David Stevenson: Scottish Mortgage and the confusing slump in quality tech

Despite their selloff across the board, conflating all tech and growth stocks makes little sense. But that doesn’t mean a rebound is coming for either Baillie Gifford or Cathie Wood’s concentrated funds.

I’m fairly sure most investors in the UK will not have heard of a business called Teladoc unless, that is, they have a weird fetish for checking through past holdings of Scottish Mortgage (SMT ) investment trust.

Late last month this US-based telemedicine business had a bear moment. It announced poorly received quarterly numbers after trading closed on 27 April, sparking a massive selloff. The next day the stock tanked over 40%.

Those of us who’ve followed Teladoc over the years were a little confused by the reaction. Its numbers were bad but not that bad. It made a huge paper write-off of a previous deal (buying Livongo), and it announced it was lowering its revenue guidance for the year downward by $150m (£184.8m) to a range of $2.4bn to $2.5bn.

Boss Jason Gorevic also noted there were challenges in the first quarter especially around poor marketing returns but the market freaked out regardless – its share price is now down nearly 90% from its peak valuation in February 2021.

In truth, Teladoc’s story was less about telemedicine and more about Cathie Wood, the eponymous boss of the go-go tech disruption asset management firm ARK Invest. She’s dazzled the markets over the last few years with all her talk of massive tech disruption and Teladoc has been one of her poster stocks. In fact, she was so convinced of the firm’s strength that she started buying more shares in Teladoc in the days after those poorly received quarterly numbers. She now owns roughly 11.4% of the company across all her exchange-traded funds (ETFs).

Sadly, Teladoc’s share price hasn’t shown much evidence of rebounding, which is probably bad news for the ARK range of actively-managed technology funds. The table below shows the scale of carnage being inflicted on their flagship ETFs. Her best-known fund, the ARK Innovation ETF, is now down a staggering 58% over the last year with little sign of imminent improvement.

On this basis, probably the best investment anyone in the UK could have made this year would have been to buy into Leverage Shares’ ARK Innovation reverse tracker – it’s short three times on the downside – which is up 228% year to date. My instinct is that there’s even more carnage to come.

Carnage at Cathie Wood’s funds

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ARK funds Ticker 1-month price change in USD (%) 3-month change 6-month change 1-year change 3-year change
ARK Fintech Innovation ETF ARKF -25.4 -40.9 -62.8 -60.1 -11.4
ARK Genomic Revolution ETF ARKG -25.0 -36.1 -57.3 -59.5 2.7
ARK Autonomous Tech & Robotics ETF ARKQ -14.7 -19.3 -37.6 -32.2 63.5
ARK Innovation ETF ARKK -24.9 -40.0 -62.2 -58.4 -0.9
ARK Space Exploration & Innovation ETF ARKX -13.4 -13.0 -29.7 -27.5  
ARK Next Generation Internet ETF ARKW -24.0 -37.7 -61.5 -55.6 16.3
S&P 500   -8.1 -10.1 -12.0 -2.6 43.6

Source: SharePad (to 6/5/22)

It may be unfair to focus all our attention on just Cathie Wood. Another casualty of this selloff is our very own tech poster child, Scottish Mortgage. Its recent performance as shown in the table below has been dreadful and it’s currently trading at a small discount to net asset value (NAV). That said, much of that NAV is in leading tech names which have had a terrible year to date, bar Tesla. The table below shows the top six holdings in the fund and their returns over periods ranging from three months to one year. Read it and weep.

Scottish Mortgage’s slumping stocks

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Stock Ticker 3-month price change in local currency (%) 6-month change 1-year change Forecast price-to-earnings (PE) ratio
ASML Holding NV ASML -19.0 -35.2 -16.3 31.9
Moderna Inc MRNA -18.1 -43.3 -17.6 4.9
NVIDIA Corp NVDA -30.1 -39.1 26.1 33.1
Tencent Holdings Ltd 0LEA -29.9 -26.3 -44.4  
Tesla Inc TSLA -7.1 -15.4 28.8 69.6
Scottish Mortgage Investment Trust SMT -28.3 -47.3 -34.3  
S&P 500   -10.1 -12.0 -2.6  

Source: SharePad (to 6/5/22)

Given these dreadful numbers, many of my investing friends have started passing around the next chart below which shows the Microsoft share price (in black) heading into the 2001 tech blow-up versus the benchmark S&P 500 index (in blue). Notice how even seven years after the dotcom meltdown, Microsoft’s share price was half its peak. On this basis, the bears argue, we could be in for a multi-year cycle of pain and despair for Scottish Mortgage and ARK investors.

