Interactive Investor

Will Scottish Mortgage’s plan to tackle its discount work?

Scottish Mortgage’s board is taking action in an attempt to reduce its double-digit discount. Kyle Caldwell explains that while share buybacks can help shrink a discount, they are no panacea.

18th March 2024 09:34

Kyle Caldwell from interactive investor

The plan announced by Scottish Mortgage (LSE:SMT) at the end of last week to make at least £1 billion available to buy back its own shares over the next two years was warmly welcomed, causing its share price to rise by 5.3% on 15 March. 

Buying back its shares is an attempt to address Scottish Mortgage’s discount, which stood at 15% to its net asset value (NAV) prior to the announcement. Scottish Mortgage has been trading on a discount during the past couple of years due to performance coming off the boil. Prior to hitting a share price peak of £15 in November 2021, the trust had typically traded on a small premium for a number of years.

Scottish Mortgage’s innovation-focused portfolio, which holds both listed and private companies (up to 30%), has been hurt by the higher interest rate environment, which has reduced the appeal and valuations of growth companies offering jam tomorrow”.

By reducing the number of shares in circulation, there is less of an imbalance between supply and demand. In theory, this will reduce the trust’s discount, benefiting shareholders as the share price will receive a boost as it narrows towards the value of the trust’s underlying investments.

Justin Dowley, chair of Scottish Mortgage, said: “We remain committed to using share repurchases strategically to enhance liquidity in our shares and to seek to facilitate trading around net asset value. Our company has a strong balance sheet, and its portfolio companies are delivering strong operational results.

“We are acting upon this investment opportunity by materially increasing the capital available to our liquidity policy over the next two years with the aim of maximising returns for our shareholders.”

However, while buying back shares is a sign of confidence from a board, which views the discount the trust is trading on as unjust and too cheap, it is no panacea. Buybacks won’t prevent discounts widening if there is no demand for the shares.

Much more important over the long term is the performance of the underlying investments held by the trust. This has the biggest influence on the overall total shareholder returns. Put simply, if the trust doesn’t perform well, it is likely to consistently have a high discount due to a lack of demand for its shares.

Scottish Mortgage’s share buyback move was given the thumbs up by analysts. Broker Numis said it is “excellent news for Scottish Mortgage shareholders”.  

It added: “The willingness to buy back such as significant sum also highlights that the board and manager are comfortable that there is sufficient headroom on limits on private company exposure and gearing, with circa £450 million of short-term debt repaid over the last two years.

“In addition, we believe this demonstrates that the board and manager must have significantly more comfort about the outlook for cash flow and liquidity from the private portfolio. They are delivering strong operating performance having adapted to the high interest rate environment and difficult funding environment, through generating cash to fund future growth opportunities. 

Matthew Read, a senior analyst QuotedData, also welcomed the share buyback plan. He said: “We are pleased to see the board of Scottish Mortgage stepping up its efforts to address the trust’s discount. It is no secret that, on the back of its very strong performance, SMT raised a lot of money from investors, when interest rates were low and its strategy was very much in favour.

“We have long believed that where funds have taken in a lot of capital in the good times, they should also be prepared to provide their shareholders with liquidity when times are tougher and the fact that Scottish Mortgage has some illiquid assets does not make it immune from this. Irrespective of the underlying asset class, buybacks should always be done in a measured way that also protects shareholders’ interests.

“It can be harmful to shrink a fund and make it subscale and, for funds with illiquid assets, value could be eroded should a trust aggressively fund buybacks to the extent that it does not have sufficient cash to fund follow-on investments when needed.

“Size is not an issue for Scottish Mortgage and the board and manager have clearly been cognisant of the risk of not being able to provide liquidity where required.”

The prospect of the interest rate cycle peaking would be positive for funds such as Scottish Mortgage that have a growth-focused approach to investing.

However, arguably a bigger catalyst would be positive news, such as an IPO, from the unlisted stock part of the portfolio, which accounts for just under 30%.

Numis notes: “We believe there is potential for liquidity events in the portfolio, with capital markets showing signs of life, which would simultaneously address multiple investor concerns such as proving valuations, reducing private exposure and giving flexibility to manage the balance sheet or provide cash for buybacks.”

Read is in agreement. He says: “With inflation and interest rates past their peak, Scottish Mortgage’s style could come increasingly back into favour. If so, it may not need all that firepower and it might not be so long before it is issuing stock and growing again.”

However, Read notes that if its style does not come back into favour “the level of buybacks” may not be enough to reduce the discount towards NAV.

“A bigger concern for us is the level of buybacks that SMT is committing to. £1 billion sounds like a lot, but is around 9% of the fund’s market cap today, or 4.5% per year once this is spread over two years. This is a decent start and should shift the discount but may not be enough to move it back to where it has traded historically.”

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