As with any investment, your capital is at risk.
On 29 March, Scottish Mortgage managers sat down with commercial director Stewart Heggie on a live webinar to answer shareholders’ questions. This article provides an overview of the topics covered during the discussion, based on the questions submitted before and during the webinar. These ranged from recent performance and investment approach to the resilience of particular holdings.
If you click the title of the topic you are interested in below, a written overview will appear beneath it.
In light of recent media coverage regarding the Scottish Mortgage board of directors, Tom opened the session by apologising to shareholders: “It is not helpful to anybody to see the trust in the headlines...”
Tom shared his experience of the board as, “one of independence, strong governance and appropriate challenge for the managers over the years.” He observed that the board had helped the managers get better and that he has enormous respect for what the board has done over the years.
The first questions that the managers addressed were concerning the fall in the share price performance of the trust. The managers acknowledged the painful experience endured by shareholders throughout this challenging period.
They provided context by reminding shareholders that looking back over historical performance, progress has never been a straight line for Scottish Mortgage or the companies it invests in. Over its history, the trust has suffered a number of material falls, several of which were more significant than today’s setback. Even so, it has recovered each time, as have broader markets.
In response to the question – how many companies in the portfolio are loss-making or not cash generative – it was confirmed that about 13 per cent of the listed companies are not producing either positive earnings or positive free cash flow. Of the private companies, 18 per cent is cash generative. And some of those companies are incredibly cash generative. Lawrence listed some ways the managers are actively trying to alleviate the pressures of short-term volatility.
The managers are seeking to find, own, and look within the portfolio for companies with excellent long-term growth prospects that are trading at materially lower valuations than they were before this period of volatility.
One example of this would be adding to MercadoLibre, the leading Latin-American ecommerce and fintech platform, over the course of last year. The trust did that at a valuation where the share price was 50 per cent lower than it was two years ago, despite the remarkable operational progress at the company.
The managers continue to invest in companies they believe will provide transformational returns for shareholders in the future. This has included investments in companies such as Climeworks, a company making machines that remove carbon dioxide from the air and store it, and UPSIDE Foods, which hopes to revolutionise meat production and consumption, and more advanced growth companies such as Cloudflare and Roblox.
Despite the stresses and difficulties of this period, the managers stay true to the core approach of Scottish Mortgage, remaining long term in approach and outlook.
Ultimately, to generate returns for shareholders, we’re trying to back companies that drive radical change in the world. Because that change is so extreme and they are trying to genuinely change the world, we believe the impact of what they will do, over time, will be valuable irrespective of that broader macroeconomic context.
Lawrence used Amazon and Apple as examples. In 2001, Amazon fell 90 per cent. During the financial crisis, Apple fell about 60 per cent and was sitting at a $100bn market cap. Today, it’s $2.5tn. This illustrates that the managers should not give up on what they believe to be the exceptional growth companies of the future due to short-term volatility.
He concluded, “We’re remaining long term because we think that is core to our edge, core to our distinctiveness. It is very easy to be long term when times are good, it is much harder when they’re difficult.”
The companies held in the portfolio recognise that the environment has changed and they need to take different actions. They’re focusing on using this period as an opportunity to cut costs to streamline their operations. This comes after a decade of excess in the tech sector, where there hasn’t been so much of a focus on cost.
The managers hope that some of our companies use this as an opportunity to exit a storm on a better financial footing than they entered it.
Lawrence also highlighted cheap capital and the silver lining that exists there. Many of the portfolio companies are market leaders that have seen vast amounts of capital coming in to compete against them. That capital has now been rescinded, so many are using their position to consolidate market share and push towards profitability.
On the companies’ performance, the managers were asked which has surprised them the most over the last year and why. Lawrence pointed to MercadoLibre, a company that got a pandemic boost, yet it is still growing 40 per cent in US dollar terms. Ecommerce penetration rose to around 11 per cent.
At the same time, it has made incredible progress in delivering financial services to those who aren’t served well or at all, by the country’s large banks and traditional financial industry. While it’s an exceptional opportunity, it’s also driven by an exceptional management team that has navigated the conditions remarkably well.
Tom pointed to SpaceX and the over 60 launches it did last year, more than one a week. He noted, “Basically, in the space of a single year, it’s created the commercial space industry. And, you know, I think that could be huge over the coming years.”
He also noted a less positive surprise with a comment on Carvana, a US retailer of second-hand vehicles. The managers still believe that selling vehicles online is a much better experience for consumers. But they have been surprised how quickly that business model has come under pressure and unravelled.
