Scottish Mortgage Investment Trust — Annual Report 2005

Managers' Review — Baillie Gifford (year ended 31 March 2005)

Context. A year of respectable but unspectacular returns (NAV per share +9.6% against an 8.6% benchmark rise). The review marks a strategic turn: the managers declare the attempt to beat regional benchmarks leads to sub-optimal stock selection, abandon geographical performance attribution, and identify the rising economic power of the emerging nations as the key theme for the next twenty 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' Review

Overview

Returns were respectable but unspectacular in the last twelve months. Given the dramatic succession of bull and bear markets of recent years modest positive returns are an unusual outcome but one which may be more frequent in the future.

Our relative performance was modestly ahead of the index aided by gearing. The geographical details of our performance can be found on page 17. As explained last year, we treat these figures with considerable caution. We manage the portfolio on a global basis with a core UK exposure to maintain our dividend yield. As the Chairman's Statement explains, we think that the attempt to beat regional benchmarks leads directly to sub-optimal and unduly diversified stock selection. From next year we will not be giving the geographical performance attribution on a regular basis. Instead we will aim to give clear guidance as to which stocks have added and subtracted value.

We have continued to reduce steadily the number of equity holdings. The year saw a reduction from 120 to 101 stocks. We expect a small further fall in the year ahead but we are now close to our preferred portfolio shape. Greater concentration should reinforce our conviction that all our holdings can add significant value for shareholders whilst still offering broad exposure to world economic growth and adequate risk diversification. We think that this policy differentiates us from many other large investment trusts.

The key theme for us remains the rising economic power of the emerging nations. This is likely to be the case for the next twenty years. Economic growth in China, India, Brazil and Eastern Europe was strong once again, last year. Markets in these areas were, however, volatile as rising US interest rates took some toll. We regard such setbacks as offering opportunity as we think that major macroeconomic improvements in emerging markets mean that they are no longer dangerously exposed to modest rises in American interest rates.

United Kingdom

The UK market returned 15.6% in the year to 31 March, the second successive year of double digit positive returns. This represented a decent showing compared with the other major markets, where profit growth has been stronger but starting valuations tended also to be higher. Profit growth was similar to the market's rise and dividend growth continued to accelerate to close to 10% year on year, which meant that valuations were broadly unchanged over the period and remain at attractive levels.

Our own UK portfolio performed slightly worse than the FT All-Share Index, with most of the shortfall attributable to the decision not to own either BP or Shell, two of the largest UK stocks, whose longer term attractions strike us as underwhelming, not least in comparison with other alternatives from within the energy sector. While we remain deeply sceptical of the long term investment case for either company, recent strength in the oil price has given both a profit boost which, in turn, led to strong share price performance. Beyond these two, the only significant disappointment came from the hedge fund manager Man Group, where continued asset and profit growth failed to convert into a rising share price, largely because of growing scepticism about the prospects for the hedge fund industry as a whole on the back of dull short term investment returns. While holding no strong views on the attractions of hedge funds as an asset class, we see no evidence to [...] distribution cannot continue to grow its returns to shareholders and we added to our shareholding following weakness.

Portfolio activity was somewhat higher than usual, with a number of new purchases and complete sales. The overriding theme was to reduce exposure to companies with limited longer term growth opportunities and refocus the portfolio on businesses where we perceive greater potential. For example, we sold Gallaher and Scottish & Southern Energy, each of which has performed well in recognition of its strong management record but which both appear destined to grow at a below average rate given the limitations of the tobacco and utility sectors. We believe that BSkyB, Hays and Kingfisher, three of our recent purchases, offer significantly greater opportunities for growth and profitable investment over the next several years and we were able to acquire shares in each at a point when expectations were relatively subdued. Similarly, within the banking sector we can now muster little enthusiasm for HSBC or HBOS and subsequently sold out, while we are excited by the prospects for the smaller and more focused Standard Chartered and Northern Rock, both of which represent significant holdings after recent share purchases.

