reports explaining the investment approach
- Consistent and skilled management from James Anderson and Tom Slater
However, given the fact that we've enjoyed an almost unbroken decade of very strong global equity returns it is likely that we're about to see more choppy waters ahead. Consequently, the returns of equity funds in general and Scottish Mortgage Investment Trust in particular are likely to suffer given its use of leverage, its high allocation to emerging markets and its focus on risky growth stocks.
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