Scottish Mortgage Downgraded To Sell

It has been a tough period for the country’s biggest investment trust, Scottish Mortgage (LON: SMT), whose growth-oriented portfolio has been hit hard by the sharp increase in interest rates. In 2022 the trust’s share price was down 46% and the shares are currently trading at an 11% discount to NAV.

Despite the sharp de-rating, the broker Investec has just issued a sell recommendation in which they warn that the coming months could bring a second leg of the sell-off. It is all a far cry from when they sat down with lead manager James Anderson towards the end of the global financial crisis and listed to him outline his vision for the portfolio with ‘laser-like precision’.

His views were prophetic with Scottish Mortgage going on to deliver “best in the world” returns, ranking first out of a peer group of 2,408 global funds. From the low point in November 2008 to the peak in November 2021, the NAV total return was 2,921%, an average compound rate of 30.1% per annum.

Anderson retired from the company last April, with longstanding co-manager Tom Slater taking over the helm, but the broker’s concerns are of a more fundamental nature than the change in personnel.

What Could Possibly Go Wrong?

The first point that worries them is that they think the balance sheet looks stretched. In particular the gearing, which they say is 17%, is significantly above the 10% target and the highest it has been for a decade; a real risk given the high beta nature of the listed equity portfolio and the fact that the unlisted exposure is at full capacity.

Scottish Mortgage’s unlisted portfolio currently accounts for a massive 35.9% of the NAV, with Investec concerned about the valuation time lag between these types of late-stage venture capital holdings and similar high growth listed stocks. Although they accept that the manager’s valuation process is more proactive and dynamic than the industry norm, they expect a further significant write-down that has not been fully discounted by the market.

Their other main worry is that they think the unsupportive macro backdrop is likely to continue with more persistently elevated inflation resulting in higher-for-longer interest rates. Given the widely held expectations of US rate cuts by the end of the year, markets would have to adjust to this new environment, which would represent significant downside risk for long duration assets.

Clear Approach But The Environment Has Changed

Scottish Mortgage has a clear objective: to identify, own and support the world’s most exceptional growth companies that have the ability to transform society. This is supported by the managers’ long-term and patient approach, with investments made on a five-to-ten-year horizon.

Slater and his colleagues believe that there is much to be optimistic about despite the new macroeconomic landscape. They say that the drivers of innovation and an acceleration in: technological change, advances in computing power, energy transition and biology are entrenched. This is what really matters and powers the long-term performance.

Investec however are more cautious and believe that SMT is vulnerable to a sharp correction in the coming months, hence their decision to downgrade it to a sell:“In the past quarter, global equities have rallied on hopes that inflation has peaked, the Fed will shortly pivot, a soft landing will be achieved and we will swiftly see a return to the previous regime. We are not as sanguine.”