Scottish Mortgage (SMT) has announced its annual results for the year ended 31 March 2020, which suggest that the trust has provided an effective shelter against the storm of covid-19. During the year, the trust provided Nav and share price total returns of 13.7% and 12.7% respectively, which are very respectable given the unfortunate timing of its financial year end which captures the worst of the market falls from the pandemic. In comparison, SMT says that its benchmark, the FTSE All-World Index, saw a fall of 6.2%. Furthermore, the trust’s shares have risen a further 23% from 31 March to 12 May, which has pushed its market capitalisation through the £10bn mark. SMT says that its performance has been driven by the strength of the portfolio’s performance, although, regrettably, there is no specific commentary on the key contributors so we cannot discuss these here.
Proposed investment policy change to allow increased exposure to unquoted
SMT says that its AGM notice will include a resolution proposing an update to the Company’s Investment Policy. There is only one proposed change, which is to raise the current limit on all assets not listed on a public exchange by 5% to 30% at time of purchase of the next such asset.
SMT says that the flexibility to invest in the best companies, regardless of the capital structure, has been an important driver of the returns generated for shareholders over the last decade. It says that, as an increasing number of the best growth companies have remained private until much later in their development, it has enabled the Managers to maintain the quality and depth of their opportunity set and to invest simply in any company which met their investment philosophy and criteria. This capacity utilises the benefits of Scottish Mortgage’s closed-end structure and low-cost proposition to its shareholders’ advantage.
Investment manager’s review
The investment manger’s review comprises comments from Tom Slater, James Anderson and Catharine Flood on a variety of topics. Rather than try and summarise, we have provided these below so you can review them in full.
Managers’ Report – comments from James Anderson
We cannot know the consequences of COVID-19 beyond human tragedy. It is presumptuous to make predictions about complex and inherently uncertain matters at any time. Under conditions of stress in society and markets it is even more dangerous. We are better observing rather than concluding prematurely. When faced with the extraordinary it’s far too easy to retreat to preconceptions. As investors we would like to see the current crisis provoke a further acceleration in digitalisation and healthcare innovation. As observers we would hope that the current crisis will prompt increased concern over the threat driven by other extreme outcomes in inequality or climate decay. But it isn’t at all clear that these are more than pious hopes.
It is far harder to identify how and why the pandemic has changed our views. Generally it’s perilously early to do so. It’s also dangerous to focus solely on one event however terrible. Two years ago this report quoted the late, great Hans Rosling. He frequently cited a global pandemic as his greatest fear. But he also warned that unusual and negative events warp our minds: ‘If we are not extremely careful, we come to believe that the unusual is usual: that this is what the world looks like.’ At some point he emphasised that we need to return to ‘the secret, silent miracle of human progress’.
The End of Carbon
One such miracle may already have occurred. It may eventually be seen as equally historic and as beneficial as the pandemic has been malign. The age of carbon may have ended before the virus spread. For all the drama of the Saudi-Russian clash or of negative oil prices this was a transformation long foretold but finally turning unstoppable in the first quarter of 2020. The remorseless fall in the prices of renewable energy has at last translated into savage competition against traditional fuels.
In the first three months of 2020, 52% of German electricity came from renewables. In the UK that figure was 45%. No wonder the share prices of Exxon, BP and Schlumberger were already falling sharply in January and February. Sad though it is to say pandemics are far more common than energy transitions in the history of the world. The rise of renewables and the electrification of transportation will be central to the investing world of the next twenty years at least. It matters.
COVID-19 has already exacerbated the name calling between America and China. It could hardly be otherwise given the characteristics of leadership in both countries. But it seems clear to us that the geographical centre of the global economy continues to move to Asia, generally at an accelerated pace. This is an observation not an endorsement of one country or a political system. It’s likely at the simplest level that Asian GDP can grow in 2020. That’s improbable in the USA and impossible in Europe. Before and beyond the virus we have been disconcerted by the extent to which business model leadership and systemic dynamism appear to be fading in America, even on the West coast. This too appears to be in contrast to Asia and, in the world of corporate giants, particularly relative to China. I will leave the specific examples to Tom Slater to discuss in the next section of this Report to our shareholders.
