Morning Note: Market news and updates from Scottish Mortgage IT and Croda.

Market News

Asian shares were mixed this morning – Nikkei 225 (+0.1%); Hang Seng (-1.7%); Shanghai Composite (+0.5%) – after China’s debt swap programme looked insufficient to some investors and data showed persistent deflationary pressures in the world’s second largest economy. UBS cut its China 2025 GDP growth forecast to about 4% from 4.5%. TSMC was told by the US to halt shipments of some advanced chip to China, Reuters reported.

US equities were strong last week, with the small cap stocks enjoying their best week since the pandemic. The Republicans expected to hold at least 52 Senate seats. The Federal Reserve’s Neel Kashkari says the economy is strong but inflation is ‘not vanquished’, meaning the Fed may reduce rates less than previously expected. The dollar rose for a sixth straight week to its highest weekly close in five months. Gold slipped to $2,670 an ounce, while Bitcoin breached the $80,000 level for the first time. This week, we have October CPI, a speech from Fed Chair Powell, and retail sales figures.

The FTSE 100 is currently trading 0.7% higher at 8,128. The UK Government has sold a £1bn stake in NatWest, at a price of 380.8p a share, following which its stake will fall from 14.2% to 11.4%. Sterling is $1.2895 and €1.2062.

Brent Crude fell back to $73.80 a barrel. OPEC+ may want to extend supply cuts again at its December meeting in a push to avert oversupply. However, economic turbulence and loss of market share to the US may make the group’s defence of oil prices an arduous job, Bloomberg Intelligence said.

In Germany, Olaf Scholz said he’s open to holding a vote of confidence before Christmas, potentially allowing for a February national election. Opposition leader Friedrich Merz, currently dominating polls, told Stern he would aim to ink deals with Donald Trump.

Source: Bloomberg

Investment Trust News

Scottish Mortgage Investment Trust is a £14bn 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 an 89% 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 results for the six months to 30 September 2024. During the period, the NAV rose by 1.9%, behind the 3.6% increase for the benchmark index. The share price fell by 6.4% in the period as the discount to NAV widened slightly. However, the long-term performance track record remains impressive – over the last ten years, the NAV is up 349%, versus a return of 211% for the benchmark.

The fund currently holds a small number of high conviction ideas – there are around 95 holdings, although the top 30 account for 80% of assets. The manager targets strong businesses with above average returns that have the potential to double sales over the next five years. In the latest reporting period, the companies have mostly continued to deliver strong operational performance and remain in robust financial health.

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 has previously highlighted that when considering AI 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, such as Meta Platforms). Despite growing conviction that generative AI will be a transformative general-purpose technology, the manager reduced the position in NVIDIA, due to concerns about the sustainability of current capital equipment spending, including NVIDIA chips. The weighting in Meta Platforms has been lifted – the manager believes AI will improve Meta’s products (Facebook, Instagram, and WhatsApp) and its business model provides many options for funding the necessary computing capacity.

The report highlights two larger positions that dampened NAV growth. Firstly, drug developer Moderna has struggled to make up for the decline in its COVID vaccine franchise with a new vaccine for respiratory syncytial virus. Secondly, Northvolt, the European battery manufacturer, has struggled with production delays.

At the end of September 2024, the largest holdings were: Mercado Libro (Latin American e-commerce platform, 6.3%); Amazon (5.9%); Space Exploration Technologies (4.6%); Tesla (4.2%); and NVIDIA (advanced semiconductors, 4.1%).

The portfolio is global – only around 4% is listed in the UK – and so offers good geographic diversification. The high weighting to the US (50%+) brings exposure to the global centre of entrepreneurial excellence but also to a highly-rated stock market. Regarding China (around 10%), 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. Clearly, the result of the recent US election adds to that uncertainty. However, the vast domestic market and exceptional entrepreneurs mean the manager has taken a different approach, backing exceptional Chinese companies where they believe the upside justifies the risk. The fund’s holdings have been performing well. Meituan, the food delivery company, has been growing at over 20%, improving margins, and Pinduoduo, the ecommerce platform, has achieved explosive growth in export markets.

