Scottish Mortgage Investment Trust — Annual Report 2004

Managers' Overview and Managers' Portfolio Review — Baillie Gifford (year ended 31 March 2004)

Context. A recovery year after the prolonged bear market: the trust exceeded its benchmark return by a considerable margin (NAV per share +33.6% against a 24.7% benchmark rise). The managers moved the trust's oil exposure away from the UK majors towards emerging-market producers and continued to raise exposure to Asia and Emerging Markets, which they describe as a historic shift in the global economy that will dominate the investment scene for the next 20 years. The review text carries no individual byline; elsewhere in the report James Anderson is named as manager of the portfolio.

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Managers' Overview

It is pleasant to be able to report on a much improved year. This comes as a relief after the prolonged bear market but we are particularly pleased that we have been able to exceed the benchmark returns by a considerable margin.

Part of our success stemmed from maintaining our gearing. It need scarcely be said that the experience of recent years has made us very conscious of both the dangers and opportunities inherent in long term borrowings. We have made significant improvements in our bond capabilities in recent years and this should allow us to handle our borrowing levels more effectively and consistently in the years ahead with the guidance of the Board.

At a geographical asset allocation level we have continued to benefit from our rising exposure towards Asia and Emerging Markets. We think that this reflects an historic shift in the global economy that will dominate the investment scene of the next 20 years. There will, of course, be interruptions to this process as politics, valuations and — above all — economic cycles play out and we will try to take account of these whilst keeping the strategic picture firmly in mind.

For the third year in a row overall stock selection has been positive. UK performance continued its consistent record whilst the contributions from Asia and Emerging Markets selection were noteworthy and that from Europe a relief after a period of poor performance. There were no major areas of concern with both America and Japan performing in line with their regional indices. We regard all these figures with a degree of interest but it is far more important to consider the overall stock selection picture as we view the Trust's portfolio on an integrated global basis. We have, for example, added significantly to our returns by moving our oil exposure away from the UK towards Emerging Markets.

Our current view is that world economic growth will be strong in the year ahead and that corporate earnings are likely to continue to rise. We see some signs of renewed dividend growth which is refreshing. Whilst the global political scene remains of serious concern we think that the decisive issues in the year ahead will prove to be the sustainability of strong growth with low inflation. Britain is no exception to this issue but developments in America and China will be critical. We are cautiously optimistic.

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Managers' Portfolio Review

United Kingdom

In common with other stockmarkets around the world, UK share prices staged a very welcome recovery in the year to 31 March. We believe this rise in share prices is well-founded. Though an important element of the recovery is the increased willingness of investors to own sometimes volatile assets, there has also been an improvement in profitability at many companies. We are also encouraged by the fact that, after a long period of rather paltry distributions, the average rate of dividend increase from UK companies has begun to accelerate.

The performance of the Company's UK investments was strong in absolute terms and tolerably good when compared to the wider UK market — the Company's UK investments returned 32.4% which compares to the total return on the FTSE All-Share of 31.0%. Many holdings saw exceptional gains in their share prices, most notably the hedge fund manager Man Group, the building materials distributor Wolseley and the cruise-line operator Carnival. It is particularly encouraging that these share price gains have been accompanied by operational performance that either met or exceeded our initial expectations. The Company also profited from additions to more cyclical stocks such as the electronics group Spirent and the publishing company United Business Media.

Inevitably there were parts of the portfolio that shone less brightly. Where this was felt to reflect a fundamental disappointment in the business, the holding has been sold. However, we have been reluctant to dispose of long-standing investments which have performed well operationally simply because their share price has lagged the market during the last 12 months. Vodafone, for example, delivered a total return half that of the market but we believe the likely progress in its earnings will reward handsomely the patient investor and we have therefore increased the holding. Similarly, the number of shares held in Royal Bank of Scotland is higher now than a year ago. The investments in tobacco companies which, in aggregate, lagged the market return have also been increased.

The net effect of transactions though has been to reduce the Company's exposure to the UK market. Primarily, this has been a function of views on individual stocks and the fact that, whenever our enthusiasm for a particular UK-domiciled company waned, we did not automatically seek to reinvest the proceeds of any sale into other UK companies but instead looked to where that money can be most profitably invested regardless of geographic domicile.

