Scottish Mortgage Investment Trust — Annual Report 2001

Managers' Overview & Portfolio Review — Baillie Gifford (year ended 31 March 2001)

Context. A year in which the trust "struggled" as its heavy telecommunications and technology exposure drove a severe first-half downturn (FTSE All-Share -12.8%, TOPIX -31.2% in sterling). The managers sold British Telecom, Deutsche Telekom and Sonera, called Intershop their "single worst misjudgement of the year", and rotated into economically defensive growth stocks.

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Managers' Overview

Scottish Mortgage struggled this year. As the geographic reviews make clear we have suffered from our initial heavy exposure to telecommunications and technology companies. This had been very helpful in the previous year but accounted for the severe downturn in performance in the first half of the year under review. The second half saw our performance virtually match that of the index. The only concern over this period was further underperformance in Europe, where we have been unwilling to move away from the technology sector to the same extent as elsewhere.

Managers' Portfolio Review

United Kingdom

The FTSE All-Share Index fell 12.8% over the year to 31 March 2001. In the first half of this period, the market traded up and down with no firm direction. In the second half sharp falls in telecoms, technology and media stocks led the index lower. The sector moves reversed those of the previous 12 months: previously fashionable sectors stumbled (telecommunications fell 52%, media 36%, and technology 60%) whilst defensive sectors came to the fore. For example, beverages rose 32%, food and drug retailers 26%, and tobacco 47%. Some cyclicals also fared better, notably the housebuilders. We made a further reduction in the UK holdings of £154m.

We made several changes to the portfolio during the year, in general taking steps to increase its defensiveness. Our initially overweight position in telecommunications hurt performance, but our subsequent move to underweight this area and the increased defensiveness of the portfolio helped, leaving us marginally behind the index for the year.

Our perception of the prospects of the telecommunications industry changed dramatically in the course of the year. While growth in mobile phone subscribers has continued apace, the economics of the industry deteriorated. The 3rd generation license auctions saw the start of a large increase in costs for the operators: not only are they now paying much more for licenses, but rollout costs for the new networks are considerable, debt has increased, and there are more competitors in most markets. Our main exposure remains through a reduced holding in Vodafone. We sold British Telecom as serious price deflation emerged in some of its core businesses, debt levels spiralled and earnings estimates were slashed. We also sold smaller holdings in alternative carriers such as Atlantic Telecom and Energis, where overcapacity is driving down pricing even more than we had anticipated.

We have increased exposure to economically defensive stocks that at the same time have reasonable growth prospects. We increased our pharmaceuticals position through the purchase of AstraZeneca, which has an exciting pipeline of new drugs. The merger of Glaxo Wellcome and SmithKline Beecham created one of the world's largest drug companies. We think that if GlaxoSmithKline can reap the rewards of scale while retaining a culture of drug innovation, it should perform well. Our overweight position in tobacco paid off handsomely. In the beverage sector we purchased Allied Domecq. This increasingly focused drinks company offers good scope for growth as well as a low valuation.

We retained a successful overweight in banks. The market became more confident that interest rates were not going to rise much (indeed interest rates finished the period under review 0.25% lower than at the start), and earnings growth remained solid. Our investment in the Royal Bank of Scotland was particularly helpful. After the acquisition of NatWest, the company has found greater cost savings and generated faster growth than the market was expecting. We also increased our holdings in the oil sector as the crude price seemed likely to us to remain higher than the market expected. This turned out to be correct.

We increased our small position in the media sector through purchases of Reed International (business journal publishing) and WPP (one of the largest advertising agencies in the world). Reed is insensitive to economic conditions and is emerging from a period of rigorous restructuring. Fears of a major slowdown in US advertising growth enabled us to buy WPP at an attractive price and the outlook for long-term growth is very solid.

The economic outlook for the UK is fairly favourable. GDP growth is running at 2.5% and whilst unemployment is low inflation is very subdued. The Bank of England has the scope to cut interest rates further and the government to ease fiscal policy once again if the international slowdown proves more damaging than is currently thought likely. Whilst we are still finding it difficult to identify many new buying ideas the British market does offer a degree of stability in both economic conditions and corporate earnings that is welcome at present.

Continental Europe

It has been a very disappointing year for our European investments. The FTSE Europe Ex UK Index lost 15.6% in local terms or 12.6% in sterling after the modest recovery in the euro. Unfortunately our portfolio performed much worse than this owing to its very heavy exposure to technology as well as our failure to participate fully in the rally in economically defensive stocks.

The speed and scope of the profit squeeze in the technology sector surprised us. Whilst we recognised the likelihood of a modest setback as internet idealism faded and capacity increases proliferated we did not expect that demand would fall as sharply as has occurred. Nor did we think that margins would collapse as dramatically as has happened. We were probably too confident in our views given the success of our investments in this area in the previous year. However, we are determined not to sell our holdings in businesses with highly attractive long-term growth opportunities and market positions simply because of the current cyclical problems. Pleasingly we think that many of our holdings are indeed proving their relative strength in the present demanding circumstances.

