Scottish Mortgage reports on “challenging yet rewarding year”

Scottish Mortgage (SMT) has published its annual results for the year ended 31 March 2024. In what its chair, Justin Dowley, describes as a challenging yet rewarding year, SMT provided NAV and share price total returns of 11.5% and 32.5%, which it says compares to at 21.0% return from its FTSE All-World Benchmark. Dowley comments that conflicting forces have been pulling investors in different directions. On one hand, there is a sense of optimism regarding the integration of Artificial Intelligence (AI) into business models, on the other, the macroeconomic and geopolitical factors driving market anxiety are too numerous to mention. Much of this was reflected in unusual patterns of stock market returns. Gains were highly concentrated, driven by a handful of large AI enabled companies in the US, augmented by beneficiaries of strong energy prices and high interest rates although Dowley goes on to say that SMT remains well positioned to navigate such environments, arguing that SMT’s long investment horizon provides the opportunity to step back from the noise.

Ongoing charges for the year were 0.35%, representing a small increase on the previous financial year (0.34%).

Discount management

As we have previously discussed, SMT has recently stepped up its efforts at managing its discount, which had attracted Elliott Advisors on to its register (click here to see our coverage of that). These efforts have borne fruit with SMT’s discount moving in significantly during the year (from 19.6% to 4.5%), which has given rise to the particularly strong share price performance detailed above. Dowley says that “the investment opportunity was clear, the discount unwarranted, and concerted action was required”. As a result, in March 2024, the board announced that the company would make available at least £1 billion for the purpose of buybacks over the following two years. SMT says that its board and managers are committed to facilitating trading around net asset value in normal market conditions.

Managers’ Review – Tom Slater

“We live in a world of ongoing geopolitical tensions, shifting monetary policies and disruptive technology. Against this dynamic backdrop, Scottish Mortgage remains steadfast in its mission: seeking out exceptional companies capable of delivering long-term growth and transformative change.

“The volatility of economies, company profitability and our own stock price prompts the question of whether investing as we do has become riskier. We do not believe that it has. Instead, our diagnosis is that volatility reflects the world becoming a more uncertain place. We must adapt to life with greater uncertainty. That does not mean a flight to the perceived safety of dull companies with low growth and established entry barriers. That would increase our risk profile with the world in flux. What it does mean is that for our companies to achieve their potential, they must first be resilient, and they must be able to adapt.

“Events like the Covid-19 pandemic, supply chain disruptions, two global conflicts and an emerging cold war between the US and China are eroding trust in the fundamental arrangement of the economy. People are more uncertain about trade agreements, financial structures, democratic provisions, the reasonableness of judicial decisions, and the dependability of public health provisions. This feeling of instability makes the idea of rational decision-making less reliable.

“With basic economic assumptions in question, globalisation is slowing. For reasons of stability and national security, countries are hesitant to rely as heavily on foreign partners. There’s a push to bring the manufacturing of critical goods and resources back within domestic control. The US has decided that semiconductor manufacturing is far too sensitive and important to leave to China or even to Taiwan and has passed the Creating Helpful Incentives to Produce Semiconductors (CHIPS) and Science Act, stimulating hundreds of billions of dollars of domestic investment. Similarly, the EU, as a result of the war in Ukraine, had to bring home a lot of energy production previously farmed out to Russia.

“This economic shift is a major adjustment after a long period of relative stability post-World War II. It’s unclear when, or even if, the previous stability will return.

“The tension between China and the US may prove manageable within current frameworks. There is the small but growing possibility of rupture and a move towards a multi-polar world order. There is a strong incentive for some of the world’s big growing economies to seek alternatives to dollar-denominated trade.

“Ongoing disruptions from technology (particularly generative AI, covered by my partner Lawrence Burns later in this report), climate change, and geopolitics will force continued economic transformation. Optimisation and profit maximisation are desirable and rational in a settled environment, but they can be dangerous in an uncertain one. Optimised systems are brittle and can break despite even modest disruption . We are placing greater emphasis on resilience. Adaptability is a crucial attribute in a world of uncertainty. It is a multifaceted quality with financial components, such as high margins or strong balance sheets, and cultural elements that are equally important. Diverse organisations are more likely to contain the ingredients for success in a shifting environment than are monocultures. This change in emphasis doesn’t diminish our focus on imagining what a company will look like ten years from now. It is an acknowledgement that businesses must face challenges in the interim as they exist today.

