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James Carthew: Scottish Mortgage seeks 1.3% of the very best global companies

13 January 2020

Scottish Mortgage managers’ presentation last week touched on some of the biggest questions facing investors.

Scottish Mortgage (SMT ) made a presentation to analysts last week. It was extremely well attended, unsurprising perhaps given that, with an £8.6bn market value, the trust has become the flagship for the investment companies sector. The discussion touched on some of the biggest questions facing investors and I think some of these are worth exploring here.

Identifying the winners of tomorrow is hard and SMT’s managers James Anderson and Tom Slater are trying to find these companies at an early stage in their development. One approach that Baillie Gifford has adopted is to seek inspiration from academia, being prepared to fund some studies.

In the past, the managers have cited a research paper by Hendrik Bessembinder and others which concluded that over 90 years, just 4% of US stocks generated the entire gain in the US stock market. In July 2019, the research was expanded to cover the returns of almost 62,000 global stocks between 1900 and 2018 and concluded that just 1.3% of these stocks created all the gains in global markets. 

The inference is that picking these stocks is key to long-term success. Baillie Gifford’s research effort is geared towards identifying these companies. You could also draw parallels between the Baillie Gifford approach and that of Nick Train, although he puts more faith in the lasting power of brands rather than technological edge.

The study is interesting in that it suggests that relatively few companies create lasting value for investors but it assumes a buy-and-hold strategy. I think it is important to point out that there are other ways to run money and this is not the only path to riches.

In a year where the implosion of Woodford and the M&G Property fund suspension generated a lot of negative headlines towards illiquid/unquoted investments, SMT lifted its exposure to private companies. These accounted for 21.2% of the portfolio at the end of November. However, as I have stressed before, if you are going to have exposure to illiquid investments, investment companies are an ideal way to do it.

SMT’s managers seem increasingly agnostic about whether a stock is listed. Their focus is much more on a company’s growth prospects than its corporate structure. I can envisage the trust’s 25% cap on unquoted exposure being lifted again. I agree with the managers that fast-growing businesses are probably better off as private companies, given the public market’s obsession with short-term profitability can stifle investment.

SMT’s ability to hold unquoteds opens up a much wider range of investment opportunities. Many of the world’s most exciting companies are not listed. For small investors, SMT is one of only a handful of vehicles that offers access to these areas.

We are living in an era of rapid technological change and SMT’s managers are aiming to benefit from this. They are investors in growth and think that last quarter’s value-style renaissance might prove short-lived. Value investing is reliant on mean reversion and that is not possible when companies are struggling not because of normal cyclical fluctuations in demand but because their business is being disrupted by new entrants.

Perhaps the most striking observation in relation to this was Anderson’s comment that the falling cost of renewable energy bundled with energy storage will soon make even gas plants unviable. He predicts it will also put downward pressure on power prices. The vast oil and gas industry becomes increasingly irrelevant in that scenario and this could have significant consequences for geopolitics.

Big data and artificial intelligence are important themes and alongside well-known western companies such as Amazon, Facebook and Alphabet, some of the Chinese tech giants are making great strides in this area. The success of these companies is giving rise to concerns about monopolistic/oligopolistic situations. 

In some quarters, for example from Democrat presidential candidate Elizabeth Warren, calls are growing for increased regulation or enforced breakups of these companies. SMT’s managers fear that regulation discourages new competitors and entrenches existing market positions. It can also stifle innovation.  The managers think many monopolies fail because they do not adapt to new technology, citing IBM and Microsoft as examples.

A more recent example of this in SMT’s portfolio is Baidu (China’s Google), where they think overly centralised decision-making led to a group of developers leaving to establish video sharing platform ByteDance (TikTok), leading to reduced market share of online advertising for Baidu. 

ByteDance is interesting because it has expanded beyond the Chinese market. The coming decade might see more examples of this, creating new challenges for the US firms.

Healthcare is also an important component of the portfolio, reflecting the huge potential of advances in synthetic biology. The managers seemed more on the back foot when discussing this area, however. When compared with the managers of trusts such as International Biotechnology (IBT ), Biotech Growth (BIOG ) or Syncona (SYNC ), it is not obvious that Baillie Gifford has a competitive advantage, although it does have access to external research.

I wonder though whether companies in this area can sustain long-term growth in a way that fits Baillie Gifford’s buy-and-hold objective. Innovation here is moving at such a fast pace, patents aren’t that long and the threat of regulation regularly overhangs the sector.

The stock in the portfolio that probably generates the most debate amongst investors is Tesla. Electric and self-driving vehicles, drones and the need to improve fleet utilisation offer big opportunities. It isn’t clear to me why they back Tesla over other companies focused on this area, however. The managers alluded to unspecified ‘competitive advantages’ when talking about the stock.

I think it is important to remember though that Anderson and Slater don’t have to get every stock right, just a majority of them. SMT’s growth in net asset value (NAV) was good in 2019 but lagged its more conservatively managed stablemate Monks (MNKS ) and dedicated tech and biotech trusts such as Polar Capital Technology (PCT ) and Biotech Growth. 

The managers would stress that a year is too short a period to measure SMT’s success, and I agree. 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.

James Carthew is a director at Marten & Co, operator of the QuotedData website. The views expressed in this article are his and do not constitute investment advice.


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