Scottish Mortgage Investment Trust — Annual Report 2002

Managers' Overview & Portfolio Review — Baillie Gifford (year ended 31 March 2002)

Context. A year of two very different halves, dominated by the market collapse after 11 September and the Enron scandal; the trust performed almost in line with its benchmark. UK defensive holdings in tobacco and beverages (Gallaher +25%, Imperial Tobacco +70%) carried performance while Japan was "the most problematic market".

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Managers' Overview

Scottish Mortgage performed almost in line with its benchmark in the last year. This obscures two very different six month periods. In the first half of the year markets fell and our relative performance was also unsatisfactory. Both these factors reversed in the second six months of the year. Given the overall weakness of markets the gearing of the Company was unhelpful and it was this that edged returns marginally below the index.

Performance in UK equities was, however, consistently good throughout the year. The portfolio was underweight in telecommunications and profited from its heavy exposure to defensive growth areas such as beverage and tobacco stocks.

The picture abroad is more complex. Over the course of the year performance in North America was pleasing with good stock selection only marginally hindered by the underweight position in American assets. We were helped by the exposure of the portfolio to financials linked to the buoyant fortunes of the US housing market and by our general avoidance of the more troubled parts of the technology and telecommunications sectors.

Japan was the most problematic market for us this year. The combination of our overweight position and our stock selection caused the underperformance. Details can be found on page 16 of this report. It should be noted that our longer-term performance in Japan remains good.

In Europe the portfolio recovered in the second half of the year. The European holdings tend to be more exposed than those in most other regions to both the economic cycle and the health of financial markets so the Managers regard this area as being prone to volatile results. In Asia we endured a troubled start to the year as an overweight exposure to Hong Kong and weak results in Australia took their toll.

Our performance in bonds was disappointing. Exposure to the telecommunications sector was unhelpful. As noted in the Chairman's Statement Baillie Gifford is devoting considerable efforts to improving results in this area.

Managers' Portfolio Review

United Kingdom

The FTSE All-Share Index fell 5.7% in the year to 31 March. After initial optimism, share prices fell away through the summer as it became increasingly clear the world economy was in trouble and profits were set to disappoint. The terrible events in the US on 11 September led to further sharp falls so that by 21 September, the All-Share Index had fallen some 30% from its level at the start of 2001. In line with most markets, UK equities then staged a strong recovery, encouraged by interest rate cuts and a swift prosecution of the war in Afghanistan. From its September low, the All-Share Index had risen 19% by the end of 2001. Since then, the market has been range-bound.

As in the previous twelve months, the result for the market as a whole masked a wide spread of returns at the sector level. In the first half of the period defensive sectors did well at the expense of cyclical sectors. In the second half, cyclical sectors recovered and defensive sectors were mixed. Banks produced a positive return for the whole year as did oil stocks. The pharmaceutical sector performed well between March and September before falling away. Telecommunications stocks again had a very poor year.

Against this difficult backdrop, the Company's UK stocks performed creditably. Changes made last year had introduced a more defensive slant to the portfolio and the general drift of transactions through this year reinforced it. The largest overweight sector position throughout the year was in tobacco where two stocks were held, Gallaher and Imperial Tobacco. They made an impressive contribution to performance with Gallaher rising 25% and Imperial over 70%. These figures exclude dividend payments. Tobacco manufacturing continues to generate substantial amounts of free cash which enables these companies to increase earnings per share either through share buy backs or selective acquisitions. Gallaher and Imperial Tobacco have both made large acquisitions in the last year which should enable them to maintain their enviable record of earnings growth.

In the beverage sector, we purchased Diageo and increased the holding in Allied Domecq. Diageo is increasingly focused on premium spirits brands and through its acquisition of the Seagram drinks business has assumed a leading industry position. This will have material benefits in terms of scale economies and in increasing its control of the distribution chain. Allied Domecq is also improving the quality of its drinks portfolio and its shares trade at a discount to the market despite better than average cash generation and earnings growth. Both companies saw their share prices make large gains.

The Company has continued to run with a profitable overweight position in banks. Despite the economic slowdown, profits held up well. Our stock selection within the sector produced mixed results with the Royal Bank of Scotland and Lloyds TSB notable successes. The holding in Royal Bank is one of the Company's largest overweight positions in the UK market. The revenue growth and cost cutting produced since its acquisition of NatWest are impressive and should underpin further share price appreciation.