The managers were asked, “What could you have done differently?”
Lawrence reflected that there will always be lessons and in periods such as these, intensive learning to take forward.
One lesson was about investing in China:
I think we were slower than we should have been to have realised that there was more of a seismic change in the way that the Chinese government was interacting with its companies. We spent a lot of time with the companies trying to understand this, but I think we were slower to sort of incorporate that into our mental models of investing in the country...
Another lesson was about recognising market sentiment towards countries:
Going back a couple of years ago, our companies were displaying incredible fundamental performance. That was recognised very quickly by the market and although we had, and continue to have, faith in a lot of those businesses over the long term, I think we could have been more cognisant of where the market valuations were pushing them...
Numerous questions were submitted by shareholders regarding private company investing. To address these, Tom went back to basics by asking: “Why do we invest in private companies?”
He explained that many of the world’s greatest growth companies are choosing to stay private for longer for several reasons:
He concluded, “And so the view that we've had is, if we're going to invest in the world's greatest growth companies, we have to have the flexibility to invest in public or private.”
It is important to note that these are not early-stage or start-up companies. Take the top five holdings, comprising about 50 per cent of the private company exposure in the portfolio:
So, these aren’t small companies. They are large, established businesses which we believe have substantial growth opportunities from here.
Tom advised, “We shouldn't think of this [private companies] as an asset class. We don't invest in the asset class, we invest in a relatively small number of companies, which we feel have got exceptional growth opportunities.”
And while being mindful that there are headwinds and we must ensure we get the valuations right, these are some of our best ideas.
For more information on our private company exposure, check out our Five fast facts on private company investing.
On the topic of private companies, shareholders asked questions about the valuations process and the resource the trust has in place to carry these out. Tom outlined the process.
The starting point is that a third party – S&P Global – do the valuation assessments of private companies.
That valuation assessment is then passed to Baillie Gifford’s private companies valuation committee. We have five accountants who work full-time on this. They take the third-party valuation assessment and will provide another layer of challenge. Our objective is to get the best estimate we can of the value of these private companies if those shares were to trade today.
The output of that private valuation company is reviewed by the audit committee of the board and then the external auditors.
And these assets may be held in not just Scottish Mortgage’s portfolio but other trusts and funds managed by Baillie Gifford, meaning they will get three or four external audits from ‘big four’ audit firms.
Those revaluations happen on a regular cadence. Every three months under normal circumstances, but when there are significant moves in the company’s listed peer group, as over the past year, these valuations are revisited much more frequently.
|Percentage of portfolio revalued 2+ times||95%|
Percentage of portfolio revalued 5+ times
You can read more about our private company valuation process here.
To indicate the level of investment expertise that the managers can draw upon, Baillie Gifford’s investment department is split into 22 teams, totalling 179 investors. Most investors are based in Edinburgh, enabling them to share views and ideas easily. Our investors are first and foremost analysts, and their research is made available to all on a proprietary platform.
Within that, approximately 30 ‘hybrid’ investors source, research, and lead on private and public investments at Baillie Gifford. They leverage their experience of public markets and our ability to hold companies through IPO. They contribute ideas to our private-only funds, investment trusts, and segregated client accounts with an allocation to private equities.
Investing in private companies is a strategic focus for Baillie Gifford. In addition to ‘hybrid’ investors, the firm has developed a specialist Private Companies investment team led by Peter Singlehurst, a partner of the firm. The team comprises eight investors: one investor is based in San Francisco, one in Shanghai, and six are based in Edinburgh.
Our private company investments are made and managed by our in-house Private Companies Legal Team, which comprises four individuals. The legal team manage NDAs, term sheets, legal, due diligence and negotiation of investment documents, corporate actions and shareholder consents. The team also provide advice and support for all aspects of the ongoing management of private company holdings, including restructurings, sales, and IPOs. They work closely with our investors and with support from external counsel if required. We have a wealth of resources outlining the legal processes involved in making private company investments which can be supplied.
Working alongside the investors and legal counsel is the in-house Private Companies Valuation Team, comprising of five individuals.
Scottish Mortgage has a shareholder approved restriction in place. It states that the percentage of the portfolio that can be invested in private companies is 30 per cent, measured at the time of purchase. Which in turn means that the percentage held in private companies can grow and exceed 30 percent, it is not a cap. Several questions were submitted by shareholders, asking the reason for that limit, whether the managers feel constrained by it, and if it affects their relationships with the companies they invest in.