The initial falls in European markets last spring were provoked by the high cost of 3rd generation mobile phone licences and by evidence of increasing competition in the entire telecommunications market. This was exacerbated by indulgent use of plentiful capital and we responded by selling our holdings in Deutsche Telekom and Sonera, two of the worst offenders in this regard. In recent weeks we have become slightly more confident about the telecommunications sector as excessive competition has died away and as valuations have collapsed. Most notably we have bought a holding in Orange which enjoys an extremely strong position in the French market and which was floated at a low valuation.

By last autumn markets were becoming nervous about the prospects for all technology companies. Telecommunications equipment makers saw orders fall sharply. We have subsequently reduced our holding in Nokia and begun to sell Ericsson. Nokia's share price has suffered from the general deterioration in growth expectations but we admire the way it has exploited the current market weakness to make substantial market share gains. Semiconductor demand and prices fell away at the same time. We have reduced our holding in Philips but we have been determined to maintain our stake in ASML. This semiconductor equipment company has become ever more dominant in world markets through increasing technological leadership and the purchase of an American competitor. Internet related equipment expenditures collapsed by the winter. We were badly hurt by the weak earnings reported by Intershop in this segment. We regard this as our single worst misjudgement of the year and we have subsequently sold the stock.

Our performance in the other sectors of the market was mediocre but improved in the course of the year. We have slowly rebuilt our holdings in European pharmaceutical companies as we have been delighted to see evidence that their pipelines are now healthier than at any time in the recent past. We have purchased Aventis, Novartis and Akzo Nobel as strong examples of this general trend. In the financial sector our general approach has been to focus on the fund management and asset gathering segments. Here two German stocks have impressed us. Deutsche Bank is finally exploiting the strength of its domestic fund management franchise and MLP has proved both dynamic and secure in its dominance of the regular savings market for the German professional classes.

We have been slightly disappointed by indications that the European economy has slowed markedly in recent months. We are concerned by the reluctance of the European Central Bank to cut interest rates as we see no sign that inflation is a danger. Despite these concerns we see no reason to become too gloomy. Helped by widespread fiscal stimulus European economies are still growing, even if at a more modest pace than we had once hoped. Corporate earnings are proving volatile rather than depressing. We would emphasise that many of our holdings are showing pleasing underlying trends amidst the cyclical anxieties. In many industries continental companies are improving their global position. We believe that markets should perform better in the coming year and think that this will also be true of our portfolio.

United States

The S&P 500 Composite Index fell by 22.6% in dollar terms over the year although the strength of the dollar reduced this to a loss of 13.1% in sterling terms. Our US equity portfolio matched this performance despite our slight slowness to reduce the substantial exposure to technology stocks which had contributed greatly to the previous year's good performance.

The most notable development in the United States this year, other than the fall in the stockmarket, has been a sharp slowdown in the pace of economic growth. At the end of 1999 the economy was growing at an annual rate in excess of 8% in real terms. By the end of 2000 growth was barely 1%, although initial estimates suggest a small rebound in the first quarter of 2001.

The Federal Reserve believes that the slowdown is the result of a normal cyclical correction in business inventories, but is concerned that part of the corporate sector's response to this correction, job cuts, may affect consumer confidence and so lead to a more severe downturn. It is therefore willing to cut interest rates sharply in an effort to bolster sentiment. In addition the new Republican administration plans to cut taxes although the size of the package is proving contentious within Congress.

The outlook for consumer spending, which makes up two-thirds of the economy, remains central. The current evidence is mixed. Property prices have continued to rise and purchases of big ticket items such as homes and cars have held up surprisingly well so far. However, borrowing levels are high, the savings rate is low, stockmarket losses have come as a shock and unemployment has started to rise. On balance we think that the current monetary and fiscal easing will prove sufficient to maintain the traditional willingness of the American consumer to support the economy but plainly the next six months will be critical.

The prospects for the technology sector deteriorated far more dramatically than we initially anticipated. Production capacity had risen sharply in the sector in the past two years. When investors reassessed their enthusiasm for financing internet and start up telecommunications ventures capital spending by these companies collapsed. The resulting inventory overhang will take several quarters to clear but we wish to retain positions in a number of technology companies that can demonstrate strong market leadership and bright prospects beyond the current cyclical difficulties.

In the last annual report we signalled our intention to raise the Company's exposure to the wide range of strong businesses available in North America. During the year we made net purchases of £80m, taking the Company's North American stake to 19.5% of total assets. These purchases were largely concentrated in the defensive growth sectors of the stockmarket and included Brown-Forman, a bourbon producer; William Wrigley, the chewing gum company; and CVS, a pharmacy chain. We also increased exposure to the financial and media sectors in anticipation of further interest rate cuts. We are likely to make further additions to the American stake if our current belief that a recession can be avoided is borne out in the coming months.

