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Investment trust Scottish Mortgage (OTCPK:STMZF) has seen a turnaround in its share price fortunes since I last wrote. Since I last covered the name in my “buy” piece from last April, the shares are up 27%.
It continues to trade at a sizeable discount to net asset value (NAV), though, and well below its peak of recent years.
The company said this month that its portfolio companies are doing well and have adapted to a higher cost environment. It said that “free cash flow from the portfolio companies (has) more than doubled over the past year.”
Running Out of Ideas?
Having felt when I last wrote about the name that its shares were undervalued, there would have been a case to be made for the trust investing in its own shares.
Since that piece, admittedly, the share price has gone up by over a quarter. That does not necessarily mean that the share price does not still offer good value, though, something I discuss below. This month, Scottish Mortgage announced that it has decided to make at least £1bn available for share buybacks over the next couple of years. That comes on the back of £353m of such buybacks over the past couple of years.
On share buybacks, the company had this to say:
Share buybacks are a key component of capital allocation decisions. Buybacks provide shareholders with significant benefits including improved liquidity in the Company’s shares, an immediate accretion to the net asset value per share and are a strong demonstration of confidence in the underlying valuation of the portfolio.
All fair and good if one takes that line (personally I think that the theory of share buybacks when shares are undervalued does not always equate to value creation for shareholders in practice, for reasons including the price at which shares are actually bought and also the common practice of buying back and cancelling shares only to issue new ones for purposes such as executive remuneration, rather obscuring the wider picture).
In the case of Scottish Mortgage, though, I think a large share buyback (£1bn equates to approximately 8.6% of the trust’s current market capitalisation) raises an additional question: is it the best use of funds that management can envision? I think it is fair to presume that, in proposing sizeable buyback, the trust believes it can create more value than it could through alternative potential uses of that capital, including investing in other companies. As that is the lifeblood of the trust, though, what does that mean? Has it completely run out of ideas? Or does it simply not like the current valuations offered by the sorts of businesses in which it invests, and so for now at least prefers to buy back its own shares?
The rationale for the buyback was given thus: “the Board now intends to take more concerted action to address the discount to net asset value at which the Company’s shares continue to trade.” That seems reasonable if one’s metric as an investor is whether the shares trade at an unreasonable discount to NAV, although in fact, I think when Scottish Mortgage has done well over the past decade it has been by investing in the right growth shares at the right point and letting its own share price broadly reflect that success, rather than by focussing on the discount (or premium) to NAV.
While the trust said its public and private portfolio companies collectively are performing well operationally and when it comes to free cash flow, and that it has strengthened its balance sheet, the buyback announcement was silent on the question of whether it is finding attractively priced compelling investment opportunities in the current market. My presumption, based purely on the buyback, is that it is not.
In November’s announcement of its interim results to the end of September, the trust had this to say:
Our objective is to find companies with the potential for exceptional growth and then own them patiently as they deliver. There are times when stock markets reward this approach and times, as now, when they do not.
That does not necessarily mean that opportunities are drying up: it could be read as a commentary on the trust’s weak share price and NAV discount. Yet at that point, the company also had this to say: “Declines in stock prices have made valuations more attractive.” If that is so, why is Scottish Mortgage now proposing to spend a large sum on its own shares rather than those of other businesses that match its growth focus?
The answer remains unclear, which I find unsatisfactory. I think a fair presumption is that the board reckons a buyback could close the NAV gap, creating value for shareholders, while it hopes its existing portfolio will continue to perform well (questionable if valuations are falling, as while that may not matter in the long term, it will push NAV down) and it can look for more opportunities down the line.
That feels like a conservative, financially focussed approach to me more than the sort of swashbucklng search for growth some investors have come to expect from the trust.
Dividend is Held Flat
At the interim stage, the trust held its interim payout flat. Having last cut its annual payout after the fallout of the 1929 crash, I would not expect a cut in anything other than dire straits. But, seemingly flush with cash (given the size of the buyback), why not raise the interim payout?
The company provided no commentary on this. There are rules on the size of a dividend an investment trust can pay but I do not see that would be an issue here. 2020 also saw a flat interim dividend but an increase in the total for the year, so we may yet see that again this year. Having grown 31% between 2019 and last year, the annual payout has seen strong growth in recent years, but the yield is only 0.5%.
Shares Still Look Cheap
The shares continue to trade at a discount of 15% to NAV. Whether a buyback will close that gap remains to be seen: all other things being equal, it should help.
On top of that, I continue to like the long-term prospects for the trust’s portfolio, as I outlined in my previous piece. Its second biggest holding currently is NVIDIA (NVDA), for example, a stock that has been on fire and yet continues to look cheap on some metrics, dependent on future earnings growth rates.
Accordingly, I maintain my “buy” rating.
But I feel the trust has had a shift in gear. For now, at least, it is not obvious that it is actively growing its portfolio of growth shares, rather than trying to strengthen its valuation by closing a discount gap.
Whether that is a reaction to current market circumstances, or a long-term strategic shift, remains to be seen. The trust managers still talk about the same growth investment strategy, but the buyback move does not sit well with that in my view. Once the buyback is complete, it will be interesting to see how actively (or not) the trust invests in new opportunities, which I think would be the long-term driver of exponential, not incremental growth.
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