Investors everywhere learn to climb the ‘wall of worry’ so Tom Slater, co-manager of Scottish Mortgage Trust (SMT), got straight to the point at a presentation in the City yesterday – posing a question he knows many of his shareholders ask themselves after a decade in which the investment trust has quadrupled their money.
Should I sell Scottish Mortgage?
It’s a natural question after 10 years in which the global fund bounced back from the financial crisis to deliver an impressive 332% total return. How long can the good times last when the £6.6 billion trust – now ensconced in the FTSE 100 – is packed with US and Chinese ‘technology’ stocks whose lofty valuations seemingly epitomise an over-extended bull market?
Predictably enough, Slater’s answer to his question was an emphatic if unspoken ‘no’ as he made several important points about what he and co-manager James Anderson are doing.
This is not a ‘FANG’ fund
Slater said he understood shareholders’ anxieties as he posed a similar question to himself every day at work. While the managers turned over less than 10% of the portfolio last year and had not taken profits on their winners as other more timid – or pragmatic – investors would do, that did not mean they were not constantly scrutinising their stocks.
Although Scottish Mortgage holds US tech titans Facebook, Amazon, Netflix and Google-owner Alphabet, Slater dislikes the ‘FANG’ acronym, particularly when applied to his fund. Slater said it was a ‘deeply unhelpful term’, drawing false equivalents between entirely different businesses.
He recalled how Scottish Mortgage was referred to as a ‘BRIC’ fund at the start of the century because at the time it invested a lot in the leading emerging markets of Brazil, Russia, India and China. However, the incredible growth in China, which in the first 15 years of the BRIC label added the equivalent of a new economy 2.5 times bigger than the other three nations, revealed what a flawed concept it was, he said.
‘There never was a BRIC and nor is there a FANG,’ Slater stated.
The only thing the FANG stocks – and other companies in Scottish Mortgage’s top 10 – shared in common was their ‘phenomenal growth’, he added.
Did that make them expensive? Not really, he argued, when you considered that the stunning 342% average growth over the past five years in its top 10 stocks was underpinned by sales growth of 248.6%. By contrast, the FTSE All World’s mediocre 82% return over five years was backed by even more paltry sales growth of 17%, making the index look over valued rather than Scottish Mortgage (data to 31/12/17 in sterling).
But was there more growth for these companies to go for, Slater asked?
‘Absolutely massive’ Amazon
Slater is convinced that Amazon (AMZN.O), its biggest position at 8.7% of the portfolio, remains an ‘absolutely massive’ opportunity despite a five-year share price rise of 370%. He pointed out that the $100 billion retail sales it generated in the US last year was under 2% of the market and less than a third of retailing colossus Wal-Mart (WMT.N). Yet it was catching up with huge investment in deliveries leaving its traditional rivals in the dust.
Slater highlighted four areas where Amazon had demonstrated its huge growth potential in 2017: US fashion, food, India and web services.
In fashion the e-commerce giant forced Nike (NKE.N) to cut a deal and start selling its trainers and clothes through Amazon, wiping $1 billion off the shares of sports retailers when the tie-up was announced in June. That was nothing to the $20 billion knocked off grocery stocks with Amazon’s unexpected acquisition of Whole Foods in the same month, he added.
In India, Amazon had showed it had learned from its difficult experience in China and quickly established market leadership, much to the discomfort of its local rival, Flipkart, one of the smaller unlisted positions that Scottish Mortgage has established in the past three years.
Meanwhile, the potential scale of Amazon Web Services was growing all the time as companies moved their computing operations to the Cloud. ‘This is more of a winner-takes-all market than we previously assumed,’ said Slater.
Is it time to sell China?
The ten-fold growth in Chinese consumer spending was an ‘amazing wind up the back’ of Amazon’s equivalents in China: Tencent (0700.HK), the second biggest holding at 7.8%, and Alibaba (BABA.K) in third place with 7.3%.
On ‘Singles Day’, named after the single digits in the date it occurs on 11 November, Alibaba sold $25 billion of goods online, compared to the record $6.6 billion achieved in the US on its ‘Cyber Monday’ a fortnight later.
‘It is the route to market for the Chinese manufacturing sector and it is the distribution channel,’ he emphasised.
Slater was struck by how Alibaba took its remarkable sales growth in its stride. ‘They don’t see it as an achievement but a good way to stress test the platform which they believe will face this kind of volume every day in five years.’
Turning to Tencent, he compared the global leader in mobile internet services favourably to Facebook (FB.O). While they generated similar annual revenues of $32 billion and $36 billion respectively, Facebook relied on advertising and earned an average of $30 a year from each of its users.
Tencent has a different business model: it makes only $2 per user from advertising but charges customers for a growing number of services, whether game playing or ordering a taxi. Given China’s now urbanised population, with 160 cities with over 1 million people compared to just 10 in the US, the growth potential was clear for the network.
Time to sell Tesla or Illumina?
Anderson and Slater get more grief over Tesla (TSLA.O), their fourth biggest holding at 6%, than any other company. There is something about Elon Musk, the visionary founder of the electric car company, and the ten-fold rise over five years in the shares of the loss-making business that winds up other investors.
Slater conceded that Tesla had struggled with a production bottleneck for its latest models but insisted its lead over traditional car makers was growing, pointing to BMW’s failure to unveil a category killer at the Frankfurt motor show in the autumn.
The advent of driverless cars was even more revolutionary, Slater claimed, saying he was surprised that Alphabet’s Waymo division had not received more attention for announcing its success with autonomous cars in Phoenix, Arizona in November.
‘Once Waymo has cracked the Phoenix market it is a relatively little step to see transport systems around the world to adopt autonomous vehicles,’ he said.
Illumina (ILMN.O), the manufacturer of low-cost gene sequencing machines, is having a similarly disruptive effect on healthcare. Scottish Mortgage’s sixth biggest holding – at 5.7% of assets – is the reason why the managers have got back into healthcare, with a total of 15% in the sector having dropped all traditional pharmaceuticals in 2008.
After slumping in 2016, the stock revived last year and is up 355% over five years. By providing the ‘picks and shovels’ for a new generation of medical discovery companies, Illumina had opened up a new era in which patients could expect treatments tailor-made to their genetic make-up. As a result genetic screenings would become common place, boding well for Illumina’s accelerating sales growth.
Search for extreme winners
Scottish Mortgage has invested in 71 new companies in the past five years, more than you might imagine for a low turnover portfolio of 70 stocks. Slater explained that he and Anderson did not need a ‘big funnel’ of ideas but were constantly re-testing their investments to see whether they could deliver a five-fold increase over five years. Perfectly good businesses – such as Danish biotech Novozymes (NZYMB.CO) or US customer relationship management software provider Salesforce.com (CRM.N) – had been sold because they no longer offered the extreme upside they sought, he said.
This is the asymmetry of returns that Anderson has spoken about before. The duo don’t take profits on their big winners because they believe they are still big winners.
Anderson concluded the presentation by returning to this theme, using academic research from last year to show how just 86 stocks had generated half of the $32 trillion net wealth created on the US stock market between 1926-2015.
The clear implication is that investors who think Anderson and Slater still have what it takes to find the equivalents of these 86 stock market giants will probably not want to sell Scottish Mortgage.