How cheap is Scottish Mortgage?

Growth investors have tended to argue that their investee companies are holding up well operationally despite the severe share price falls of the last year. However, a grim third-quarter earnings season for the US tech majors has put that belief to the test, from Meta Systems (US:META) reporting a decline in revenues to worries about slowing growth for the cloud computing divisions of Amazon (US:AMZN) and Microsoft (US:MSFT). With a recession seemingly on the cards, contrarians should ask what’s really priced in for anything 'cheap'.

So we turn to Scottish Mortgage (SMT), the investment trust that has eased up on its exposure to US big tech in recent years but nevertheless serves as a high-octane play on disruptive companies in growth sectors. The trust’s shares have definitely looked cheap by certain metrics: they traded at a 7 per cent discount to portfolio net asset value (NAV) on 9 November, still much wider than the 3.9 per cent average for the preceding 12 months. The trust has also featured in one of our Alpha service’s recent investment trust reports, which identify trusts enjoying recent share price momentum but looking 'cheap' relative to their own history.

Scottish Mortgage's shares have often tended to trade at around par to NAV, especially in times when performance was strong and the board would carry out prolific issuance of shares. Discounts used to present a rare opportunity to access a winning fund at a lower valuation. But there do appear to be some real risks baked into the current price.

Scottish Mortgage’s fondness for disruptive companies in the flashier corners of technology and healthcare has left it especially exposed to the sell-off. The trust’s last annual report, covering the 12 months to the end of March 2022, noted some especially big drawdowns for its listed holdings.

The trust’s portfolio of 52 unlisted companies, which accounted for 31.8 per cent of assets at the end of September, endured its own problems via a swathe of write-downs in the first half of this year. The trust’s investment parameters could create additional problems here: as discussed in our investment trust special issue the portfolio managers are only allowed to have a 30 per cent allocation to unlisteds at the time of purchase. Some worry this could potentially prevent the team from supporting private holdings with extra money in a challenging economy in the future.

Growth aficionados have praised the operational performance of their holdings and the Scottish Mortgage managers have certainly done that. In the case of Moderna (US:MRNA) they used the trust's latest interim report, published this month, to reiterate the case that its technology would have applications "well beyond Covid".

Moderna remained the biggest holding, making up 6.9 per cent of the portfolio at the end of September, followed by Tesla (US:TSLA) on 6.8 per cent. The interim report, which covered the six months to the end of September, noted: "Despite the economic headwinds, Tesla has been able to sell every car it can manufacture and continues to scale up its production capabilities rapidly. Its execution in a challenging operating environment has been impressive, as has its ability to control costs while growing sales."

ASML (NL:ASML), a supplier to the chipmaker industry, represented 5.2 per cent of the portfolio. In terms of activity over the six-month period the team made a further investment into Northvolt, an unlisted European battery producer the fund's managers see as "increasingly well placed to supply the rapidly growing demand for electric vehicles", making it one of the top 10 holdings. They also supported capital raisings from Climeworks, a private Swiss company developing a technology to capture carbon from the air, and Upside Foods, which seeks to produce animal protein in bioreactors and therefore produce meat without the carbon intensive rearing and slaughtering of animals.

The managers have increasingly focused on China as a source of innovative companies over the years, but that stance appears to have softened more recently. The team noted in the interim report that it had reduced several Chinese holdings, including long-standing investments in Alibaba (HK:9988) and Tencent (HK:700), warning: "The regulatory environment in China remains challenging, and we are concerned that ongoing uncertainty will harm the risk-tolerant culture that has driven the long-term success of China’s private sector."

Tencent made up 2.8 per cent of assets at the end of September, down from 4.2 at the end of March, while the trust's exposure to Alibaba has come down from 2.5 to 0.9 per cent. These drops should reflect a combination of divestment and share price falls. Overall, Scottish Mortgage still had a 15.7 per cent allocation to China at the end of September, putting it at odds with the many other major global equity funds focused predominantly on developed markets.

Uncertainties aside, shareholders may nevertheless stay focused on the trust’s success in the long term – something reiterated in an interim report stressing that "corporate potential has little to do with the cycles of greed and fear in stock markets". But recent events remind us this is a niche, racy fund with volatility to match.