Scottish Mortgage Investment Trust — Annual Report 2006

Managers' Review — Baillie Gifford (year ended 31 March 2006)

Context. A strong year: the share price rose 57% and net asset value per share 46% against a 26% benchmark rise, the third successive year of double-digit UK market returns. The review explains why the managers have ceased providing regional performance data, restates the global growth-stock approach adopted three years earlier, and records new purchases including eBay and Amazon.com. 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

The Year in Review

Returns have been strong in the last year. Global equity markets have risen steadily. Our own performance has been good. As proposed last year we have ceased to provide geographical details of our performance. We provide overall figures for the trust and individual stock results for our top 30 holdings. We have nothing to hide but we are ever more convinced that providing short term regional performance data is damaging to the application of common sense and intelligence in fund management. The tendency to be held in thrall by index weights and the daily noise of volatility interferes with both the commitment to searching out stocks that offer superior long-term returns and the ability to be courageous in purchasing stocks when they are out of favour. Three years is the absolute minimum over which skill rather than randomness can be assessed and we try very hard to apply this standard of judgement to our own efforts. Since we started articulating this philosophy three years ago the results have been encouraging but we reiterate that this is the bare minimum for any serious judgement of our abilities. We will endeavour to remember that over confidence is a besetting sin of fund managers.

There has been another substantial fall in the number of equity holdings from 101 to 86. We would be surprised if this process of concentration goes much further although there may still be scope for a small shrinkage in the number of UK listed stocks in order to express our stock preference with more conviction but little extra risk. We now have just five Japanese holdings as opposed to 12 a year ago. Some readers may find it provocative that this has happened at a moment when the Japanese economy had finally shown signs of vitality and when many managers are optimistic about prospects for the Tokyo market. We are confident that the economy had revived at least temporarily but we are sceptical whether this translates into a stock market offering many companies with clear and powerful competitive advantages. Of those that did offer such attractions the number of bargains in a global context has sharply diminished. We would cite our sale of the long-held and still admirable retailer Yamada Denki as falling into this category.

As long-term investors we believe that the possibilities open to us have seldom been greater. We have little ability to predict the direction of markets over the next year and find some amusement in the confidence with which others offer such forecasts. Yet precisely by trying to put aside some of the habits of fund management as commonly practiced today we have the scope to add significant value for our shareholders over lengthy periods of time. More and more managers, aided and abetted by the rise of hedge funds, the influence of the investment banks, and the unintended consequences of ill-considered regulation have abandoned the effort to invest in individual companies and instead speculate as to the direction of markets, countries, sectors and stocks over the next three months. This leaves those less obsessed by the volatility of indices with ever greater opportunities.

We invest globally. We think this is the most rational approach in a world in which the impact of globalisation is a truism. We find it puzzling that so many investors still think in terms of national or regional stock allocations when both companies and countries are so inextricably bound in a multinational web. We are sceptical of the theoretical or practical rationales for thinking in terms of national market multiples or risk premiums. Our sole concession is that we take our commitment to real dividend growth seriously. This means that our UK exposure (though declining) is greater than it would otherwise be but here too we do our best to incorporate the global context in assessing opportunities.

Although we consider all forecasts with caution we think the path of least resistance in the next decade leads to ever greater globalisation and the associated rise of what are conveniently, if questionably, known as 'emerging markets.' The impact of the profound changes being seen in China, India, Eastern Europe and Latin America is likely to become the dominant backdrop to investment decisions. This does not mean that the economies of these markets will continually prosper and still less that their stock markets will always flourish but it does mean that we should consider how each of our stocks fits into this global transformation. Equally, historic relationships and assumed correlations will frequently break down throughout the world as this takes place. The risk models that many rely too heavily upon will probably be a hindrance rather than a help.

We are growth stock investors. This has been unpopular for the last five years. Whilst this has been frustrating it has meant that we are now in the pleasant position of being able to find many companies with strong secular growth opportunities trading at ratings that are undemanding relative to both the broader market and their own history. It may require patience to benefit from this situation but that is precisely what our investment trust ought to be able to offer.

The Portfolio

In this section twelve months ago we discussed the rise of emerging markets, their commodity and industrial impacts, the attractions of disciplined technology investing, the virtues of selected US financials and consumer staples and the undervaluation of growth. All these themes remain central to our thinking about equity opportunities for the years ahead.

