Scottish Mortgage Investment Trust — Annual Report 2000

Managers' Overview & Portfolio Review — Baillie Gifford (year ended 31 March 2000)

Context. A year in which the trust outperformed the local indices in Japan, Europe, the Americas and Asia, driven by large technology and telecommunications holdings, while results in the UK were disappointing. The review covers Vodafone's all-share take-over of Mannesmann and the build-up of "New Japan" positions such as NTT DoCoMo and Softbank at the height of the dot-com boom.

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Managers' Overview

Scottish Mortgage enjoyed an outstanding year in overseas markets. As the figures below demonstrate, the Company outperformed the local indices in Japan, Europe, the Americas and Asia by a significant margin. In all of these areas the key contribution was made by our large holdings in the technology and telecommunications sectors.

Results in the UK were disappointing. The portfolio failed to exploit the opportunities in the media sector. Despite reducing our holdings in British banks in the course of the year our heavy exposure to this area was damaging.

Asset allocation relative to the new benchmark of 50% FTSE All-Share and 50% FTSE World Ex UK was helpful. This was particularly the case in the second half of the year when the substantial European weighting greatly aided performance and the belated reduction of the UK position was also beneficial.

Managers' Portfolio Review

United Kingdom

The FTSE All-Share Index gained 7.5% over the year to 31 March 2000. For the first half of this period, the market traded in a narrow range. The second six months was much more volatile and was notable for its very wide range of returns between different sectors. Telecommunications, media and technology were by far the best performing areas of the market as investors focussed on them as the prime beneficiaries of the explosive growth of the internet. The information technology sector index rose by 129% while media registered a 68% gain and telecommunications gained 49%. By contrast, defensive sectors were friendless, especially those where companies are finding profits growth difficult against a background of low inflation. The water sector was the worst performing area of the market (down 30%) followed closely by transport, retail and tobacco.

We made a number of changes to our portfolio during the year, primarily in order to increase exposure to telecommunications and technology at the expense of those companies with poorer growth prospects but also to reduce the interest rate sensitivity of the portfolio. Although these changes were beneficial to performance, our portfolio as a whole lagged the FTSE All-Share Index. Most of the underperformance came at the end of the review period. In particular we suffered from our underweight position in the media sector. We exacerbated this situation by our sale of Reuters on the grounds that earnings continued to be disappointing whilst the market preferred to focus on the internet potential of the business.

Part of the increase in our telecommunications exposure stemmed from Vodafone's successful all-share take-over of Mannesmann. Nearly one in two Britons now owns a mobile phone and we continue to expect rapid growth in subscriber numbers, revenues and profits, as new technologies, such as wireless internet, gain acceptance. Other purchases during the period included Energis, Atlantic Telecom, British Telecom, ARM and Computacenter.

Most noteworthy among the "old economy" additions to the portfolio were the mining companies, Billiton and Anglo American, which are beneficiaries of the strong growth of the global economy. We also increased our exposure to the building sector, purchasing Hanson, the aggregates producer, and a number of housebuilders such as Bovis and Barratt. These additions were funded by the sales of Stagecoach, Boots and Whitbread – all of which announced disappointing profits. In a similar vein, we reduced our stake in Glaxo Wellcome. We also cut back our exposure to the banks sector (including the sale of Halifax) where investor sentiment has been damaged by increasing competition and rising interest rates.

Although the interest rate outlook deteriorated slightly during the year, Britain continues to enjoy a favourable combination of robust growth and low inflation. Growth in domestic demand has been especially strong (with the housing market at its most buoyant since the 1980's) and, as a result, most commentators expect interest rates to rise further over the coming months. Against this background, we maintain a slightly cautious view on UK equities and, after sales of £164m, have reduced our stake to 43.1% of total assets. In part, this reflects our preference for overseas equity markets where the choice of attractive technology stocks is generally greater.

Continental Europe

After a sluggish start European markets performed well in the period under review. The FTSE Europe Ex UK Index rose by 34.6% in local terms although this was reduced to a gain of 21.2% in sterling terms. Our own portfolio performed considerably better than this thanks to dramatic gains in our technology and telecommunications holdings.

During the year we made net purchases of £42m. In the first half of the year we had been disappointed by the halting progress of major European companies such as Daimler-Chrysler and Novartis and this led to a modest reduction in the continental stake. By the end of the year we were considerably happier with the development of the European economy and the advance in corporate earnings. Over the course of the year the European stake has risen to 22.5% of total assets despite the take-over of Mannesmann by Vodafone. Mannesmann had been our largest European holding.