The clearest example of this effort is the transactions in the UK oil majors, BP and Shell. Having begun the period under review with some £34m invested in these stocks, Scottish Mortgage no longer has any money invested in either of the two companies. We are not persuaded that either company can provide the investor with a total return in excess of that offered by the wider UK market. Instead, any enthusiasm for oil exposure has been channelled into other companies, often domiciled in developing countries, whose production prospects appear stronger and whose valuations are usually lower.

The other aspect to the reduction in UK exposure, though less important an influence than stock specific views, is that the duration and extent of the earnings recovery in the UK may prove less than that in other markets. The British economy has been relatively robust in recent years and this means there is less scope for a cyclical rebound in earnings. The economy has also been supported by enthusiastic borrowing on the part of consumers. The gradual tightening of monetary policy that the Bank of England appears to have embarked on is likely to restrain this hitherto important contributor to growth.

Continental Europe

European stocks rose sharply in the year under review. The European economy deserves very little credit for this as the global recovery was barely perceptible in continental data. Some of the responsibility for this depressing state of affairs lies with the appreciation of the Euro but it has been disappointing that previously relatively buoyant economies such as France have succumbed to the widespread stagnation and that even Ireland has shown only moderate growth. The strength of European markets was instead a reflection of the intense sensitivity of many continental companies to the progress of the global rather than regional economy. For many of the more successful companies this has allowed sales and profitability to benefit from the boom in Asia whilst for others falling global interest rates and risk premiums have allowed balance sheet restructuring and an end to threatened insolvency. We have concentrated on the higher quality set of these companies but we have also profited from the recovery in troubled shares such as Ericsson. In combination this has enabled us to outperform the regional benchmark and to contribute to the overall performance of the Trust.

Looking forward to the year ahead we see little evidence that European growth is likely to accelerate. We therefore intend to retain our focus on companies that have the geographical range and competitive strengths to enable them to flourish globally. Long-standing examples of this approach include the French hair care giant L'Oreal and the luxury goods company Hermes. Perhaps less predictably we would make similar claims for several European industrials. For instance, BMW and Porsche both seem to us to exemplify brand strengths that comfortably transcend the limitations of the German domestic market. Equally the manufacturing skills and broad international operations of Atlas Copco, MAN and a revived ABB appear to us to offer good earnings growth rates and low valuations. SAP has thus far demonstrated the market leadership and growth potential to show that there are some areas of technology where Europe can compete but the faltering efforts of Nokia have disappointed us.

Given the unpromising economic and political prospects we see little reason to expand our European holdings. We much prefer to focus on the small selection of companies that appear to us to be both globally competitive and attractively rated than to build an entire portfolio of stocks that gives broad exposure to continental equities and economies. We hope that this approach will again be successful in the year ahead.

North America

The US economy grew rather faster than expected last year as tax cuts and mortgage refinancing boosted consumer spending. The scope for further such stimulus appears limited — the budget deficit is approaching 5% of GDP and interest rates are expected to rise this year [...] some slowing in personal consumption growth in the medium term.

It is therefore encouraging that the corporate sector is showing signs of life. Profits have now been rebounding for two and a half years and while executives language remains cautious, their actions have become a little bolder — there has been a pickup in mergers and acquisitions activity and advertising and capital spending are rising gently.

There were a number of new purchases during the year. Iron Mountain is the dominant record management company in the US and UK. After a decade of heavy investment the business's strong and growing cashflows should increasingly be returned to shareholders. T Rowe Price is a conservatively-run investment manager which is unusual among its listed peers in having grown largely without making acquisitions and which is currently taking share in the mutual fund market. Mohawk is the leading US producer and distributor of floor coverings. In recent years it and a subsidiary of Berkshire Hathaway have consolidated the industry and now control 70% of the carpet market between them. Loblaw is a well run Canadian supermarket chain with attractive growth prospects.

The most notable sale was of the semiconductor company, Analog Devices. Despite additions to the Company's remaining American tech stock, Microchip, this sale resulted in a further reduction in the Company's already limited exposure to the US technology sector. While technology demand continues to recover, we remain concerned about valuations: the technology sector is trading on a large premium to the rest of the market, particularly when options are expensed.