How We Think about Investment in Emerging Markets

Whilst we have already touched on the rise of the emerging economies some more specific words may be of interest. We apply the same investment standards to companies headquartered in emerging markets as we do to those in developed markets. We do not purchase them simply because they are based in emerging markets but because they have the competitive positions, growth opportunities and valuation attractions that would appeal to us anywhere in the world. That these characteristics can frequently be found in emerging markets stocks hardly seems surprising to us given the human capital, educational progress, technological prowess and resource endowment that many of these countries offer. That valuations have been so attractive shows to our mind just how far the memory of past economic crises, investor adherence to index weights and unwarranted scepticism about the importance of profitable growth has become. If the long predicted downturn in the global economy triggered by inadequate US savings and consequent indebtedness does occur then naturally emerging markets will tremble but the real risk and damage will be done in America and other mature economies as their problems extend beyond losses in profitability to serious balance sheet quandaries. At a time of crisis it is balance sheets that dominate investor mentalities. From General Motors to the US government the debtors are predominately in America — not emerging markets. In short from both a risk and an opportunity stand-point we think emerging markets are better placed than the developed world. To us when we can find individual stocks that meet our criteria the natural response is still to be prepared to add to our exposure. We are puzzled at the limited exposure so many investors maintain. We would very much like to understand where else they think the growth opportunities in the global markets are going to come from in the next twenty years.

None of this means that there will not be setbacks inspired either by economic and political setbacks or stock overvaluation. The country that we worry most about at present is Poland where the combination of populist politics and economic imbalances seems the worst attempt to re-invent the toxic mixtures that led to the emerging market crises of the past. We have no exposure to this economy.

From a valuation perspective we regret that the two Indian stocks that we have owned, Hero Honda and HDFC, have risen to ratings that are now more demanding than we would prefer. Given that valuation is at best an inexact science we have cut back rather than sold our holdings but this represents the first time that we have found this necessary in companies for which we still retain much admiration.

Commodities

Many of our most profitable investments over the last year have been in natural resources. We did not start with a particularly notable exposure to this subsequently fashionable area but we were fortunate enough to have owned a selection of companies that have been powerful beneficiaries of rising commodity prices. In fact we are quite surprised just how much we have benefited from our preference for resource rich rather than index heavy stocks. Most notably Petrobras and Gazprom have risen to be our two largest holdings. Whilst we would be surprised if their performance of the last twelve months can be replicated in the year ahead we remain comfortable with the size of the holdings. Petrobras is able to expand production and reserves in a manner that is the envy of the traditional majors at a still undemanding rating. Gazprom continues to be a controversial but successful investment. Over the last year it has ever more clearly demonstrated the awesome power of its resource base and pipeline infrastructure whilst making surprisingly significant efforts to see that shareholders are the beneficiaries of this dominance. We still have no desire to own the shares of the British, American or European oil majors. We think the last year has only emphasised the paucity of their reserves and the difficulties they face in rebuilding them. We are somewhat agnostic about the likely course of oil prices but we would be surprised if crude fell below the approximately $40 level which would start to undermine the long-term case for our holdings.

Broader commodity prices have also been driven higher by the combination of persistent Chinese demand and improved OECD economic activity. Whilst this has been of benefit to our portfolio we are becoming concerned that even a modest slowing of global growth could affect pricing as supply gradually increases. We are therefore redoubling our search for companies that have a sufficiently secure competitive position to ride out a potential downturn. We are more confident that this is most evidently so amongst the focused emerging market quoted stocks rather than the diversified giants. We particularly admire the strong market position and iron ore reserve base of CVRD and have been building up this holding at the expense of the BHP Billiton position. We have been rewarded for last year's patience with Anglo American Platinum by a return to market favour of this metal and, latterly, by takeover speculation that has prompted us to reduce our holding.

Industrials

One of the challenges for us as growth investors is trying to move towards companies and sectors that have outstanding prospects for the future rather than to become unduly attracted by what has grown in the past. This has been critical in thinking about the broad industrial field. The scope for profitable growth has been transformed by opportunities in emerging markets. This is becoming a generally accepted orthodoxy now but was an unusual hypothesis only two years ago. We continue to think that there are appealing investments to be made but the greater recognition of the virtues of many of the stocks in our portfolio makes us determined to be ever more selective. We have remained enthusiastic supporters of the Swedish engineering duo Atlas Copco and Sandvik. In both cases the last year has seen their focus and it is typical of the disciplined and patient capital allocation of these two companies that such activities were supported and expanded in times when many less resilient managements would have despaired of seeing adequate returns. We have, however, sold ABB as we felt that the rise in the share price was sufficient to make our questions over their sustainable competitive advantages more relevant. Thus far this has proven a premature decision.

We are still owners of three automobile stocks. Porsche, BMW and Nissan all appear to be amongst the few winners in this tough industry. The two German companies continue to exploit their brand strength and the global appetite for luxury product, whilst Nissan's low cost manufacturing, product strength and tough management have produced a model turnaround. If we have a concern over any of these companies it is probably at Porsche where we are yet to be entirely persuaded of the virtues of building a stake in Volkswagen but we are wary of second guessing a management with such a formidable record.

