Scottish Mortgage Investment Trust — Annual Report 2008

Managers' Review — Baillie Gifford (year ended 31 March 2008)

Context. The year in which the trust's five-year evolution — from a collection of index-aware regional portfolios into a single focussed, stock-driven global entity — reached completion with a final re-balancing away from British equities. The review is built around the current top five holdings (Vale, Atlas Copco, Petrobras, Porsche and Gazprom), potentially important holdings including Google and Nintendo, and alternative energy, closing with future policy after three months of market nerves.

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Managers' Review

Over the last five years this review has charted Scottish Mortgage's evolution from a collection of index aware regional portfolios with a heavy bias to UK listed companies into a single focussed, stock-driven global entity investing for the long term. We have commented on our suspicions of excessive diversification and the exaggerated fears of temporary share price volatility based on dubious correlations and near meaningless quarterly earnings releases.

We have now reached a point where the structure of the portfolio is as we would wish it after a final re-balancing away from British equities. Therefore this review will discuss a selection of the individual investments that have been critical to our performance and some that may be vital in the future.

The Current Top Five

CVRD (Brazil)

CVRD or Vale as it is now to be called is the world's largest iron ore company. Its reserves are the most productive to be found anywhere. Production capacity has risen sharply at comparatively low cost. We have owned the shares since 2004 since when they have risen 475%.

Plainly this return has been gratifying but it raises the question as to whether the virtues of Vale are now fully recognised and discounted by the markets. One of the features of the iron ore market that attracted us was that world class capacity was concentrated in just three hands (Vale, Rio Tinto and BHP) and pricing was settled by a system of annual price negotiations with major steel manufacturers. This translated into an industry with better and more stable returns than was the case for most commodities. We have some concerns that these features are starting to break down under the pressure of the extraordinary boom induced by Chinese infrastructure demands. New competitors are gradually entering the market whilst a spot market has appeared and as the cost of shipping from (now strong currency) Brazil has soared. At the same time Vale has been tempted to use its substantial cash flows to diversify away from the very assets that have made it great. In fairness we found the deal to buy Inco appealing as it brought the prospect of a genuine franchise in the concentrating nickel market but we have been unsure that talks with Xstrata are likely to be as beneficial. We were therefore glad that they have been broken off. However we have trimmed our holding and remain wary of such ambitions undermining a superb and still lowly valued core business.

Atlas Copco (Sweden)

This Swedish engineering company has been owned by Scottish Mortgage for well over a decade. The move to a global approach has led to a significant increase in the scale of our holding. Previously the exposure has been limited by concerns over its size relative to European or even Scandinavian assets whilst its outstanding business prospects may have been underestimated. Atlas continues to boast formidable strength in its core compressor business which has shown impressive levels of profitability and market share. More recently it has also built a powerful mining equipment division that was assembled at a time when the industry was in the doldrums. With over 40% of orders now derived from emerging markets the obsessive desire of the market to see the ghosts of past US recessions as a harbinger of doom for Atlas seems miscalculated. We have steadily been adding to our stake and regard the stock as highly attractive at current share prices.

Petrobras (Brazil)

Since the end of March Petrobras has become our largest holding by dint of renewed excitement over the prospects for its drilling success in deep offshore Brazilian waters. It appears probable that its finds may be amongst the largest discoveries ever made if also being amongst the most technically demanding. None of the traditional Western oil majors has remotely comparable prospects.

Petrobras captures core aspects of our investment philosophy. We have been fortunate enough to have seen the market value of the shares rise tenfold over the last five years but this outcome could only have been of significant benefit to us because of our willingness to invest in the most attractive stocks without constraint by index weights and geographical preconceptions. Equally we have owned it because of its great potential not simply to have a set percentage of assets in the oil industry. BP has risen only 28% in the last five years by comparison. In recent weeks Petrobras has even exceeded BP in market capitalisation. Inevitably the valuation of Petrobras now includes some acknowledgement of its dramatic reserve potential. Our future holding size will depend principally on how far the scale of the discoveries outweighs the development costs in the years ahead.

Porsche (Preference shares) (Germany)

We consider Porsche to be a thoroughly misunderstood company. Its share price oscillates violently according to the mood of the markets about US economic activity and the dollar combined with screaming newspaper headlines pointing at the supposedly vainglorious ambitions of the Porsche and Piech families.

We see Porsche in a very different light. Its Chief Executive, Wendelin Wiedeking has been one of the outstanding global corporate leaders of the last twenty years. We believe Porsche's growing control of Volkswagen is driven by shrewd economic assessment rather than dynastic pride. Porsche is rapidly moving its original brand towards leading positions in emerging markets to replace reliance on the whims and bonuses of bankers in London and New York. Given that the valuation of Porsche still reflects a more pessimistic and to our mind passé view we remain enthusiastic owners of the shares.

