Scottish Mortgage Investment Trust — Annual Report 2003

Managers' Overview & Portfolio Review — Baillie Gifford (year ended 31 March 2003)

Context. A third consecutive year of falling markets (FTSE All-Share -32.1%), closing with the Iraq crisis; the trust's portfolio returned -31.4% against a benchmark decline of 30.6%. The managers discuss the damage done by long-term borrowings, forced equity selling by UK life assurance companies, a bond portfolio that returned 20.1%, and a sizeable increase in emerging-market exposure including Russian oil companies.

---

Managers' Overview

It has been a challenging year for equity investors. All major markets have fallen sharply. We have tried to maintain a balance between exposure to the more defensive areas of the market that have been less badly affected by the harsh conditions of the last three years and an increasing desire to add to our holdings in the segments of world markets that seem to us to have become unduly depressed and that offer more potential gains in the event of improved market conditions. Selected telecommunication and financial stocks fall into the latter category. This task was complicated by the Iraqi crisis with the year-end of the Company falling at a moment of particular global anxiety.

Although we offset a substantial part of our gearing through our successful bond investments the chart below makes it clear that the costs and impact of our long-term borrowings were damaging in the savage equity market conditions of the last year. We retain a belief in the eventual benefits of our gearing but we will continue to examine all our options in a full awareness of the short-term penalties that such a position can exert.

Performance in UK equities continued to be relatively good but we were disappointed that the London market fared no better than its international counterparts. Concern over the deterioration in British economic fundamentals has led us to trim the UK position but we are encouraged by both the prospects of the companies in our portfolio and their depressed valuations.

Our major stock selection problem was in Europe. We regard this as a reflection of both the best long-term corporate opportunities available to us in Europe (which tend to be in economically sensitive sectors such as automobiles) and of the excessive volatility of many continental markets.

In America our stock selection was good for the year as a whole. This was concentrated in the first half of the year when the solid results and low valuations of our holdings particularly stood out in an anxious market. We are still to be convinced that the recent relative rally of technology shares is justified by either corporate fundamentals or valuation levels.

As noted elsewhere we are committed to increasing our exposure to emerging markets. This already made a modest net contribution to our performance last year but we would regard this as an area where the opportunities for the Company are substantial in the years ahead.

Managers' Portfolio Review

United Kingdom

The year to 31 March was a miserable one for investors in the UK equity market. Over this period, the FTSE All-Share Index fell 32.1%. The Company's UK equity investments recorded a very substantial decline. The UK economy grew at a modest rate through the period with employment holding firm at a high level and household incomes rising. Whilst perhaps not the best combination for profit margins, this economic backdrop does not explain such a dramatic loss of investor confidence.

The sharp fall in share prices may be a reappraisal by investors of what the appropriate valuation range is for equities. However, some specific factors can be identified. The most important of these was forced selling by life assurance companies to meet regulatory capital requirements. This forced selling of equities caused further falls in share prices and yet more equity selling.

A second negative factor has been provided by UK corporate pension schemes. For some years now, they have been shifting their asset allocation away from UK equities and into either bonds or overseas equities. This has led to the absence from the market of a major historic source of demand for UK equities.

The Company's UK portfolio has had a defensive slant for the last two years and perseverance with this policy allowed the worst of the declines to be avoided. However, the sell-off was very broadly based and most of the Company's investments declined in value during the year. There were exceptions to this. Once again, the large positions in tobacco companies proved beneficial with the share prices of Gallaher and Imperial Tobacco both posting gains for the year on the back of decent earnings growth and a re-rating. Two of the house-building companies, Bovis Homes and Bellway, also saw their share prices rise. However, these instances are few and far between.

We avoided some of the more precipitous share price declines. The holding in Royal Sun Alliance was sold before it warned over profits and capital strength. We again found no attraction in such diverse companies as Abbey National, BT Group, BAE and Reuters and the absence of their shares from the portfolio was helpful.

One change of view worth highlighting concerns Vodafone, the mobile phone group, which has during the course of the year become the Company's largest single investment. Its profits are growing rapidly as robust sales growth combines with operational and financial leverage, high levels of cash generation permit continued investment in infrastructure and its sheer scale brings benefits in marketing and procurement. It does not, however, signal a change of view on the entire UK telecoms industry. Vodafone remains our only holding in this sector.