The US market rallied strongly during the year as optimism over the economic and profit cycles grew. Despite having very little exposure to the most cyclical parts of the economy, the Company's North American portfolio marginally outperformed the market, thanks largely to very solid profit growth from large holdings like Golden West Financial, Wellpoint and Moody's.

In aggregate the Company's North American investments remain both considerably more profitable and no more expensive than the market as a whole and we expect them to continue to grow profits faster than the market over extended periods. Whilst there will be further individual stock changes in the portfolio these characteristics should remain intact.

Japan

Japanese equities finally returned to form in the year under review with Tokyo offering the best return amongst developed market indices with a gain of 50% in local currency terms. This followed a fall that had taken the main equity indices to their lowest levels in nearly 20 years by March 2003.

The relatively modest economic expansion that began in 2002 continued last year. Industrial production rose further, helped by export demand and rising private capital spending. Unemployment fell although private consumption has been steady rather than buoyant over the last year. In addition, nominal GDP growth is not yet clearly positive, as price levels have continued to fall in certain areas. The outlook for prices is one of the more interesting issues for Japan at the moment. Over the past decade, and particularly in recent years, falling prices have depressed profitability and exacerbated the banking sector's troubles. Recent trends in some property prices and consumer prices suggest that downward pricing pressure has eased, although it is too early to confidently project a sustained period of rising prices.

The situation in the banking sector remains pivotal. The sector's health is improving and perceptions have changed dramatically over the course of the year to the considerable benefit of our holding in UFJ. The effective bailout of Resona by the government in the spring of 2003 was critical, and the larger banks have also made some progress in increasing their profitability. A reduction in debt levels at the most highly geared companies have also contributed to an improvement in the quality of the banking sector's loan portfolios.

The remainder of the Trust's investments are mainly concentrated in Japanese companies that boast a record of successful expansion. These include holdings in companies with globally competitive businesses, such as Canon and Toyota Motor, or in those with very strong domestic positions, such as consumer products manufacturer Kao. However, changes in management style are widespread, and provide opportunities to invest in businesses with latent strengths but erratic track records. For example, we purchased a holding for the Trust in Tokyu Corporation, a collection of operating businesses with a private railway company its core. The value of these assets is being enhanced by various management improvements, although the better environment is acting as a tailwind. We will continue to look for similar situations, whatever path the economy takes next.

Asia Pacific and Other Emerging Markets

It has been a remarkable period in the Asia Pacific region and the other emerging markets. For the first time markets have begun to recognise the full impact of Chinese growth. 2004 may also turn out to be the year in which the crippling deflation in some Asian economies, most notably Hong Kong, finally comes to an end. Elsewhere declining risk premiums and improved economic management have allowed India, Russia and Brazil to prosper.

The most notable feature of markets globally has been the accrual of pricing power to producers of raw materials and energy, as Chinese demand has surged. Our portfolio has benefited from this powerful trend through holdings such as Petrobras, Lukoil, Norilsk Nickel and BHP Billiton. A note of caution may be due now, as the current high returns in these industries are bound to attract substantial new supply. Nevertheless, we think that a substantial position in certain energy and commodity stocks may be warranted for some considerable time.

We have made some increases to our direct Chinese investments, for instance with new purchases of Zhejiang Expressway and Sinotrans, the freight forwarder. Although there is some risk of slowing activity over the next year, we believe that some of the most exciting individual long term growth stocks are becoming apparent as Chinese companies develop the management capabilities to exploit the inherent growth of their markets. We have continued to be encouraged by the growth that India is now producing. We have replaced our successful holding in the State Bank with Oil and Natural Gas Corporation on price grounds.

Comfortably our largest individual holding in the region is in Samsung Electronics. Once again this company has exceeded forecasts and has prospered in each of its major business segments. We continue to add to our position as despite its excellent stock price performance the rating still seems abnormally cheap in a global context.

We will be surprised if the year ahead offers such smooth progress as we have recently enjoyed. A period of nerves over Chinese economic overheating or Russian politics is probably overdue, whilst rising global interest rates are seldom helpful to volatile assets in Asia and Emerging Markets. We intend to use any such periods of nervousness to add to our exposure to these regions as we strongly believe that the economic and corporate opportunities available are still highly attractive in the years ahead.