Risk and the index
Scottish Mortgage has long believed in the energy revolution. But we cannot become unduly confident. It’s critically important to test all our beliefs. This applies more strongly to our general contentions than to our individual stock decisions. The latter are necessarily subject to specific uncertainties that we cannot wish or diversify away. But if our underlying beliefs are structurally wrong and we are therefore unable to make sense of the investing world for a prolonged period, then we need to reassess. We need to ask ourselves if our philosophy is adapted to the world as it will be rather than as we hope it is. This applies at all times. It applies at least as much when we have been successful as in times of disappointment. It applies even more when the shape of the investing world is changing dramatically.
Two years ago in this report we wrote that ‘We do not share the presumption that Scottish Mortgage is doomed to suffer unduly in a bear market. To us the underlying cause of the next market retreat is most likely to be the dawning realisation that broad swathes of the stock market that are assumed to be strong and stable in difficult market conditions are instead acutely vulnerable to severe setbacks’. Three years ago we said that ‘We do not accept that risk resides in owning a portfolio that is different from the index’ and suggested that this definition of risk owed more to the self-interest of the investment industry than to economic reality. We did not predict the current pandemic although the possibility of such a disaster was always present as experts in healthcare and fragility have repeatedly observed. So we did not suspect that the trigger for the collapse in the businesses and share prices of so many major index constituents would lie in COVID-19. But they were indeed vulnerable to severe setbacks even if we expected this to unwind over a decade not a year.
There’s not much evidence that capital market ideology will take much notice of the crass failings of its prescriptions. Managers and consultants will continue to talk to themselves of tracking errors and Sharpe ratios as risk controls (the reader is fortunate if they are unexposed to such terms) whilst their clients suffer. The curriculum of the ever more dominant Chartered Financial Analyst (CFA) will not change although its teachings bear little resemblance to market outcomes.
These comments are meant to convey meaning beyond irritation. The opportunity for us in the last decade has come about because stock markets did not learn. This is unusual. Normally investors, speculators and traders leap restlessly onto new paradigms however questionable their underpinnings. But that hasn’t happened despite, for example, the clear evidence of the power of the internet, the increasing returns to scale it tends towards and the consequent deep competitive moats it offers. Instead of embracing exponential growth, investors and asset allocators have fled. Performance chasing has its own evils but replacing it with endless rebalancing towards ‘value’ strategies backed by a blind conviction that reversion to the mean is inevitable has been an investment tragedy. It’s largely been prompted by misguided theorising. But the theory has been reinforced by the extraordinary grip that Warren Buffett has exercised over the investment world. Of course the very long term record of Berkshire Hathaway is brilliant, of course Buffett has a splendid way with words and the public, of course he doesn’t believe in the silliness of risk as divergence from the index. But Buffett’s success has sanctified a freezing of the investment narrative. Or as Buffett’s brilliant partner, Charlie Munger, puts it with the clarity of a 96 year old, too many investors are ‘like a bunch of cod fishermen after all the cod’s been overfished…that’s what happened to all these value investors. Maybe they should move to where the fish are’. So where will the fish be in the future?
Whilst the collective investment world has shown little enthusiasm for shifting to new hunting grounds the market has adapted, as it does, without most participants. This carries potential problems. The universe of great growth whales is swallowing the minnows. At one point in April the US Nasdaq index, dominated by technology companies, enjoyed a market capitalisation greater than all the developed markets outside America. Or on a plaintive local note Amazon and Alphabet combined are more highly capitalised than all quoted British companies. It’s not clear that this is unjustified. Moreover the perception of relative vulnerability has changed. Most investors craving safety now see Amazon and its kin as far less exposed to economic angst. In general our quoted portfolio has therefore become more conventional and gradually, then suddenly, less differentiated from the index than in the past. This does not unduly concern us at present as the world adapts to wrenching changes but it may become an issue in the future. We must continue to evolve.
Managers’ Report – comments from Tom Slater
Through the patient provision of capital, we aim to support the people and companies that are building the future of our economy. So the absence of dramatic change in the portfolio over the past twelve months should come as little surprise. We still own 29 of our top 30 holdings from a year ago. We believe that having long-term, committed owners can increase the chance of success for companies. Moreover, long-term ownership is the key to capturing the value created by the small number of exceptional companies that drive long-term wealth creation. Our objective is to find such companies and own them long enough to earn that return.
