Morning Note: Market news and an update from Scottish Mortgage Investment Trust.

Market News

Investors are looking ahead this week to a swath of inflation prints that is expected to influence the direction of global monetary policy.

US equity markets were closed yesterday for holiday – the S&P Futures are currently predicting little change at the open this afternoon. This morning in Asia, markets ticked lower: Nikkei 225 (-0.1%, as investors eye BoJ rate hike timing); Hang Seng (-0.2%); Shanghai Composite (-0.6%). The FTSE 100 is currently unchanged at 8,304.

UK markets aren’t afraid of a Labour victory, Mark Gilbert and Marcus Ashworth write for Bloomberg. Gilts and the pound are relaxed about the prospect of Keir Starmer becoming prime minister, reflecting a weary realisation that the fiscal outlook is so bleak that there’s very little flexibility available to any government.

According to the BRC, price increases at UK retailers fell in early May to their lowest level in over two years. The rise in shop prices slowed to 0.6% in the first week of May. Increases in food prices slowed to 3.2% in the May survey from 3.4% the month before. Non-food, meanwhile, was deflationary for the second month in a row at -0.8% in May versus -0.6% in April. Sterling trades at $1.2770 and €1.1750.

The oil price moved up to $82.90 a barrel on escalating Middle East tensions. Wheat rose to a 9-month high as growers hold on to stockpiles amid unfavourable weather, IKON Commodities said. The dollar slipped and Treasuries were little changed – the 10-year currently yields 4.46%. Gold ticked up to $2,344 an ounce.

Emmanuel Macron said the EU must stop being naïve in the face of growing competition from the US and China, and repeated calls for a “buy European” strategy.

Source: Bloomberg

Investment Trust News

Scottish Mortgage Investment Trust is a £13bn global equity investment trust run by Tom Slater and Lawrence Burns, two highly regarded fund managers at Baillie Gifford. The fund has a strong long-term performance record compared to its benchmark to beat the FTSE All-World Index (in sterling terms) on a rolling 5-year basis. The fund is actively managed, with a 90% deviation from the index, and an average holding period of more than five years. The manager believes that over long time periods, it is through supporting and holding just a small number of extraordinary companies that exceptional returns can be achieved. However, the manager highlights that investing in such companies at the forefront of structural change means share price peaks and troughs are inevitable, for both the companies the fund owns and the trust itself.

Last week, the company released its Financial Report for the year to 31 March 2024. Following two years of negative returns in both NAV and share price terms, the company posted a positive return – the NAV rose by 11.5% compared to a 21% increase for the benchmark index. The long-term performance track record remains impressive – over the last ten years, the NAV is up 382%, versus a return of 218% for the benchmark. The share price rose by 32.5% in the last year as the discount to NAV narrowed sharply (see below).

The key themes across the fund continue to include:

- the merging of healthcare and technology, with innovative treatments being developed faster and cheaper than ever.

- the move away from carbon-based energy generation and transport towards electrification and renewables.

- the digital transformation that has revolutionised the retail, media, and advertising industries broadening into fields such as food, finance, and enterprise.

The manager provides useful insight on AI and highlights that when considering investment opportunities, it can be helpful to divide them into three layers, companies in each of which the fund is invested: hardware (e.g. Nvidia, ASML, TSMC), infrastructure (e.g. cloud providers, such as Amazon, and database companies), and applications (that make productive use of AI in the real world).

The fund currently holds a small number of high conviction ideas – there are around 100 holdings, although the top 30 account for almost 80% of assets. The manager targets strong businesses with above average returns that have the potential to double sales over the next five years. The companies have continued to deliver strong operational performance and remain in robust financial health.

The largest holdings are currently NVIDIA (advanced semiconductors, 8.0%), AMSL (lithography, 8.0%), Moderna (biotechnology, 5.4%), Amazon (5.4%), and Mercado Libro (Latin American e-commerce platform, 4.7%). Nvidia has been the biggest driver of the funds’ returns as demand for the company’s chips has vastly exceeded expectations. Going forward, the manager’s key consideration is the duration of the edge Nvidia has built over the competition. The fund added to its position in Amazon as the manager believes the company is now reaping the benefits of substantial capacity increases made during Covid-19. The fund reduced its position in Tesla partway through the year.