Pharmaceutical stocks traditionally provide a safe haven when market conditions are difficult. Unfortunately, this last year has proved an exception. GlaxoSmithKline had a particularly poor year. It is generating substantial cost savings from the merger last year of Glaxo and SmithKline Beecham but the market has focused instead on temporary weakness in the product pipeline. Although a modest overweight compared to its index position, the share price fall was disappointing. We hope for better in the year ahead.

Heightened tensions in the Middle East supported oil company valuations. We had begun the year with an overweight position. The third oil holding, Enterprise Oil was also reduced towards the end of the year but the bulk of the investment was still held when, just after the Company's year end, it agreed to a bid from Shell.

Last year's report detailed how prospects for the telecommunications industry had worsened because of increasing financial costs and price competition. Our downbeat view on the telecommunications sector stocks proved correct and the underweight position was a major contributor to overall performance.

One pleasing aspect of performance has been the Company's investments in medium sized companies. Many of these have seen strong share price gains, particularly the builders merchant Travis Perkins and the house building stocks. With the housing market buoyant, these continue to look attractive. We have also made efforts to increase the cyclical exposure of the mid cap holdings which should bear fruit as the economy recovers.

Later in the year we increased the cyclical content of the larger capitalisation stocks, notably through the purchase of P&O Princess Cruises, the holiday cruise company. That said, valuations in the UK are reasonable and we are confident the current portfolio can produce a positive return.

Continental Europe

European markets have rallied in the last six months but this could not prevent a second consecutive year of losses after a dismal start to the year under review. The FTSE Europe Ex UK Index fell by 8.1% in local terms and 8.8% adjusted to sterling. Our own portfolio underperformed the index for the period but has recovered sharply in both relative and absolute terms in the last six months. We have cut the exposure to European equities to 15.4% of total assets from 20.5% to reflect our doubts about the continental profit outlook.

The European economy has slowed in the last year but is now showing signs of stabilisation. Within this general picture there have been significant national variations. Once again the weakness of the German economy has been revealed by a slowdown in international demand. The domestic consumer has been unwilling to offset this impact and the burden of former East Germany remains heavy. France has been less seriously affected by the international environment whilst the Italian economy is showing some signs of improved performance and Spain continues to thrive. The European Central Bank is still struggling to find the correct policy balance to confront sluggish growth and lingering inflation anxieties. Any persistent strength in oil prices would complicate their task severely.

Just as the French economy has proved to be relatively resilient so we have also found most of our new purchases in the Paris market over the last year. We have been impressed by the quality of earnings and potential for further growth demonstrated by a surprisingly large range of French equities. We have bought Sanofi-Synthelabo, which seems to us to have one of the most promising pipelines in the global pharmaceutical sector and L'Oreal, which continues to demonstrate an unrivalled leadership of the international cosmetics industry. We have also purchased a holding in the luxury goods company Hermes. Here too earnings prospects are bright and consistent despite the troubles of the important Japanese market. We have even found some opportunities in the more cyclical parts of the French market. BNP Paribas has maintained its credit quality and management poise despite the challenges of the international economy and its own merger process to become one of the most appealing European banking franchises. Publicis too seems to have coped with the challenges of acquisitions and weak demand to turn itself into a major and effective presence in global advertising.

In Germany we found fewer new investments. The exceptions to this have been Porsche and Qiagen. The former continues to thrive in the face of subdued operating conditions in the global automobile industry and we think that its new models and customer focus will enable it to repeat this achievement in the future. Qiagen is a supplier of DNA to the biotechnology sector with an enviable dominance of its niche and a level of profitability that is both high and potentially rising. Of our older holdings in Germany we would note that we still believe in the opportunities offered by the financial services provider MLP despite the decline in the share price over the period and we would note the solid results that the company has reported. In contrast we have been pleased by the strong performance of SAP in the struggling software sector and think that SAP is rebuilding its global leadership after a challenging product transition phase.

The most depressing feature of the year has been the inability of the European telecommunications industry to rebound from its severe downturn. This has forced us to reduce our exposure to both the operators and their equipment suppliers once again. A good example of this trend has been Orange. We admire the ability of Orange to dominate the French mobile market but we have sold the stock as the potential involvement of the company in Germany appears to us to be damaging to both returns and balance sheet. Until there is evidence that consumer demand for 3rd generation mobile services is substantial we will retain a sceptical attitude to telecommunications investments.

The £157m net reduction in European holdings in the last two years has brought our exposure to a level with which we are now more comfortable. The European corporate sector in aggregate has performed more impressively over long periods of time than it is usually given credit for by investors. We see encouraging evidence that strong market positions and impressive product pipelines will enable this to be the case in the coming years too. We are therefore likely to retain our current weighting despite the inevitable nerves that the current real but hesitant economic recovery will provoke.