Technology

Last year we commented on the generally subdued share performance of our technology investments. This year there has been some improvement in prices but we still feel that the excellent business performance of many dominant companies is only being grudgingly acknowledged by markets. Some of this scepticism is just the general reluctance to embrace growth stocks that we have already commented on but there also seems to be a specific set of anxieties over technology that probably owes much to a reaction against the long gone but emotionally draining days of the internet bubble. We have therefore added to our existing holdings and made new investments which excite us for the future despite the downbeat market mood.

We have increased our holdings in Samsung Electronics, SAP and Canon. These three stocks have little in common by geography or technology but all of them possess dominant global leadership and demonstrate an admirable willingness to reinvest in their core businesses and an associated refusal to pander to short-term earnings guidance obsession of the markets. We would be disappointed not to own these stocks for years to come.

We have bought holdings in eBay and Amazon.com. These purchases are the key reason that our US exposure has risen in the course of the year. Neither has helped our performance as yet but we continue to view share price weakness as an opportunity to add to our holdings. We are particularly attracted by the outstanding network driven competitive advantages and returns that eBay enjoys. We regard both continued investment in its global footprint and the purchase of Skype as sensible despite their dampening impact on short-term earnings.

Financial, Consumer Staples and Housing in America

US equities have continued to under-perform global indices over the last year. Despite this the US stocks that we own have once again added value for our shareholders. We think that the discipline of simply picking equities that we believe to be intrinsically and individually attractive rather than making a decision to allocate a set percentage of assets to North America has helped us to invest sensibly. We must again pay tribute to the calibre of advice and decisions in our US department which has long refused to behave as index sensitive traders in favour of remaining dedicated stock pickers with particular skills in assessing consumer staples and financials. A notable example of this has been our successful holding in Moody's, the credit rating agency, with a franchise that we cannot find elsewhere in the world and a simplicity of business model that is unusual in the complex world of unwieldy financial conglomerates. Only valuation has made us trim our holding in recent months.

We have added to our holding of Hershey. Whilst we consider it implausible that its chocolate will interest global appetites it is clear that it remains a brand with powerful mind-share in its American heartland with strong profitability and consistent growth prospects. We sold our successful investment in Wendy's as the value of its ownership of Tim Horton's had become more apparent to the market. We replaced it with a stake in Brown-Forman, the maker of Jack Daniels and Southern Comfort, as the power of its focused marketing expertise continues to drive pleasing sales growth.

We are intrigued by how many people throughout the world appear to be worried about the stability of the US housing market. Whilst these anxieties may have some economic basis what seems much clearer is that US house-building equities already discount a great deal of bad news. Given the demographic tailwinds, prime property scarcity, increasing scale advantages, solid balance sheets and near book value ratings we think that this is becoming an area of considerable interest. Returns are higher and valuations substantially lower than for UK builders. At present we have purchased Ryland, which appears to us to be one of the best run and more conservative companies and we may increase our exposure in the year ahead.

The UK Market

The UK market returned 28.0% in the year to 31 March, the third successive year of double digit positive returns. Although domestic growth was subdued, the market [...] economy which allowed profits and dividends to continue to rise at a healthy rate, while the abundance of cheap credit contributed to a boom in takeovers and corporate restructuring which pushed share valuations higher.

Our UK portfolio modestly beat the FT All-Share Index despite a relatively low exposure to the resource industries, where we find the [...] outside the UK stock market. We added to our position in Rio Tinto, attracted by the combination of low cost long life reserves with a consistent and long-term management approach but we have continued to shun the UK listed oil majors BP and Royal Dutch Shell, both of which were poor performers over the period. Underperformance and a steady rise in expectations for future oil prices and profits have combined to reduce the prospective valuations on both companies but for the time being we continue to identify better investment opportunities in overseas markets. Towards the end of the period we also sold our preferred UK energy company BG, following a surge in the share price and valuation, in part fuelled by takeover speculation.

Elsewhere we benefited from a strong recovery in the share price of the hedge fund manager Man Group and also from Standard Chartered and Northern Rock, all of which had seen substantial purchases in the previous year, although our continued confidence in the investment appeal of Royal Bank of Scotland has yet to be repaid. The UK property sector has also been a highly profitable area for the fund over recent years, with a recovery in rents and falling yields translating into very strong share price performance thanks to high financial gearing and the narrowing of discounts. Most of these drivers now look to be slowing and with future returns likely to be much more modest we have begun to reduce exposure. Disappointments included Vodafone, where we made significant reductions in the face of deteriorating prospects, mainly driven by falling prices. We remain hopeful that the UK consumer's appetite for DIY will recover and are retaining our so far unsuccessful investments in Kingfisher (owner of B&Q) and Travis Perkins (owner of Wickes), while we have taken advantage of weakness in Royal Bank of Scotland, Reed Elsevier and Carnival to add to our already significant positions.