Gazprom (Russia)

Our stake in Gazprom has been controversial. There is no stock about which we receive more sceptical questioning and there are few stocks that have been more rewarding for our shareholders (with a gain of over 750% in the last five years). Whilst we cannot guarantee that there will not be adverse political developments in Russia we think that the odds are significantly in our favour in investing in Gazprom. We own the same shares as the Russian government and regard its continued support as both beneficial to the company and economically justifiable. It is reasonable expect Ukraine to pay market prices for gas and to anticipate liberalisation of domestic prices. It is surely more rational to be worried about foreign resource holders in Russia than about Gazprom.

Even more critically the valuation of Gazprom shares suggests that the opportunity remains very significant. Reserves are still valued at little more than a tenth the level per barrel as for Western companies. For the greatest reserve base in the world this seems an exaggerated discount. We think the risks associated with investing in Gazprom are far more likely to be rewarded than those of allocating our assets to Western majors with stagnant or declining reserves.

Potentially Important Holdings

All these five stocks have helped our shareholders in the past. We believe they will continue to do so in the future but we would also like to point to several areas which we have been adding to in recent months and about which we have great hopes for the future. If the flavour of the top five holdings encapsulates the powerful trends of globalisation and industrialisation of emerging markets then we would emphasise that we see technological innovation as almost as critical a force in shaping the global economy in the years ahead.

Investing in technology companies involves willingness to accept both volatility and diverse returns in the search for the select band of companies that will prove to be persistent winners in their sectors but the rewards for doing so can be dramatic. In the last year this battle has been exemplified by the success of Amazon and the struggles of eBay but the net effects have been pleasing.

As might be imagined anxieties over the US consumer have badly hurt the share prices of many companies in this area in recent months. We think this is giving us significant opportunities if we can retain our patience. In particular we have started buying Google and Nintendo which seem to us to be extraordinarily strong businesses whose growth and value will endure well beyond current market nerves. Google's ability to revolutionise the advertising industry and to disrupt traditional software markets seems to be accelerating rather than fading. We intend to continue buying the shares even if the period of greatest opportunity may now be past.

In the case of Nintendo we are thrilled that after almost twenty years of decline we have now found at least one additional Japanese stock that excites us both in its business model and by its low valuation relative to its foreseeable returns. Nintendo's success in attracting a far wider set of participants to its Wii and DS platforms than traditional gaming companies seems to us to be emblematic of a distinctive and thoughtful approach that is curiously simple yet hard to imitate. That both Google and Nintendo relish competing with Microsoft is perhaps non-coincidental.

Finally we would highlight our exposure to alternative energy companies. This is a difficult, volatile and complex field and some of our most thoughtful shareholders have expressed doubts about prevailing valuations but on balance we consider that this remains an intriguing area for future expansion. In particular we think that the progress being made in solar power is deeply encouraging. We estimate this ought to translate into parity of cost with traditional energy sources within 3-5 years — or well within our investment horizon. We have tried to use the excessive volatility of these stocks to add to our holdings in a disciplined manner. We see little sensible reason for the collapse of this sub-sector in the market nerves of the last three months especially since energy prices have remained so disconcertingly buoyant. We have therefore added to our holdings in two companies where we feel the dynamism of technical progress and business execution has begun to translate into structural advantages. One, First Solar, is the clear leader in thin film technology and the closest to grid parity. Its early backing by the Walton family (of Walmart fame) is now set to pay off in initial US utility contracts. The second is Q-Cells which has turned a favourable research and subsidy environment in Germany into scale and technology leadership. The potential scope and profitability of these companies reconciles us to their ratings within the overall portfolio context. As we also have holdings in two Danish companies in the form of Vestas (wind power) and Novozymes (enzymes) our investments in alternative energy have significantly contributed to a stock driven rise in our European assets.

Future Policy

Our policy will remain set on the course we have pursued over the last five years. It would be a pleasant surprise if this were to prove quite as dramatically successful in the years ahead. In particular it would be strange if the experience of the last year in which only two of our top twenty holdings (held throughout the period) deducted from absolute or relative performance were to be easily repeated. Indeed we cannot hope to generate good overall returns unless we are prepared to accept the near inevitability of several holdings disappointing.

These cautions aside we feel optimistic about the future of the Trust. Tactically we are finding many opportunities. As indicated above several of these are now to be found in the angst ridden markets of the West as well as in the structural growth areas of Asia and Emerging Markets. There are even some banks that we have been tempted to start buying — if prematurely at the date of record. For these reasons we have been happy to see gearing levels edge higher. To our minds a world economy less dominated by Anglo-American consumers and bankers and more exposed to the march of China, India and Brazil away from poverty is a more appealing and better balanced environment for equity investors rather than a cause for panic.

In strategic terms we feel that the advantages of a genuinely global approach run with the discipline to endeavour to distinguish underlying change from the cacophony of noise that preoccupies markets and offering the flexibility offered by the combination of the ability to borrow with a strong foundation of permanent capital is becoming ever more valuable. It is these advantages that we constantly need to try to exploit rather than falling into the trap of behaving as a lightly disguised index fund or an extravagantly remunerated hedge fund. If we can achieve this then the prospects are good given reasonable good fortune.