Scottish Mortgage’s dire recent share price performance has created a buying opportunity

A wide discount to net asset value and a focus on growth enhance the trust’s long-term appeal

Selecting investment trusts based on recent share price performance is commonplace among private and professional investors. Indeed, it is far easier to justify the purchase of a trust that has vastly outperformed its benchmark over the past one, two or three years compared with a rival that has lagged its peers.

However, recent past performance tells investors surprisingly little about a trust’s future prospects. For example, the Scottish Mortgage investment trust has underperformed its benchmark, the FTSE All-world index, by 31 percentage points over the past year and by 2 percentage points over the past three years.

While the departure of one of its co-managers and holdings of Chineselisted companies during a challenging period for the country’s economy weighed on returns, the main reason for the trust’s underperformance is relatively straightforward. It is unashamedly focused on growth and has suffered from the effects of rising interest rates on company valuations and the global economy.

Not only do rising interest rates mean higher discount rates are used when calculating the present value of a company’s future cash flows, thereby reducing its market value, they cause weaker economic growth that itself slashes corporate earnings prospects. Investors generally pivot to “value” stocks and trusts during periods of interest rate rises as they adopt a defensive mindset that prioritises a return of capital over a return on capital. While such a mindset could persist over the short run, it is unlikely to last in perpetuity. Just as previous economic slowdowns and periods of weak investor sentiment have given way to renewed growth and an ebullient feeling among investors, the current era of negativity is almost certain to follow suit.

Rather than buying value-focused trusts that have outperformed over the past few years, this column believes investors should be positioning their portfolios for growth. Although doing so could mean a bumpy short-term ride, it is likely to lead to attractive returns in the long run as the investment “herd” gradually realises that the status quo is never permanent.

Crucially, growth-orientated trusts such as Scottish Mortgage currently offer supremely attractive valuations. Its shares trade at a 16pc discount to net asset value. This is significantly below their five-year average discount of 1pc and highlights just how unpopular the trust has become.

Even so, it has still delivered a 67pc capital return since first being tipped by this column in August 2017. This is 60 percentage points greater than the FTSE 100’s return over the same period. And over the past decade,

‘During periods of interest rate rises investors adopt a defensive mindset that prioritises a return of capital over a return on capital’

which offers far greater insight into the success of its strategy, it has outperformed its benchmark by 198 percentage points.

The company’s top holdings highlight its focus on long-term growth. For example, semiconductor company ASML, electric carmaker Tesla and battery developer Northvolt are widely expected to experience growing demand for their products as today’s new technologies and cleaner forms of transportation become increasingly commonplace.

Similarly, long-term trends such as higher demand for healthcare as the world’s population grows and rising incomes across emerging markets mean the prospects for holdings such as Moderna and Kering could improve. And with a broad geographic spread, it is exposed to a range of growth opportunities that are set to catalyse its performance over the long run.

The trust has a concentrated portfolio, with its top 10 holdings amounting to 44pc of total assets and the largest 30 holdings accounting for 78pc of its portfolio. Alongside 28pc of the trust’s holdings being private companies, which is close to its 30pc limit and equates to additional risk due to potential valuation challenges, this means its share price performance is likely to be relatively volatile.

Gearing of 15pc has been unhelpful to the company’s share price performance recently. However, it has the capacity to enhance future returns in what is likely to be a far more upbeat period for the world economy.

When an improving economic outlook and stronger investor sentiment will return is unknown. However, the trust’s focus on a range of growth opportunities, its large discount to net asset value and excellent 10-year track record mean it remains a sound long-term purchase. Questor says: buy

Ticker: SMT

Share price at close: 710p