Of the other large sectors in the UK market, pharmaceutical, bank and oil stocks all performed broadly in line with the market. We are happy to continue with a large holding in GlaxoSmithKline on the strengths of its modest rating and early stage research portfolio but have been reducing the holding in AstraZeneca where the share price appears too highly rated given uncertainty over new drug launches. Amongst the banks, Royal Bank of Scotland and HSBC and HBOS did relatively well offset by a poor performance from Lloyds. We have reduced the holding in Lloyds. The largest transactions have been in the oil stocks. For much of the period, the prospect of war in Iraq kept the oil price high and we were reluctant to make any significant sales despite an increasing awareness that, for the largest companies such as Shell and BP, long term growth prospects were very poor. However, some sales were made to fund purchases of other oil companies with better prospects notably those operating in emerging markets. A swift prosecution of the Iraq war has now removed any reluctance to sell and further reductions have been made in recent weeks.

Whether an end to military operations in Iraq sparks sustained optimism amongst UK companies and investors remains to be seen. We claim no insight into precisely when the bear market will end. We also recognise how difficult it is to maintain conviction in the benefits of long term equity investment after such a depressing period. However, common sense suggests enthusiasm for the market is better rewarded when stocks are bought on low valuations. We believe UK equity valuations are currently cheap.

Continental Europe

It has been a dismal year for European markets. In local currency terms the FTSE Europe (ex UK) index fell by 42.8%. The rally in the previously weak euro cut this to a decline of 35.7% in sterling terms but this still exceeded the losses in the UK, US and Japanese markets. Our own portfolio performed worse than this after a bad first half of the year although results for the second half were in line with the index.

The main anxieties contributing to this market collapse have been weak economic growth and strains in the European financial system. Germany has been at the centre of both of these concerns. German consumption has remained weak as unemployment has grown and disposable income has remained under pressure from low wage growth, high tax demands and deteriorating demographics. At the same time the perennial problem of inadequate profitability in the German banking industry and the high equity exposure of insurance companies has undermined the solidity of the financial system. These issues will require more vigorous responses than they have yet received if they are not to fester in the years ahead.

Our exposure to the German market is now modest. In the course of the period under review we sold Deutsche Bank and, belatedly, MLP, our only holdings in the financial sector. Our largest holding in Germany is the business software giant SAP which appears to have coped with a demanding environment in exemplary fashion. This company and our two holdings in the automotive industry, BMW and Porsche, are reminders that Germany still offers companies of considerable attraction despite the gloomy economic situation.

The French economy has slowed in the last year but it has avoided the stagnation that is prevalent in Germany. We retain considerable confidence in several of our long-term holdings in the Paris market. Sanofi-Synthelabo (pharmaceuticals), L'Oreal (cosmetics) and the luxury goods company Hermes all fall into this category. The only new purchases this year have been in the telecommunications industry as we think that France Telecom has finally confronted its balance sheet problems and that its Orange mobile subsidiary has an extremely strong position in the domestic market.

The telecommunications industry remains critical to European market trends. This is as true of the Scandinavian equipment suppliers as it is for the operating companies. Whilst equipment demand remains subdued Nokia's dominance of the global handset market continues to grow and profitability has remained strikingly high despite the difficult environment. We have added to our holding in the course of the year. We are less happy with our position in Ericsson where volumes and profitability have been disappointing. We have maintained our holding as we still believe that we have been premature rather than wrong in our belief that improvement will occur.

We have made net sales of £175m of European equities in the last three years. We now have 8.8% of total assets invested in the region and we would be surprised to see this exposure fall significantly further. We can now find many equities with sustainable business franchises selling at low ratings by historical standards, by international comparisons and relative to their local bond markets. The timing of any market rally is uncertain but valuation levels are already supportive. We hope to be able to report better absolute and relative performance in the year ahead.

North America

The US economy grew modestly last year. Meanwhile corporate capital expenditure remained weak in the face of lingering excess capacity and shows few signs of revival. We believe the outlook for the economy remains one of subdued growth as, following the consumer spending spree of recent years, there is little pent-up demand and the scope for further stimulus is limited by the growing Federal budget deficit and the already low level of interest rates.

The US stockmarket fell by nearly a third in sterling terms during the Company's year. This fall was concentrated in the first four months and in this period the Company's defensive portfolio outperformed sharply. Relative performance was weaker in the second half of the year as more cyclical stocks came into favour and as litigation fears resurfaced at Altria, formerly known as Philip Morris. Nevertheless the Company's North American investments outperformed their benchmark for the year as a whole.

For the last three years the Company's portfolio has been dominated by high quality business franchises with clean accounting and defensive growth prospects. While we remain unconvinced that a strong economic recovery is likely, we have slowly increased the cyclicality of the portfolio as we have found opportunities to invest in companies with strong longer term prospects at valuations depressed by difficult recent trading. Among these are two retailers with rather different customer bases: Tiffany, the jeweller, and TJX, the largest American seller of discounted branded clothing. Both have strong management teams and formidable competitive advantages – Tiffany in its carefully nurtured brand and TJX in its scale and buying expertise.

