Morning Note: Market news and an update on Scottish Mortgage Investment Trust.
Market News
Bond yields reversed some of their recent decline as hopes faded that the Federal Reserve has finished its tightening policy. Neel Kashkari would support overtightening to bring inflation down to 2%, he told the Wall Street Journal. While the economy has proven resilient, the Minneapolis Fed chief said he has concerns about inflation “ticking up again.” The 10-year Treasury currently yields 4.65%. The dollar advanced, while gold slipped to $1,968 an ounce.
US equity markets only just ended last night’s session in positive territory – S&P 500 (+0.2%); Nasdaq (+0.3%) – boosted by tech shares. This morning in Asia, markets drifted lower: Nikkei 225 (-1.3%); Hang Seng (-1.5%); Shanghai Composite (flat). Imports into China grew for the first time since February. The 3% increase was in stark contrast to market expectations for a 5% decline. Exports fell by 6.4%. The Reserve Bank of Australia raised interest rates for the first time in five months because of ongoing inflation. The 25 points increase to 4.35% was widely expected.
UK inflation will soon fall in line with the lower rates seen in the rest of the world, Bank of England Huw Pill said. He said the way consumer energy bills are set by government regulations are partly to blame for keeping Britain’s inflation above its peers. According to Halifax, UK houses prices fell by 3.2% year on year in October. However, prices rose by 1.1% versus the previous month as a shortage of houses for sale pushed up the value of properties that did change hands. Sterling trades as $1.2316 and €1.1512. The FTSE 100 is currently trading 0.1% lower at 7,408.
OpenAI will let users build custom versions of ChatGPT for specific tasks as it seeks to beat back competition. The new option doesn’t require coding. The firm is also introducing a preview of GPT-4 Turbo, a faster and more powerful version of its large language model.
Source: Bloomberg
Fund Update
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 93% deviation from the index, and an average holding period 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.
Yesterday, the fund released its Interim Financial Report for the six months to 30 September 2023. During the period, the NAV fell by 2.7% compared to a 4.3% increase for the benchmark index. However, the long-term performance track record remains impressive – over the last ten years, the NAV is up 358%, versus a return of 190% for the benchmark. The share price fell by 1.0% and the discount to NAV narrow slightly.
The key themes across the fund continue to include: healthcare and technology are merging and innovative treatments are 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 is now broadening into fields such as food, finance, and enterprise.
The fund currently holds a small number of high conviction ideas – there are around 100 holdings, although the top 30 account for 77% of assets. The manager targets strong businesses with above average returns that have the potential to double sales over the next five years. The free cash flow from the listed portfolio more than doubled in the twelve months to the end of June.
The largest holdings are currently AMSL (lithography, 7.3%), Moderna (biotechnology, 6.1%), Tesla (electric cars, 5.5%), NVIDIA (visual computing, 5.0%), and Mercado Libro (Latin American ecommerce platform, 4.6%).
The portfolio is global – only 3.0% is listed in the UK – and so offers good geographic diversification. The weighting in the US and China is 53.8% and 13.4% respectively. The high weighting to the US brings exposure to the global centre of entrepreneurial excellence but also to highly-rated stock market. The fund has continued to reduce its exposure to China – the regulatory environment remains challenging, and the manager has some concern that ongoing uncertainty will harm the risk-tolerant culture that has driven the long-term success of China’s private sector.
The manager believes that the long-term risk taking, essential to economic and social progress, is continuing to migrate to private markets. The fund now has 30% 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. Also note the fund’s private company exposure tends to be weighted to the upper end of the maturity curve, focussed on late-stage private companies who are scaling up and becoming profitable.
The group believes the market 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 Trust 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 strong 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 – 15% of NAV at the end of September – as the Board believes this offers a potential source of additional value for shareholders over time. 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 is below 3%.
Although the focus of the fund is capital growth, the company has committed to pay a small dividend – an interim payout of 1.60p, in line with last year, has been declared – currently equating to a yield of 0.6%.
The size of the fund helps to keep costs low, with an ongoing charge of 0.34%, although the Key Investor Document highlights total costs of 0.96% in the year to March 2023. 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 has more than halved as rising bond yields have 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 has led to significantly greater volatility compared to the peer group. The shares currently trade at 684p, around a 15% discount to NAV.
Source: Bloomberg