Over the last 10 years, the Scottish Mortgage Investment Trust (LSE: SMT) has been the undoubted star of the FTSE 100. In that time period, the share price has risen over 700%. However, those heady days of growth now seem like a distant memory with the share price down 33% in just over two months. But are the shares a value trap or a bargain?
Growth vs. value stocks
The fall in Scottish Mortgage share price recently can be put down to one single factor – investor fear of rising interest rates.
When the pandemic struck, central banks slashed interest rates to 0% and pumped colossal sums of money into the economy. With such favourable conditions, a whole raft of tech-related stocks surged in price. This included many of the stocks that Scottish Mortgage invests in.
However, Scottish Mortgage not only invests in well-known names like Tesla and Nvidia. Of its portfolio, 20% is in unlisted companies. Such companies are highly speculative bets in nascent industries. In other words, they don’t make a profit.
As inflation soars and rising interest rates loom, two problems have emerged with growth stocks:
- Increasing cost of capital eats into the returns of companies that are highly indebted to fuel their growth ambitions
- The future cash flows of tech-related businesses have to be discounted back to the present day by a larger amount to offset the effect of rising inflation
In such an environment, investors are rotating out of growth and into value stocks. These stocks are historically undervalued and offer near-term growth potential. For example, look at Shell and BP. With rising oil and gas prices, they are a much safer bet for investors at the moment than speculative plays.
Is Scottish Mortgage a falling knife?
So, is the Scottish Mortgage share price an opportunity to get a great investment at a lower price, or a danger to be avoided – the proverbial falling knife? This question is best answered by considering an investor’s time frame. If I intend holding the stock for less than five years, then the downside risk outweighs any potential short-term share price bounce. I have for some time argued that the US stock market is in a bubble with many stocks reaching valuations that are completely detached from their underlying fundamentals.
I draw parallels between the unlisted companies in Scottish Mortgage with Cathy Wood’s Ark Innovation ETF. This fund, the undisputed No.1 of 2020, has completely imploded over the last year. Indeed, the highly speculative nature of this ETF reminds me of Neil Woodford’s foray into such investments. We all know how that one ended.
Of course, Scottish Mortgage does invest in high-quality businesses too. Most of these have delivered astonishing growth over the last few years. But the simple reality, is that the higher the stock price goes the lower the expected future returns become; and an ever diminishing one at that, once you factor in runaway inflation.
To my mind, the only way to make money by investing in Scottish Mortgage is holding for the long term (10+ years). That gives the investment trust time for its investment thesis to play out. One only has to look at Amazon and Tesla for evidence of that. Therefore, until the bubble deflates in US equities, I will not be investing. The risks are too great for me.
