After slumping 46% last year, what's next for Scottish Mortgage?

After a spectacular couple of decades, the Scottish Mortgage Investment Trust fell by 46% last year. We take a look at the trust's performance and discuss what's next for the business.

The Scottish Mortgage Investment Trust (LSE: SMT) has been part of the MoneyWeek investment trust portfolio since its launch in 2012.  

It’s likely this trust features in many of our readers’ portfolios and it has been a winning bet for much of the past decade. 

At one point, the shares were up 1,000% on our purchase price, making it a key contributor to the 17% annual return the portfolio achieved between launch and the end of 2021.  

As the trust has soared in value over the last decade, we’ve resisted the temptation to take profits mainly as a hedge against being wrong.  

However, after a decade of market-beating returns, we’re now seeing what happens when the market turns against growth stocks

After their outstanding run, shares in the trust plunged 46% last year. 

Meanwhile, the trust’s discount to its underlying net asset value (NAV) has exceeded 10% in recent months.

These declines have wiped out most of the gains the trust achieved during 2020 and 2021, but its long-term performance is still impressive

Over the past five years, the stock has returned 11.5% per annum including dividends, while the trust’s NAV has risen 13.8%. Over the past 10 and 15 years respectively, the stock has produced a total return of 18.2% and 14.7% per annum. 

Scottish Mortgage Trust’s year of poor performance

Formerly managed by star Baillie Gifford fund manager James Anderson, who was responsible for the re-engineering of the trust and its focus on growth stocks, Scottish Mortgage had to deal with both a manager transition and market volatility last year. 

Its lead investment manager is Tom Slater, who took over the helm last year, and has admitted that 2022 was a “humbling year” for the firm. 

At an investor event at the beginning of January, Slater told shareholders that while Baillie Gifford hates “losing our shareholders’ money” setbacks of the type seen last year are “inevitable consequence of the way we manage the trust.”

Scottish Mortgage is a growth investment trust, and as its returns show, this approach can be highly lucrative. But it does come with its challenges, notably the fact that growth stocks can be very volatile. 

A lot of investors struggle with growth investing for that very reason - they can’t stand the ups and downs of market gyrations. 

It takes time to grow a company and patience on the part of investors, which is something the trust’s managers are well aware of. 

In an interview in November, they stressed the long-term nature of Scottish Mortgage and said they wanted to thank shareholders for their support, “because we couldn't take the approach that we do unless we had buy-in to this approach of long-termism and really sticking to our guns, regardless of the market environment.”

Scottish Mortgage is looking to take advantage of the volatility

In November, the managers argued “innovation is effectively today on sale,” and they seem to hold the same view today. 

At the January investor event, Slater noted that many of the holdings in the portfolio are now cheaper than they were before the pandemic. Some haven’t been cheaper since the lows of the 2008 financial crisis. 

“That’s not to say they cannot go cheaper. Who knows where markets will go in the short term, but the starting point is interesting. Looking at our top 10 holdings, they have gone from an average sales multiple of seven times to around five times in a year. That’s a 30% fall in the value of the assets, which has little to do with their long-term potential,” he noted. 

With growth companies, it’s the long-term potential that’s important, not short-term share price movements. 

“We have a set of companies here that are all relatively early in their growth opportunity, from Moderna in healthcare, through to how early we are in the penetration of electric vehicles, to new areas such as autonomous drones,” Slater explained. 

These stocks might seem expensive today, but if they can double or triple their sales over the next five or 10 years, they look cheap. 

A complex investing environment in China

Chinese companies like Tencent, Alibaba, Baidu and Meituan have turbo-charged the investment trust’s growth over the past decade.

Scottish Mortgage’s exposure to China has at times exceeded 20%, although it is currently hovering around 16%. 

It’s exposure to Chinese equities has hit returns this year. “We have been slow to recognise the consequences of the shattering China-US relationship, and we had thought that a number of Covid-induced changes would be more permanent,” Slater noted at the investment event. 

Nevertheless, the managers remain committed to the region as they’re looking for the world’s best companies, which means they have to look in other markets apart from the US. 

To manage the uncertainty in China, the trust has sold some smaller Chinese positions, such as digital freight platform Small Truck Alliance, and reduced its stake in internet giants Alibaba Group and Tencent last year. 

Scottish Mortgage Trust’s private portfolio 

One of the reasons why investors have moved away from the trust over the past couple of months is to do with its private investments

Just under 30% of assets are invested in private businesses. Private companies have seen their valuations crash over the past year, and the firm’s in the portfolio have not been immune to this decline. 

Scottish Mortage marked down the value of its private portfolio by nearly 23% in the first half of 2022. 

Despite these challenges, the managers are sticking to their guns. 

“We have been able to support our existing investments when we have needed to and deployed about £280 million of capital into private markets in 2022,” Slater noted at the recent investor event. 

Why has the Scottish Mortgage share price slumped

Scottish Mortgage’s returns over the past decade have been boosted by low interest rates. 

As rates have dropped, investors, lacking alternatives, have rushed to buy growth stocks – a trend that went into overdrive in 2020/21.   

However, today investors can earn 5% or more from high-quality bonds. That changes the equation. If I can earn 5% with limited risk, why would I try and pick growth stocks, some of which might end up going to zero? 

Higher rates are also making it harder for early-stage and growth companies to raise new funds. As these enterprises tend to devour capital, easy access to financing and more importantly cheap financing can be the difference between success and failure.  

Focus on the long-term potential for SMT

There’s no doubt the Scottish Mortgage Investment Trust is struggling against some major headwinds like uncertainty in China and rising interest rates, but its portfolio is stuffed full of some of the most innovative and forward-thinking businesses in the world.  

For example, a top holding is ASML, one of the only companies in the world with the ability to produce the equipment and tools required for semiconductor manufacturing. 

Then there’s European battery producer Northvolt. Now the trust’s fifth-largest holding, Scottish Mortgage thinks this private battery producer looks increasingly well-placed to supply the rapidly growing demand for electric vehicles.”

Investors might not be willing to pay as much for growth stocks today as they were a year ago, but over the long term, company fundamentals matter more than anything else. As these businesses grow their top and bottom lines, shareholders, including the Scottish Mortgage Investment Trust, should reap the rewards.

• Additional contributions from Ruth Emery.

• The authors of this articles do not have holdings in Scottish Mortgage Investment Trust

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