Source: SharePad 

But I also think some perspective is needed at this juncture. To make my point, I have two questions for readers today:

  • Do you think interest rates are going to rise and possibly stay higher for some time (months/years)?
  • Are we at the end of a multi-year technology cycle?

I believe the answer is ‘yes’ to question one. We may even see interest rates spike above 4% if the interest rate bears are right.

By contrast, I think question two is more of an ask. Yet judging by the market’s kitchen-sink stance – absolutely everything is now interest rate dependent – saying ‘yes’ to the second question follows on naturally from the first. It is undoubtedly the case that higher interest rates make the case for higher rated ‘growth stocks’ more problematic, but it doesn’t mean that everything tech related is about to go haywire for many years to come.

Ask yourself why a sudden and perhaps temporary increase in interest rates necessarily means that the huge wall of capital spending on new technologies is going to dry up overnight and stay that way for the rest of the decade? I can accept that an imminent recession might prove problematic for 2022 earnings numbers, but I have not heard a single convincing argument as to why the huge supercycle of technological change is entirely dependent on interest rates.

More to the point, I suspect that markets are confusing different bundles of stocks. Meme stocks for instance – especially those that benefited from working from home – are indisputably toast and will continue to be on the receiving end of a thorough thrashing as the marginal buyers of these stocks slowly slink away nursing vast losses.

But these two categories of ‘tech’ and ‘growth’ stocks don’t actually encompass all growth tech stocks.    

There’s also a lengthy list of businesses that are a) tech related, b) were popular in lockdown, and c) might very well keep growing rapidly even if rates rise. The current cycle out of growth into value – stocks considered cheap by some metric – will undoubtedly clip valuations for this last ‘quality tech’ category. But there’s no reason why they should end up in a Microsoft-like decades-long funk.

The other side of the story

A case in point is Google-owner Alphabet, which announced quarterly numbers around the same time as Teladoc with markets reacting with more muted horror. For the first quarter, the company reported a 23% increase in revenue to $68bn in the three months to the end of March, slightly below forecasts of $68.1bn. A year prior, revenues had increased 34%. Net profits fell 8% year-on-year to $16.4bn.

These weren’t great numbers but, as the Financial Times observed at the time, the overall results were only ‘slightly disappointing’ at worst, based on analysts’ expectations. This is a business still churning out huge amounts of cash as are most tech leviathans in its league. 

Sure, earnings will probably stumble in the coming year because of the impending slowdown, but valuations are already pricing in a nasty recession. The table below shows that a motley collection of tech giants is now trading on an average of between 26 and 28 times earnings (better known as a PE ratio). That’s probably 10 to 20% above where trough valuations should be, but it’s not an insane set of numbers.

My point here is that we confuse different types of stocks in a mass selloff. Sure, the crazy tech disruptors deserved their crash but if you are seeking quality cashflows, then many growth tech stocks are starting to look much more sensible in terms of valuations, if still a bit toppy. And remember that at some point, very soon in my view and perhaps next year, interest rates will start to fall sharply and those quality tech names will shoot back up investors’ buy lists.

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Stock PE ratio Forecast PE
Meta Platforms Inc 14.5 16.5
Apple Inc 28.1 25.6
Alphabet Inc 23.4 20.2
Microsoft Corp 34.8 29.4
Netflix Inc 16.9 17.4
NVIDIA Corp 48.2 32.9
Amazon.com Inc 62.2 52
Average 26.9 27.7

Source: SharePad (to 6/5/22)

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