As elsewhere in the world markets have been overwhelmingly dependent on their exposure to technology and telecommunications. European markets are surprisingly well endowed in this respect even if the geographical distribution of technological excellence is at odds with historic economic leadership. Scandinavia rather than France and Germany is the main driving force in Europe's endeavour to respond to American economic dominance. This is most evident in mobile telecommunications. We have added to our large positions in both Nokia and Ericsson as the former retained and the latter regained our confidence in their leadership of respectively the global handset market and mobile infrastructure markets. We have also benefited from ownership of Sonera but we recently reduced our holding as the valuation of its mobile telecommunications technology has become demanding. We have been less enthusiastic about the traditional telecommunications incumbents elsewhere in Europe but in the case of Telefonica we feel that there has been a valiant attempt to build new businesses in the mobile and internet world.

In contrast to the impressive progress of Europe's technology leaders we have been frustrated in our efforts to find attractive businesses in most other segments of the market. In particular we have been disappointed by the failure of most banks and insurance companies to meet the challenges of consolidation and technological change. We have therefore reduced our holdings in the financial sector. We have sold Societe Generale, Banca di Roma and Bayerische HypoVereinsbank on the basis of their flawed approaches to potential and actual mergers. We have also sold Munich Re and reduced our holding in Zurich Allied as we have been puzzled by their managerial approaches. As yet only the sale of Munich Re has proved a mistake and we feel disinclined to rebuild our exposure to major continental financial institutions. The burgeoning flows into European equities and into internet banking seem to us to be captured more satisfactorily through smaller and more vibrant organisations such as Bankinter and Julius Baer.

European markets have enjoyed a buoyant phase. European economies are adequately placed. Growth has improved, inflation has remained subdued and unemployment has fallen surprisingly sharply. The political environment has become more favourable – notably with Chancellor Schroder moving firmly towards economic liberalisation. Despite this the euro has behaved depressingly for reasons that we are still struggling to understand. We do not feel that this should distract us from the appealing economic prospects and exciting corporate opportunities that the continent continues to offer investors.

United States

The S&P Composite Index rose by 16.5% in dollar terms and 17.9% in sterling terms over the year. Our US equity portfolio bettered this performance by a healthy margin. This was a marked improvement in relative performance compared to the previous year and is largely attributable to a substantial increase in our exposure to technology stocks.

Technology stocks accounted for the bulk of the net purchases of £17m, which increased our US stake to 12.9% of total assets. We bought Applied Materials, which is the world's leading producer of capital equipment for the semiconductor industry and Scientific-Atlanta, a producer of equipment for cable broadcasting. We also purchased a series of companies exposed to the strong demand for semiconductors and telecommunications devices: Analog Devices, Texas Instruments and Motorola.

Following another year of strong performance, valuations in the technology area are undoubtedly high by historical standards. Recent turbulence has only sharpened our awareness of the need to monitor our exposure carefully. Nevertheless, while stock prices are likely to be volatile, the fundamental outlook for technology companies remains excellent. This is particularly true for those which, like the bulk of our technology holdings, are exposed to the burgeoning demand for internet infrastructure and mobile telephony equipment.

By contrast, and despite the continuing and exceptional strength of the domestic economy, more traditional sectors of the stockmarket have struggled again this year. This has reflected concerns over the impact on corporate profitability of rises in interest rates, raw material prices and a further tightening in the labour market.

In an attempt to rein in the economy and to pre-empt inflationary pressure the Federal Reserve raised interest rates by a quarter point five times during the Company's year, thus reversing the rate cuts of autumn 1998 and modestly tightening policy. While we welcome these moves, they have as yet had little effect on consumer demand, which has remained extremely robust and has been the main driver of both economic growth and record trade and current account deficits.

Current valuations and the obvious imbalances in the external accounts and the labour market led us to be very selective in our purchases. Despite this we continue to be attracted to US equities by the unrivalled variety of strong businesses to be found there. Our exposure to America is therefore more likely to rise than fall in the year ahead.

Latin America

It has been an encouraging year for Latin America. The Brazilian devaluation in January 1999 had the potential to cause serious macro-economic problems for the region, but policymakers generally reacted responsibly to the crisis. As a result, interest rates and inflation in much of the region are once again trending downwards and economic activity has been accelerating following weakness last year. A more favourable external environment, including the firming of many commodity prices, has helped the recovery. In particular, the Mexican economy continues to benefit from robust demand for its exports from the US. During the year we made £5m of net disposals from the Latin American equity stake but price appreciation increased the value of the holdings to 1.7% of total assets by the end of the year.

We have retained our Argentine bond position, valued at £83.6m or 3.8% of total assets. Argentina has weathered the storm of the Brazilian devaluation, growth is returning and the new President appears to be committed to fiscal rectitude and market-oriented policies.