“A pertinent example of this is last year’s largest holding (and biggest headwind), Moderna. Vaccine fatigue has presented a challenge for the company, with vaccination levels for endemic Covid-19 well below expectations. There are several possible explanations for this, but the virus remains more lethal than influenza and vaccination rates are less than half. Moderna is resilient in the face of these events. The windfall it received from its Covid-19 vaccine has given it a substantial cash position to fund the deployment of its technology into other areas.

“Our reasons for having a significant investment in the company remain unchanged. In the near term, the company’s respiratory vaccine franchise will grow. It has seen promising results from its trials of RNA-based vaccines for flu and RSV and ought to be able to combine these vaccines with Covid-19 into a single shot, which will be better for patients and cheaper for the healthcare system. As its work on other respiratory viruses comes to fruition, it should be able to add these and update for prevalent strains to ensure maximum efficacy. Reducing hospital bed occupancy in the winter flu season will be highly beneficial. The work the company is doing on several other viruses, such as EBV and CMV, will help prevent these infections and, importantly, address the impact that they can have on health later in life. The data from trials of a personalised cancer vaccine that enables the body’s immune system to identify cancerous cells and remove them continue to be very encouraging.

“Our largest holdings, NVIDIA and ASML, are in the semiconductor industry. Demand for NVIDIA’s chips has vastly exceeded expectations, which has been an important driver of our returns. Without NVIDIA’s silicon or software, we would not be seeing such remarkable progress from AI systems. Our key consideration is the duration of the edge it has built over the competition. ASML, the Dutch manufacturer of the lithography equipment needed to produce cutting-edge semiconductors, has one of the most apparent competitive advantages we’ve ever encountered. Its innovations are the central enablers of miniaturisation in semiconductors. Growth in datacentres and AI applications augment the growing demand for chips in many industries. At the same time, chips are getting bigger, and the desire for greater sovereignty in semiconductors is fuelling demand for capital equipment. The offset to these encouraging trends is geopolitics impinging on the company’s equipment sales in China. The immediate challenge is demonstrating that innovation can continue following the retirement of CEO Peter Wennink and President and CTO Martin van den Brink.

“Amazon and Spotify have taken drastic action to increase their resilience in the past year, and stock markets have strongly rewarded them both. We added to Amazon, and it has regained its position as one of our top holdings. It is now reaping the benefits of substantial capacity increases made during Covid-19. Periods of investment and cost increases at both companies have ended, and there has been a much greater focus on efficiency, reflected in margin improvement. The growth opportunities are exciting, and both exemplify the types of businesses that seem likely to benefit from developments in AI. We are seeing many companies invest in AI systems to improve their operations but for investors, there is an essential question of whether this generates additional returns or ends up being a zero-sum game. Spotify is a platform business that benefits from the breadth and scale of content on its platform. AI will likely lead to an explosion in available content, improving its economics in a way that others cannot mitigate. If AI revolutionises how we purchase products, this is likely to favour Amazon, the company with the most consumer data and a vast physical infrastructure for getting products to those consumers.

“Tesla, which we reduced partway through the year, is at a fascinating juncture. Its recent products have been hugely successful, and preliminary sales data indicate that the Model Y was the best-selling vehicle in the world last year. However, the rise in interest rates has reduced the affordability of all high-ticket items, including Tesla vehicles, depressing demand. At the same time, the rapid scaling of Chinese electric vehicle production, along with improving quality, is a powerful source of competition and pricing pressure. All of this may be irrelevant to the long-term investment story. Tesla’s massive investment in AI looks to be paying off with the rapid improvement in its self-driving software. User reports on the latest version, now entirely AI-controlled, are very favourable, and the company is installing it in all new US vehicles. Tesla is harnessing the same investments to produce humanoid robots, whose capabilities are progressing along an exponential trajectory.