North America

The US economy remained weak throughout the year but did not deteriorate as much as feared, mainly because private consumption remained strong with the help of cuts in interest rates and taxes. Indeed the economy contracted in only one quarter in calendar 2001, thus avoiding the usual definition of a recession. This performance was all the more noteworthy given the unexpected and tragic events of September 11. Recent economic data suggests that a steady, if undramatic, recovery has now begun.

While an economic recession was avoided, the profit recession continued for the bulk of the corporate sector. Technology and telecom companies were the hardest hit for a second year. Non-recurring charges for the companies in the S&P 500 Composite Index were huge – equivalent to two thirds of the total for the previous two decades. But even ignoring these charges profits were down sharply in 2001. Nonetheless we believe that we are now near the low point of the profit cycle. American companies have been quick to implement substantial cost cuts and so profits should be leveraged to even a modest economic recovery.

The end of a long bull market has, as usual, been accompanied by a number of scandals and frauds of which Enron is only the most publicised. The downturn has also focused wider attention on the extent to which many companies' "true" earnings are significantly lower than their reported earnings. We have continued to emphasize underlying earnings in our analysis and stock-picking and have moved the balance of the portfolio still further towards stocks with clean earnings. Largely thanks to this our US equity portfolio outperformed the S&P 500 which fell by 1.1% in dollar terms and 1.3% in sterling terms over the year.

As foreshadowed in last year's annual report, we have continued to raise the Company's exposure to the wide range of attractive equities available in the US market. During the year purchases exceeded sales by £46m, taking the Company's North American stake to 24.7% of total assets. One notable feature of the sales was the elimination of the portfolio's exposure to the telecoms equipment sector where prospects continued to deteriorate throughout the year, earnings quality is poor and valuations remain high.

The new names in the portfolio can be characterised as offering robust franchises, high quality earnings streams and usually some economic sensitivity. Automatic Data Processing (payrolls), State Street (custodian services) and DST (mutual fund records) are all involved in outsourced processing services and are leading players in their respective niches. Moody's is a bond rating agency, operating in what is close to a duopoly market. Eli Lilly is one of the few pharmaceutical companies with a strong product pipeline. We also increased exposure to the financial sector during the year as interest rates fell. We would anticipate making further modest additions to the American stake in the coming year.

Japan

Japan's equity market again underperformed its global peers in the year under review. Domestic deflation, financial sector fragility and disappointment over the lack of structural reform measures undertaken by the Koizumi administration combined to diminish the attractiveness of Japanese assets. The TOPIX fell by 17.0% in local currency terms, and yen weakness worsened this to a decline of 21.6% in sterling terms. As it became clear the Company's overweight position was inappropriate we reduced exposure significantly. With net disinvestment of £9.7m, the Japanese weighting dipped from 7.5% to 4.4% over the period.

Our relative performance has been disappointing this year. The blame for this lies with individual company decisions rather than the balance of the portfolio. In particular we have suffered from the weak results of Fast Retailing, the previously successful clothing retailer, Konami (video games) and Nippon Electric Glass (where pricing has collapsed). We have sold all these three stocks. We retain a holding in Promise (speciality finance) as we are more hopeful of a return to growth in this case.

Declining equity prices and a huge ongoing burden of bad loan write-offs have exposed the limited size and quality of the city banks' capital bases, ensuring that the equity market was haunted by the spectre of banking crisis. We feel that Japan's malfunctioning financial system, which is hampering both the efficient allocation of capital and effective use of monetary policy, is a major factor in its economic problems. Banks themselves are at last becoming a little more active in addressing their difficulties, taking some steps to improve profitability, reduce risk assets and raise new capital. However, a more aggressive reform and recapitalisation programme is required and the government's lack of action on this crucial issue has been regrettable.

Investors have been disappointed by the lack of policy initiatives since Prime Minister Koizumi came to power in April 2001, given his previous reputation as a reformer. Anti-reform elements in the LDP coupled with bureaucratic inertia have been considerable obstacles to progress, and the tense international political situation diverted Diet attention towards defence issues.

The Japanese economy suffered a major slowdown over the past year, as cuts in global capital expenditure, notably in telecommunications hardware and semiconductor production equipment, have hit the industrial sector. Industrial production fell by 7.9% in 2001 to reach its lowest level since 1994, and companies have reacted by cutting capacity and labour, with unemployment rising beyond 5%. Deflation remains a serious problem, exacerbating the nominal value of debts and postponing planned consumption. Many have called for more active monetary policy from the Bank of Japan in response. Recent data suggests that Japan's economy is reaching a cyclical bottom at last, but the timing and amplitude of any recovery is hard to predict.