There are many factors that go into that number:
And that’s not an exhaustive list. Because there are so many variables, it’s worth keeping in mind that it's a volatile number that can quickly change. As previously mentioned, five companies make up 50 per cent of the private company allocation. If even one were to list on the stock market, that would bring the percentage down.
Yet, as Tom said, companies are staying private for longer, and as such, no private companies in the portfolios pursued a listing last year. However, we remain long term, and we encourage companies to do what’s in their best interest for long-term value creation.
Lawrence reiterated, “We want companies to do what makes sense on a five- and 10-year view, not what might make sense for us or them on a six-month view.”
In terms of being constrained by this limit, there was one investment they would have liked to have made last year but couldn’t because they were close to the limit. However, the managers invested around £260mn into private companies last year, so it's not been too much of a constraint so far.
Tom reassured shareholders that if the managers felt it was either a problem for Scottish Mortgage shareholders and the returns they can earn, or that it would impact our relationships with companies, the managers would have that conversation with shareholders. He explained:
That’s the history of it. When we started doing these things back with Alibaba in 2012, there was no limit on the Trust’s ability to invest in private companies. I think it was either 2015 or 2016, we came to shareholders and said, ‘We’re doing more of this’. We had a discussion about where to put the guardrails around it, and then we put the limit at 25 per cent. And then we came back in 2020 and said, ‘We’ve seen more opportunities, we believe it’s in the best interest of shareholders to raise it’, and again, had that dialogue. So, if we think there are missed opportunities, we’ll come and have that conversation with shareholders.
One shareholder asked: “Is it time to abandon China?”
Lawrence reflected that over time, we've had to recognise that the bar has increased for Chinese holdings within Scottish Mortgage. There are two reasons for that.
We take these factors into account, but they do not mean one should abandon the world's second-largest economy and one of the world’s most dynamic economies. There are still some exceptional growth companies there, and we invest with our eyes open.
NIO, as an example, is developing into one of the most efficient maker of electric vehicles in the world. Or Horizon Robotics, one of our private companies, is a leader in computing solutions for intelligent vehicles.
A follow-up question was, “Your private investment into China's ByteDance, owners of TikTok, has had several problems like potentially being banned from the US and other countries, as well as a very high valuation. Can you please comment on why you think it's still a great investment?”
Lawrence responded that ByteDance is a holding performing well on the fundamentals. Much of that comes from the domestic China business, which today accounts for the vast majority of its value. Currently, the risk to the company is around the US business, so the valuation is adapting to that fact. This recently made the headlines with Congress questioning TikTok’s chief executive.
So, while there is risk and uncertainty, for Scottish Mortgage, “ByteDance is a once-in-a-generation business that has incredible scale. It’s become an incredibly important platform, just in China alone, and is continuing to move and expand into new areas.”
During this turbulent time, a Scottish Mortgage shareholder caught in the Woodford crisis asked if the same might happen to Scottish Mortgage.
Tom outlined three critical differences in approach between Woodford and Scottish Mortgage.
Watch our short animation here to learn more about the difference between open-ended and closed-ended funds.
Because Scottish Mortgage shares are bought and sold on the stock market, the share price is affected by supply and demand. That means that the share price can be higher (at a premium) or lower than (at a discount) the value of the assets, known as the Net Asset Value (NAV).
To learn more about discounts and premiums, watch our short animation here.
For context, investment trusts are sitting on the highest discount level we've seen for about a decade. And that is also the case for Scottish Mortgage. The discount is about 20 per cent. Many shareholders asked about the approach taken to managing the discount and its impact on the running of the portfolio.
Lawrence explained, “The policy of the trust is to try as much as possible to have a share price that is close to the NAV because we think that is the fairest situation for all stakeholders.”
An important mechanism for doing that is ‘buybacks’, meaning that the trust buys back its shares. One of the effects of that is that it raises the share price, bringing it closer to the NAV and therefore narrows the discount. Another significant benefit is that by buying those shares, you’re effectively buying back the portfolio at that discount.
The company repurchased its shares on 45 occasions and spent about £230mn on buybacks during last year. Lawrence concluded, “that’s the mechanism that we’ll continue to use in the future.”
To learn more about buybacks, watch our short animation here.
As with any other listed business, Scottish Mortgage can borrow money, and that's known as gearing. Shareholders asked, “What is the interest rate the trust is paying on debt? And secondly, have you got the leverage under control in stressed scenarios?”
To learn more about gearing, what our short animation here.
Tom took this question, “We think it makes sense for shareholders to have a modest amount of debt within the company because we think that their portfolio will rise in value over the long term. And so having a small allocation of debt will increase the returns to equity owners.”