This increased focus on growth and longer term potential has shaped most of our trading activity over the year and has contributed to a further reduction in our UK stake. Net sales of £21m, represent the third consecutive year that the UK exposure has fallen and by the end of the year UK investments represented 45.5% of total assets, down from 47.5% twelve months earlier. While the UK economy has continued to grow at a satisfactory rate with modest inflation and a sensible pre-emptive tightening of monetary policy, future growth is unlikely to better the longer term trend and there are risks that activity could disappoint even modest expectations. Of course, the UK stockmarket offers exposure to much more than just the domestic economy, but the recent tailwinds of a rapid increase in consumer borrowing and expenditure now look likely to convert into headwinds and, at the margin, reduce the number and scope of domestically quoted investment opportunities. We have tended to reduce the UK stake simply because we have been able to find a broader range of potential investments elsewhere in the world.

World excluding United Kingdom

We manage the international portfolio on a global basis, without geographical or sectoral constraints. We have therefore decided that it is inappropriate to persist with our previous practice of reviewing the portfolio region by region. Indeed, we think that such a focus can have damaging consequences for portfolio management. In the endeavour to meet regional performance targets, holdings in companies of significant weight in local indices, but little claim to global investment appeal, can appear in the portfolio. Over time there is a remorseless trend away from one international fund to several regional portfolios. We do not think that this is in the interests of shareholders. Our efforts to reverse this process have led to a welcome decrease in the number of stocks that we own. We are pleased that our holding sizes are now much more closely aligned to our conviction in each individual stock, rather than being a hostage to regional allocation and index weights. We think that this should prove beneficial in the years ahead.

The structural rise of emerging markets and portfolio structure

The key issue for the world markets is whether the rise of the major developing economies of China, India, Latin America and Eastern Europe continues and can offset the inevitable, if much delayed slowdown in American consumption. We are relatively confident that this will be the story of the next decade. This belief is reinforced not only by the increasingly sound fiscal, monetary and micro-economic policies being pursued in these nations but also by their generally impressive standards of educational achievement. Above all, it is backed by the improving and frequently impressive performance of the corporate sector. We would not wish to own stocks in these markets simply because their local economies are growing. This remains a constraint in China but not in most other emerging markets. We require evidence of strong business models and competitive strengths in the same manner as we try to identify in the developed world. At the same time we think that the opportunities offered by the growth in emerging markets extends far beyond companies listed in these locations. From oil and mining stocks to manufacturers of industrial equipment to suppliers of brand name luxuries, the power of emerging market demand is driving improved operating conditions. We accept that there will be pauses in this process and that this may be temporarily painful in equity markets but we are determined to use such setbacks as opportunities to add to our exposure rather than to prompt alarm. In particular we regard modest rises in US interest rates leading to a selloff in emerging markets as a classic example of misguided and outmoded emotion overcoming economic logic. We would only anticipate reconsidering our support for emerging markets if we were to see evidence of a secular rather than cyclical reversal in improvements in their GDP per capita. This would seem most likely to be prompted by major changes of political direction at the local or global level. Plainly recent actions in Russia have the potential to develop in this direction. As former shareholders in Yukos we have seen the direct consequences of the abuse of political power but we tend to think that this is a specific case and that global pressures towards liberal economic and political management remain formidable. In short, we think that the focus of global economic and stockmarket activity will move remorselessly to the now developing world in the decades ahead. We think that our asset allocation should reflect this and that there are individual stocks from these areas that thoroughly deserve to be in our portfolio.

Commodities

The most striking feature of the last year has been the sharp rise in the price of oil. Primarily we regard this as yet another consequence of the rise of Chinese demand. This said we also believe that the supply of oil is comparatively constrained. Whilst we consider it probable that Saudi Arabia can increase production, it requires a structurally high oil price to fund the necessary capital expenditures. Meanwhile the Western oil majors are struggling to find and develop worthwhile reserves. It appears to us to be an eventually self-defeating process to invest in these declining companies to gain exposure to a prolonged period of high oil prices. We prefer to look for oil and gas companies with the ability to increase reserves and production or those that enjoy significant earnings gearing to the current high prices. Some of these can be found in North America. Oil sands reserves have come into their own for Suncor whilst supply constrained markets permit strong pricing power as shown by EOG whilst ConocoPhillips has the refining position and production potential to make us more confident than is the case for so many integrated oil majors. Our search for reserve and production growth has led us to several emerging markets stocks. Petrobras seems to us to be highly appealing. It has a good exploration record (particularly in offshore Brazilian waters where others have failed), improving production prospects and a remarkably low valuation despite the increasing stability of the Brazilian economy.

