Scottish Mortgage’s share price is almost 60% below its November 2021 peak, writes James Carthew.

It published results for the 12 months ended 31 March 2023 this week and they were not pretty. Over the period, the NAV return was -17.8%, but – as the discount widened – the return to shareholders was -33.5%.

Discount at 30-year record

Scottish Mortgage’s discount now stands at 22.2%, which by my reckoning is about the widest that it has been for at least the past 30 years. The next-widest discount in Scottish Mortgage’s sector is that of stablemate Keystone Positive Change (17.2%), and beyond that there is a cluster of funds trading on a discount of about 10%.

I feared that the trust might develop a discount problem. In an article written for Citywire in January 2020, I said that “I do worry though how short-term some investors in SMT might be if it had a poor year, hopefully they have bought into the manager’s long-term ethos”, but in reality, I rather suspected that this was another case of investors crowding into a ‘hot’ stock in the hope of short-term gains.

The board’s failure to stem the collapse of the trust’s share price relative to its NAV deserves to be criticised, but it also provides new investors with a potentially attractive entry point. With the share price at three-year lows, is it time to consider buying/adding to the sector’s largest trust?

Risk considerations

The first and probably most important consideration should be that this fund is not without risk.

The trust’s gearing is pretty high, which amplifies moves in the NAV. Potential gearing at the end of April was 17%, but the managers had offset this slightly with about 2% of cash. The good news is that the trust’s interest bill is relatively low. It issued some debenture stock that needs to be repaid in 2026 that comes with an effective interest rate in excess of 10%.

However, that is a small part of the total. Most of the debt is much longer dated and the overall interest rate averages out at about 3% per year. That gives the trust flexibility as, should it want to repay some of this debt early, there should not be much, if any, penalty associated with early repayment.

The debt is also in a mix of currencies, which helps mitigate the negative effect of a stronger pound on the valuation of foreign investments.

Next, is the 30% limit on the trust’s exposure to unlisted investments. At the end of April, the trust was close to breaching this limit, with 29.9% of its portfolio in private companies. Swings in the value of its listed stocks, amplified by the gearing discussed above, could easily take it through the 30% level.

There is no penalty attached to this. However, unless shareholders give permission to lift the limit, the managers would be prevented from adding to its unlisted exposure. This could be problematic as Scottish Mortgage was a significant backer to many portfolio companies.

If they needed cash but could not rely on Scottish Mortgage, there is a greater chance that they could be forced to issue shares well below the price that Scottish Mortgage had paid, diluting its exposure – a lose-lose scenario for the trust.

Private equity is not a bad thing

It is probably worth me reiterating that there is nothing wrong with Scottish Mortgage having exposure to private equity in our eyes. The argument that by investing in unlisted companies it can gain access to a wider range of businesses, especially those operating in at the forefront of new technology, is a valid one. As a closed-end fund, Scottish Mortgage is a more natural home for such investments. The problem is the hard limit, which I think should be scrapped in favour of a softer, target range for unlisted exposure.

Former manager is optimistic

James Anderson stepping down as co-manager on 30 April 2022 will have made no real difference to Scottish Mortgage’s recent performance. It is interesting, though, that at 63 he’s returning to a fund management role at Lingotto Investment Management, a firm set up by EXOR, the holding company for the Agnelli family’s investments that is also a holding in AVI Global’s portfolio.

Tellingly, in an FT article on the move, he said “One of the great puzzles to me is that markets have become so sceptical and short term at a time when the pace of innovation and change, and the prospects of returns over five, 10 and 20 years, has got greater than less”.

The period under review was marked by very low turnover on the portfolio. At end April 2023, annual turnover was running at just 4% and quite a bit of that will have been freeing up cash to fund share buy backs. This is evidence, should it be needed, of the manager’s buy and hold strategy.

One notable sale was a reduction in the trust’s position in Illumina, the sequencing company. It is being forced to sell off its cancer screening company Grail (which was a Scottish Mortgage holding in its own right before Illumina bought it in 2021). Some have questioned the usefulness of Grail’s tests on the grounds that they can produce false positives as well as false negatives.

The manager’s statement waxes lyrical about Moderna, which alongside ASML is one of the largest positions (7.8% of total assets at end April 2023). The investment case is based on the company’s vaccine technology and its potential application in treating cancers as well as infectious diseases such as COVID.

The success of its COVID jabs propelled its share price well above $400 in 2021, but today, as COVID fears fade, it is less than one third of that. In December 2022, Moderna and Merck announced the results of a phase 2 trial where a Moderna cancer vaccine was used in conjunction with Merck’s Keytruda therapy to treat patients with stage III/IV melanoma.

The combined treatment reduced the risk of recurrence or death by 44% compared to just using Keytruda alone. A phase 3 trial will start soon. The trial outcome suggests great potential upside to come for Moderna.

ASML is a global leader in equipment used to make advanced semiconductors. It recently announced a 91% year-on-year increase in revenue and 180% increase in net income for Q1 2023, both well-ahead of analysts’ expectations. The target for 2023 as a whole is more modest, +25% in sales, but its order book is so strong that this growth is pretty much certain.

The number three position, which Scottish Mortgage has been adding to, is Latin American ecommerce/payments business MercadoLibre. Its figures for Q1 2023 showed year-on-year growth of 58% in revenue and an expansion in its margins from 6.2% to 11.2%. The firm has similarities to giants such as Amazon and PayPal and dominates the markets that it operates in.

Then there are the two Elon Musk stocks – Tesla and Space Exploration Technologies (or SpaceX). Tesla is trying to spark a growth spurt and regain some market share in electronic vehicles by cutting prices. The manager’s statement highlighted its AI credentials, given the work that it has done on autonomous driving.

SpaceX is Scottish Mortgage’s largest unlisted holding. While the failure of its recent Starship launch has attracted headlines, the success of its reusable Falcon 9 rockets has helped it cut launch costs by 95% relative to NASA’s space shuttle.

Starlink, its global communications satellite network, is taking shape and already offers coverage across Europe, East Asia and Australia, North America and much of South America. It feels too early to tell how successful this will be, however.

Many investors fret about the accuracy of the valuations of Scottish Mortgage’s private investments. The statement stresses the frequency of asset revaluations – 532 over the 12 months to 31 March 2023, with everything revalued at least four times (quarterly) and 84% valued five times or more. It notes that values dropped by 28% on average against a 14% fall in the NASDAQ. It also stresses how many sets of eyes, including a number of auditors, get to review these valuations.

The overall picture suggests that Scottish Mortgage has come back to earth with a bump, but while we cannot rule out further weakness and we think that a recovery to previous highs could be years in the making, it seems to us that we are not far from the bottom. This is not the sort of fund that you should be betting the farm on, but it may suit a diversified portfolio.
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economic and political review

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