08 Mar 2012 | Person To Person

Finding opportunity where others fear to tread 

It may not be a widely held view but the management team of Baillie Gifford’s Scottish Mortgage Investment Trust are
feeling upbeat about future prospects.
 

No-one can argue that these aren’t difficult times. Global economies are under huge strain and many companies are finding it increasingly tough to survive as consumers tighten their belts and shy away from spending due to the fear of taking on even higher levels of potentially crippling debt.

However, such a challenging economic backdrop may still present fantastic opportunities for canny investors with that ability to hunt out bargains that could pay them back their commitment many times over in the shape of substantial profit increases during the coming years.

That’s certainly the philosophy of James Anderson and Tom Slater, who manage Baillie Gifford’s Scottish Mortgage Investment Trust with the aim of maximising total returns from a focused and actively managed global portfolio of businesses that have above average returns. “We’re feeling quite optimistic about the outlook for long-term investors – and that contrasts markedly with the doom and gloom you read in the newspapers,” says Mr Slater. “From an investment standpoint there’s a lot of value in trying to think about the potential upside.”

There are a number of reasons for this optimism. The first centres on technology and the impact this has had over the past decade. “There’s never been an era in which a group of already significant companies has been able to grow so quickly with such promise, yet with little requirement for capital,” insists Mr Slater. “This has been down to a combination of rapid technological change, successful networks and globalisation.”

He cites a number of household names as perfect examples. “Sales at Apple are up +39% year-on-year, while those at Google are up +33%,” says Mr Slater. “Amazon’s turnover has risen more than +44% which defies the concept of the apparently dull consumer environment.”

Another important contrarian stance for the Trust is China. Despite the fact that so many commentators are publishing negative pieces on the country, Mr Slater is adamant that it is ignored by investors at their peril.

“There seems to be an almost universally bearish view of what’s going on in China, with everything from it having an inflation problem to the prospect of a house price crash,” he says. “However, we don’t think those arguments bear up to a great deal of scrutiny as China is a multi-decade phenomenon that is capable of throwing up some really interesting investment opportunities.”

For example, Baidu.com, the Chinese internet search provider, is one of the Trust’s largest individual positions and stands out for having fended off Google’s brilliance in this field. This is especially impressive considering there’s very few countries that Google hasn’t managed to dominate. “There’s a very significant chance that this business could be several times its current size five years from now,” predicts Mr Slater. “The internet search potential in China is huge and I think we’ve got a management team that will exploit this opportunity.”

Of similar importance in the portfolio is Amazon. “In Jeff Bezos (founder and chief executive officer) you have someone that owns a very significant portion of the equity, absolutely focused on the long term, and not interested in Wall Street and its quarterly earnings game,” he continues. “Amazon remains a pretty small business relative to offline competition - less than one tenth the size of Walmart - but there’s a very good long-run opportunity for it to grow sales. At the end of 2000 it was a books business but the category it is most excited about at the moment is apparel - and that’s many times the size of the book market.”

Despite these exciting individual stock stories, Mr Slater is unsurprised at the broadly gloomy outlook held by many of his peers. “It’s just human nature that when everyone you’re speaking to is so downbeat about the world you can follow,” he says. “This is particularly the case within the financial services industry which has been the epicentre of the problems and seen 200,000 job cuts last year.”

Scottish Mortgage, which is a low-cost trust with a total expense ratio of 0.5 per cent*, contains around 80 equity investments from around the world which have been chosen due to their longer-term potential. Therefore it bears little resemblance to the benchmark FTSE All World Index.

In fact this benchmark is only used to measure performance over five year rolling periods. Of far greater importance is the focus on achieving adequate diversification and embracing an unconstrained approach with no fixed limits on either geographical or sector exposures.

As long term growth oriented investors the management team acts as owners of stocks rather than renters of the shares. “We are bottom up stock-picking investors and our decisions are made on the basis of companies,” he explains. “Although you will find bigger themes in the portfolio, it’s really important that these are consistent with what you observe going on in the companies you choose to put your money in.”

So what is its investment process? Companies are analysed using questions that aim to assess important issues such as the strength of management, its competitive position, the perception of customers, the prospects for sales going forward, and its valuation. “The first questions we ask are concerned about the scope for significant growth in sales over the next five years and what happens at that point,” explains Mr Slater. “We are very explicitly focused on the long-term growth and continually push ourselves to look beyond the next year or two.”

The questions then seek to analyse competitive advantages, how the management teams at the helm are incentivised, and the valuations placed on it by the market. The end goal for the Trust is to be absolutely clear on how – and why - its view of a stock differs from that of the wider market. In addition, the Trust has scope to own fixed income and has one significant such position in Brazilian Government Index Linked Bonds for the principle reason that it believes the country’s economy looks to be in a pretty strong position.

“If you go back to the financial crisis of 2008/09, Brazil was a net lender to the IMF which is unprecedented in its history and reflects the progress made in addressing past inflation issues,” he says. “It also has an emerging middle class with very significant spending power.”

While struggling to find many individual companies that are exposed to the domestic Brazilian economy, the Trust’s managers expect interest rates to normalise from current very high levels and point out they get paid a substantial real yield on index linked bonds in comparison to equities.

Looking to the future, Mr Slater says the Trust is concentrating on the long-term and explicitly searching for growth by remaining steadfastly stock-focused. “We don’t think volatility within equities is too risky and are confident there are some big opportunities around the world,” he says. “As a global trust we have the opportunity to back those names, regardless of the sector or market they are in.”

Clients that are keen on this approach – and who can recognise the benefits of having a low cost approach in an environment where keeping charges to a minimum should be high up the agenda – may want to consider what the Trust has to offer. “We aren’t trying to offer an index like return and our performance is likely to be more volatile than funds run in that way, so if that’s a concern people shouldn’t become shareholders,” he says. “However, over the longer run we believe our approach may be the best way to generate returns for shareholders.”

For those that embrace the Trust he also urges patience. “Shareholders need to look at our performance over five years,” he says. “The outcome in any one year is little more than random chance. We are focused on the longer term and are feeling positive because of the companies we are able to invest in and the opportunities we see available at the moment.”

*As at 31st March 2011.

Scottish Mortgage Investment Trust PLC
Standardised Past Performance 

31/12/06 - 31/12/07	31/12/07 - 31/12/08	31/12/08 - 31/12/09	31/12/09 - 31/12/10	31/12/10 - 31/12/11
30.1%	-44.8%	52.9%	34%	-15.2%

Source: Morningstar, share price mid to mid, total return

Past performance is not a guide to future performance.

Please remember that changing stock market conditions and currency exchange rates will affect the value of investments and any income from them. Investors may not get back the amount originally invested. 

Investment trusts can invest in emerging markets where difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.

Investing in emerging markets may cause greater fluctuations in the value of the trust compared to investing in established markets.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information on investments which does not constitute independent investment research and accordingly it is not subject to the protections afforded to independent research.

Author: Tom Slater
Tom is the Deputy Manager of Scottish Mortgage Investment Trust.  He graduated BSc in Computer Science with Mathematics from the University of Edinburgh in 2000.  He joined Baillie Gifford the same year and worked in the Developed Asian and UK Equity Teams before joining the Long Term Global Growth Team in 2009. Tom became a CFA charter holder in 2003.