Our two Russian holdings, Gazprom and Lukoil, offer such formidable reserves that we believe the potential rewards hugely outweigh any political dangers that can be envisaged for two such government favoured giants.

Just as the oil market has been influenced by China so have broader commodity prices thrived on this new source of demand. Whilst we are wary that supply is less constrained than it is in oil markets and unpleasantly prey to speculative excesses we do accept that dominant, low-cost suppliers of key raw materials are in a strong position for some years to come as weaker competitors will find it difficult to finance and develop economic capacity even at currently prevailing prices. BHP Billiton and CVRD (Brazil) appear to have sufficiently strong positions (notably in iron ore) and to be disciplined enough in their pursuit of balance between future expansion and current shareholder reward to deserve places in our portfolio. Anglo American Platinum has, in contrast, been unpopular with the markets as platinum prices have withered and rand strength has eroded returns. We have recently added to the holding as we feel the structural demand picture for platinum remains powerful despite these immediate anxieties.

Industry

Whilst markets have tended to focus on the commodity impact of Chinese demand there has been less attention paid to broader industrial themes linked to the rising importance of China but also India, Eastern Europe and Latin America. With the dynamics of global growth moving away from American consumers towards emerging economy industrialisation there are swathes of previously staid manufacturing enterprises that can now boast improved growth opportunities and competitive positions strengthened by years of industry consolidation and capital redeployment. The prime exemplars of this are perhaps two Swedish engineering holdings, Atlas Copco (a long-run holding added to this year) and Sandvik (purchased in the last year). Both companies have attained global leadership in their respective compressor and carbide tool markets and both have strong mining equipment franchises in addition. Both have been investing in emerging markets capacity for years and have built strong local presence and customer links to protect themselves against domestic competition. For BMW and Porsche the protection lies instead in brand strength that appears to be global in reach. At a time of nervousness about the automotive industry these virtues are ever more important and apparent.

Technology

Our technology investments have generally not enjoyed a good year in share price terms. We do, however, feel reasonably confident that our individual stocks are well placed and that ratings are becoming statistically attractive for the first time in many years. We are therefore contemplating purchases in areas such as internet commerce that have previously been unappealing to us. Samsung is currently our largest technology holding to which we have been adding steadily. We remain fascinated by the growing power of the company in memory chips, mobile phones and flat screen technology. Given the cyclicality of these businesses, the notable willingness of Samsung to invest counter cyclically and to impose scale, earnings will be as volatile as the share price. The ultimately impressive returns and low-rating make us patiently optimistic. Our other major holding is the German business software company SAP. This too has been a dull performer but continues to churn out consistent annual earnings growth, increasing margins, and growing industry dominance. Software is an industry that rewards scale so we think this is a self-reinforcing trend. We would also draw attention to an increase in our holding of Canon. This seems to us to be one of the few Japanese companies to offer the industry leadership, concentration on its core business [...] world-class. The persistent de-rating of the company despite earnings consistently exceeding expectations strikes us as being symptomatic of a global disillusion with growth stocks and an undue preoccupation in the Tokyo market with all too often illusory restructuring and domestic demand recovery stories.

