Setting our sights on private companiesCatharine Flood, Corporate Strategy Director, Scottish Mortgage Investment Trust
The value of shares in Scottish Mortgage, and any income from them, can fall as well as rise and investors may not get back the amount invested.
Breaking Down Artificial Boundaries
Over the last decade, a significant and growing number of companies around the world have been staying private for much longer in their development before listing on a public stock exchange. The value created while a company remains private is out of reach of most investors, or at least extremely expensive to access.
In order to maintain the same quality of opportunity set for Scottish Mortgage, we have simply continued to invest directly in any company, public or private, which meets our investment philosophy and criteria. This was achieved with the support of the Board and shareholders. It utilises the benefits of the Company’s closed-end structure and low-cost proposition. There are no additional fees hidden here.
Equity investing is all about capturing long-run compounding returns
One of the important advantages that Scottish Mortgage has when investing in established private companies is the ability to continue owning such businesses as and when they become public companies. This means that it is possible to capture the benefits from the long-run compounding of returns as they grow from a lower starting value.
In 2012, Alibaba became the first private business Scottish Mortgage invested in directly. It became a public company in 2014. Scottish Mortgage still holds every single share in Alibaba that it bought in 2012 as well as many more besides and it has been a top ten holding for years now.
Since then, a number of the other private businesses in the portfolio have also subsequently become public companies, most of which continue to be held today. A handful of the unlisted businesses have been taken over while we have held them. Most importantly though, a wide variety of new private companies have continued to enter the portfolio and the overall number and weight of these have continued to rise over time as this has simply been where the best new investment opportunities were found. We have included this graph from the Annual Report. It shows the growing importance of this flexibility over the last decade.
The graph shows the growth in the total assets of Scottish Mortgage, the growth in the percentage of the portfolio invested in those companies that we initially bought when still private, regardless of their status today and, starting in 2014 at Alibaba’s initial public offering (IPO), the level of the assets which are not listed on a public market. The companies which started out as unlisted holdings, whether public or private today, now account for well over a third of the total portfolio. As shareholders will have gathered from the Company’s Interim Reports, the flexibility to invest in this way has been an important driver of returns over the last decade.
The importance of reputation and relationships
Not only does our reputation open doors when we seek out opportunities, but we have also seen an increasing number of private companies approach us in recent years. Further, as key individuals work with multiple companies, we see a network effect from these relationships. We go on to select only a very few of the opportunities available. Over this financial year, we considered several hundred private companies but invested in only seven.
We have found that it is often possible to have more open discussions with the management teams at private companies, precisely because both sides have made a long-term commitment. This helps to build a solid foundation for our relationship, improving the quality of the insights we gain from those running these businesses. The relationship created during the first couple of years of investment, while Alibaba was still private, helped us to understand the development not only of the company but also of China better. Such relationships can also be valuable in another way. Scottish Mortgage’s initial investment in Alibaba enabled us to invest in Ant Financial, the financial services giant that Alibaba created directly.
Putting the private companies in the portfolio into context
We seek companies where the likelihood of them succeeding in their extraordinary ambitions combined with the potential returns from doing so far outweigh the likely risk to the capital invested from failure. Though size alone is also not a definitive indication of where this balance of risk and potential return might be in a company, it is somewhat more reflective of this than the public/private distinction used as a proxy by many.
Today, Ant is the largest unlisted holding (2.3% of the total) and also the largest such company by market value in the portfolio. Its payments platform alone already handles a multiple of the transactions each day that Visa’s does across the globe, yet payments only represents one of the five broad areas of financial services it offers. Were Ant to be listed on the London Stock Exchange (LSE), it would be the largest company in the FTSE 100 based on its size.
Ant is far from the only private company held already of a scale equivalent to those in the FTSE 100 Index. At the end of March 2020, just under half of the weight of the assets invested in individual private businesses was in companies which would have been already within or very close to joining this group based on their scale, if they were UK listed public companies. Nor is this a new phenomenon. In 2015, when we first invested in Meituan Dianping, it was already of a similar scale to Amazon when we first invested in that company in 2005 and would also have come within the FTSE 100 cohort by valuation. By the time it became a public company in 2018, it was almost three times that size. Similarly, Spotify was already a global company when we first invested in 2015 and would have come within this group on the same basis. Again, it was almost three times that size when it became public. These are not the only examples.