For clarity, the managers don't increase or decrease that exposure in response to short-term market levels. Tom explained, “We’re stock pickers, we focus on company fundamentals, not trying to time markets. But over the past 10 years, where we’ve seen such strong asset appreciation, we've gradually raised more debt to try and keep that overall percentage of debt roughly the same.”
Over the past year, when the managers have seen substantial declines in the asset value, they've made modest reductions in the debt level.
And as to interest rates on that debt, the company has been responding to the trend they’ve seen over the past five years – when interest rates have been so low – by proactively taking out long-term borrowings. Switching the balance of the debt from being predominantly bank debt to being largely private placement debt with a tenure of 25, 30, or 40 years for which the company is paying about 3 per cent, on average.
The trust has some relatively small revolving facilities, which are more expensive, about 4.5 to 6 per cent. The company also has some short-term debt, 3, 4 and 5-year debt, for which we’re paying about 2 per cent.
The managers stressed the importance of balance. The number one priority will always be investing in the growth companies of tomorrow to create returns for shareholders. Secondary to that mission, but also important, is making sure that the company is managing the debt within an appropriate range, and also trying to, where possible, influence the discount between the share price and the asset value.
The managers often refer to exceptional growth companies, which prompted the question, “How do you tell an exceptional company from an average one?”
Tom reiterated that the core mission at Scottish Mortgage is to look for and to back companies driving radical disruption in their industries that can grow to multiples of their current size. He said, “There will always be fantastic businesses, but perhaps they're in markets that aren't growing or don't have the prospect of meaningful growth. In this case, for all the good qualities they may have, it's unlikely that business is going to be a multiple of its current size in the future.”
So, the first question is: ‘Is there an opportunity that's big enough that if we're right about it, it could grow to be a multiple of its current size?’
The second question is: ‘What is it about that company that places them uniquely to exploit that opportunity? Why do they have a greater likelihood of success than other companies?’.
That may be to do with some structural or geographical advantages. But looking at the big winners over the past 10, 20 years, often, it’s been intrinsic qualities of the firm that have been really important. Often, we've seen the influence of founder managers allowing businesses to take very long-term decisions that aren't focused on maximising short-term profitability.
During the discussion, the managers were asked to comment on three holdings – Moderna, SpaceX and Ginkgo Bioworks.
With the decreased urgency for a Covid-19 vaccine and mRNA technology being as nascent as it is, the size of the holding was brought into question.
The managers felt it worth pointing out that Moderna is a software company within the healthcare sector. This isn’t typically a sector that you would associate with software companies but as Tom commented, “[it is] a sector where the problems are harder, but the rewards for success are bigger. And we see lots of signs that this business operates in the same way as some of the big, successful software companies of the past decade”.
Lawrence also highlighted that the company wasn’t created to develop a Covid-19 vaccine. “It was created as a platform for mRNA technology to address many potential ailments. It just so happened, it was one of the most nimble and effective platforms for addressing Covid-19,” He said
Over the year, we’ve seen further scientific validation of that broadening platform. It’s developed in a very short space of time, a world-leading flu vaccine. It’s also developed an RSV vaccine, addressing a common virus which often causes coughs and colds, something that’s never been available on the market. It’s even developed a personalised cancer vaccine in conjunction with Merck that cuts the risk of the cancer reoccurring or death by about 44 per cent.
Lawrence commented, “That’s been incredibly meaningful in terms of these new areas that it’s unlocking that could be hugely valuable and make a huge difference to human health, well beyond Covid.”
The managers believe the value has been affected by the market’s focus on its Covid-19 revenues in any given year. However, what those Covid revenues have done is give Moderna the resources to go after all these other things. The balance sheet is $20bn today. So not only has Covid-19 validated its platform, but it's also given the company an enormous cash pile to pursue these big opportunities.
Moving from software in healthcare to synthetic biology, due to the recent poor share price performance of Ginkgo Bioworks, a shareholder asked if this investment has been a mistake or if the managers still believe it can make money.
Ginkgo Bioworks is a biotech company that uses automated biology technology to design, build and test living organisms for use in a variety of industries.
The managers invested in it as a private company, and subsequently, it went public. When it did so, it came at a valuation which, in the long run, it couldn’t support. As a result, the performance has been disappointing in share price terms. Yet, Tom affirmed, “We believe the company is doing all the right things from an operational standpoint…absolutely we still have faith in the team that is driving that opportunity.”
