The flagship ‘growth’ trust from Baillie Gifford has been battered by higher interest rates – but will it recover in 2023?
Scottish Mortgage investors suffered one of their worst-ever years in 2022, with shares falling around 50% as higher interest rates burst the bubble in speculative growth stocks, which promised to transform the world but had little in the way of profits today.
Despite the hit to performance, Scottish Mortgage maintained its place at the top of the most-bought investment trust list among interactive investor customers throughout 2022. Investors kept the faith, hoping that the “transformational” stocks that Baillie Gifford invests in will come good again once they show signs of meeting their potential.
But how will the trust perform in 2023, and is it still a good long-term investment? We look at the key themes that will affect performance.
A long-running theme for Scottish Mortgage has been its bet on Chinese internet stocks, such as Tencent and Alibaba. These firms have dented performance in the past couple of years, as Chinese lockdowns and a crackdown from the government on tech profits have hurt investor sentiment.
However, Scottish Mortgage’s 12% allocation to China may turn out to be an advantage this year. Although this is provided that the trust does not continue to reduce its exposure to Chinese shares. Two years ago, the trust had more than 20% in China shares. In 2022, it moved to reduce exposure amid concerns over regulatory risk following intervention in markets and the economy from China’s communist government.
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Since November, the MSCI China index, as measured in sterling, has risen 30%. China is beginning to scrap its zero-Covid policy, with quarantines ending and fewer restrictions on travel. This has been a boost to the stock market, with investors now betting that the economy will recover as the government prioritises growth over containing the virus.
If Chinese shares continue their winning streak, then Scottish Mortgage will have an advantage over other global funds that have shunned the communist state.
Another standout feature of Scottish Mortgage, compared with other global investment strategies or index funds, is its big bets on a coming revolution in healthcare. Its biggest position, at 10% of the portfolio, is Moderna.
Moderna recently made a breakthrough at finding a vaccine for the most serious form of skin cancer - melanoma. Using the same messenger RNA approach that powered its Covid-19 vaccine, and working with pharmaceutical company Merck & Co Inc (NYSE:MRK), it managed to reduce the risk of death or recurrence of melanoma in high-risk patients by 44%.
Baillie Gifford’s Lee Qian, who manages the Positive Change fund, which is also a big backer of Moderna, says that finding a cancer vaccine would transform Moderna and give it a slice of the cancer treatment market worth hundreds of billions of US dollars a year.
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A year of breakthroughs in healthcare would reward Baillie Gifford and Scottish Mortgage.
Interest rates and the economy
While some sectors in the Scottish Mortgage portfolio may perform better than others, the biggest influence on its share price this year will be the economy and how central banks act to control inflation. Interest rates are the key factor, with higher rates bad for the valuations of the expensive stocks Scottish Mortgage owns.
When rates increase, the return from bonds does too, meaning that investors can get a better return from “risk-free” assets, such as UK or US government debt. This then makes owning unproven companies relatively less appealing.
The biggest influence on interest rates currently is inflation. If prices continue falling next year, then central banks will be able to cut interest rates to stimulate the economy. This would be good for growth stocks.
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However, if inflation remains stubbornly high, central banks may keep rates higher for longer, even if economies are slowing. This outcome would be negative for Scottish Mortgage shares.
Fund group Vanguard says that global inflation will be “persistently surprising”, as the war in Ukraine continues, threatening another surge in energy and food commodities prices, and supply-demand imbalances linger in many sectors as global supply chains have yet to fully recover from Covid-19.
This outcome would be bad for Scottish Mortgage, but there are signs that inflation is easing.
Inflation in Britain and the US continued to fall in November. Prices in the UK eased to 10.7% year-over-year growth, compared with 10.9% in October. In the US, they rose 7.1% for the year, down from 7.7% in October. Core inflation, which strips out volatile items such as food and energy, was 6.3% in the UK and 6% in the US.
What do the pros think?
Peter Hewitt, who manages the CT Global Managed Portfolio Growth (LSE:CMPG), which owns around 40 investment trusts, says that now is not a bad time to begin building a position in Scottish Mortgage. He has been an investor in the trust since launch in 2008, but sold half his shares in January 2022. He said: “I think you'll not see (Scottish Mortgage) starting to perform until we see interest rates beginning to come down. And that may not be till later in 2023. So, do I think Scottish Mortgage is going to perform in the next week, month, quarter? Probably not. But if you didn’t own it, it wouldn’t be a bad time to start building a position because genuinely it’s one you should be holding on a five to 10-year view.”
Hewitt argues that Baillie Gifford is very well placed to find the next generation of winning companies. He says: “What they do is find some of these high growth opportunities in new areas and they take investments in them. Some can fail, but the winners are big. I’m going to [say] they made something like 160 times their money in Tesla and Amazon.
“Now, they’re not going to do that again because they’re already humongous companies. But there could be ones coming behind, which will give you some interesting returns. So, I'm still relatively confident about that.”
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Scottish Mortgage is still a member of interactive investor’s Super 60 Investments as an “adventurous” investment option, despite the steep share price drop this year.
Head of funds research Dzmitry Lipski says Scottish Mortgage is well positioned to grow the capital of patient investors as its managers' expertise, and their commitment to work with academia, should allow them to find modern portfolio ideas in both private and public markets.
“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,” said Lipski.
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