Scottish Mortgage Investment Trust: high risk, high reward

Scottish Mortgage (LON: SMT) shares are still up 77% over the past five years, despite recent falls.

And as central banks make increasingly hawkish noises, its share price is now trading at a 12.7% discount to net asset value.

However, this could represent a FTSE 100 buying opportunity.

Scottish Mortgage: Chinese downturn

Manager Tom Slater recently told investors that ‘in retrospect, it has been a mistake to reduce our holdings in Western online platform companies rather than their Chinese counterparts.’

15% of the trust’s holdings are located in China, including Alibaba, Tencent, and Meituan. While these stocks skyrocketed during the pandemic, 2022 has sent most into freefall.

Partially due to ‘zero-covid’ policies that have sent Shanghai into a lengthy total lockdown, retail sales fell by 11.1% in April compared to a year ago, industrial output was down 2.9%, and the unemployment rate in China’s 31 largest cities rose to a high of 6.7%.

And China’s National Bureau of Statistics warned the ‘increasingly grim and complex international environment and greater shock of (the) Covid-19 pandemic at home obviously exceeded expectation, new downward pressure on the economy continued to grow.’

Moreover, Nomura analyst Ting Lu thinks ‘local lockdowns will still severely impact the production-end of the economy in May and (we) view a quick turnaround as all but impossible’

In addition, increasingly restrictive anti-monopoly laws on ‘platform stocks,’ the regulatory battle for greater financial oversight between China and the SEC, and heightened political tensions over the Ukraine war, have together created significant uncertainty for the US-listed Chinese tech stocks that constitute such a substantial portion of Scottish Mortgage’s portfolio.

And despite analyst enthusiasm over Premier Li Keqiang’s remarks encouraging China’s big tech companies to list on ‘domestic and overseas markets in accordance with laws and regulations,’ the risk of short-notice regulatory change remains elevated.

Long term strategist

However, Slater defends that while ‘Chinese companies have suffered from president Xi’s regulatory crackdowns,’ most of its investments have still delivered ‘exceptional levels of growth over two years.’

And the trust has always warned of its ‘aim to achieve a greater return than the FTSE All-World Index (in sterling terms) over a five-year rolling period,’ and that ‘it is only over periods of five years or longer that durable competitive advantages and managerial excellence within companies are truly reflected in returns.’

Based on this metric alone, Scottish Mortgage is still delivering on its mandate, with an uncanny ability to selectively invest early in disruptive winners.

This high risk, high reward approach has seen the trust benefit from near the beginning in companies including NIO, Tesla, Amazon, and Spotify. In a recent example, it’s held shares in privately held Tik Tok owner Bytedance for years, the company that has been cited by Meta's Facebook and Alphabet's YouTube as a key market competitor.

Of course, accessible investing in private companies has always been a key attraction for UK retail investors, who hold an estimated 75% of Scottish Mortgage shares.

But Jefferies analyst Matthew Hose has warned that they could now account for 30.4% of its holdings, above the 30% policy limit. And this could limit the trust’s ability to buy back shares in the future.

Moreover, Chelsea Financial Services analyst James Yardley argues that ‘higher inflation and rising interest rates create an unfavourable environment for the type of high-growth companies that the trust backs.’ Accordingly, Scottish Mortgage has been usurped by 3i Group, the other FTSE 100 investment trust, as the largest in the UK.

But Deputy Lawrence Burns has encouraged that ‘the pressure to sacrifice long-term gains for immediate respite grows by the day. Should our own time horizon ever meaningfully shorten, we would be destroying our greatest advantage…we have no intention of ever doing this.’

And Numis analysts led by Ewan Lovett-Turner remain optimistic, arguing that the trust has always maintained that ‘the approach could be volatile, and returns will differ significantly from market returns. Investors may have been aware of this, but it will not stop the recent period hurting.’

They enthused that ‘buying a manager or approach which has a good long-term record at a time when it is out of favour is normally a profitable approach.’

It’s worth noting that there has been an average share price increase of circa 40% in the year following every substantial fall in Scottish Mortgage’s share price.

And while timing the market is notoriously tricky, pound-cost averaging into the newly unfashionable Scottish Mortgage could yield significant rewards.