Among falling vehicle prices, loss of competition from the mainstream manufacturers, and no new models yet, some may ask, where now for Tesla?
Tom, reflecting on the past two years, suggested we’ve seen fantastic execution. With the challenges of Covid-19 and the extreme pressure on supply chains, Tesla’s managed to grow volumes consistently and successfully through that period. We’ve also seen a significant expansion and profitability. The cash flow that it’s generating has put it in a solid position to invest for the future.
The company aims to accelerate the world's progress towards a sustainable energy future. To do that you need to drive down the price points and drive up the volumes. And that's precisely what it’s been doing.
In terms of competition, others have been struggling to grow volumes. He concluded, “I am more convinced than ever, about Tesla's advantage, both as a manufacturer and in terms of its software, and its position relative to other manufacturers. I think they have a huge opportunity in front of it”.
Two significant areas the managers have discussed in the last year or so have been the intersection between healthcare and technology, and the energy transition.
A more recent area of opportunity is artificial intelligence. The managers have been considering its impact as an area in and of itself, but also thinking about the various potential applications for our existing holdings.
Lawrence observed that we don’t yet know what this looks like, “But we know it could be quite meaningful and quite radical and would not be contained to any one industry or sector.”
When asked for a message to leave shareholders with, Tom referenced the quote, “No bear market ends until every bottom-up investor has a nuanced view of the macroeconomics”.
We firmly believe that, over the long run, what matters is the fundamentals of the companies. We don't know when the current macroeconomic situation is going to improve, nor do we think we have any edge in trying to predict it. It's a complex system. But over the long run, share prices follow fundamentals.
Tom summed it up:
I just think one of the frustrations of the past year, 18 months, is this disconnect between what we're seeing at a fundamental level, the opportunities, both at the companies but also in the progress of technology. And then the gloom and pessimism that pervades financial markets at this point in time.
In response, he stressed the importance of staying true to the trust’s philosophy and not changing course based on short-term volatility:
We will continue to do what we've always done. We acknowledge that our approach hasn't produced a good outcome for shareholders over the past 12 or 18 months. But as we've always said, our time horizon is five years or more, and in that time, markets go down as well as up. But if we focus on the long run fundamentals of businesses, that's what will ultimately drive their share prices.
|Scottish Mortgage Investment Trust plc||4.6||24.8||110.5||10.5||-45.7|
Source: Morningstar, share price, total return, sterling.
The trust invests in overseas securities. Changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up.
The trust has a significant investment in private companies. The trust’s risk could be increased as these assets may be more difficult to sell, so changes in their prices may be greater.
The trust invests in emerging markets where difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.
The trust can borrow money to make further investments (sometimes known as “gearing” or “leverage”). The risk is that when this money is repaid by the trust, the value of the investments may not be enough to cover the borrowing and interest costs, and the trust will make a loss. If the trust's investments fall in value, any invested borrowings will increase the amount of this loss.
The trust can buy back its own shares. The risks from borrowing, referred to above, are increased when a trust buys back its own shares.
The trust can make use of derivatives to obtain, increase or reduce exposure to assets and may result in the trust being leveraged. Derivatives are most often used to compensate for possible unfavourable currency and market movements. This may result in greater movements (down or up) in the net asset value of the trust. It is not our intention that the use of derivatives will significantly alter the overall risk profile of the trust. A further risk exists in respect of the counterparty with whom the derivative transaction is made. Due care and diligence is exercised in the selection of counterparties, however, the possibility of the counterparty failing to pay sums due to the trust still remains.
Stewart Heggie is a commercial director, focused on serving the needs of Scottish Mortgage shareholders. Prior to joining in 2019, he spent 15 years as a discretionary fund manager, before which he helped design the investment platform of a large UK bank. Nowadays, Stewart enjoys a varied role that spans across several areas involved in running a listed investment company. He plays a key role in developing the company’s strategic direction and broadening out its ownership. Beyond that, he works closely with the managers to maintain current portfolio knowledge; regularly meets with potential and existing overseas shareholders; and acts as a key contact for the board of directors.
This communication was produced and approved at the time stated and may not have been updated subsequently. It represents views held at the time of production and may not reflect current thinking.
This content does not constitute, and is not subject to the protections afforded to, independent research. Baillie Gifford and its staff may have dealt in the investments concerned. The views expressed are not statements of fact and should not be considered as advice or a recommendation to buy, sell or hold a particular investment.
Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). The investment trusts managed by Baillie Gifford & Co Limited are listed on the London Stock Exchange and are not authorised or regulated by the FCA.
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