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One of my closest personal friends told me a few years ago to keep an eye on the Scottish Mortgage Investment Trust plc (OTCPK:STMZF). This particular friend, although he was not a professional investor, have been very successful with his personal investments. So much so that he ‘retired’ from his day job as a chip design engineer and managed his own money full time. So when he recommended Scottish Mortgage, it piqued my interest to do some digging into the fund.
Fund Overview
The Scottish Mortgage Investment Trust (“Scottish Mortgage”) is a closed-end fund (“CEF”) listed in London that is managed by Baillie Gifford, an Edinburgh-based investment manager with over a century of history.
Scottish Mortgage was initially created in 1907 by Augustus Baillie and Carlyle Gifford as the Straits Mortgage and Trust Company Limited during the Panic of 1907 to lend money to rubber planters in Southeast Asia. After the 1907 credit crisis subsided, Scottish Mortgage’s mandate was widened to include bond and equity investments across the globe and the company was renamed The Scottish Mortgage and Trust Company Limited.
Contrary to the fund’s name, Scottish Mortgage does not actually invest in mortgages. From its earliest days, Scottish Mortgage has been a growth-oriented investment fund, from investing in industrialisation opportunities in North America in the 1930s, to early investments in Japan as foreign investment rules were lifted in the 1960s, and most recently Chinese investments in the 2000s as China joined the WTO. Over the years, Scottish Mortgage has been at the forefront of many growth opportunities.
Formally, Scottish Mortgage’s mission statement is to “identify, own, and support the world’s most exceptional growth companies.” The permanent nature of its capital base (closed end funds’ capital cannot be redeemed, unlike mutual funds) meant that Scottish Mortgage can take a long-term view to fund and support companies and entrepreneurs building the economy of the future.
Today, Scottish Mortgage has £12.8 billion in total assets, including £1.3 billion in borrowings, or 15% leverage (Figure 1). Due to its immense size, Scottish Mortgage is able to keep operating costs low, charging a 0.34% expense ratio.
Figure 1 – Scottish Mortgage overview (scottishmortgage.com)
Portfolio Holdings
Scottish Mortgage’s portfolio is centered around several key investment themes: Technology Meets Healthcare, Decarbonisation, Digitalised World, and Beyond (Figure 2).
Figure 2 – Scottish Mortgage portfolio is centered around major investment themes (scottishmortgage.com)
Scottish Mortgage is a fairly concentrated fund with its top 10 holdings accounting for 46.1% of the portfolio as of September 30, 2023 (Figure 3).
Figure 3 – Scottish Mortgage top 10 holdings (scottishmortgage.com)
Unique Access To Private Companies
To me, the most unique and attractive feature of the Scottish Mortgage fund is its ~30% exposure to private investments (Figure 4).
Figure 4 – Scottish Mortgage has 30% exposure to privates (Scottish Mortgage factsheet)
Scottish Mortgage currently holds investments in 52 leading private companies including Space-X, ByteDance, and Stripe. In fact, as one of the largest growth funds in the world with a long history of investing in world-changing companies, Scottish Mortgage has unique access to invest in the best private companies years before they come to the public markets.
Scottish Mortgage did not aspire to be venture capitalists. Instead, the fund was merely reacting to the changing marketplace in which increasing amounts of company value was created before companies reach the public markets.
For example, when Amazon became publicly traded in 1997, it was listed at a $400 million in market cap. However, over the next decade, world changing companies increasingly chose to stay private for longer, as they were able to raise capital privately to fund their growth outside of the scrutiny of public markets: Google listed in 2004 at a $23 billion market cap while Facebook became public in 2012 at a $100 billion market cap (Figure 5).
Figure 5 – Companies are staying private longer (Scottish Mortgage annual report)
For Scottish Mortgage, this meant that exceptional businesses and the returns they generate were being kept out of public markets. Therefore, in order to access this value creation opportunity, Scottish Mortgage began to gradually invest in pre-public companies such as Tencent in 2008 and Space-X, Stripe, and ByteDance in recent years.
