Scottish Mortgage's Tom Slater on performance woes, AI and China

Few investment trusts are so widely held – or so widely discussed – as the sector's second-biggest portfolio, Scottish Mortgage Investment Trust (SMT). Its focus on exciting future trends, from healthcare breakthroughs to the digitisation of everyday life, has helped to produce some serious capital gains, be it a 280 per cent share price total return over the past decade, or a 2020 where the shares doubled investors' money.

But the fund has plenty going against it, too: higher interest rates make life harder for immature, high-growth companies with a propensity to burn through cash, and recent history has been extremely painful for the portfolio. A persistent share price discount suggests investors still have plenty of questions that need answering, too, from reliability of valuations on the fund's private holdings to the public spats that unsettled the board last year.

SMT’s shares have struggled in recent weeks, having enjoyed a major uplift from the big growth rally in the final quarter of 2023. But manager Tom Slater argues that the fundamentals of portfolio companies are shining through.

"You've seen growth decelerate, so companies are still growing but not as fast as they had been previously," he tells Investors' Chronicle. "You've seen a significant decline in valuation multiples. Underlying that, if you look at individual companies they continue to grow strongly: our top 10 publicly listed holdings are growing revenue at just under 40 per cent."

He says that companies held by the trust have been "adapting to that change in conditions; you've seen that capital has a cost". Slater points to the fact that free cash flow generation from the portfolio had "almost doubled" in the past year, noting: "There's a healthy dose of prioritisation going into projects; companies are focusing on generating cash from operations because they don't have other sources."

All this, he argues, is backed by structural tailwinds related to the trends the fund targets – even if making money from such tailwinds isn't always as simple as it looks.

Nvidia and AI

Artificial intelligence (AI) was the big theme of 2023 and certainly one of relevance to Scottish Mortgage: Nvidia (US:NVDA) has been a holding since 2016, albeit a position the team had actually reduced in size in the year to the end of March 2023. The stock's meteoric rise last year has boosted its presence in the portfolio, with it recently making up 5.1 per cent of assets.

Slater acknowledges that the Scottish Mortgage team was "surprised by the pace of progress" seen on the AI front in the past 12 to 18 months, but believes investors are now noting companies that have emerged as leaders in the sector.

"The way technology paradigms evolve, you have this underlying process of capitalism with new methods and new markets," he says. "They drive progress and markets but don't move at an even pace – they have periods of calm and periods of rapid change. Incumbents tend to thrive in periods of calm but new players come in periods of change."

He adds that we are now "transitioning away from the periods of calm" to a point when profits are being driven by AI, the most obvious sign being the huge boost to revenue related to AI first showing up in Nvidia's accounts.

The extent to which incumbents from other parts of the technology world can be superseded is yet to be seen, however. It's notable, for example, that Scottish Mortgage initiated a position in Meta (US:META) late last year, having sold out of the company's shares back in 2020.

The investment team has identified the company as a big potential beneficiary of generative AI, arguing that WhatsApp and Facebook Messenger have not been sufficiently monetised.

The team believes that AI should help to "improve advertising opportunities and facilitate better monetisation through increased user connections", for example by sending people who click on ads directly into conversations with businesses.

Founders and Faangs

The Meta buy also relates to a focus on founder chief executives who have technical nous and can exploit the opportunities thrown up by big technological trends, with Slater saying Mark Zuckerberg fits the bill. "If you're going to own a stock for six months, company culture doesn't really matter at all," he says. "But if you extend the timeframe to five years, 10 years, it becomes almost the only thing that matters."

Such a focus has, of course, given the fund a few awkward moments thanks to its long backing of Tesla (US:TSLA) and SpaceX leader Elon Musk, mired as he often is in spats and controversies. However, Tesla's share price surged again in 2023, and Slater argues that successful, disruptive companies need bosses who are "unreasonable" and "really prepared to take on the status quo".

The Scottish Mortgage team, on a similar note, has previously voiced concerns about Jeff Bezos stepping back as Amazon (US:AMZN) chief executive, but the trust's latest interim financial report pointed to the managers increasing their exposure to the company.