We bought Wyeth, a pharmaceutical company formerly known as American Home Products, after a run of disappointing news, which we think is now ended. The purchase of Wendy's, one of the strongest operators in the fast food sector, was rather less well timed as it was almost immediately caught up in one of the periodic price wars between its rivals McDonald's and Burger King. Other purchases included Microchip, the only large, focused manufacturer of microcontrollers, and Suncor, a Canadian oil company with very substantial reserves and an unusually attractive production profile.

The accounting issues discussed in last year's report have attracted still further attention and a raft of legislative and regulatory initiatives. These reforms are welcome and moderately useful, but the key discipline imposed on companies has come from the markets – falling share prices have been more effective in changing behaviour than regulation. Nonetheless we continue to feel that two important accounting issues have not been fully absorbed by the market – the impact of options grants and pension fund problems at companies, largely in the telecoms and industrial sectors, with defined benefit schemes.

These issues heavily influenced our sales during the year, which largely involved further reductions to our positions in technology and telecoms. We now have no money invested in North American telecoms companies and very little in technology companies. There seems to us little prospect of a strong rebound, given the economic outlook and overcapacity, yet valuations remain high, in both absolute and relative terms, especially when options grants are expensed.

While valuations at the aggregate market level do not yet appear cheap, they are at least more reasonable. Reports such as these inevitably focus on what has changed over the course of the year, but it is important to note that the bulk of the portfolio is unchanged from a year ago. In particular we continue to find our largest holdings, Golden West, Freddie Mac and Wellpoint highly attractive as strong, well managed franchises trading at below average valuations.

Japan

The Tokyo equity market declined again in the 12 months under review, falling by 25.7% in local currency and 25.2% in sterling terms. Although the TOPIX fell to levels last seen in 1984, the market's performance against its global counterparts over the year was relatively resilient. With net investment of £2.0m the Japanese weighting inched up to 4.5% of assets over the period.

Our relative performance has been slightly disappointing this year owing mainly to poor stockpicking among financials. We invested in the city bank UFJ on the grounds that its valuation against core earnings looked attractive, but the share price declined sharply as the equity market focused on balance sheet risk. Consumer lender Promise underperformed as news on non-performing loans continued to deteriorate. We have retained holdings in both, believing that current valuations more than discount asset quality concerns. Elsewhere, Nintendo's share price was very weak as the new Gamecube made little impact on Sony's dominance of the games console market so we sold the holding.

The Japanese economy has enjoyed a mild recovery over the last year. Initial impetus came from a rebound in exports, which encouraged a revival of industrial capital investment, while consumption trends have remained steady despite rising unemployment. Fiscal year 2002 GDP growth seems likely to be reported at around 1.5%, significantly above consensus expectations a year ago of negative growth. Japan's growth dynamics remain export-dependent, but we expect China to continue its emergence as a major stimulant to Japanese growth.

Attention has again been dominated by the travails of the city banks. Although Takenaka's policies in practice have not proved as radical as initially expected, there has been limited progress. A body called the Industrial Revitalisation Corporation has been created to remove problem loans from balance sheets, and the Bank of Japan has started buying banks' equity cross-holdings. Meanwhile the banks themselves have become more proactive in raising new tier 1 capital and cutting costs. Still, it is fair to say that Japan's malfunctioning financial system remains one of the major factors in the country's economic problems, and a final solution is some way off.

We continue to be more impressed by the actions of industrial Japan to improve its margins, balance sheet efficiency and shareholder returns. Despite meagre economic growth, corporate operating profits have bounced back strongly in fiscal year 2002, and share buybacks have accelerated markedly. We are seeing merger and acquisition activity becoming a key element of several important industries, such as semiconductors and steel, as companies at last address problems of overcapacity and lack of focus. We invested in Konica following the announcement of its merger with Minolta; management expects earnings to more than double over the next few years given the potential for synergies and cost cutting in the core office automation and imaging businesses.

With Japanese valuations now on the whole reasonable compared to international counterparts and corporate behaviour improving the equity market has some attractions but the technical situation is currently difficult owing to forced selling by corporate pension funds being returned to the government. Banking reform would encourage us to increase our weighting.

Asia Pacific

During the year to 31 March we have made a net investment of £10m into the markets of the developed Asia Pacific region and £11m into the emerging markets. These both reflect two broad themes, the increasing relative attraction of stocks in these markets on a case-by-case basis, and the emergence of secular trends which appear to benefit these markets disproportionately. Foremost of these is the rising economic influence of China and India, which is causing deflationary cost pressures globally while simultaneously raising demand for a number of basic materials. The investment implications include increasing demand for outsourced goods and services, while volumes and prices for certain commodity-producing companies may be on an improving trend. These provide favourable industry backgrounds for a number of companies in the Asia Pacific and emerging markets. The purchases made during the year have substantially increased our holdings in energy and primary commodities, notably Yukos and Norilsk Nickel in Russia and BHP in Australia.