“Our largest private position, SpaceX, now a bigger holding than Tesla, launched 96 rockets last year (accounting for two-thirds of all commercial launches). It has no peers when it comes to scale and cost efficiency. The company’s latest rocket, Starship, has unprecedented capabilities and will transport 150 metric tonnes of payload. It is close to commercial launch. Starlink, the satellite communications subsidiary, has 2.3 million subscribers and is growing rapidly bringing connectivity to underserved parts of the world. Its unique access to launch capacity puts it way ahead of potential competitors. It already has sufficient scale to generate cash.

“There has been little change elsewhere in our private portfolio. Our top ten private holdings represent approximately two thirds of our private exposure, and the operating performance of these companies has been encouraging. We selectively supported holdings that raised money in the year. With financial markets activity subdued, very few companies moved from private to public markets.

“The combination of a weak domestic economy, an uncertain regulatory environment and geopolitical concerns have made the inclusion criteria for Chinese stocks in the portfolio more demanding. However, the vast domestic market and exceptional entrepreneurs mean we continue to take Chinese investments seriously. Ecommerce giant Pinduoduo has a proven track record of building a discount retail offering in China and turning it into a profitable business. It is now attempting the same thing overseas, and the pace of rollout for its platform, Temu, has been very impressive. The international pattern of profitability is tracking what we have seen previously in China. We added to Meituan, the local services company, which has proven leadership and the scope for meaningful profit growth in the years to come.

“We have sold our position in Tencent*, the Chinese mobile platform, which has been a prominent holding for us over the past fifteen years. We have massive respect for the team there, who have proven to be phenomenal operators and astute investors. We think that ongoing political and regulatory developments mean that the constraints that go with scale for Chinese businesses have increased substantially. As a result, it will be difficult for Tencent to meet our more demanding inclusion criteria over the coming years.

“We also sold another long-standing holding, Illumina. We believe that genomic sequencing is a fundamental building block for improving healthcare in the coming decades. However, the company’s execution could have been better, and the work required to drive demand and lower costs will be challenging for some time. Several other holdings are utilising genomic sequencing to improve health outcomes. The progress made by Tempus in using sequencing data to guide the treatment of US cancer patients is impressive, and potential applications of the approach continue to multiply.

“There is a lot to be excited about. Artificial intelligence, digitalisation, scientific and engineering progress, and the opportunities presented by transitioning our energy model will provide fertile investment territory for years to come. Jeff Bezos stressed the importance of focusing on the things that don’t change as you build a business. For Scottish Mortgage, that means seeking the most exceptional growth companies, being patient and constructive owners, and harnessing the outsized impact of the small number of extraordinary companies to drive our returns.”

Managers’ Review – Lawrence Burns – Peeling Back the Layers of Artificial Intelligence:

“In the summer of 2018, I was fortunate to spend two full days in Palo Alto talking with Professor Brian Arthur, one of the world’s most influential thinkers on technology and the economy. He told me he thought artificial intelligence (AI) would be the most significant invention since the Gutenberg printing press.

“It was quite a statement, given that the printing press was invented over half a millennium ago. Before its invention, scribes painstakingly copied books by hand. Most were kept in monasteries chained to desks to prevent theft. Gutenberg’s invention made knowledge accessible, allowing ideas to spread like never before. It powered the Scientific Revolution, the Reformation, and countless political revolutions. Its impact was profound and immeasurable.

“AI has the potential to impact the world similarly, but instead of externalising information, it is externalising intelligence. Making it available at rapidly decreasing cost anywhere in the world, instantly and on demand. That could be to write a high school student’s essay on the reign of Queen Victoria or to help a radiologist identify a cancerous tumour. Given that you can do even more with intelligence than you can with information, Brian Arthur concluded that, logically, AI’s impact should be even more significant than the printing press.

“Fast-forward nearly six years, and his views look increasingly prescient. The latest AI models now very nearly match or exceed human performance in a growing number of tasks, including image classification, reading comprehension, visual reasoning and competition-level mathematics. The progress in surpassing human performance benchmarks has been so fast that the editor-in-chief of the AI Index recently commented that a decade ago, benchmarks would serve the AI community for five-to-ten years, but now they often become irrelevant in just a few years.