The portfolio is global – only 4.4% is listed in the UK – and so offers good geographic diversification. The high weighting to the US (53.9%) brings exposure to the global centre of entrepreneurial excellence but also to a highly-rated stock market. Regarding China (10.3%), the combination of a weak domestic economy, an uncertain regulatory environment, and geopolitical concerns have made the inclusion criteria for Chinese stocks in the portfolio more demanding. However, the vast domestic market and exceptional entrepreneurs mean the manager continues to take Chinese investments seriously, with holdings including Pinduoduo (e-commerce) and Meituan (shopping platform). However, the position in Tencent has been sold as the manager believes its scale will constrain its future growth.

The manager believes the long-term risk taking, essential to economic and social progress, is continuing to migrate to private markets. The fund now has 26% of its assets in 52 unquoted investments, providing exposure to early-stage businesses that investors would not usually be able to gain access to. Although this increases levels of volatility in the fund, the manager believes these investments provide the potential for asymmetric returns, with a maximum 100% loss set against the potential for unlimited upside. The fund’s private company exposure tends to be weighted to the upper end of the maturity curve, focussed on late-stage private companies which are scaling up and becoming profitable. The largest private position is SpaceX, with the top ten representing two thirds of the fund’s private exposure.

The group believes the market’s scepticism around the performance and valuation of its private assets is misplaced, and that they will be a significant source of value creation for the fund in the coming years. The manager aims to hold private company investments at ‘fair value’, i.e., the price that would be paid in an open-market transaction. Valuations are adjusted both during regular valuation cycles and on an ad-hoc basis in response to ‘trigger events’. The valuation process ensures that private companies are valued in both a fair and timely manner. The company revalues the private holdings on a three-month rolling cycle, with one-third of the holdings reassessed each month. Continued market volatility has meant that recent asset pricing has moved much more frequently than during stable market conditions. However, encouragingly, the operational performance of the group’s major private businesses has been ‘encouraging’, despite the difficult prevailing conditions.

Scottish Mortgage is in a robust financial position. The fund continues to deploy a ‘strategically appropriate’ level of gearing in the portfolio as the board believes this offers a potential source of additional value for shareholders over time. However, given the level of volatility in markets and the repayment of debt facilities, the manager reduced the level of gearing during the year from 14% of NAV to 11%. The manager also highlights that rising rates have little impact on the company. During the years of exceptionally low interest rates, the company proactively extended the term of its debt and most of its borrowings do not come due until after 2036, while the interest cost of 3.18% is well below the Bank of England base rate.

Although the focus of the fund is capital growth, the company has committed to pay a small dividend – the total payout for the year is up 3.4% to 4.24p – currently equating to a yield of 0.5%.

The size of the fund helps to keep costs low, with an ongoing charge of 0.35%, although the Key Investor Document highlights total costs of 0.89% in the year to March 2024. This is much less than most actively managed funds invested in public equities and significantly less than private equity funds.

Given the growth/technology bias of the fund, it is no surprise that there is a strong correlation with the Nasdaq. As we have previously highlighted, the fund is at risk from falling stock markets, particularly if highly-rated stocks fall out of favour, or their valuations are questioned. Since peaking at 1,568p in November 2021, the share price more than halved as rising bond yields impacted the valuation of, and appetite for, highly-rated stocks. The use of gearing, combined with investment in private companies, and the concentrated nature of the portfolio led to significantly greater volatility compared to the peer group.

At the beginning of 2023, the shares fell to a discount to NAV of more than 20%. In response, the company has been buying back its shares. Most importantly, in March 2024, the board announced the company would make available at least £1bn (8% of the market cap.) for the purpose of buybacks over the following two years. By acting upon what the company sees as a clear investment opportunity, it aims to maximise returns for its shareholders. As a result, the discount to NAV has narrowed substantially and the company remains committed to facilitating trading around NAV in normal market conditions. The shares currently trade at 900p, still at a 7% discount to NAV.

Source: Bloomberg