340. Risk, resilience and rewards with Scottish Mortgage

7 November 2024 (pre-recorded 21 October 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This interview shares insights into balancing risk, navigating market cycles, and seizing opportunities in dynamic sectors. With a forward-looking perspective, we consider key themes shaping the global markets of tomorrow. However, please note, this interview was recorded prior to the US elections.

Chris Salih (CS): I’m Chris Salih and today we’re joined by Hamish Maxwell, investment specialist on the Elite Rated Scottish Mortgage Investment Trust. Hamish, once again, thank you very much for joining us.

Hamish Maxwell (HM): Thank you very much for having me, I’ve been looking forward to this.

[INTERVIEW]

CS: No problem. Well, let’s get straight into it then. Let’s sort of start by a bit of the sort of process and philosophy behind the fund. I mean, essentially Scottish Mortgage is well known for looking for sort of the most exceptional growth companies, but maybe let’s sort of dig a little deeper and maybe you could explain to the listeners just exactly what that means and sort of how you go about finding those companies.

HM: Sure. So our purpose is to maximise long-term returns for our investors. And to do that we do aim to invest in the most exceptional public and private growth companies. And the businesses we want to own are gonna be addressing large and growing opportunities. They’re often doing that through some sort of new technology or new business model or meeting some form of new demand, which means they can rapidly take market share. And this is what we mean when we sometimes say that change can drive growth.

And our holdings are often doing just that, they’re disrupting industries or even creating brand new ones like, you know, BYD is with electric vehicles, or SpaceX is with space logistics, or Nvidia is with artificial intelligence. So exceptional growth companies have got very strong and enduring competitive advantages within these newer or changing industries, and they’re very often led by founders and they have strong cultures as well.

But the final point, I think, which is really key in terms of our alignment with the sorts of companies we’re looking for, they’re thinking about the long term. You know, you’re not going to change an industry or create a new one overnight. It’s gonna take five to 10 years or more, and it’s gonna involve some mistakes along the way. And then our end of the bargain, therefore, when we find what we think is the best growth company, it’s to be patient and supportive shareholders on that journey.

CS: Just quickly on that then, does that mean a lot of it is trust in the management then, because there’s is a bit of a leap of faith in there, isn’t there? If you mentioned five years?

HM: Yeah, so, you know, we go really deep in our research. We are fundamental bottom up analysts, and our view is that only a few companies in the stock market will generate the majority of returns. The evidence shows that. And so we are looking for those special companies that are doing something unique. They’re able to outcompete others within their industry. And again, it’s this idea that change drives growth. Something about that comes from this sort of founding vision. What’s the point of the company? How did it come to be and what is special about management? And it helps with us being so long term and being able to form relationships with companies, we get good insight to that, to how management and how culture can shape companies and their and their chances of success.

CS: Okay. Sort of after a period of volatility, I mean, I just want to go into a bit deeper onto the edge that you sort of see yourselves having over the market. I mean, how do you think about your sort of levels of concentration versus the market? Maybe just explain to the listeners what that looks like.

MH: Yeah, yeah, yeah. Okay. So to put it, certainly if you want to beat the market, you have to take different views to the market and sometimes it’s worth stating the obvious particularly after periods of volatility. But to do that, you need to be brave enough.

Once you find the companies that you believe in, you have to back them during inevitable periods of tougher performance because active management is ultimately about recognising that most of the thousands of companies in the stock market aren’t actually gonna add material value over the very long term. A lot of them are actually being disrupted by new businesses on new technologies. So it’s about this idea that only a few companies actually matter. And the evidence is really, really clear on this. A small number of companies create the majority of returns. And for us, that’s really exciting. You know, our aim is to invest in just those biggest winners. And it means that, if you’re able to do that, returns can be exceptional.

The edge question is important because by taking that five to 10 year view can be really difficult. You know, investing can be emotionally challenging, particularly when you come up against inevitable periods of adverse sentiment. One thing you can do is look for different sources of information. So again, if you want to beat the market and you take different views to the market, and it’s about trying to find people who can help you understand how the world’s changing. So it’s academics, it’s authors, it’s research institutes, it’s a longer term view and it’s thinking about the things that are going to drive change in economies and societies. And our private company’s exposure helps in that too.