The fund has exited several smaller holdings where the growth outlook has changed. These include HelloFresh, as the meal-kit market’s potential seems more limited now, and Zalando, which is facing increased competition from companies leveraging the Chinese supply chain. While Zoom remains best-in-class in communication software, Microsoft Teams’ fierce competition has diminished Zoom’s market opportunity. The manager has also reduced the position in ASML, the lithography equipment maker, while initiating a new position in its close partner, TSMC.

The manager believes the long-term risk taking, essential to economic and social progress, is continuing to migrate to private markets. The fund has 23% of its assets in 50 unquoted investments, providing exposure to early-stage businesses that investors would not usually be able to gain access to. Although this increases the level 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 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. Year to date, most revaluations have been decreases (11.3% on average), with a small number of companies successfully raising capital, and in some cases easing short-term liquidity pressures. However, the operational performance of the group’s major private businesses has been ‘encouraging’, despite the difficult prevailing conditions. While the manager can’t predict when the funding environment for private companies will improve, they are confident in the quality of the companies, many of which are self-sustaining, and remain patient, supportive investors.

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 current level of gearing is only 13% of NAV. 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 just over 3% is well below the Bank of England base rate.

Although the focus of the fund is capital growth, the company has committed to paying a small dividend – with these results, an interim payout of 1.6p has been declared, in line with last year.

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 its growth/technology bias, this equity fund is at risk from falling stock markets, particularly if highly-rated stocks fall out of favour or their valuations are questioned. The use of gearing, combined with investment in private companies, and the concentrated nature of the portfolio also leads to significantly greater volatility compared to the peer group.

Having traded at or around NAV for years, since 2022 the shares have traded at a discount, which widened to around 20% in 2023. 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. In the six months to 30 September 2024, the company repurchased £880m of its shares at an average discount of 8.9%, which compares well to the 16.2% discount over the previous financial year. As a result, the discount to NAV has narrowed substantially, although it remains sizeable (currently 10%) and the company remains committed to facilitating trading around NAV in normal market conditions.

Source: Bloomberg

Company News

Croda International has this morning issued a third quarter trading update, highlighting performance in line with management expectations. The company has reiterated its full-year outlook and, in response, the shares have been marked up by 5% in early trading.

Croda generates annual sales of £1.7bn from high performance ingredients and technologies. Its products are found in pharmaceuticals, sun protection creams, and agricultural products. The company’s portfolio has been repositioned to align with emerging megatrends such as the move to sustainable ingredients and the increased use of biologics. However, over the last couple of years, Croda’s performance has been impacted by customer destocking and weaker economic conditions.

Although the overall trading environment remains challenging, during the three months to 30 September 2024, group sales rose by 8% at constant currency (cc) to £407m, benefitting from more stable customer inventories and volume demand in key markets.

The company operates across three divisions. In the Consumer Care business, sales rose by 7% in cc terms to £228m, driven by higher sales volumes as demand stabilised and ongoing customer regains were realised. Performance was in line with management expectations – the company saw ongoing momentum in Fragrances & Flavours and Home Care, as well as good demand from local customers in Beauty. However, demand from multi-national Beauty customers was lower compared to the previous quarter.

In Life Sciences, sales rose by 6% in cc terms to £129m. Sales were higher in both Crop Protection and Seed Enhancement, with increased sales volumes benefitting from more stable customer inventories and demand. In Pharma, the lipids business continues to grow as customer pipelines for next generation drugs continue to expand. Sales for consumer health applications are yet to see a recovery.

Industrial Specialties sales rose by 16% in cc terms to £50m.

Although there was no update on the group’s financial position, we note the balance sheet is robust – at 30 June 2024, financial gearing was only 1.4x net debt to EBITDA. In October, the group successfully refinanced its bank Revolving Credit Facility with a new 5-year £630m multi-currency facility.

Croda has reiterated its guidance for full-year adjusted profit before tax to be between £260m-£280m, driven in part by continuing cost control actions. We note, this is still well below the results in 2022 (£463m) and 2023 (£309m). Currency movements are expected to have a £14m adverse impact.

Source: Bloomberg