Interactive Investor

Scottish Mortgage reduces China holdings following crackdowns

11th November 2022 12:12

Kyle Caldwell from interactive investor

Scottish Mortgage has changed its stance on China, having six months ago stuck by its exposure to the region, which has seen political meddling rise notably.

Scottish Mortgage (LSE:SMT) has moved to reduce exposure to China amid concerns over regulatory risk following intervention into markets and the economy from China’s communist government.

In its half-yearly results, released this morning, Fiona McBain, chair of Scottish Mortgage, disclosed: “We have reduced several Chinese holdings, including long-standing investments in Alibaba (NYSE:BABA) and Tencent Holdings (SEHK:700). The regulatory environment in China remains challenging, and we are concerned that ongoing uncertainty will harm the risk-tolerant culture that has driven the long-term success of China's private sector.”

The investment trust has had a longstanding and significant exposure to China, with a particular preference for its internet companies, which also include Meituan (SEHK:3690) and ByteDance, the owner of TikTok.

When Scottish Mortgage reported its annual results in May (covering the year to end of March), lead fund manager Tom Slater said the decline in exposure to China, from 24% a year earlier to 16%, was a reflection of share price falls rather than holdings being sold down.

Over the past 18 months, China’s government has introduced stringent regulation into a number of sectors, notably technology, education and property. In regards to technology, regulatory reforms have clipped the wings of the sector’s growing influence.

A big concern, which has led some fund managers to completely sell out of China, is that further regulatory crackdowns could be made in the future that will stifle the growth of successful companies.

Addressing this concern in May, Slater acknowledged: “The challenge now for Western investors is twofold: incorporating the low but increased chances of future US sanctions into their evaluation of Chinese investments, and considering how the Chinese state may limit the upside in stock prices for the breakthrough winners.”

However, at the time Slater said that he is sticking with China. “Our Chinese holdings have remained largely unchanged through this period of turbulence,” he said.

In terms of its half-year results (covering the period to the end of September), Scottish Mortgage reported a total return net asset value (NAV) decline of 15% compared to a smaller loss of 7% for its benchmark, the FTSE All-World index. The share price fall over this period was 23.7%.

McBain urged shareholders to be patient and think long term, pointing out that “six months of data is always too short a period to infer much that is useful from stock prices”.

Over five years, the global trust has returned 115% in NAV terms against 53% for its benchmark index.

Why Scottish Mortgage has struggled in 2022

Scottish Mortgage was one of Baillie Gifford’s many star performers during the pandemic, due to exposure to fast-growing technology firms and businesses with strong online operations, which benefited from the shift to working from home during lockdown periods. Such companies successfully grew their market share due to offering solutions to consumers and businesses.

However, the tailwind has now turned into a headwind, due to high inflation, which in turn has led to interest rate rises. This backdrop devalues the future earnings of growth companies, due to their valuations being based more on their potential rather than the amount of profit made today. As a result, such companies have become less attractive, and their share prices have come under pressure.

Scottish Mortgage’s share price has almost halved since early November. At the time, it was at an all-time high of 1544p, but today the shares are trading at 817p.

In providing an outlook to shareholders, McBain said: “Powerful forces of change are creating significant opportunities. These include society's transition away from carbon-fuelled transport and energy generation and the application of information technology to our understanding of the molecular basis of disease.

“While rising interest rates and increasing friction between the US and China create a problematic environment to navigate, the long-term advantages of companies are often built in periods of stress and capital shortage.”

Scottish Mortgage is classified as an adventurous option in interactive investor’s Super 60 list of Investment Ideas.

The author owns shares in Scottish Mortgage, along with other investment trusts and funds.

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