Analyst explains why he thinks ‘the next few months may bring the second leg of the sell-off’ for Scottish Mortgage.
Investec analyst Alan Brierley has switched his Scottish Mortgage (LSE:SMT) recommendation from “hold” to “sell”, amid concerns that there’s further pain to come for the FTSE 100-listed investment trust.
The globally-focused portfolio targets disruptive growth companies, both public and private. It has seen its share price slump due to the change in the macroeconomic backdrop, with interest rates rising in an attempt to cool red-hot inflation. Since its share price hit an all-time high in November 2021, Scottish Mortgage is down 52.1%.
In a note published on 19 January, Brierley gave three reasons why he thinks “the next few months may bring the second leg of the sell-off”.
The first concern is Scottish Mortgage’s borrowing levels, known as gearing. Brierley points out that gearing is 17%, the highest level for a decade. He said: “We struggle to reconcile this sudden appetite for gearing. Given the extremely high beta characteristics of the listed equity portfolio, and significant exposure to private investments, the risks are clear.”
Gearing is calculated by comparing a trust's borrowing against the value of its assets. When a trust's portfolio falls in value, its gearing will rise, which is what has happened with Scottish Mortgage. By the same token, if an investment trust portfolio increases in value, gearing will fall.
The second issue he identifies is Scottish Mortgage’s unlisted holdings. Brierley is concerned about the “valuation lag” between unlisted and listed companies with similar higher growth characteristics.
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Scottish Mortgage’s unlisted valuations are carried out by a “valuations committee” at Baillie Gifford, which takes advice from an independent third party, IHS Markit. It values a third of the private component of the portfolio each month, so each three-month period provides a full portfolio valuation.
The predicament that investors face is that, due to the time lag of when these valuations are reported, the valuations potentially do not reflect the reality of what those assets could be sold for today.
Brierley expects a valuation reset for high-growth unlisted stocks. He says: “Although the secondary market for these investments is highly illiquid, ultimately there will be price discovery and for many companies, this valuation reset could be brutal. To date, down rounds have been limited to companies that have run out of cash.
“However, the reduction in valuations may gather momentum as audited year-end valuations for private funds that have such a valuation lag begin to feed through.”
Brierley also points out the private investment exposure is at full capacity, having hit the 30% level, with Scottish Mortgage currently unable to make follow-on or new investments.
His third concern is the “unsupportive macro backdrop”. Higher interest rates have hurt growth stocks, particularly those that are promising profits in the future rather than making money today.
Brierley says: “Central banks are struggling to control inflation, the global economy is at risk of tipping into recession, and an acceleration in quantitative tightening will further drain liquidity. Over the next few months, this environment could bring further strong headwinds for Scottish Mortgage’s ‘growth at unreasonable prices’ philosophy, with the manager favouring stocks with growth of an explosive nature.”
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As its shareholders would expect, Scottish Mortgage is not wavering in its approach of adopting a long-term focus to finding the most exciting companies in the world, and ignoring macroeconomic noise.
At an investor conference earlier this month, lead fund manager Tom Slater said that while 2022 may be remembered as a bad year in terms of Scottish Mortgage’s share price performance, there was some notable progress from some of its portfolio companies.
Scottish Mortgage asks investors to judge performance over five years, so this is the minimum holding period that investors should adopt. Over five years, it has returned 61% versus 45% for the average global trust, according to Morningstar via the Association of Investment Companies (AIC).
The trust is one of interactive investor’s adventurous options on its Super 60 investment ideas’ list.
Dzmitry Lipski, head of funds research at interactive investor, 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.”
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