Scottish Mortgage Investment Trust — Annual Report 2007

Managers' Review — Baillie Gifford (year ended 31 March 2007)

Context. A positive year — NAV, share price and benchmark all rose 3.9% — despite two short but violent outbreaks of market turbulence (May–June 2006 and February–March 2007). The review describes the next stage of the trust's evolution towards a truly global, index-insensitive portfolio: deeper emerging-markets exposure with Brazil to the fore, a vigorous pruning of UK holdings, and new positions in technology and alternative energy.

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Managers' Review

The outcome for the year was positive with the NAV, share price and benchmark all rising 3.9%. However, it has been a year during which months of steady equity market progress have twice been interrupted by short but violent outbreaks of turbulence. In May and June of 2006 the damage took several months to repair but thus far the falls of late February and early March have proved easier to overcome. Indeed, from our own point of view, this most recent outbreak of volatility has been fortuitous as it enabled us to press on with the next stage of our evolution towards a truly global and index insensitive portfolio.

The chance to do this was accentuated by the strange way in which stock markets operate today. In outbursts of turbulence the common practice amongst investment banks, hedge funds and the bulk of the investment management industry is to consult their risk models in rather the same way as many newspaper readers consult their horoscopes — and with similar levels of success. What you should sell is determined by what has been volatile in the past even if the conditions that led to this past volatility are no longer present and despite the inevitable herding and cascading of actions that this provokes. What this has tended to mean in recent years is that in periods of volatility emerging market stocks and industrial cyclicals are sold indiscriminately. We think this presents opportunities if we are able to be both patient and moderately courageous. We stress that we do not think that this makes our portfolio more risky, indeed we think it is less vulnerable to permanent loss of capital than those managed with avoidance of volatility in mind. We have considerably more confidence in the economic development of our preferred Emerging markets and stocks over the next decade or two than we have in traditionally more secure sectors and stocks that cannot escape from the heavily indebted Anglo American consumer and the perhaps exaggerated profitability of the financial systems of much of the developed world.

The changing nature of Emerging market investment

Over the last five years we have talked in generic terms about 'Emerging' markets. This shrewd marketing phrase has become a useful shorthand for what may be the most important development in the world economy in the last two hundred years. The increasing importance of China to global manufacturing and commodity demand, the challenge of Indian technology and service sector skills and the resource bases of Russia and Brazil are transforming the patterns of global growth. From an investment point of view their importance may be even greater as they are disruptive factors that upset the fixed mind sets of many investors and the extrapolations of so many inflexible risk models. This is an opportunity the like of which seldom occurs. We feel that we have a great chance to exploit these radical changes as our Emerging market colleagues have great talent and experience and such splendidly forthright views that dangerous preconceptions are regularly challenged.

What is becoming clear is that the value of the Emerging markets label is fast diminishing. The specific attributes, roles and limitations of the individual countries, stock markets and corporate characteristics that make up this huge field are becoming increasingly critical as their power and influence spreads. Ironically the more globalisation occurs, the greater the need to differentiate between Emerging markets. Even the four giant empires of China, India, Russia and Brazil that are so frequently linked by investors have profoundly different virtues and drawbacks. Still more critically they will have very divergent impacts on the development of the global economy. To take a comparatively simple example the fate of many industries and of inflationary pressures throughout the world will be dominated by the race between Chinese domestic demand and Russian resource supply in the decades to come. American (and British) policy makers will be virtually powerless to influence this balance.

The imperative to think more specifically about the major developing economies is redoubled by the shifting growth prospects away from export and commodity strength towards the domestic consumer and the financial sector in so many emerging economies. This requires more analysis of domestic economic management and prospects than has been the case in our prior investments. It also demands more detailed investigations of the competitive advantages that are both more nebulous and more vital than in commodity companies driven by the comparative simplicity of resource bases and low cost production. On balance this is pushing us towards a slightly broader selection of stocks and markets in the emerging economies than has been the case. This is a pragmatic approach that we feel should override excessive dogmatism about the level of concentration of the portfolio or the ratings for which we are willing to pay. We have, for instance, purchased individual stocks such as Walmex in Mexico or Infosys in India where we feel that the long run competitive advantages are such that we should not become too preoccupied by the comparatively high ratings of current earnings on which they trade. We are also prepared to venture into countries where volatility is likely to be a constant companion. We think that Garanti (Turkey) and Standard Bank (South Africa) are well run parts of improving financial systems. We will endeavour to view the inevitable oscillations of political and economic sentiment in such countries as at least as likely to present opportunities rather than evidence of a permanent deterioration in prospects. Such ought to be the advantages of long term and genuinely global investment portfolios.

Amongst the major developing economies we currently have the most exposure to Brazil. This is partly in tribute to the excellent positioning and returns being generated by its dominant companies and partly an acknowledgement that steady and responsible economic management is allowing the extraordinarily high risk premium on Brazilian assets to decline. The most impressive achievement of last year came from CVRD which has deployed its huge cash flows both in reinvestment in high grade, low cost iron ore but has also succeeded in building a new oligopoly in the nickel market through its well-executed takeover of Inco of Canada. We continue to feel this is a much superior business model to the over-diversified approach favoured by the other major mining groups.