And then the other edge I suppose we can aspire to is a behavioural one because again, it’s this idea that investing can be painful. So if you can be disciplined, if you can avoid a focus on sentiment and what’s happening now, and the macro picture that’s changing things every, you know, one quarter to the next, if you can think about the fundamentals and the longer view, then then the result is, you kind of have a portfolio that can really strongly outperform over five to 10 years. And you mentioned the word concentration. The result for us is by backing conviction. We have ended up with a relatively concentrated portfolio. We can go into that if you wish.

CS: Just quickly, because there’s a few things I wanna unpack there. But just firstly on the emotion in these sort of periods of down,  how hard is it to control that in those tough periods and go like, this business is struggling, but you know, we’re as strong as supporters as ever of it because of A, B, C, D, but everything is telling you maybe we should take the easy route out, sort of here. Is is that a challenge in the role?

HM: Yeah, humans evolution has bestowed upon humans a tendency towards the near term because you’re looking for immediate gratification in your domestic productivity or your agriculture productivity. You’re thinking about one season to the next, the industrial age and the capital age has changed that because we’re doing things on a scale and a timeframe that we never had to before. So it’s about adopting a new way of thinking and avoiding the temptations of the immediate pressures of the market and the immediate stresses.

So think about the period from up until about 2020, right? A decade or so, up to that, up to 2020. There fantastic conditions overall for growth in general — you had low, really low interest rates, you had increasing globalisation and a relatively benign period of geopolitics. Now even through that period, it was important to remind ourselves that we’re gonna come up against volatility. Now that’s gonna happen. And again, the evidence shows that you can’t time it, but it’s gonna come round every decade or so.

The point is understanding what might cause that. So 2022, you saw interest rates go up that has an immediate effect on share prices because of discounting. Basically that’s the maths that incorporates interest rates into share prices. Our job then was to look at our holdings and examine them and ask the question, is anything broken or is this a short term valuation change? And if our confidence is that the fundamentals are still there, we have to discipline ourselves towards that longer term view.

CS: As I mentioned, you mentioned quite a lot earlier on a few buzzwords in the market. We talked about those five year views and disruption. It brings us nicely onto AI. Obviously the predominate growth theme in the market, I think it’s fair to say. But not everything is sort of linked to AI and not everything linked to AI will sort of offer for the good upside. You know, there’s gonna be disruptors, there’s gonna be failures, you know, it is just the nature of it. How do you look for value in that area? Do you go straight to the centre or are you looking sort of in those outer circles to try and figure out where those are?

HM: Yeah, it’s an exciting question. You know, after decades of science fiction, AI is actually here, computers are doing things at a comparable level of intelligence to us, or superior in some ways, and this is really interesting, it’s really valuable in innovation does drive profits. And so your point is correct that AI and AI innovation has been a primary contributor to market performance recently, but there are going to be some companies doing it better, creating more value than others. And for us there’s a few phases.

So phase one is it’s the hardware that makes AI possible. You call them microchips or semiconductors more accurately. But right at the heart of the supply chain, you find three of our holdings. You’ve got Nvidia, which designs the very best chips for AI. You’ve got TSMC that makes chips for companies like Nvidia, and it does so using ASML’s unique machinery, right? So that’s the very start of the hardware supply chain.

Next in the supply chain, you’ve got infrastructure. So these are the companies using semiconductors to make the powerful AI models. And these are companies like the cloud providers or the network infrastructure or data analytics or security. And we like companies in this area like Amazon, Meta, Snowflake, Databricks, and CloudFlare.

But then the last phase the visual, the periphery, the visualisation that you suggested in your question. The third phase is the companies that are incorporating AI models into their business models to improve their productivity or grow their revenue. And you’ve got loads of different examples in the portfolio. Tesla is developing autonomous driving, you’ve got Recursion using AI to to discover new drugs or Chuan the Chinese local services platform that makes recommendations by AI and optimises delivery routes. So there’s loads and loads of excitement by AI, but for us it always comes back to stock picking what are the companies at a fundamental level using this the best.