We have included the graph below from the Annual Report, which places the scale of the private companies held against a familiar frame of reference for shareholders. The graph plots the market capitalisations of the companies in the FTSE 100 and FTSE 250 against their rank in those indices. The bubbles on the line indicate approximate equivalent ranking in these indices of the private companies held based on their market value, along with their portfolio weights.
Scottish Mortgage's Unlisted Holdings
The table below ranks these companies by their size and gives their main area of business and their overall portfolio weight .
Unlisted Holdings by Scale
This is a diverse group of businesses, operating across a wide range of industries, but they must also be considered within the context of the whole portfolio for Scottish Mortgage.
The fair valuation pricing policy for these assets is detailed in the Annual Report and on the Company’s website. The disciplined application of our valuation policy means that the prices of these assets will also be impacted during turbulent times in public markets. We saw this most clearly towards the end of the Company’s financial year in March. However, this policy does also ensure that the published net asset values for Scottish Mortgage remain reflective of the prices we would likely be paid at that point for all of the assets in the portfolio, allowing shareholders to make informed investment choices.
Investment Policy Update
Initially, the level of the private companies in the portfolio remained very modest and was monitored by the Board. By 31 March 2016, the unlisted assets represented 11.8% of the total portfolio and it was agreed that it was an appropriate moment to provide further clarity in this area. Shareholders approved a resolution at the Company’s Annual General Meeting (AGM) in June 2016 to update the investment policy. This included the following new provision: “the maximum amount which may be invested in companies not listed on a public market shall not exceed 25 per cent. of the total assets of the Company, measured at the time of purchase.” Although this construction meant that, if this level were to be exceeded, no further unlisted investments may be made while this remained the case, it also protected Scottish Mortgage from becoming a forced seller of these private companies based purely on relative and/or absolute changes in the values of the assets.
As at 31 March 2020, the unlisted assets represented 20.1 per cent. of the total. Though the level has previously been higher than this, it has consistently remained under one quarter of the whole portfolio. While we have not yet been formally prevented from simply investing in the best companies available, in practice as the level draws near to the limit considerations over the best use of the remaining capacity do weigh on the investment decisions taken.
It is just as important to ensure that further investments may be made in those private companies showing real progress, as it is to ensure that all new opportunities may be judged equally on their fundamental merits. Accordingly, we are seeking shareholder approval to raise the current limit by 5 per cent. to 30 per cent. The scale of Scottish Mortgage ensures that this will be a material amount of additional flexibility in absolute, but not relative, terms. It will enable us to continue to invest simply in the best opportunities available, be they public or private companies, without changing the nature of the investment proposition. Without this change, this valuable flexibility will become severely constrained and largely dependent on the timings of the IPOs of our existing unlisted companies, which we believe would be to the clear detriment of shareholders.
IMPORTANT INFORMATION AND RISK FACTORS
The views expressed in this article are those of Catharine Flood and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in May 2020 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is the authorised Alternative Investment Fund Manager and Company Secretary of the Trust. The investment trusts managed by Baillie Gifford & Co Limited are listed UK companies. Scottish Mortgage Investment Trust PLC (Scottish Mortgage) is listed on the London Stock Exchange and is not authorised or regulated by the FCA.
Please remember that changing stock market conditions and currency exchange rates will affect the value of your investment in the fund and any income from it.
Scottish Mortgage invests in overseas securities. Changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up.
The Trust has a significant exposure to unlisted investments. The Trust’s risk could be increased as these assets may be more difficult to buy or sell, so changes in their prices may be greater.
The Trust invests in emerging markets where difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.
A key information document is available here.
This document contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.
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Catharine Flood Corporate Strategy Director
Catharine joined Baillie Gifford in January 2007 and is a Corporate Strategy Director for Scottish Mortgage Investment PLC and a Client Service Director within the Clients Department. She joined Baillie Gifford in January 2008 and is the client contact for Scottish Mortgage Investment Trust PLC. Prior to this role, Catharine specialised in the firm’s International Growth and Diversified Growth strategies, servicing institutional clients in North America and the UK. Catharine graduated BA in Law from Clare College, Cambridge in 1999. She spent a short period working in China before being called to the Bar of England and Wales in 2003.
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