Long-term shareholders of Scottish Mortgage Investment Trust (LSE: SMT) have enjoyed handsome returns over the past decade – a return of over 400% in fact. So far in 2022, however, the trust is down by over 40% as investors worry about inflation and other macroeconomic issues. I believe this decline represents an opportunity for me to add to my own position.
What’s in the portfolio?
There has been a noticeable shift in the portfolio over the past couple of years. The trust sold out of Facebook and Google parent company Alphabet, and reduced long-term holdings Amazon and Tesla. The largest holding today is Moderna, the vaccine biotechnology company, which has built a platform that effectively writes code in the form of RNA to program cells. The managers believe the company has the potential to apply its technology well beyond Covid-19 vaccines into areas such as influenza, HIV and even cancer. If so, they think Moderna has the potential to become the first trillion-dollar healthcare company.
Bessembinder’s outliers
For many years, the managers of Scottish Mortgage Investment Trust noticed that the portfolio’s returns were being driven by a vanishingly small number of stocks – usually three to five over a five-year period. This motivated them to seek out academics who might be able to explain what was happening. One was Hendrik Bessembinder, a finance professor who had published a paper demonstrating that almost 60% of global stocks failed to outperform one-month Treasury bills over the previous 28 years. Indeed, between 1926 and 2016, nearly all stock market returns were attributable to just 4% of listed companies. And over half of this wealth creation was created by just 1% of companies!
The trust’s objective is to identify this 1% of outliers as early as possible and hold onto them for outsized returns.
Not without risk
One risk I see with Scottish Mortgage Investment Trust is in the valuation of its private holdings, which at present account for around 29% of the trust’s assets. Unlike their public counterparts, private companies are only evaluated every few months, so we could still see further drops in the value of its private holdings in the near future. There’s also a risk that inflation lingers on, which could put the share price under further pressure as many of the trust’s holdings are early-stage and might need to raise additional capital at higher rates of interest.
That being said, I’m not overly worried about inflation and higher interest rates. Would a macro backdrop of 3% interest rates have severely impaired the underlying operational progress – and the increase in shareholder value – of Amazon or Google over the last decade? I doubt it. The enormous market opportunities they were capturing were secular, beyond FED rates and yield curves.
So, overall, I still have confidence in Scottish Mortgage’s ability to identify the next generation of big winners. And I will be putting my money where my mouth is and adding to my position this year.