CS: Well, I’m gonna wrap the sort of next question into that then because obviously you’ve got Nvidia, we all know the Nvidia story, huge growth, sort of keep batting every sort of threat out of the way. Do you still see a huge upside case for Nvidia or is the upside case that outer circle that we just talked about from here or is it both?

HM: Yeah, yeah. I mean, what an amazing company. The $3 trillion chip designer, we first invested in it in 2016. So a good few years before the recent AI explosion and in what nearly 10 years we’ve owned it’s returned over 80 times our original investment. And so this has been one of those, you know, really profound upside stocks. Nvidia made a bet some time ago that their graphics processing unit chips, GPU chips, which are originally designed for computer graphics, that they were actually gonna be ideal for AI. And that proved to be correct. And so what you saw 24 months ago or so when ChatGPT came on the scene and showed everyone just how intelligent AI is becoming. AI awareness grew rapidly, demand grew. And so NVIDIA’s share rise in share price has been a story of earnings growth. You know, it’s PE ratio barely shifted as it moved towards $3 trillion, which is amazing. We have actually reduced Nvidia opposition this year a little bit.

CS: Is that because it’s reaching upper limits or is that for another reason other than that?

HM: So we we can have up to 8% in any one holding that time of purchase. And for our highest conviction positions we tend to use that headroom when we believe in the company. And we have more recently allowed Nvidia to get up nearer there. It was position one in the portfolio, now it’s still in the top 10, but it’s a bit smaller. So it’s become one of the world’s largest companies. The the thing for us is as we look out to the next five years, you start to see a little bit more of a symmetric returns potential versus the asymmetry that we look for. In other words, we are looking for companies that you could do much better if you’re right than the loss if you’re wrong. And it’s become a bit more symmetric for Nvidia simply because they have delivered so much already.

CS: Is that easy to do? Because I mean, a lot of the managers I speak to, there’s a real dispersion in terms of, is Nvidia cheap or not? There’s no real, you know, there’s no sort of real historical test that shows you because it’s delving into the industry that’s sort of so growing so rapidly and so new. How do you reach that point that you just mentioned there?

HM: It’s, that’s exactly the right framing when you’re talking about a company that is breaking new ground. And, you know, as we began this conversation with, that’s the point of Scottish Mortgage and we’ve been doing it for over a hundred years. What the imagination required is a challenging aspect. And so, you know, I mentioned one of the edges that we can try to have as investors and it’s about talking to people. It’s deliberately talking to people outside of the industry to give ourselves a long-term view on the opportunity. So there’s a research institute in Europe, for example, that works on semiconductors. There’s a another research institute in the west of America, which has been thinking about AI for a long time, long before the recent excitement. And so it’s about trying to imagine the possibilities, but it’s such a broad range of outcomes that there is an argument to be had that, you know, NVIDIA’s story is just getting going because so much more is going to be connected to the internet. So much more is gonna become artificial intelligence.

But our decision, it’s still within our top 10, so it’s a large position. We still back this company very strongly what we’ve done. I mentioned Nvidia, ASML, and TSMC. We put a little bit of capital towards TSMC because, you know, it’s another example of upside here where, whatever the latest technology is, TSMC is going to bring it into its fabrication plants. And so that’s a slight diversification within the overall concentration, if that makes sense. If you can allow me that that paradox. But the idea is great upside. There’s just a couple of other interesting ideas as well.

CS: Let’s move on to the private companies. So you can hold up to 30%. Maybe just explain why you include that private allocation and what that gives you. Does it turbocharge the portfolio? Maybe just explain what that specific private does for the listeners.

HM: Yeah. So up to 30% in private companies, I would suggest that this is one of Scottish Mortgage’s strengths. So it’s a blending of public and private in a liquid and low cost form. And that’s actually a very difficult thing to find. So our investment trust format allows us to offer that. And we’re determined to have low fees as well, so that that helps. With the access, the relevance of private companies has been increasing lots over the last couple of decades. The average age of a company in America going to IPO in the 2000 was was eight years old. Today it’s 12 years old. And back in the year 2000, the amount of value in private late stage private markets was around $10 billion. Now it’s near a $2 trillion, right? So there’s a lot of values sticking in that later stage private, and you can go into the reasons for that. Certain types of company companies need less capital these days, for example, or less access to capital markets. But anyway, that is the fact.

