We all thought the cockroach was the most indestructible thing on Earth.
Turns out it’s the Nasdaq 100.
When the US index renowned for its high growth and technology stocks plunged 33% in 2022, the obituary writers went into overdrive.
The easy money era was over, they crowed. And with it had died the euphoria for disruptive innovation companies, software as a service, price-to-sales ratios through the roof, and price-to-earnings ratios through the floor.
Value was back! Commodities were king! Dividends were to die for!
Yeah… about all that.
As you were, lads
The Nasdaq didn’t get the memo. It’s surged 39% so far in 2023.
We’ll have to see if this rally is a continuation of tech’s previous decade-long secular bull run or just a dead cat bounce (albeit off a trampoline…)
But one early lesson might be that in an era of ever-faster technological change, you write off the best firms driving those breakthroughs at your peril.
True, all that has really lifted tech share prices this year is valuation multiples expanding as investors have gotten less gloomy about the prospects for inflation, interest rates, and the global economy.
Yet by the same token this is simply the flip-side of the ratings compression that previously drove down the shares of good companies in the crash.
The volatility has been about investor perception, in other words. As for the actual businesses, the best have mostly kept chugging along and posting great results.
The leaders – Alphabet, Amazon, Microsoft, Tesla – didn’t really miss a beat.
Scotland the brave
You might think this should all be music to the ears of shareholders in the UK’s largest investment trust, Scottish Mortgage.
The incongruously-named collective fund from Baillie Gifford is a classic way for adventurous British investors to get exposure to technology – a sector conspicuously absent from London Stock Exchange.
And Scottish Mortgage certainly took its lumps in 2022 with the Nasdaq.
The trust’s shares fell 46%, thanks to a one-two punch of portfolios declining with the market and then, as investor sentiment soured, the gap that opened between the trust’s share price and the value of its holdings (its net asset value, or NAV).
Yet despite the strong recovery in US growth index in 2023, there’s no little relief for Scottish Mortgage. As I write it’s still down year to date!
Pretty frustrating if you were the sort of chump – me, for instance – who bought Scottish Mortgage anticipating a renewed appetite for growth stocks.
I felt the market had been going through one of those phases where it tosses out the baby with the bathwater. And having lived through the Dotcom boom and bust, I saw the post-Covid mania as less deranged. Frothy, sure, but the tech sector was now led by trillion dollar companies doing hundreds of billions in sales. It wasn’t all fantasy metrics this time.
Admittedly Scottish Mortgage favours the more up-and-coming firms that are still – hopefully – growing their way to dominance. The trust doesn’t own so much in the way of those cash-cows that now dominate the Nasdaq.
Still, that strategy had been enough to multiply Scottish Mortgage’s share price 13-fold in the decade to November 2021. A return that trounced not only the market, but almost all its rivals.
So I hoped for a big uplift when sentiment changed and tech rallied again.
Where’s my recovery?
As things have turned out though, I currently feel the same way about my Scottish Mortgage shares as when the sporty boys were picking teams at school and I was left with the shrinking pool of no-hopers.
While the Nasdaq has been flying, its gains – and also those of the much broader S&P 500 index – have been in large part driven by those few tech giants.
Scottish Mortgage, as I said, mostly sold out of such firms long ago to recycle its capital into newer business with theoretically better growth prospects.
It’s not all gloom: Scottish Mortgage’s NAV is actually up nearly 8% year-to-date.
But that pales against Apple (up 56%, year-to-date) or Microsoft (up 48%).
Scottish Mortgage does own Amazon (58% ahead) and Tesla (up 169%). But that’s not been enough to overcome the deadweight of the trust’s less-favoured – or downright disliked – holdings.
Which brings me to the second reason for Scottish Mortgage’s relative weakness – its substantial investments in private unlisted companies.
The market hates private companies right now – and they represent about 30% of Scottish Mortgage’s book.
Private equity and venture capital trusts have been hammered. Most trade at huge discounts. Scottish Mortgage is being heavily discounted too, on account of the unlisted holdings in its portfolio.
Indeed that’s the third problem. Not only did the trust’s discount to NAV not narrow with 2023’s gains – it has actually doubled! As I write the discount is 20%. In theory you can get £1 worth of Scottish Mortgage’s portfolio for just 80p.
Seems a bargain? I agree, which is why I own the stock. But that’s a minority view.
Finally, the strength of the pound in 2023 hasn’t helped. A strong pound reduces the value of overseas holdings to UK investors when converted back into sterling.
A mere 2% of Scottish Mortgage’s assets are British, so recent currency strength has been a major headwind.
All of the above could also be said of Scottish Mortgage’s closest stablemate – the Baillie Gifford US Growth Trust.
I know because – alas – I hold that one too.
It’s a similar story: huge gains prior to the market correction, a large stash of unlisted assets, investor love turning to disgust as represented by a thumping 20%+ discount, and finally the exchange rate acting as a headwind in 2023.
Will this disdain last forever?
I doubt it.
Growth stocks always get hit the most in bear markets. But those vast mega-cap technology firms leading this year’s charge only got to that size by growing there.
Giving up on them during temporary reversals would have been ruinous.
Of course, there’s survivorship bias at play – plenty of would-be giants floundered in their wake – but the quality of Baillie Gifford’s unlisted firms is pretty striking.
Staff at Elon Musk’s SpaceX would surely be astonished to hear its (unlisted) shares are being effectively warded away with a bargepole on the London market, for instance, given the space exploration firm just hit a record valuation $150bn.
Yet as of the last count, more than 3% of Scottish Mortgage’s portfolio – and over 6% of the US Growth Trust’s – were in SpaceX shares. The holdings are implicitly being marked down by investors in London (as reflected by the big discounts) even as investors scramble to get their hands on SpaceX shares in the US!
Most of the trusts’ other unlisted holdings – such as payment processor Stripe – also seem attractive to me.
Even better – for the majority of its holdings in private companies, Bailie Gifford secured preference shares. These offer extra downside protections.
Incidentally, back in the US Cathie Woods’ infamous ARK Innovation ETF – which lost more than two-thirds of its value in 2022 – has rallied roughly 60% in 2023.
That contrasting gain is another a hint as to how a growing discount to NAV and the shunning of unlisted equities have held back Baillie Gifford’s tech trusts lately.
Oh Flower of Scotland
I agree the markets got over-heated in 2021. The mania for the likes of the ARK ETF was palpable. We needed a reset.
And as I’ve conceded, only time will tell if the 2023 Nasdaq recovery has legs.
But no bull market can advance forever largely on the back of half-a-dozen winners. If 2023’s rally is set to go the distance, then more of the momentum will eventually come from the riskier and more exciting growth stocks. Investors will also rediscover their appetite for the most exciting unlisted opportunities.
When that happens, Baillie Gifford’s heroes turned villains will be lauded again.