Interactive Investor

Scottish Mortgage sell-off: how should investors respond?

26th January 2022 10:52

Kyle Caldwell from interactive investor

Should investors hold, fold or buy or more? We run through the options.

History is repeating itself for the UK’s largest investment trust, Scottish Mortgage (LSE:SMT), which has once again seen its share price fall sharply on the back of a sell-off in growth and technology stocks. 

Year-to-date Scottish Mortgage’s share price is down 19.4%, as of close of trading yesterday. It is trading on a discount of 3.3%, according to analyst Winterflood. The trust’s board actively buys back its own shares in an attempt to keep its discount under control.

Last year, from mid-February to early March, Scottish Mortgage’s share price fell 30% peak to trough, due to a sell-off in technology companies.

The reasons for the sell-off last year are broadly the same this time around; investors are questioning the potential end of the decade-long run for growth shares as interest rates rise in an attempt to combat high inflation levels.

The market has in recent weeks been rotating towards value shares, which tend to be more economically sensitive and benefit from higher interest rates.

At the other side of the trade, many growth and tech shares have come under the cosh, with investors questioning their high valuations and taking profits following a strong run of performance over the past decade and since the start of the Covid-19 pandemic.

High inflation levels and the prospect of higher interest rates devalues the future earnings of tech shares, and this has unnerved investors.  

Scottish Mortgage backs disruptive companies that have a technological edge over competitors. It also has a sizeable position, just under 20% of its assets, in unlisted companies. Many of these companies are at an early stage of development. Therefore, when there’s a heavy sell-off in tech companies, Scottish Mortgage is negatively impacted.

In contrast, when tech shares are in favour, this provides a boost to performance. In the 12-month period to the end of March 2021, Scottish Mortgage posted the strongest ever yearly return in its 112-year history, with its share price up 99%.

James Carthew, head of investment companies at QuotedData, says: “The onset of the pandemic supercharged the performance of Scottish Mortgage as investors looked for companies generating their own growth rather than relying on the growth of the wider economy; also as a whole class of companies saw an acceleration in revenue because they offered solutions that supported economies affected by social distancing measures.

“As we hopefully start to put Covid-19 behind us, the focus has switched to the inflationary effects of all the money injected into economies over the last couple of years. As inflation soars, the expectation is that interest rate rises won’t be far behind. Higher rates make high-growth businesses whose profitability is weighted towards the distant future look less attractive. The common approach is to value these on a discounted cash flow basis and a higher discount rate means a lower estimated value.”

Should investors hold, fold or buy or more?

Given the dominance of growth and technology shares in recent years, it is first worth assessing how much exposure you have to such companies. If your portfolio is full of tech, then it has a style bias and is not sufficiently diversified.

Instead, it is more prudent to have exposure to both growth and value stocks, rather than bet the house one way or the other. Indeed, even if the rotation continues to play out, there will still be winners and losers among both growth and value stocks.

In 2021, Scottish Mortgage recovered from its share price slump. It ended the year up 10.5%. This year, the macroeconomic backdrop is different. Whereas a year ago the market was worrying about the prospect of inflation rearing its ugly head, increases in the cost of living have now hit high levels. UK inflation is currently at a 30-year high of 5.4%. Across the pond in the US, inflation is at 7%, the highest point since 1982.

Therefore, there could be further short-term pain to come for growth and technology shares, as central banks raise interest rates. The Bank of England has already made its first move, and many investors expect a further rise next month. The US central bank, the Federal Reserve, is expected to raise rates a couple of times this year.

The fund managers of Scottish Mortgage, James Anderson and Tom Slater, will be unfazed by the short-term share slump. When there’s a heavy tech sell-off, it is out of their control. Anderson is retiring from fund management at the end of April, and Slater will become lead manager.

Instead, it is the duo's job to identify the companies they believe will perform well over the long term. The trust asks investors to judge performance over five years, so this is the minimum holding period that investors should adopt. Over five years, the trust has returned 214%, according to Morningstar via the Association of Investment Companies (AIC).  

Iain Scouller, an investment trust analyst at Stifel, last week upgraded Scottish Mortgage from neutral to positive following its rocky start to the year. He suggests drip-feeding rather than investing a lump due to the risk of further market setbacks to come. 

He says: “None of us know when the growth stock de-rating will reach the low point, but taking a contrarian view, the shares are starting to look interesting. Given the volatile nature of the portfolio, we suggest 'drip-feed' investing – there is clearly a risk the rotation from growth continues for some time, with the price consequently falling.”

According to Scouller, the unquoted investments provide some 'ballast' when the share prices of listed companies are volatile. He adds that the innovative companies Scottish Mortgage backs will continue to grow value for long-term shareholders.

Numis, the investment trust analyst, is also positive. It makes the point that going forward there “is likely to be more differentiation in performance between the winners and losers among growth stocks”.

It adds: “On this basis, we believe that it might be an interesting time to buy Scottish Mortgage, which has repeatedly proved that it can identify companies that are benefiting from the next big mega-trends.

“It is often a volatile ride for investors in the short term, and investors may need to be brave, but it has delivered over the long term and we believe it can in future, even in a higher rate environment. In addition, it is active in protecting the discount.”

Carthew echoes the point Numis makes on risk. He comments that “Scottish Mortgage isn’t the sort of trust that ought to dominate your portfolio unless you are comfortable with swings like the ones we have seen recently.”

He adds: “The outlook for 2022 is uncertain. Nevertheless, an investment in Scottish Mortgage should be an investment for the long term. It helps a great deal that the company is making a serious effort to moderate the shifts in its discount/premium.”

Dzmitry Lipski, head of funds research at interactive investor, agrees that investors need to remember that Scottish Mortgage is an adventurous option. This is how the trust is classified in interactive investor’s Super 60 list.

He says: “While past performance is not an indicator of future results, Scottish Mortgage Investment Trust’s track record over the long term speaks for itself, underpinned by a solid investment strategy, which targets disruptive growth companies, public and private – which are inherently long-term investments. Investors should remember that it is a higher-risk investment due to high portfolio concentration, exposure to tech and unquoted companies and gearing, so it works better as a satellite holding in a well-diversified portfolio.”

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

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