The Australian market has suffered less badly than most developed markets during the year. The improving background for commodities has lent strong support to the Australian dollar, which has seen significant appreciation over the year. As well as increasing our holding in BHP, we have made substantial changes to our other holdings. Both Brambles and Coles Myer continued to produce disappointing operating performances, and we made complete sales. We bought a new holding in the successful beer and wines company Foster's Group. We also sold our holding in Commonwealth Bank of Australia as we grew concerned that its wealth management business was vulnerable to market conditions, and replaced it with the more conservative ANZ Bank. These changes have been helpful to performance.

In Hong Kong our portfolio is virtually unchanged. Companies like supply chain manager Li & Fung and PC producer Legend have coped satisfactorily with difficult market conditions, and we have made small additions here, but we have been disappointed with the performance of Hutchison Whampoa, whose European telecoms businesses have been slow to make headway. We made a change in Singapore, where we sold Singapore Press, whose growth prospects appear to have been disabled by a persistently feeble local economy, and bought Singapore Exchange, a high-yielding stock with more opportunity to increase its earnings.

We have maintained our relatively large position in Samsung Electronics, although we have some concerns about cyclicality of demand for some of its products. Elsewhere in Korea we sold Kookmin Bank before the development of a serious consumer credit crisis, and took a new position in SK Telecom, one of the most technically sophisticated and well-positioned telecoms operators anywhere in the world. In India we increased the size of our holding in software. After the year-end, however, Infosys reported a worrying loss of pricing power, prompting us to sell out even after a steep fall in the price. We took a new holding in Hero Honda, a producer of motorcycles which benefits particularly from the increase in middle class purchasing power.

Other Emerging Markets

During the year we made a sizeable increase in our exposure to Russia, where we feel that corporate governance continues to improve dramatically. We were rewarded by a rise in the market in contrast to so much of the investment world. We raised our stake in the rapidly growing integrated oil company, Yukos, and bought positions in Norilsk Nickel, Lukoil and Gazprom, three other commodity producers. We also purchased a holding in Teva, an Israeli company that is one of the leading generic pharmaceutical companies in the world. We think that this industry will continue to benefit from major patent expiries from the proprietary pharmaceutical companies.

Latin America was disappointing last year, with the MSCI Latin American Index falling by 37.4% in sterling terms. Although our holding in the Baillie Gifford Latin American Fund outperformed its benchmark by a significant margin, it still suffered a substantial loss. Within this, Mexico was impacted by the weakness in the US economy and Brazil was hit by concerns about the new left-of-centre government. We reduced our exposure to the region during the year but remain positive about the medium term outlook, especially given the current low valuations.

We continue to believe that emerging markets offer the most appealing investment opportunities available to us. Economic and corporate prospects are strong whilst ratings remain reasonable. It is probable that we will make further net purchases in the coming year.

Fixed Interest

As of 31 March 2003 the Company held 29 fixed interest securities and one bond fund with an aggregate value of £94.4m. The average redemption yield on the portfolio is 7.0% and its average expected maturity is 9.8 years. The portfolio is composed exclusively of corporate bonds with a range of credit ratings from AAA to B. The average credit rating using the Moody's credit rating agency's methodology, is BBB-. Over the year the bond portfolio has increased by 24% by market value and the number of holdings by eight. The return on the portfolio over the review period was 20.1%. This was a highly satisfactory result. The income earned on the portfolio is relatively high – its running yield is in excess of 6%.

At the beginning of the review period the Company had significant exposure to bonds issued by European banks. This approach has prospered: as the sophistication of financial markets has grown and regulatory oversight tightened, well run banks have better managed exposure to corporate credit risk than in previous cycles. We have now taken profits on much of this position. We subsequently bought a position in investment grade telecom companies through France Telecom. The company laid out a clear plan for reducing its indebtedness and has the advantage, for now, of unusually high profitability in mobile telephony. France Telecom has executed its recovery plan well so far and the risk premium on the bonds has fallen sharply.

The outlook for interest rates is unclear. The world economy is pulling out of recession more slowly than we were expecting. The outlook for corporate bonds is similarly balanced. There are high expectations of corporate deleveraging allowing over-indebted companies to improve their credit standings. While we see some good examples of this (as in the case of France Telecom), many other companies are falling prey to the consequences of past strategic errors. Within such an ambiguous market environment, successful credit selection and monitoring will be vital.