Japan

The Japanese equity market continued to recover strongly during the period under review as optimism grew over the prospects for economic recovery. TOPIX posted an increase of 34.6% over the year to 31 March 2000, and yen strength increased this to 57.3% in sterling terms. Scottish Mortgage's Japanese portfolio did substantially better than this owing to its focus on 'New Japan' stocks, which boast above-average growth rates and value generation. Japanese exposure rose as a proportion of total assets from 5.4% to 6.8% despite net sales of £46m over the period as a whole. We sold the Nikkei index linked bond in order to invest directly in our favourite companies.

Early 1999 saw a marked improvement in economic conditions, driven by strong growth in export demand and by government-funded stabilisation of the country's precarious banking system. This recovery levelled off in the second half of the year because of a rising currency and continued weakness in consumption influenced by labour market uncertainty, and GDP data indicated that Japan slipped back into recession. However, we are sceptical about the accuracy of these GDP figures, which are based on flawed and incomplete activity measures. Other indicators, such as output-based monthly series, business sentiment surveys and anecdotal evidence from companies, paint a stronger picture. Extremely high rates of expansion in technology sectors, as corporate Japan attempts to catch up with global IT standards, should provide a tangible boost to overall capital expenditure and economic growth.

The stockmarket has been boosted by significant liquidity inflows, both from domestic investors and from foreign institutions. These have been almost exclusively into 'New Japan' telecommunications, media, technology and services sectors, resulting in a polarisation of performance even more marked than that elsewhere in the world. This is partly a reflection of the massive structural problems still facing most traditional 'Old Japan' industrial and financial sectors, and the unwinding of cross-shareholdings between them. We bought stakes in companies such as Softbank, a leading global internet investor, Fujitsu, an IT services and equipment supplier, and Benesse, a provider of educational services, while increasing existing holdings in technology stocks Rohm, Sony and Hitachi. This strategy proved successful, as the valuation premium attached to Japan's relatively small component of high growth stocks expanded dramatically. Our largest holding is NTT DoCoMo, the dominant cellular operator, which rose more than threefold over the year, helped by strong new subscriber growth and rapid adoption of its i-mode mobile internet service.

We reduced our Japanese exposure towards the end of the period under review, on concern that valuations of the market's highflying technology stocks were becoming over-extended by global standards and vulnerable to a change in sentiment, especially in cases where a company's operational performance fell short of expectations. However, we believe that liquidity flows should continue to be supportive of the market during the year ahead, with domestic retail funds expected to shift from maturing postal savings deposits into equities.

Asia Pacific

Asia's economic revival, which had already begun twelve months ago, accelerated over the course of the year. Firm demand from America and a revival of trade with Japan led to strong export performance across the region, which in turn fed through into improved consumption and investment. Even the most depressed economies, notably Hong Kong and China, had moved out of their deflationary phase by early 2000. We comfortably outperformed the 20.2% rise in the FTSE Pacific Basin Ex Japan Index (in sterling terms).

This economic improvement was primarily responsible for the strong movement of stockmarkets in the first half of the year, as almost all Asian markets rose in unison. Latterly there has been a differentiation among Asian markets, which has been a reflection of the sector-driven polarisation witnessed in all major stockmarkets. Those markets such as Hong Kong, Taiwan and Korea, which have a heavy exposure to telecommunications and technology, have fared significantly better. Holdings such as Cheung Kong and Samsung benefited from this trend. We were underweight in Australia, which underperformed steadily throughout the year.

In economic terms, the outlook for the region depends most on the severity of any slowdown in the American economy. That aside, the recovery in most Asian economies seems to have become self sustaining, and any rise in Japanese activity would be beneficial. Much of the export revival stems not from the traditional Asian outputs of commodity goods, but from demand for electronic goods and semiconductors, which are increasingly prominent. Thus trade activity should remain strong as long as global consumption of mobile handsets, set-top boxes and the like continues to swell. With currencies mostly floating and little sign of overheating, there are currently few financial stresses in Asian economies.

Many Asian companies, especially in north Asia, have embraced the opportunities brought by new technologies and the internet with tremendous vigour. This has led to a dramatic change in the established composition of stockmarkets, as traditional heavyweights like banking and property have been pushed aside by fast-growing newcomers in telecommunications and software. China's long march towards the market economy has finally begun to produce companies of genuine importance, and the new entrepreneurialism unleashed in India is potentially bringing another new giant into the picture. These dynamic market conditions are providing copious individual opportunities, but are making the performance of Asian markets increasingly reliant on global industry and stockmarket trends.