For years now we have been pathetically grateful to the Scottish Mortgage Investment Trust (LSE: SMT). We have talked a few times about taking it out of the MoneyWeek investment trust portfolio on the basis that many of its holdings have been horribly overpriced (to our value-orientated eyes). But we’ve pulled back from the brink every time – we know we aren’t always right and we always like to hedge against the possibility of being wrong.
And thank goodness for it – Scottish Mortgage has been the main driver behind the out performance of the portfolio pretty much since day one. Without it I’m afraid the portfolio would have been a pretty pedestrian business.
With that in mind, I bring you bad news: thanks to the general carnage in the tech-stock world, the trust is now down 15% in the year to date and 26% from its highs. That may turn around, of course – the shares are now on a 3% discount to their net asset value (they are accustomed to being on a premium) and Stifel’s Iain Scouller reckons it is time to drip feed money back into them. But even if it does, with inflation high and monetary policy tightening, it is hard to imagine SMIT offering the same returns over the next five years as it has over the five to, say, the end of 2020.
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There are some stock specific problems in here, of course. Pandemics, lockdowns and mass vaccination mandates are better for the likes of Moderna and Netflix than normal life. But there’s more to it than that. For some thoughts on what, you might listen to this week’s podcast with Barry Norris of Argonaut Capital (steel yourself – he is bound to offend on at least one topic) or to last week’s chat with Ian Lance and Nick Purves from Redwheel (once RWC Partners).
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But the core of the argument is that with inflation looking genuinely embedded now, the immediate future looks pretty bad for over-valued “long duration assets” – those that derive much of their value from low interest rates. And the “most egregious example” of these? According to Lance and Purves (and Norris for that matter) it is technology stocks. The ten largest stocks in the UK now have a median price/earnings ratio of 37 times. The largest five trade on 46 times their free cash flow.
Look specifically at software stocks and the valuation problem is even more striking: they are on a median 18 times sales. That makes them almost twice as expensive as they were at the peak of the technology, media and telecoms bubble.
If you honestly believe interest rates will stay at their current levels for ever, you could, at a pinch justify this kind of thing, but no one really thinks that now (not with US CPI at 7%), something you can already see playing out in parts of the market. It has very little breadth, for example – four stocks (Microsoft, Apple, Nvidia and Google) generated over half of the S&P 500’s return in the final six months of last year, and beneath the surface there were signs that things were far from healthy even before the tech carnage of 2022 began.
Note, for example, that the Goldman Sachs non-profitable technology company index lost 28% in a month, and that bitcoin is down over 40% from its high. Bloomberg also recently pointed out that 40% of Nasdaq Composite stocks are down 50% or more from their 52-week high. Ouch.
There is a view that you can escape all this simply by holding really high quality profitable stocks – stocks such Microsoft, Visa Paypal, Amazon, Alphabet and Apple. These companies are so strong, we are told, that they can weather any storm. That bit may be true – the companies are, of course, largely amazing, but that doesn’t mean they can’t be trading at the wrong price.
Can it really be true that their share prices will do as well in a high interest rate and high inflation environment as in a low interest rate and low inflation environment? Maybe. But as Lance and Purves note, the utterly dismal performance of the Nifty Fifty stocks during the inflationary 1970s “doesn’t seem to support this thesis.” Nor does 2022. Amazon is down 15% so far this year. Apple is down 10% and Alphabet is down 10%. Quality can come at the wrong price too.
