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Scottish Mortgage’s search for the holy Grail of investment

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Scottish Mortgage’s search for the holy Grail of investment

High-flying technology ‘unicorns’ are no longer ‘capital light’ businesses like Airbnb and Spotify delaying their stock market flotations, or initial public offers (IPOs), because they don’t need shareholders’ money, says Scottish Mortgage Trust (SMT).

The blunt truth is many of the world’s most innovative businesses just don’t like the hassle of battling what Scottish Mortgage’s James Anderson calls ‘quarterly fund manager capitalism’ in the £5.3 billion trust’s annual report.

Tom Slater, Anderson’s co-manager on the top-performing global fund, picked out Grail, the cancer detection start-up that raised nearly $1 billion from investors this year, as exemplifying the trends they were trying to exploit.

Grail, which last year spun off from Illumina (ILMN.O), the US gene-sequencer that is a top 10 holding in Scottish Mortgage, has leaped into first place in the fund’s increasingly important portfolio of unquoted stocks, with a stake worth £60 million.

Writing in the annual report, Slater said Grail epitomised the reasons why he and Anderson had started to invest in pre-IPO companies such as China’s Alibaba (BABA.K) five years ago.

‘It is building its business, accessing a large pool of capital and investing against a long-term opportunity away from the gaze of public market investors,’ he writes.

‘Having its management and finances scrutinised every quarter by those trying to predict short-term share price movements would likely be a serious distraction and an impediment to underlying progress,’ he adds.

However, unlike some of its 28 unlisted holdings; such as Airbnb, the online accommodation website; and Spotify, the music streaming service; which reached global scale without accessing stock market capital, the new privately-owned, US-based therapeutic healthcare pioneers in SMT’s portfolio, such as Grail, Unity Biotechnology, which is researching a cure for ageing; Intarcia, a diabetes specialist; and Denali, a developer of treatments for neurodegenerative diseases, would require significant funds, said Slater.

‘We do not expect these companies to operate the capital light business models we’ve seen amongst the large online networks. Instead, they are attempting the difficult and expensive task of researching novel therapies for big disease categories,’ he explained.

This marks a big change from the traditional funding of biotech and drug companies which are only granted sufficient money to reach the next development milestone of their products. While that could encourage a frugal and disciplined approach to money, it could tempt companies to prioritise short-term goals instead of long-term objectives, Slater said.

‘We are interested to find out whether more substantive funding for these companies at an earlier stage of their existence will extend time horizons and increase the chances of success,’ said the manager.

Grail, which accounted for 1.1% of SMT at the end of March, needed huge sums of money because of the scale of its ambition to detect cancer in seemingly healthy individuals.

‘To do this it will need to sequence the DNA of hundreds and thousands of people and learn from that information. This can only be done with access to data storage capability on a scale that few companies globally can provide.

‘Human analysts cannot extract useful information from such datasets; advanced learning expertise is required,’ he said pointing out that, as a former engineer at Google, Grail’s chief executive Jeff Huber was the right person to oversee the task.

With shareholder approval, Anderson and Slater have grown the unquoted portfolio to 13% of Scottish Mortgage’s assets. They recently told analysts they would like to expand it to 20%, a big increase but well within the 25% ceiling imposed by the trust’s board.

Although growing in significance, the unlisted investments are not yet generating big returns for shareholders. The annual report reveals it is the ten biggest quoted holdings in companies like Amazon (AMZN.O), which alone accounted for 9.5% of the fund at the end of March, that are doing the bulk of the heavy lifting for investors.

Over half (54%) of investors’ assets are held in the top 10 stocks, which also include Illumina, Tesla (TSLA.O), the electric car to collar energy group, and Tencent (0700.HK), the Chinese internet giant. On their own they generated over two thirds of the portfolio’s return or 25.6% of its 38% increase in net asset value.

By contrast, the unquoted investments barely register in the analysis of returns.

That’s not a problem, says Anderson, because the unquoted companies are there to ‘widen the funnel of opportunity’ and increase the chances of finding the limited number of ‘outstanding companies’ like Amazon and Facebook (FB.O).

Anderson defends the concentrated nature of Scottish Mortgage as a rational response to an astounding statistic. He says a third of the wealth created in US equity markets between 1926 and 2015 came from just 30 out of 26,000 quoted stocks.

This has led him to an important conclusion. Fund management is less about navigating the gyrations of markets or guessing which regions, sectors or even stocks will do well in the next 12 months. Instead, he says his and Slater's job is to provide long-term business stewardship and allocate shareholder money in the support of companies looking for solutions to some of the world’s big problems.

‘Ultimately, we endeavour to generate returns for savers and shareholders by helping to build and sustain excellent businesses over long periods.’

He concludes: ‘Naturally this requires determination and unusual skills on the part of these companies. But over the course of time – often measured in decades – such unusual enterprises can generate abnormal profits and unusually high shareholder returns.’

Scottish Mortgage is the second best performer in the AIC's Global sector with a 302% total shareholder return. At yesterday's closing price of 397p the shares stood at 3% premium above their net asset value.  


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