September 24, 2020

Scottish Mortgage Cuts Its Position In Tesla But Maintains The Long-Term Approach (OTCMKTS:STMZF)

Note: I have written about Scottish Mortgage previously, investors should see this as an update to my earlier article on the company.

The meteoric rise in the Tesla (TSLA) share price over the last year has significantly boosted Scottish Mortgage’s (OTC:STMZF) overall returns. The Baillie Gifford-run investment trust, managed from Edinburgh in Scotland, was one of Tesla’s biggest backers and was its largest external shareholder. Scottish Mortgage (SMT) has gone against its own general long-term strategy and reduced its Tesla holding recently in order to rebalance its portfolio. This is a huge credit to the outperformance that has been seen from the Tesla share price over the last couple of years which has led to Tesla becoming an over-large proportion of the SMT portfolio. Following the reduction in Tesla, Scottish Mortgage has now freed up funds to redeploy into other growth companies and shares, which they have done successfully previously. Scottish Mortgage’s long-term strategy and focus on growth companies remains unchanged and so does my previous thesis – Scottish Mortgage is a long-term winner.

SCOTTISH MORT performance chart

Source: Hargreaves Landown – SMT share price 5-year chart, pink graph is NAV.

Scottish Mortgage sells down Tesla

There was a great deal of media coverage around Baillie Gifford last week as the reduction of their position in Tesla was said to have sparked the sizable fall in the Tesla share price on Wednesday. Whilst I believe Scottish Mortgage’s sale of some of its holding did have an impact on the trading action, I believe it was minute. Rather, the market used the news as an excuse for a pullback in Tesla shares after the huge run-up over the last couple of months – a run-up that continued following the Tesla share split on Monday. As is broadly known, the market’s pricing of individual shares isn’t 100% efficient and trading is constantly driven by sentiment – Wednesday’s trading was no different as Tesla remains an incredibly volatile share with the market constantly struggling to price the entity.

Source: tesla.com

Nonetheless, the sale of SMT’s shares was less down to them seeing Tesla as overpriced but rather about Tesla becoming overweight in investors’ portfolios. SMT fund manager James Harrison put it well:

“The substantial increase in Tesla’s share price means that we needed to reduce our holding in order to reflect concentration guidelines which restrict the weight of a single stock in clients’ portfolios.”

It was the huge success of Tesla that caused the fund to reduce its holding. Nonetheless, the fund still has plenty of skin in the game with Tesla and believes in the long-term story. No update was given as to what specific size the fund now owns, all that is known is that it is now under 5% of the issued capital of Tesla.

Scottish Mortgage was one of the only market quoted investment trusts/funds that has backed Elon Musk and Tesla for a substantial period, believing in the long-term story and the opportunity that it could provide. This belief has paid huge returns to the investment trust which now stands up 294% over the last 5 years. Tesla remains a long-term holding in SMT’s portfolio as SMT allows the majority of its holdings to play out over the long run. Fund manager James Anderson highlighted this when commenting on the recent Tesla sale:

“We are immensely grateful for the extraordinary efforts and achievements of Tesla in driving forward a transportation and energy revolution in the face of persistent skepticism and often downright hostility. Without Tesla’s efforts, the possibility of averting climate disaster would have been significantly reduced.”

SMT doesn’t simply invest to book small gains and then compound these gains, they hold for the long term and seek out revolutionary companies. They stuck to their guns for a substantial period with Tesla as they saw the company as revolutionizing the EV market. They believe that many of the companies they invest in will assist and help to mitigate the most serious problems that the world faces.

How does the fund look now?

Whilst the fund managers cite portfolio imbalance as a reason for the sale, I believe it couldn’t have come at a better time for the fund. Tesla’s share price is hitting all-time highs, and whilst investors could speculate all day over whether the carmaker is overvalued, SMT has seen phenomenal returns and I believe there are now strong arguments for the fund managers to take some money off the table and invest it elsewhere. Of course, for investors looking at SMT now, past performance matters less than the future as prospective investors will be buying near underlying net asset value (NAV) prices after the run-up in the portfolio. What matters now is how the portfolio is shaping up for the future.