Despite disappointments on the political front there are still positive signs of improvement among Japanese companies, which are continuing to cut costs and refocus their operations. On the key issue of shareholder returns we are starting to see some progress, partly thanks to increased foreign equity ownership and direct investment. We invested in Japan's first activist shareholder fund, an unquoted vehicle called M&A Consulting (MAC), which takes large stakes in companies with inefficient balance sheets and exerts pressure on them to improve shareholder returns. It is currently involved in a proxy battle, the first of its kind in Japan, with an apparel maker called Tokyo Style, to force the company to pay a special dividend rather than invest in more property.

We reduced the weighting in financials considerably in further reflection of the sector's difficulties, selling the bank UFJ, securities house Nomura and non-life insurer Mitsui Sumitomo Insurance. We also sold technology related shares, such as SMC, Kyocera and Fanuc, where the valuation seemed to discount fully the likely pace of earnings recovery. New holdings were focused on domestic restructuring themes, with the purchases of building materials suppliers MEW and Tostem Inax.

Valuations in Japan are now more in line with international markets than they have been since the mid 1980s, and we remain optimistic about prospects for earnings and cashflow growth at the companies in which we invest. However, firmer signs of political reform and financial sector stabilisation will be required before we increase our overall weighting in the market.

Asia Pacific

Until October the markets of the Asia Pacific region suffered from the deteriorating global demand picture. From that point on they began to rally strongly, outperforming the rest of the world. Underlying this recovery were the early indications of a business improvement which has recently become more evident. The strength of Asia's rebound reflects its relatively high dependence on export demand, particularly those industries where rapid inventory depletion followed by restocking caused unusual volatility in business orders, such as electronic goods and semiconductors. For this reason Korea and Taiwan were the best performing markets.

The portfolio's poor performance during the year relative to its benchmark was principally caused by heavy exposure to Hong Kong and disappointing stock selection in Australia. An example of our difficulties in Hong Kong was Li & Fung, a company which depends on North American markets, whose share price has been severely affected by the poor conditions in the US during the year but which has begun to recover with the American economy. We have also been disappointed by the performance of Legend, the Chinese PC manufacturer, which has seen some cyclical pressure on sales. Brambles, our largest holding in Australia, has underperformed as it has been experiencing unexpected difficulties in its pallet pool business, which we believe to be temporary.

We reduced our exposure to Asia during the summer, primarily by cutting our Hong Kong holdings, but moved back into the markets in November, concentrating on Korea, Taiwan and India. We bought a large position in Samsung Electronics and repurchased a holding in Infosys, the Indian software company. Both of these we have owned before and have regarded as being attractive investments for the long term but vulnerable to nearer term pressures. The weakness of markets in the autumn was therefore a welcome opportunity to buy them back, and Samsung in particular has since performed well. We have tended to keep faith with our Hong Kong investments in spite of their lack of performance.

Looking forward we feel that the prospects for Asia are relatively good. Even a mild export recovery should provide some support to earnings, and Asian exporters continue to surprise through their product development and cost efficiency. Perhaps more intriguing is the possibility that consumption in the region, which has been very subdued since the Asian crisis of 1997-8, is now showing signs of returning, as economies have paid off debt and investment excesses have been largely corrected.

Other Emerging Markets

During the year, exposure to other emerging markets fell to 2.6% of total assets after net disposals of £8m. The bulk of our stake is invested in Latin America, where stockmarkets had divergent returns over the year. Argentina hit the headlines with the collapse of its currency board, economic implosion and the related political turmoil. However, the very strong performance of the Mexican market was more significant for our portfolio. Mexico continues to benefit from its economic convergence with the US and was particularly helped by signs of recovery in America in the final quarter of the year. Although the Brazilian market was weak over the period, the MSCI Latin American Index rose by 6.1% in sterling terms and our main holding, the Baillie Gifford Latin American Fund, performed significantly better than this.

We continue to find particularly attractive oil companies in non-Asian emerging markets. We have retained our successful holding in Petrobras, the Brazilian integrated oil company. In addition, we have purchased a stake in the Russian oil producer Yukos, where the potential to increase production looks excellent and the valuation is appealing.

Whilst emerging markets are bound to remain volatile we have been encouraged by the ability of the other Latin American markets to cope with the debacle in Argentina. At the same time we are hopeful that in both Asia and Europe there are likely to be more opportunities in emerging economies than has previously been the case. We would expect our holdings in emerging markets to increase modestly in the future.