Studying the output of our investment process (a portfolio with modest turnover and long holding-periods) risks confusing low turnover with no turnover. Amazon does not remain our largest holding because we are contented owners. It remains our largest holding because our constant search for the world’s most exciting and innovative Growth companies has not turned up another opportunity which we think offers greater risk-adjusted upside.
This fierce competition for our capital goes part way to explaining the sale of Chinese internet search company, Baidu, once Scottish Mortgage’s largest holding. Baidu has struggled to use its enduring dominance in Search as a base to build new services for consumers. Failing to evolve means being left behind. China’s online companies have built the backbone of its consumer economy and their pace of development and innovation has been ferocious. Alibaba and Tencent have become dominant platforms through which much economic activity flows and recent events have further cemented their centrality. Whilst these companies started out in the retail and entertainment business, they now drive financial inclusion and provide access to credit. In a country where advanced software has been scarce, they are beginning to digitise and upgrade a huge swathe of China’s economy and public sector through the provision of systems and data on an unprecedented scale.
It is encouraging to see new innovative companies emerging from China’s internet ecosystem. Bytedance is a media company focused on short-form video. It was founded by several former Baidu engineers and may be the first Chinese media company to build a big presence internationally. Younger audiences have flocked to its social media platform, TikTok, which has transcended cultural and geographic boundaries. Bytedance’s core skill is in deploying artificial intelligence to predict the content that each member of its vast audience will be interested in. This skill-set should extend the opportunity well beyond current products. The addition of Bytedance to our portfolio has helped to ensure that we retain a significant exposure to Chinese companies despite the sale of Baidu. The creative ferment, intensive competition and relentless execution that exist in this vast market are a powerful combination for shaping great companies and it remains an important hunting ground for new ideas.
Chinese food delivery and local service company, Meituan, narrowly missed out on joining its geographic complement, Delivery Hero, in our top ten holdings. These businesses are driving change in the food industry and their focus on the fastest-moving countries has allowed them to achieve massive scale. Meituan delivers more than 20 million meals per day compared to a mere 500 thousand for US-based peer Grubhub (which we sold during the year). Scale is driving it forward towards profitability and dominance.
The current food industry paradigm of driving to a grocery store, pushing a shopping trolley around the aisles, queuing at a check-out, driving home, putting groceries into cupboards, retrieving them, preparing and cooking a meal then cleaning the dishes is inefficient. Amazon is attacking a number of the steps in the process as it broadens its online offerings and integrates the Whole Foods brand to provide click and collect and home delivery services. Competition in grocery is likely to be intense and capital-consumptive but that is exactly the type of environment Amazon thrives in. The scale of the opportunity is big enough to make a difference even to a company of Amazon’s size. Berlin-based HelloFresh’s subscription model of delivering locally-sourced, fresh ingredients for home-cooked recipes is seeing burgeoning demand across many markets including the US where, notably, it has outcompeted the domestic alternatives.
Bytedance’s innovation and audience creation have happened in a time of limited progress in the Western advertising industry from either a product or business model perspective. Facebook and Alphabet are smaller holdings than they once were. Whilst Alphabet continues to make good progress in Search, Facebook’s product focus has for some time been predominantly on firefighting. Thankfully we have been fortunate to benefit from the wisdom of others in navigating this evolving media landscape. We bought a holding in You and Mr Jones, an unlisted advertising agency founded by the eponymous former CEO of Havas, back in 2015. His underlying insight was that the corporate sector needed specialist help in harnessing the increasingly complex online and mobile advertising environment. That foresight has proved correct with big brands moving their business away from large agencies to You and Mr Jones.
With consumer internet development muted, it has been left to Tesla to uphold the reputation of West Coast America for bringing disruptive innovation to the world. It has made remarkable progress. The vision and ambition at Tesla have always been clear but at times the company has struggled with execution. That has changed. Steadily increasing and profitable production of the Model 3 sedan has been accompanied by the successful (and earlier-than-planned) production ramp of a new SUV, the Model Y. At the same time the company has completed a second production facility in Shanghai and launched a pickup truck which has already amassed hundreds of thousands of pre-orders. This progress has come amidst delays, cancellations and false starts in electric vehicle production for the established auto manufacturing industry. We wish we could find other big companies that were making such progress in the move to a sustainable energy economy.