Since my last article, other than the reduction in the Tesla position, there have not been huge changes to the portfolio holdings. This was to be expected due to the ‘long-term’ portfolio strategy that Scottish Mortgage abides too. The company still holds 8% in cash, which remains the same as before even after the 7% surge in the S&P 500 over this period. In my previous article, Scottish Mortgage was up 25% YTD, since then the shares have risen another 35%. Part of this rise was largely linked to the strong performance seen from Tesla shares but other tech holdings have also performed very well. Sizable holdings in both Tencent (OTCPK:TCEHY) and Alibaba (BABA) have also driven strong returns. Scottish Mortgage’s large exposure to tech has reaped huge benefits for its shareholders since the onset of COVID-19, as the market has been unable to call the top for many of the technology shares in its portfolio. Scottish Mortgage has been skilled at picking these ‘winners’ as they look for companies that are both resilient and versatile in the current environment. The recent quarterly updates from many of their holdings show astonishing growth rates through the crisis.

There have been some minor changes to the portfolio’s top 10 holdings in terms of the proportion size of each. This is due to some holdings outperforming their counterparts within the portfolio. At the end of July, both Kering (OTCPK:PPRUF) and Ferrari (RACE) had dropped out of SMT’s largest 10 holdings. Spotify (SPOT) has now become the 10th largest holding after the large run-up seen over June which was just after my last article was published, while Meituan Dianping (OTCPK:MPNGF) became SMT’s sixth-largest holding after previously not being in the top 10 holdings. Meituan Dianping has been one of Scottish Mortgage’s top performing shares, surging another 75% since my last article. Due to Scottish Mortgage’s ‘let winners run’ principle, the majority of the portfolio adjustments will be down to sizable share price movements within each holding. The majority of the shares they hold are very volatile and investors must be aware of this – to hold SMT is to have a large exposure to tech.

Scottish Mortgage leaves the majority of its holdings untouched; however, when some shares start to lose traction or underperform, they have been known to reduce their positions or sell them down completely. An example of this was Baidu (BIDU) back in 2019 where underperformance led SMT to sell their whole holding. Poor performance from holdings such as Baidu had stunted SMT’s share price growth. By taking swift action to deploy resources and capital to winners, SMT has delivered exceptional returns.

Risks and Challenges

There are two main risks and challenges facing SMT currently. The first is tech valuations and the concerns that the market may be peaking. While the company does have strong diversification across holdings, they are still heavily exposed to tech. If fears of a second lockdown or another large market downturn do come to fruition, then SMT would be hit hard – more so than other funds, as I would expect Tech/Growth shares to be hit harder than Defensive/Value shares in any market fall. This is, of course, the case with most growth-focused funds so should not come as a surprise to holders of SMT. Over Thursday and Friday of last week, the fund fell 14% through the market pullback. This shows the potential losses the fund could suffer over the short term amid market turbulence.

The second challenge is one of scale. Scottish Mortgage Investment Trust has a market capitalization of £12.4bn and is the only investment trust in the FTSE 100, the UK’s index of its largest shares. With 8% of the fund held in cash, that represents £992m of cash on the balance sheet. When Scottish Mortgage invests its cash, it now needs to take major positions in large companies and that could limit its investment opportunities. This is a well-known feature of successful and popular funds and is something that Warren Buffett at Berkshire Hathaway (BRK.B) (NYSE:BRK.A) understands very well.

Conclusion: Their strategy and my thesis remain unchanged

Following the reduction in their Tesla holding, SMT still holds the same ‘long-term’ strategy. I always focus on this strategy as it is so key to those prospective investors looking at entering Scottish Mortgage – their focus must be for the long term and the belief that Scottish Mortgage has excellent management and can succeed in picking revolutionary shares. The fund trades on a small premium to NAV (2%); however, I still believe this is justified due to the strong expertise of the fund managers in picking the top growth picks.

My thesis remains unchanged from my previous article on Scottish Mortgage as their long-term approach and strong diversification puts them in good stead for future growth. However, investors may wish to wait out a few months or wait for a greater market pullback for a potentially better entry point.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in STMZF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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