“This pace of progress has been made possible by the continued exponential improvement of the three inputs that drive AI performance: compute, data and algorithms. A way of measuring these improvements is the number of parameters a model has. Each parameter is a variable that the model can adjust during the training to better predict outcomes. In 2018, when talking to Professor Arthur, GPT-1 had just been released, and it had 100 million parameters. Earlier this year, OpenAI released GPT-4, which is believed to have 1.7 trillion parameters, demonstrating the rapid change in model size and complexity in just a few years.

“When considering investment opportunities within AI, it can be helpful to divide them into three layers: hardware, infrastructure, and applications. Scottish Mortgage is invested in companies involved in each of these layers.

Hardware

“The hardware layer is about making the physical computational devices that enable AI. In this layer, since 2016, we have owned NVIDIA, the leading designer of AI chips. The company has a dominant position, with 90 per cent of all generative AI models trained on its chips. It is the critical enabler of AI.

“However, NVIDIA only designs its chips, it needs others to fabricate them. For this, it uses TSMC, the world’s largest integrated circuit manufacturer and a recent addition to the Scottish Mortgage portfolio. It has a dominant position in an industry where scale matters with the latest foundries, such as the three it is building in Arizona, costing over $65 billion. These chip foundries are so critical to supply chains and the economy that they hold geopolitical significance. Consequently, the US government is providing over $10 billion in federal grants and loans to ensure they are built in the US.

“TSMC can be thought of as a royalty on global computing power, just as NVIDIA can be thought of as a royalty on AI. To help make chips, TSMC requires a particularly crucial piece of equipment: lithography machines. For these, it relies on another of our longstanding holdings, ASML, which has a monopoly position in advanced lithography machines. These rely on the world’s flattest mirrors and one of the most powerful commercial lasers to create an explosion 40 times hotter than the surface of the sun to pattern tiny shapes on silicon that measure just a few nanometres. This precision is what allows chips to be made containing tens of billions of transistors. To different extents, all three of these hardware companies benefit from the rise of AI while possessing dominant and near-impregnable competitive positions.

“The founder of OpenAI, Sam Altman is understandably evangelistic and has gone as far as to say that computing power may become the most precious commodity in the world. This is because the demand for computing power and intelligence could be effectively limitless with demand progressively unlocked by supply at ever lower price points. Crucially we are seeing a situation where the cost to serve continues to rapidly fall leading these three hardware companies to face a large structural opportunity even if it will likely remain a bumpy cyclical journey along the way.

Infrastructure

“The next layer is infrastructure. Here, we have the cloud service providers that buy NVIDIA’s chips and offer scalable, on-demand access allowing companies to train and deploy AI models without the overhead of building their own infrastructure. In essence, the cloud service providers democratise access to both computing and AI. There are three dominant cloud service providers. We own Amazon, which operates Amazon Web Services, the largest cloud service provider in the world.

“There are also companies that are building large foundational models for AI. Foundational models are trained on broad datasets (ie large swathes of the internet) that can be used to perform a wide variety of tasks. They are also commonly used as the base upon which to build more specialised AI models. These foundational models have become so large and complex that the computing power and energy required to train them is making them increasingly expensive. The foundational models expected to be released later this year will likely have cost close to $1 billion to be trained. That cost is expected to rise to between $5 billion and $10 billion for the latest models in 2025 and 2026, which is indicative of the growing demand for hardware companies. A consequence of this is that the ability to create such models is fast becoming the preserve of just a handful of mega-scale companies and those receiving their patronage. We have several holdings developing foundational models, such as Meta Platforms, Amazon and NVIDIA.