We believe software is going to bring profound changes to the transport industry over the next decade. Tesla’s autonomous driving functionality continues to improve as it gathers data from the sensors attached to its large and growing fleet of customer vehicles. The traditional industry will be unable to compete with this technology and we expect it will increasingly turn to companies like our holding, Aurora, which is building a virtual driver for car manufacturers to integrate into their vehicles. If the task of producing autonomous terrestrial vehicles proves too complex then it may be left to companies like Joby Aero to bring the once fanciful idea of flying cars into reality.
Healthcare has dominated the headlines of recent months but at the corporate level there have been relatively few noteworthy developments. We are encouraged by the progress of companies working at the intersection of information technology and medicine such as Grail, Zipline and Tempus Labs. Thus far their growth rates reflect their software inheritance rather than the institutional inertia of their chosen market. However, it has been the companies deploying the tools of modern biology in an industrial setting that have been making the most progress. Ginkgo Bioworks is automating the jobs performed by human scientists in order to industrialise the development of new materials. It is harnessing the power of micro-organisms to produce products across industries as diverse as food ingredients, agriculture and speciality chemicals. Without the understandable safety constraints and (less understandable) bureaucratic challenges of working within a healthcare environment, the pace of improvement and related cost declines are remarkable.
Whilst the newspapers focus on the gloom associated with the impact of COVID-19 it is important not to lose sight of the fact that we live in a time of great progress. The opportunities for Growth investors are plentiful.
Managers’ Report – comments from Catharine Flood
Breaking Down Artificial Boundaries
Over the last decade, a significant and growing number of companies around the world have been staying private for much longer in their development before listing on a public stock exchange. The value created while a company remains private is out of reach of most investors, or at least extremely expensive to access.
In order to maintain the same quality of opportunity set for Scottish Mortgage, we have simply continued to invest directly in any company, public or private, which meets our investment philosophy and criteria. This was achieved with the support of the Board and shareholders. It utilises the benefits of the Company’s closed-end structure and low-cost proposition. There are no additional fees hidden here.
Equity investing is all about capturing long run compounding returns
One of the important advantages that Scottish Mortgage has when investing in established private companies is the ability to continue owning such businesses as and when they become public companies. This means that it is possible to capture the benefits from the long run compounding of returns as they grow from a lower starting value.
In 2012, Alibaba became the first private business Scottish Mortgage invested in directly. It became a public company in 2014. Scottish Mortgage still holds every single share in Alibaba that it bought in 2012 as well as many more besides and it has been a top ten holding for years now.
Since then, a number of the other private businesses in the portfolio have also subsequently become public companies, most of which continue to be held today. A handful of the unlisted businesses have been taken over while we have held them. Most importantly though, a wide variety of new private companies have continued to enter the portfolio and the overall number and weight of these have continued to rise over time as this has simply been where the best new investment opportunities were found.
We have included a graph in the Annual Report showing the growth of the importance of this flexibility over the last decade (to view, please click on this link)
The graph shows the growth in the total assets of Scottish Mortgage, the growth in the percentage of the portfolio invested in those companies that we initially bought when still private, regardless of their status today and, starting in 2014 at Alibaba’s initial public offering (IPO), the level of the assets which are not listed on a public market. The companies which started out as unlisted holdings, whether public or private today, now account for well over a third of the total portfolio. As shareholders will have gathered from the Company’s Interim Reports, the flexibility to invest in this way has been an important driver of returns over the last decade.
The importance of reputation and relationships
Not only does our reputation open doors when we seek out opportunities, but we have also seen an increasing number of private companies approach us in recent years. Further, as key individuals work with multiple companies, we see a network effect from these relationships. We go on to select only a very few of the opportunities available. Over this financial year, we considered several hundred private companies but invested in only seven.
We have found that it is often possible to have more open discussions with the management teams at private companies, precisely because both sides have made a long term commitment. This helps to build a solid foundation for our relationship, improving the quality of the insights we gain from those running these businesses. The relationship created during the first couple of years of investment while Alibaba was still private, helped us to understand the development not only of the company but also of China better. Such relationships can also be valuable in another way. Scottish Mortgage’s initial investment in Alibaba enabled us to invest in Ant Financial, the financial services giant that Alibaba created directly.
