Fund spotlight: Scottish Mortgage Investment Trust

interactive investor's analysts give an update and view on the Scottish Mortgage Investment Trust.

The theory of increasing returns

Standard economic theory, developed early last century, shows markets and companies experiencing diminishing returns. The theory was developed in an industrial economy in which companies that produced goods such as grain, crops or coal, eventually ran into limitations as they expanded, causing them to hit equilibrium.

However, once economies transitioned from manufacturing to service markets, the underlying mechanisms that determine economic behaviour shifted from diminishing to increasing returns. This shift is associated with a new modern economy of high-tech and the knowledge-based industries. 

W. Brian Arthur, an economist at the Santa Fe Institute, argues that investing in high-tech companies is different from investing in other companies, because of the interaction they have with network effects and the law of increasing returns. 

"If a product or a company or a technology—one of many competing in a market—gets ahead by chance or clever strategy, increasing returns can magnify this advantage, and the product or company or technology can go on to lock in the market."

Although initially not understood, the theory of increasing returns has been embraced by many investors and, since then, it has been standard for investing in high-tech markets. 

At that time, an example of increasing returns at work in the high-tech industry was Microsoft (NASDAQ:MSFT), who successfully turned Windows into the operating system for almost all personal computers in the world. Even now, the theory is the foundation of the success of companies such as Google (NASDAQ:GOOGL), Facebook (NASDAQ:FB), Uber Technologies (NYSE:UBER), Amazon (NASDAQ:AMZN), and Airbnb.

The fund

James Anderson and Tom Slater, managers of the Scottish Mortgage Investment Trust (LSE:SMT), almost redefined growth investing based on this theory of increasing returns. They believe it explains the reason why growth has overtaken value as the dominant style of investing over the past few decades. 

Scottish Mortgage, Baillie Gifford's flagship investment trust, was launched in 1909. As at 31 May 2019, the trust had total net assets of £7.95 billion, making it the UK's largest investment trusts and a FTSE 100 company. 

The managers invest in innovative businesses with the power to disrupt whole sectors and industries. Their view is that market returns are not normally distributed, but that the big gains will come from a few companies. The focus is to find these future winners in a changing world, whose prospects remain underestimated by most investors. These are usually companies that address markets with huge potential at early stages, are founder or family-run for the long term and have "flexibility to change direction". 

To achieve this the managers are happy with exposure to a broad number of companies to start with, then wait patiently until the potential leader is exposed by the market. For example, they held eBay (NASDAQ:EBAY) along with Amazon as they were not certain who would dominate e-commerce. The managers also accept that sometimes, a company becomes so successful that it exhausts its opportunities. An example of this would be Apple (NASDAQ:AAPL), which the trust sold in 2016. 

With no limits on geographical or sector exposure, they are free to invest in what they consider to be the world's most exciting companies whether well-established, public companies or newer private ones. Taking a very long-term view, possibly well beyond 10 years, the managers see themselves as owners of companies rather than renters of stock, analysing the potential of the company as opposed to the current value. 

Meeting company management is very important, and Baillie Gifford's reach and reputation, as well as James and Tom's track record as long-term shareholders, allows them to build trust-based relationships with industry gurus such as Jeff Bezos at Amazon and Alibaba's (NYSE:BABA) Jack Ma.  

What's in it?

Scottish Mortgage is an unconstrained, best ideas global equity portfolio with a relatively concentrated stock-picking approach and very long-term horizon. That's evidenced by its very low turnover of around 10% on average over the last five years. There are around 80 stocks in the portfolio with an active share of 94%. 

The managers have long been keen supporters of the technology sector (over 20% of the portfolio), investing at an early stage in Google, Facebook and Amazon, and backing China's Alibaba, Baidu and Tencent. At the same time, they have some exposure to more traditional companies such as Ferrari.  

The largest holding is Amazon which is a market leader in e-commerce and cloud computing, with the potential to disrupt other industries such as food and healthcare. Tesla (NASDAQ:TSLA) is another interesting holding which managers see as years ahead of the competition in product and battery technology. 

At country level, fund exposure to the US market is 53% with weightings of 22% for China and almost 25% for Europe. The managers believe that over the next 20 years, Chinese companies will create the most value in the world, and they see Tencent and Alibaba as even more important than their US equivalents. In Europe, the trust has exposure to Delivery Hero and Kering. 

Managers are also enthusiastic about private, unlisted companies which currently represent 17% of the portfolio, including companies such as Airbnb and Ant Financial. The trust's unquoted holdings are established, often highly cash-generative companies, typically with valuations well over $1 billion. They have recognised that many successful companies delay or avoid a public listing, as they either do not need to raise capital, or it is already available to them from private investors. 

For example, the trust held Alibaba as an unlisted holding before it went public, which wasn't until it had reached a market capitalisation of $168 billion. This is an extremely important shift for growth investors, as not investing in this space results in a loss of access to a considerable period of value creation in these exciting growth companies. 

How does it perform?

The trust has benefited from exposure to heavy technology companies and has produced exceptional performance over the shorter and longer term. It's also outperformed peers and the FTSE All-World index. 

The ii view

Scottish Mortgage is a Global Equities Adventurous recommendation within interactive investor's Super 60 list of high-conviction active and passive funds. It provides global exposure to exciting disruptive growth companies, public and private, selected by highly experienced managers. The strength of their stock-picking skills combined with strong risk-adjusted performance and competitive fees make this a good choice for long-term investors. 

Investors should note that it is higher-risk investment due to high portfolio concentration, exposure to unquoted companies and exercised gearing, so works better as a satellite holding in a well-diversified portfolio. The style bias of the trust is toward growth, with less attention paid to valuation, meaning it can complement other funds with a core or value style orientation.  

• Find out why this fund is on the ii Super 60 investments list
• Click here for more information on this fund, including price, yield and charges

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