So by having an arbitrary distinction at the point of IPO, we’d basically be preventing ourselves from owning some of these fantastic growth companies. In addition to that, we learn a lot from our private companies. It tells us about the type of exciting disruption that’s coming down the line. So not are only are we getting exposure to the likes of SpaceX or Bike Dance, which are doing really well in terms of growth. We’re also learning a lot about the future of economies and societies.

CS: Okay. Just quickly, on the IPO and the offering that market, what does it look like at the moment? Is the sweet shop open? Is there plenty of things going on? Just give us a bit of an insight into just how attractive that market is because it can be feast or famine. So I just want to get a bit of a view on how you’re seeing that at the moment — are you sort of tooling up for lack of a better term?

HM: Yeah, so I mean our exposure by the way is, you know, we’re allowed up to 30%. It’s slightly nearer 20% right now. So we’re using a decent part of that allocation. Private companies were not immune to the equity drawdown that took place in around 2022. So while we saw a lot of activity in 2021, it felt IPO activity fell really sharply. 2022 and 2023 coming into 2024, we didn’t expect a rapid sudden rise in IPOs. What we thought we’d see is a few companies begin to test the water a little bit, and that is roughly what we’ve seen. There’s a number of variables that are beginning to change a bit and we think they could help open things up more fully. So interest rates do matter because they are a near term driver of valuations.

So the uncertainty about interest rate direction has led to some uncertainty about listings. But that could change as we’re starting to see. Politics and geopolitics have also weighed on sentiment. You know, you’ve got, this year was a record breaking year for democracy. Over half of the world, 8 billion people went to the polls and that creates a degree of uncertainty. So companies were, you know, avoiding listing around that. And then there’s also company specific. So businesses want to be as profitable as they can be by the time they they list because that can affect post IPO performance. So there’s a few things which can affect sentiment. They’re starting to become more favourable. And I think when it does change, when sentiment does change, we could actually see quite an increase in IPOs because there’s a lot of companies have been waiting.

CS: And then just lastly, Hamish, I mean your website offers the value proposition, invest in progress. I mean, could you just explain what forms of longer term progress are in your portfolio that might not sort of be in investors’ minds yet, and you know, essentially sell them in terms of what, why you find them exciting?

HM: Yeah, so it comes back to this idea, you know, I mentioned at the beginning, which is change can drive growth and that’s change in science or technology or new forms of demand or new business models and basically companies that are offering consumers something new and better. And therefore consumers rationally spend their money on that new and better thing. And the company takes market share. And there’s loads of really interesting examples in history, going back to steam power, electricity, flight, telephone, radio, computers, connectivity, right? These things were really, really valuable for investors. There’s no debating that.

What’s really exciting for us today though, is that this sort of innovation is taking place today. And for our generation it’s things like artificial intelligence. It’s things like robotics, it’s things like connectivity, genetics, renewables the future of food. Societies and economies are being changed and change can drive growth. To be really good at this, you need to try to, we do aspire to push the the boundary even further and think what’s the next form of change taking place. And we’ve got some exposure in really pioneering areas like quantum computing with site quantum, you know, that could really revolutionise computing power. A whole new paradigm of computers. You’ve got genetic therapeutics, you’ve got drone delivery with the likes of Zipline. And as we see, we hope to see these areas maturing over time and then competing for places in our top 10. You know, that’s the direction of travel we want to see as if we can keep an open mind and if we find the most valuable form of change and we invest in it for the long term, the evidence is clear that your returns can be exceptional and we find that really exciting.

CS: On that note, Hamish, thank you very much for joining us once again today.

HM: Thank you very much for having me.

SW: The trust typically holds between 50 and 100 companies worldwide, united by their strong growth prospects. The managers take a high-conviction approach and can invest up to 30% of the portfolio in unlisted companies. With this in mind, Scottish Mortgage may not be appropriate for lower-risk investors. However, for those seeking exposure to higher growth prospects worldwide, this trust is a well-managed option that focuses on finding tomorrow’s winners. To learn more about the Scottish Mortgage Investment Trust please visit fundcalibre.com