Portfolio activity was higher than usual, with net sales of approaching £60m, leading to a fall in the number of UK investments and a further decline in the proportion of assets invested domestically. The two largest sales were BG and the reduction of Vodafone but others included Allied Domecq and BOC, both of which received bids from European companies; the media companies BSkyB and Trinity Mirror, which are both experiencing increased competition enabled by new technologies; and the life insurers Aviva and Friends Provident. We continue to focus our portfolio on companies where we have a high degree of confidence in sustainable longer term growth and rising profitability and we bought new holdings in Yell, Schroders and Inchcape, all of which have made a positive contribution to date.

UK economic growth was sluggish in 2005 and we expect more of the same going forward, with high levels of consumer and public debt dampening domestic demand. While the stock market offers exposure to much more than just the domestic economy, some of our recent favourites have seen a significant rerating and now look less appealing. Unless we can identify a range of new buying ideas, the UK stake may continue to shrink simply because we are able to find a broader range of potential investments elsewhere in the world.

Fixed interest

Scottish Mortgage's bond portfolio earned a return of 9.6% in the year to 31 March. World economic growth has generally been higher than expected, the United States economy has grown only slightly less than in 2004 while Europe and Japan are showing signs of sustainable economic recovery. Importantly for bond markets, consumer price inflation has remained very subdued despite higher oil prices. In many respects the most disappointing economic performance has been that of the United Kingdom where growth has been lower than expected and inflation higher.

The response of both the United States and European central banks has been to raise short term interest rates from their unusually low levels. The Fed raised rates eight times to reach a level of 4.75% while the ECB raised rates from 2% to 2.5% in two steps. Against the global trend, the Bank of England cut its base borrowing rate to 4.5% in August in the face of weakening consumer spending.

US ten year government bond yields rose by 0.4% and euro government bonds by 0.2%. As a result returns were meagre in both markets — 1.9% and 2.7% respectively. Gilts did much better, ten year bonds returning 6.9% as yields fell by 0.3%. As well as the weaker economy, sterling bonds benefited from strong buying by pension funds owing to regulatory changes. Scottish Mortgage's bond portfolio benefited from strengthening currencies — the US dollar appreciated by 8.9% and the euro by 1.4%.

The Trust's fixed interest portfolio consists of bonds issued by various companies in sterling, euros and US dollars. It has shrunk in size from £75 million to £66 million over the past twelve months due to shifts in the Trust's asset allocation. The biggest change in the portfolio was the sale of our long-standing investment in Bank of Scotland Shared Appreciation Mortgage bonds which had done well from past growth in house prices. Some of the proceeds have been reinvested in a range of corporate bonds, particularly higher yielding securities.

With little anticipation of falling government bond yields, the focus is firmly finding companies whose bonds will benefit from improved creditworthiness. While strong corporate earnings are aiding this quest, there has been a clear trend towards companies taking a more 'shareholder friendly' approach. In concrete terms this means higher dividend payments, large share buy-backs and more debt-financed investment; each of these factors can lead to a company's bonds performing poorly. So while corporate bonds performed slightly better than government bonds in aggregate, this masked a highly variable pattern of returns at stock level.

We have found an unusual number of opportunities recently in the insurance industry. The increased oversight of financial regulators has considerably reduced the risks of malfeasance or poor balance sheet discipline and, in particular, UK life insurance companies now bear considerably less exposure to the equity market. 2005's extraordinarily high losses following the Caribbean hurricane season illustrated the strength of Lloyd's and the major reinsurance companies' reserves. We have, therefore, bought bonds issued by Lloyd's of London and Talanx, the owner of Hannover Re.

The economic environment and generally improved investor sentiment have been beneficial for the high yield bond market. The default rate for highly-indebted companies remained extremely low for the third year in succession. The European high yield market returned 6.6% in 2005, easily eclipsing returns on government bonds and investment grade bonds. 48% of the Trust's bond portfolio is high yield, up from 29% in 2005, and high yield was a major contributor to performance this year.

The outlook is for moderate returns from investment grade bonds. In the absence of an economic slowdown, high yield bonds will probably do rather better. In all cases, with corporate activity an increasingly volatile factor, we expect our stock-picking abilities to need to be at the fore.

Portfolio Outlook

Whilst three years of steady recovery in equities may have made investors somewhat complacent we still find scope for cautious optimism. Fundamentally we are still finding too many companies with high quality earnings streams and appealing growth prospects selling at reasonable valuations to want to raise cash or even reduce our modest gearing. A setback is always possible and there are sufficient political and economic anxieties to provide the rationalisation for any such correction but at present we would see such a development as likely to provide opportunities for new purchases and additions rather than as a cause for long-term concern. Demonstrating our ability to identify these opportunities will be the decisive task in the years ahead.