Putting the private companies in the portfolio into context
We seek companies where the likelihood of them succeeding in their extraordinary ambitions combined with the potential returns from doing so far outweigh the likely risk to the capital invested from failure. Though size alone is also not a definitive indication of where this balance of risk and potential return might be in a company, it is somewhat more reflective of this than the public/private distinction used as a proxy by many.
Today, Ant is the largest unlisted holding (2.3% of the total) and also the largest such company by market value in the portfolio. Its payments platform alone already handles a multiple of the transactions each day that Visa’s does across the globe, yet payments only represents one of the five broad areas of financial services it offers. Were Ant to be listed on the London Stock Exchange (LSE), it would be the largest company in the FTSE 100 based on its size.
Ant is far from the only private company held already of a scale equivalent to those in the FTSE 100 Index. At the end of March 2020, just under half of the weight of the assets invested in individual private businesses was in companies which would have been already within or very close to joining this group based on their scale, if they were UK listed public companies. Nor is this a new phenomenon. In 2015, when we first invested in Meituan Dianping, it was already of a similar scale to Amazon when we first invested in that company in 2005 and would also have come within the FTSE100 cohort by valuation. By the time it became a public company in 2018, it was almost three times that size. Similarly, Spotify was already a global company when we first invested in 2015 and would have come within this group on the same basis. Again, it was almost three times that size when it became public. These are not the only examples.
We have included a graph in the Annual Report which places the scale of the private companies held against a familiar frame of reference for shareholders (to view, please click on this link)
http://www.rns-pdf.londonstockexchange.com/rns/9845M_3-2020-5-14.pdf. The graph plots the market capitalisations of the companies in the FTSE 100 and FTSE 250 against their rank in those indices. The bubbles on the line indicate approximate equivalent ranking in these indices of the private companies held based on their market value, along with their portfolio weights, (to view the table listing the companies held ranked by their size with a short description of their main area of business and their overall portfolio weight, please click on this link)
This is a diverse group of businesses, operating across a wide range of industries, but they must also be considered within the context of the whole portfolio for Scottish Mortgage.
The fair valuation pricing policy for these assets is detailed elsewhere in this report and on the Company’s website. The disciplined application of our valuation policy means that the prices of these assets will also be impacted during turbulent times in public markets. We saw this most clearly towards the end of the Company’s financial year in March. However, this policy does also ensure that the published net asset values for Scottish Mortgage remain reflective of the prices we would likely be paid at that point for all of the assets in the portfolio, allowing shareholders to make informed investment choices.
Investment Policy Update
Initially, the level of the private companies in the portfolio remained very modest and was monitored by the Board. By 31 March 2016, the unlisted assets represented 11.8% of the total portfolio and it was agreed that it was an appropriate moment to provide further clarity in this area. Shareholders approved a resolution at the Company’s Annual General Meeting (AGM) in June 2016 to update the investment policy. This included the following new provision: “the maximum amount which may be invested in companies not listed on a public market shall not exceed 25 per cent. of the total assets of the Company, measured at the time of purchase.” Although this construction meant that, if this level were to be exceeded, no further unlisted investments may be made while this remained the case, it also protected Scottish Mortgage from becoming a forced seller of these private companies based purely on relative and/or absolute changes in the values of the assets.
As at 31 March 2020, the unlisted assets represented 20.1% of the total. Though the level has previously been higher than this, it has consistently remained under one quarter of the whole portfolio. While we have not yet been formally prevented from simply investing in the best companies available, in practice as the level draws near to the limit considerations over the best use of the remaining capacity do weigh on the investment decisions taken.
It is just as important to ensure that further investments may be made in those private companies showing real progress, as it is to ensure that all new opportunities may be judged equally on their fundamental merits. Accordingly, we are seeking shareholder approval to raise the current limit by 5 per cent. to 30 per cent. The scale of Scottish Mortgage ensures that this will be a material amount of additional flexibility in absolute, but not relative, terms. It will enable us to continue to invest simply in the best opportunities available, be they public or private companies, without changing the nature of the investment proposition. Without this change, this valuable flexibility will become severely constrained and largely dependent on the timings of the IPOs of our existing unlisted companies, which we believe would be to the clear detriment of shareholders.