Slater argues that Amazon should now be getting over the challenges caused by its heavy investment in retail as the world came through Covid-19. "When you go through an investment phase like that there will be inefficiencies – that hurt profitability, but they are now streamlining their capacity," he says. He believes the cloud business, Amazon Web Services, has also seen a period of weaker demand as companies look to control costs but that has also been "somewhat underestimated".

Slater also argues that Amazon is unfairly seen as behind the curve on AI, noting that its 500mn Alexa devices, once upgraded with generative AI capabilities, should serve as a "huge distribution system".

Scottish Mortgage has also continued to hold Netflix (US:NFLX) through the years, but other tech majors are notably absent. Alphabet (US:GOOG) has not sat in the fund in recent years, while Microsoft (US:MSFT) is another name that does not feature.

Slater says that this in part relates to the team's belief that such companies are struggling to replicate some of their best successes. Of Alphabet he notes that search is "one of the best business models the world has ever seen" but adds: "They have struggled to do anything in their other businesses that have a meaningful impact on the same scale."

China, and beyond

Just a few years ago, the Scottish Mortgage team pointed to China as being a more exciting region than Silicon Valley in which to hunt for innovative companies, backing names such as Tencent (HK:700) and Alibaba (HK:9988), among others.

The regulatory crackdown that tore through the Chinese market in 2021 has changed that, however, with the team dialing back somewhat. This can be seen in allocations: 23.7 per cent of the portfolio was in China at the end of March 2021. Two years later that figure amounted to just 13.2 per cent, with Alibaba no longer in the fund.

Slater acknowledges that China has been "a challenging place to invest" lately, and believes investors face two main challenges. Firstly, a tussle for power between China and the US creates a more hostile environment with knock-on effects for corporates. Secondly, the prospect of domestic regulatory interventions continues to pose threats for Chinese companies.

That second concern helps to explain the absence of Alibaba in the portfolio. Slater notes: "Alibaba's problem is being a very big company and being seen as an alternative basin of power." More broadly, he argues that the bar is now higher for a Chinese company to be included in the portfolio, with a business having to do something "very special" to justify such risks. Slater adds that companies can attract "real regulatory hostility" when they achieve substantial scale – putting a cap on their growth, among other problems.

However, as the fund's continued exposure to the region and the presence of Chinese online retailer PDD (US:PDD) among its top 10 holdings demonstrates, Slater and colleagues have not decided, like some, that the region is uninvestable. "China is home to some really brilliant entrepreneurs who have shown they can scale, so I think it's also a very difficult place to ignore as an investor," he says.

Newer pastures

Scottish Mortgage is no stranger to ecommerce plays. But as the PDD position suggests, these interests have taken the fund well beyond Silicon Valley. Ecommerce names in the fund range from the Chinese firm, which Slater describes as one of the portfolio’s best performers in recent times, to South America’s Mercado Libre (US:MELI), which has lately been the trust’s second-biggest position after ASML (NL:ASML) and South Korea’s Coupang (US:CPNG), a recent addition to the fund.

Asked if the search for growth will shift Scottish Mortgage further into the emerging markets, Slater notes that an emerging or developed market classification tells investors little about how well-run a company is. Indeed, he argues that some of the emerging market companies have thrived in tough circumstances: Mercado Libre has had to contend with much higher inflation and interest rates than its western peers, while China's Meituan (HK:3690) emerged from a "competitive melee" of similar businesses, leaving it battle hardened as it grew more mature. However geopolitical concerns do linger, with the manager remarking: "There's a challenge about the [ultimate] size of these companies because of trade disputes and having a global footprint."

It sounds, however, as if the team's hunt for high-growth companies is unlikely to lead it much further into the UK market, putting aside current exceptions such as Wise (WISE) and Ocado (OCDO). "We're always on the lookout but the challenge for us... is almost finding that ambition," Slater says. "You have great technology coming out of UK universities but [it's hard] finding a company that wants to bring that to scale, to produce a really large company."

He adds that funding can also be harder to come by, in contrast to places such as the US and China. From ecommerce plays to healthcare names such as Moderna (US:MRNA), investors will hope that many more future leaders emerge from the Scottish Mortgage portfolio. But recent years remind us that it could also be in for a rocky ride.