UK reductions

The second major feature of the year under review has been our vigorous pruning of UK equity holdings. As we hope shareholders have become fully aware, the Board and the Managers have worried that there was still a lingering temptation to view the UK stocks as a separate portfolio and an index-influenced one at that. We have therefore taken the opportunity provided by a year of general out-performance by British equities and of remarkable sterling strength to cut back our exposure. We have made net sales of 238m over the course of the year. We consider the bulk of our change to have been accomplished although we would also suspect that there will be further sales in the year ahead. This will largely be dependant on the actions and attitudes of the corporate sector. We have already reduced our once large holding in Royal Bank of Scotland as regretfully we fear that the current proposals to take-over ABN Amro offer a great deal more to shareholders of the Dutch bank than to long standing supporters of RBS itself.

Our attentions are becoming concentrated on stocks where international aspirations are high but where it is clearer to us that there is an ability to build market positions either organically or via takeovers in which scale is a more palpable benefit in driving returns. Where these conditions seem to be in place we are prepared to be patient. The attraction of Tesco for us lies in the gradual building of value in overseas markets and the apparent acuteness of the planned American venture in identifying an uncovered niche than in its now traditional UK dominance. We have also added to our holding in Wolseley as the problems in the US housing market ought to offer more opportunities for attractive acquisitions at low prices. Once again short term anxieties should be able to be turned to our advantage in an impatient world.

Our technology stocks

Last year we were hopeful that our mixed fortunes in technology investing were set to improve. We find ourselves in much the same position this year. Several of our holdings have had a difficult year in stock price terms but in the majority of cases we are still minded to view this market disfavour as an opportunity to make additions rather than a prompt for sales. This policy has had some benefits already as we have managed to add to holdings at prices that now appear to have been advantageous. Amazon would be a good example of this policy. We have also continued to add to our stake in eBay where we feel temporary execution issues have unduly bothered the market whilst the power of not just the eBay brand itself but also of PayPal and Skype continue to develop pleasingly. To us these seem to be terrific and sustainable franchises that are considerably underestimated at present.

Elsewhere we have been genuinely disappointed that SAP's revenue growth has faltered despite the buoyant global environment. We have been pleased by the continued progress of Canon — albeit aided by the substantial fall in the yen. We are puzzled that we are struggling so much to find other Japanese stocks that appear its equal in either business attraction or valuation despite the overall Tokyo market weakness.

Alternative energy

After prolonged (arguably too prolonged) thought we have bought three stocks that are directly or indirectly dominated by prospects for the alternative energy sector. The appeal of this area no longer rests on the one variable of oil and gas pricing but on demands for energy security and concerns over climate change too. This makes their continued development more predictable and less erratic. Backing is now from across the political spectrum and from a wide geographical spread in a manner that was hitherto unlikely encompassing as it does George Bush and Australia. Major utilities rather than esoteric communities are now the dominant customer base.

The most challenging part of this topic is assessing the competitive position of individual companies and technologies. Given the difficulties involved we think this is an area where it is more sensible to have a broader spread of investments than we would normally propound. This is particularly true of solar energy which has a still less developed technological road map and industry structure than other segments. Here we have bought Q-Cells which is one of many strong German enterprises in the field and which particularly appeals to us because it is both relatively technology agnostic and boasts a secure source of silicon supply. In wind power there is already one dominant supplier, Vestas of Denmark, and we see little reason to be sceptical of its continued health. The third stock is a less direct beneficiary, John Deere, which appears to us to be recovering from half a century of difficulties as bio-fuel requirements (and agricultural inflation) resuscitates long moribund farming demand. Over the course of time we would like to see our investment in this area at least increase. In the next 12 months we would like to double the 50m we had invested at the year end. Recent share price action has been too buoyant for us to want to achieve this immediately.

Fixed interest

We have tried to apply the same principles to fixed interest as we use in equities. We view our holdings as an integral part of the overall portfolio not as a portfolio to exist in its own right or to be measured on its own. We are looking for major misvaluations to benefit our shareholders in the long term. One opportunity has stood out for us over the last year. We started buying Brazil local currency index linked bonds on a 9.0% real yield. Given the Brazilian macroeconomic improvements that we have already discussed above we felt this to be extremely attractive. Yields have now fallen to 6.5% which we consider to be still too high if less extraordinary. Sadly the general compression of yields is making such opportunities increasingly scarce.

Overall reflections and future prospects

The last twelve months has seen far more activity in the portfolio than we would normally welcome (although turnover at 34% remains low by industry standards). On this occasion we feel that the changes ought to be greatly beneficial for the years ahead. We believe that we have increased the overall calibre of companies in which we invest and that we are obtaining better value whilst being more directly exposed to the deeply exciting growth dynamics of the world economy. After a prolonged period of stock market gains we are aware that complacency can set in amongst investors and that volatility can ensue. If we have concerns they are more focussed on the extended levels of profitability in the American and British financials sectors than on the fine fundamental health of the international economy. Whatever the precise nature of challenges to be faced over the year ahead we remain confident in our investment methodology and optimistic about the prospects for the next five years.