Latin America

This has been a difficult year for Latin American stockmarkets. Argentina came under pressure because of concerns that the lengthy recession was undermining the country's ability to service its debts and maintain its currency regime. This hurt confidence in Brazil, contributing to currency weakness and higher interest rates. Mexico fared better, benefiting from its stronger economic fundamentals and the continued growth of exports to the US.

Japan

Japanese equities performed even more disappointingly than their global counterparts in the year under review. The combination of the global de-rating of technology and telecommunications shares with disappointment about Japan's sluggish economy and the lack of structural reform created a miserable 12 months for equity investors. The TOPIX declined by 25.1% in local currency terms, and yen weakness worsened this to a fall of 31.2% in sterling terms. Scottish Mortgage's Japanese portfolio lagged this index owing to a high weighting in technology and telecommunications so relinquishing some of the strong relative performance of recent years.

Economic growth failed to match expectations. The initial impetus from exports and capital expenditure met with little response from domestic consumption and gradually petered out as global economic growth faded. On top of this, the fragility of the country's financial system was again exposed. The weak equity market and continuing heavy burden of non-performing loans cast fresh doubts on the capital adequacy of major banks, and several life insurance companies went bankrupt. An ill-timed interest rate rise did not help matters.

The important bright spot against this depressing background was the buoyancy of corporate profits. Quoted companies in aggregate beat their earnings forecasts throughout 2000, and the broader Ministry of Finance survey continues to show corporate Japan's pre-tax earnings growing at a rate of over 30% year on year. This suggests that companies are delivering on their restructuring promises and are achieving a strong recovery in profitability despite the absence of top line growth.

The international collapse of technology stocks had a severe impact in Japan, where valuations had become especially stretched and certain bellwether stocks reported disappointing results. We sold highly rated technology companies that were failing to deliver forecast rates of earnings growth, such as Softbank, Fujitsu, Sony and MCI. However, many other electronics and communications stocks were dragged down by sentiment despite continuing strong operational performance. We took advantage of this to increase the stakes in mobile operator NTT DoCoMo and semiconductor manufacturer Rohm, and to buy new holdings in telecommunications component supplier Kyocera and office automation equipment manufacturer Canon.

Elsewhere in the portfolio we made a successful switch in the automobile sector from Toyota to Honda. This was prompted by Honda's booming US sales and comparatively low valuation. In the retail sector we switched from Ryohin Keikaku to Fast Retailing, whose Uni-Qlo discount clothing outlets are enjoying startling growth.

Near the end of the period more encouraging signs began to appear in Japan. The central bank cut interest rates back to zero, and promised to keep them there until price deflation is over. Meanwhile the government indicated willingness to start the long overdue series of banking sector reforms necessary for improving the strength and efficiency of the country's financial system and process of capital allocation in general. We responded to this by increasing our Japanese weighting, buying the newly merged major bank UFJ, Promise (consumer lending) and Fuji Photo. We are cautiously optimistic about the year ahead and look eagerly for continued evidence that Japan is finally attempting to address its structural problems.

Asia Pacific

The performance of Asian economies has been subject to violent swings over the last year. The single most influential factor behind these changes has been the rise and decline of demand from the USA. Asia's overall economic recovery since the crisis of 1997 has been driven almost entirely by export growth, primarily from America, and as that single prop has been removed, expectations of total economic growth for the region have been revised down accordingly. Weakness in exports has been exacerbated by anaemic demand from Japan and by the fall of the yen.

Countries with the most exposed export sectors, such as Australia, Taiwan and Singapore, have seen the trade slowdown spread quickly into their domestic economies. Their reaction has been to allow their currencies to depreciate and to loosen their interest rate policies in order to sustain some growth. In doing this they have been helped by having greater policy flexibility than other countries in the region such as Hong Kong with its currency link to the strong US dollar.

Stockmarkets have all reacted poorly to the economic slowdown. Unfortunately our portfolio underperformed the FTSE Asia Pacific Ex Japan index, which itself declined by 14.7% over the year. We suffered from our exposure to the weak Korean and Taiwanese markets where earnings expectations dropped sharply during the autumn and winter. Generally technology and telecommunication stocks, the market favourites of the previous year, fell particularly sharply. Our Chinese stocks, Legend and China Mobile, were unfortunately no exception. Our Indian software holdings were also affected by increasing concerns about lower technology spending and we have sold our holding in Infosys in the face of this situation.

The outlook for the next 12 months is unclear. In the short-run Asian markets will continue to be heavily dependent on the development of the American economy. Any renewed weakness in Japanese demand and the yen would carry additional dangers. We are, however, confident that the structural trends in the Asian economy continue to offer us appealing investment opportunities. We have been particularly encouraged by the progress of the Chinese economy in surviving the global slowdown. We think that foreign investment and internal reform will make China and its associated markets an exciting area in the years ahead. Throughout the region entrepreneurial ambitions remain high and the pace of technological innovation pleasing. We are therefore intending to maintain our Asian exposure at around current levels.