Venture Capital Access At Index Fund Costs
Not only are investors able to invest in some of the most innovative companies in the world via Scottish Mortgage, they are able to do so at a significant discount to traditional venture capital funds and other closed-end funds at only a 0.34% expense ratio.
For example, a typical venture capital fund charges a ‘2 and 20’ fee structure where the manager charges a 2% of AUM management fee plus 20% of profits above a hurdle rate. This fee structure means that much of the investment returns of the venture capital fund is captured by the investment manager, and not the investor.
Scottish Mortgage is also significantly cheaper than similar closed-end funds with access to private investments like the BlackRock Science and Technology Trust (BST). BST charges a 1.11% gross expense ratio, more than 3 times that of Scottish Mortgage.
Returns Hit A Rough Patch
In terms of returns, Scottish Mortgage has hit a bit of a rough patch in the past 2 years, with the fund declining by 16.5% in the trailing 3 years to September 30, 2023, significantly lagging its benchmark, the FTSE All World Index with a 31.3% return (Figure 6). However, measured over a 5 and 10 year horizon, Scottish Mortgage still significantly outperformed its benchmark, returning 59.7% and 359.3% compared to 49.6% and 189.5% respectively.
Figure 6 – Scottish Mortgage historical returns (Scottish Mortgage factsheet)
Measured from its November 2021 peak, Scottish Mortgage’s NAV has declined by 41%, and its market price has declined by 54% (Figure 7).
Figure 7 – Scottish Mortgage has declined 41% on NAV from its recent peak (scottishmortgage.com)
Although much of the decline can be attributed to a change in the market’s perception and valuation of growth companies held in Scottish Mortgage’s portfolio, investors have arguably punished the Scottish Mortgage fund too severely, with the Scottish Mortgage fund now trading at a 16% discount to NAV.
While some of this discount may be attributed to an illiquidity discount on Scottish Mortgage’s 30% privates portfolio, I believe the discount demanded by the market may be a little excessive.
The market is basically saying leading private companies like Space-X, valued at $137 billion in its most recent fundraising in January 2023, should instead be valued at $64 billion (assuming the 16% portfolio discount is applied to the 30% privates portfolio, so the average holding is valued at 47% of its most recent financing round).
While there will inevitably be troubled companies within Scottish Mortgage’s venture portfolio, there may also be future winners that are not yet recognized by the market.
Technicals Suggest Stock May Be Bottoming
Technically, Scottish Mortgage’s shares are deeply oversold with monthly RSI of ~40, the lowest since early 2009. The fund’s 56% decline from its recent peak is similar to the 62% decline experienced during the Great Financial Crisis. The PPO indicator, a measure of momentum, is close to forming a mechanical buy pattern that have historically signaled multi-year rallies (Figure 8).
Figure 8 – Scottish Mortgage is close to a buy (Author created with price chart from stockcharts.com)
Risks To Scottish Mortgage
The biggest near-term risk to Scottish Mortgage is a weakening global economy and elevated interest rates. Growth stocks, with the majority of their cash flows far in the future, are very sensitive to interest rates. Elevated interest rates depress the discounted value of those cash flows, leading to stock price declines.
Furthermore, as the fund has significant private investments, a weak market environment may negative impact the ability of these private companies to fund their operations and their plans to go public. Without a path to a public listing, Scottish Mortgage may be unable to realize the true value of its private investments.
Conclusion
The Scottish Mortgage Investment Trust is a UK-based global growth fund with an enviable century-long track record. Although the fund’s performance has hit a rough patch in recent years with the re-rating of growth stocks, I believe Scottish Mortgage’s long-term investment process remains intact.
Importantly, Scottish Mortgage gives investors exposure to leading private companies like Space-X and Stripe at a fraction of the cost charged by venture capital funds and peer closed-end funds.
Trading at a 16% discount to NAV, I believe Scottish Mortgage shares are getting close to be a buy. I will use the monthly PPO indicator to guide my long-term investments in this outstanding growth fund.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