Financials and consumer staples in America

It is in the area of financials and branded consumer goods that the US market comes into its own in its excellent selection of outstanding companies. Whilst we are aware that operating conditions for US financials have been benign for many years we are of the view that the specific competitive strengths of our investments are enduring. Moody's is a classic example of this as the business of rating bonds relies on reputation and market share which are built up over many decades. This is a service which is becoming ever more essential in today's financial system. We retain a large holding in the California based mortgage company Golden West. Its share price has been slightly over-shadowed this year by concern over rising interest rates but it remains the lowest cost and most focused operator and earnings continue to rise impressively. The other area which we find of consistent interest in America is brand name consumer goods. This year we would note that our purchase of Gillette has paid off more quickly than we anticipated through bid activity but stocks such as Altria, Wrigley and Walgreen continue to play a significant role in our portfolio. Whilst we select our stocks on a global basis we believe our US department has a record of investing in both financials and consumer goods that we should exploit as a source of ideas. We would also highlight this to our shareholders as so many other investment trusts have struggled in their US stock selection. Without such capable input from our colleagues, we would find it impossible to invest globally with confidence.

Prospects: the undervaluation of growth

Whilst the vagaries of market sentiment will doubtless swing in unexpected directions in the year ahead we are optimistic about the underlying prospects for our investments. We think that the opportunities for growth offered by the burgeoning globalisation of economies are profound and that those companies with the strategic positioning to exploit this will be able to generate excellent profitability. These companies can be found in all parts of the globe from India to Canada to Israel and it is our task to seek them throughout the world regardless of index weight or investment fashion. If the opportunities are appealing so too is the rating that the markets currently apply to growth stocks. The hangover from the excesses of the late 1990's has led to an exaggerated suspicion of the possibilities and ratings of growing companies that has been magnified by the momentum effects that markets have become so prey to in recent years. We think that global growth stocks are now highly attractive.

Fixed Interest

Scottish Mortgage's bond portfolio earned a healthy return of 9.5% in the year to 31 March. The overall economic climate was helpful with inflation remaining subdued despite strong global economic growth. The Bank of England raised base rates from 4% to 4.75% in response to the economy's strength and to block off inflationary pressures; the US's Federal Reserve also raised interest rates, somewhat more aggressively, from 1% to 2.75%. The European Central Bank and Bank of Japan, in contrast, kept interest rates unchanged as their economies wrestled with structural problems. Bond market returns followed the rate rise pattern: best in Europe, weakest in the US, with the UK lying somewhere in between.

Company profitability has continued to grow and many companies have sought to reduce indebtedness. One reflection of robust corporate health is the Moody's global speculative grade default rate which declined to 2.1% from its 2001 peak of 10.6%. This improvement has led to a flood of money into high yield bonds and the European high yield market returned 11.1% over the past twelve months in local currency terms, or 14.3% when translated to sterling.

The Trust's bond portfolio is mainly comprised of investment grade bonds with a smaller allocation to higher yielding bonds with lower credit ratings. The former tend to have steady finances but have more sensitivity to interest rates. We look for bonds which pay a high interest rate premium in comparison to their credit risk or bonds which might be bought back at a premium by their issuer. A good example is AMP, the Australian insurer. Its exit from the UK market has both reduced business and financial risk and left a profitable domestic business. We expect that it will use surplus capital to buy back bonds and that the Trust's sterling denominated bonds will be a prime target when it does so.

In high yield bonds we look for companies which are expected to generate good cash flow to pay down debt. The ideal outcome is a de-gearing through a sale of the company or public share sale. In this year we realised profits in MTU, the German aero engines manufacturer, as speculation grew that it would return to the public stock market and in Eircom, the largest Irish telecom company, following its successful share sale. Both companies had reduced indebtedness markedly since we bought their bonds. Of our current holdings, Debenhams is perhaps the most likely to buyback its bonds: its highly successful and profitable turn-around as a private company paving the way for a public listing.

A final leg to the fixed income portfolio is asset backed bonds — bonds which have their income and capital backed by security. The Trust's bonds' assets vary from commercial mortgages through bank loans to healthcare clinics. This market segment has not appreciated in value to the same extent as others despite solid operating performance [...] year.

Our aim is to generate income while investing in assets which will hold value or, ideally, appreciate. While world growth is likely to moderate and US interest rate rises may weigh on global bond markets, we believe we can still find attractive investments in corporate bonds.