“Another set of companies providing the infrastructure for AI are database companies. The explosion of data in the world has meant that more data will be created in the next three years than was created in the last thirty years. Companies that Scottish Mortgage owns, such as Databricks and Snowflake, help businesses store, manage, and use that data in the cloud. That same data is also the lifeblood of AI, with companies increasingly looking to feed their data into foundational models, allowing the creation of powerful new applications specific to their business. For example, commerce software giant Shopify has combined its proprietary data and merchants’ data with Open AI’s GPT to create what it calls Sidekick, a conversational assistant that merchants can talk to and ask questions about how to use Shopify’s platform. It can even be asked to accomplish specific tasks, such as compiling reports on best-selling products. AI will allow companies to do more with their data and, in doing so, increase the value of those that offer tools to store, parse and effectively use data.

Applications

“The final layer is the application layer. This is about making productive use of AI in the real world. A significant number of Scottish Mortgage’s holdings are making use of it to expand addressable markets, reduce costs and dig deeper competitive moats. Tesla is using AI to make its cars self-driving and even hopes to leverage those advances to produce humanoid robots. After all, what is a self-driving car if not a robot operating in the physical world? Demonstrative of its progress is that Tesla cars have now driven 1.3 billion miles autonomously, and the company is already in conversation with another major carmaker about licensing its self-driving technology. Recursion Pharmaceuticals is leveraging AI to improve drug discovery by creating a map of human biology that could dramatically cut the cost of developing new drugs. Tempus has built a vast database of over 7 million cancer patients’ clinical records and is applying machine learning to that dataset to enable physicians to make better treatment decisions. Meta Platforms is using AI to improve advertising targeting across its platforms such as Facebook, Instagram and WhatsApp to powerful effect. Spotify is using it to enhance its personalised song recommendations and has released its AI-powered DJ to much fanfare. AI also enables podcasts on Spotify to be translated into other languages using the actual voice of the podcaster.

“The impact of AI across the portfolio is vast because all companies can benefit from the application of intelligence. AI can be thought of as a powerful new set of tools for companies to apply to their business that will, crucially, only get significantly better with time. The companies that will be best placed to use this toolkit will be those with large amounts of proprietary data, software expertise and a culture of innovation. In each of these dimensions, our portfolio companies should be well-placed.

“The opportunities of the application layer in new technology paradigms naturally lag behind those in the hardware and infrastructure layer. Those initial two layers need to scale first in order to support the development of applications. It can also take time and human ingenuity to find ways to leverage and apply powerful new technologies. We can draw an analogy with the smartphone. When the iPhone was released, it was clearly an impactful piece of hardware. Still, it took time for companies and aspiring founders to build applications to utilise the new device’s potential fully. At its release in 2007, it would have been hard to immediately predict the new business models it would go on to enable, such as ride-hailing, food delivery, mobile payments and short- form video apps such as ByteDance’s TikTok. It even took time to appreciate just how meaningful it would be for existing digital activities such as e-commerce, streaming, and social media, which saw their market opportunities greatly enlarged. Over time, the benefits of AI are likely to similarly expand to a greater number of companies and lead to new business models. After all, there is no point in investing billions in hardware and infrastructure if there are not a lot of applications to be built.

“Despite the excitement surrounding AI, it is still important to remember that progress is rarely a straight line. We cannot rule out that there could be a period of digestion following heavy investments in the hardware and infrastructure layer as companies take longer than expected to work out how to use new capabilities.

“Alternatively, we could encounter unexpected limitations to AI models requiring new algorithmic breakthroughs to be made. We are cognisant that the hardware companies, in particular, though currently propelled by insatiable demand, can be viciously cyclical businesses should they hit air pockets of demand. We continue to expect them to perform well but, partially in recognition of this cyclicality, have been making some mild reductions. This has been the case for our largest holding, NVIDIA, following exceptionally strong performance and having grown its net income by over 500 per cent last year.

“Overall, we still believe we are early in experiencing the impact of artificial intelligence. That impact has been most strongly felt in the hardware and infrastructure layers, but it should gradually expand to the application layer. The role of Scottish Mortgage will continue to be to invest in and support progress, and the developments in AI provide robust evidence that progress is continuing at pace.

“On behalf of our shareholders, we invest in transformative change. We’re greatly encouraged by the founders of our portfolio companies telling us that, to them, the pace and magnitude of technological-driven change has never appeared greater. The possibility of such change is a crucial enabler of the outlier outcomes we seek, and aim to deliver for our shareholders.”