Scottish Mortgage Investment Trust — Annual Report 2010

Managers' Review — James Anderson (year ended 31 March 2010)

Context. Post-crash vindication. Anderson opens with a warning about annual performance data: "Last year we seemed to be terrible investors. This year we appear brilliant" — same process, same portfolio, same people. The review covers the China conviction, the trust's refusal to judge itself by benchmark-obsessed short-termism, and the beginnings of the open-ended growth philosophy.

---

Managers' Review

Managers' Review

The last 12 months have demonstrated the dangers of undue attention to annual performance data. Last year we seemed to be terrible investors.This year we appear brilliant. All this comes about with the same process, the same portfolio shape, overwhelmingly the same investments and the same people. We are not conscious thal we have become any cleverer this year. Overall we are happy with the way that our companies have coped with the tough environment of the last two years (with sad but inevitable exceptions) but we think that much of their achievement was demonstrated at precisely the time that their share prices wereunder extreme pressure. Frequently markets are simply absurd. The notion that we should judge ourselves by endlessly benchmarking ourselves against their erraticbehavior is one that we complelelyreject.Ourtaskis tobuild wealth for shareholders over long periods of time wilh indices simply as a bockground guide to our basic competence over the decades. Overall we think that we have done quite a reasonable job but this is for other shareholders to judge. It may be worth repecting once more the three convictions that have doninated our slralegy over the las five years. Despite the fragile economic times and the frenetic activity in markets these have remcined solid signposts for us.They are that; ·The rise of China (and to a lesser extenl other emerging Stock markets underestimate the power of technological change in exaggerated revulsion to ihe bubble of 1998-2000. ·The Western financial systems are dangerously Hawed. It is,of course,dangerously easytobe sucked into seeing evidence that confirms the idecs that one is advoccting and it is almost equally challenging to spot the point at which concepls that are fundamentally valid have simply been pushed too far by overblown thesethree contentions.lndeed in eachcase we appear tohove

08Annualreport 2010

grasped that the mecn-reversion of China to a position of global economic leadership was probable. Yet we have underestimated both he awesome pace and scale of this development and the conclusions that this should hove forced us towards instock exposures than in localion of corporate hecdqucrters we feel this is insufficient excuse for this time last year having less than 6% of our portfolio in Chinese companies. The total has now risen to close to 9% which still seems modest by any measure apart from that of This is not lo say that we have any desire to simply buy exposure to corporate China in general but it is lo point lo the single most importont menial shit that we have gone through in the last year. Il isihai we think that China is nowhometo an entrepreneurial fury that is leading to the creation of great individucl businesses. In the years ahead we think it probable that individual privale Chinese venlures will provide much of the innovafion in the world. There has olready been amarked structural shift in our porifoliofrom state owned behemoths such as China Mobile towards youthful and ambitious companies such cs Bcidu and Tencent within the same telecom and internet space. New Oriental Educalion [the leading English language schooll,Ctrip (online travell and Belle (shce retciling] are other exomples of companies with openrended growth opportunities,competitive strengths and focused stralegies that would have appealed to us wherever in the world they could be found over We regularly review threats to continued Chinese progress.A year ago we thought the immediate challenge wos preventing the anticrisis stimulus from seeping into speculation.The domestic stock market hos shown litle sign of this but the coastal housing mcrket has plainly become loo buoyant. Forlunately, and in marked contrast to the Wesl, the cuthorities are prepared both to callincipient bubbles and to counteract them so we are satisfied that common sense is likely to prevail. We do not believe that a consequent slowdown in the housing market would undermine the Chinese economy.

school and provider of private education. Beyond this immediale concern the nexi slage of China's rise would be greatly assisted by the focus of growth shiting from the advanced Eastern provinces to encompass the interior os well as from exporis t0 domestic demand.We spent a fascinating three weeks touring China in March to investigale such questions wih a particular stress on provinces from Inner Mongolia to Sichuan that do not enjoy the optimistic than when we leff. It appears lo us thal demand has shiffed decisively to domestic demand whilst growth in the rural interior seems tobe both stronger ond sounder than wehad feared. We see no sign as yet that ihe Chinese Communist Parly is either unpopular or that it hasmademajor policy mistakes that are likely to prompt serious discontenl. Both are entirely plausible couses of We have always felt that China is of an importance that puts it in a category of its own. We are wary of generalizing about China let alone of incorporating it in a category defined as'emerging markets. Indeed we now feel that the lime hos come to obandon this phrase. The consequent gain in accuracy and clarity has investment benelits. The phrase has come to be used lo denote economic backwardness and high risk. This makes little current sense. We find it hard to see much of urban China cs low in wealth (private or public). We think it unwise io think of China and Brazil os high risk when their balance sheets, trade positions ond financial structures appear so much more solid than our own. It is a pleasing irony that one of the few countries in recent yecrs to have been reclassified as'developed' from emerging is Greece. Our own preference would be to assess individual companies,cifies ondregionsatbest ond individualcountries al most. If the investment worid demands generalizations then we would Buupp, o shamod (adns] bus, woy buuuni au o sabns empires'as themost helpful in our work.Where the USA proves tobe on this conlinuum will be critical in the years ahecd

Managers' Review

Chinese travel operator that has successfully has been in technological innovalion. Whilst the British corporate sector has created litle of new shcreholder or social value over the last 30years this sad state of cffairs is far from true of America. That this is so is principally to the credit of the technology sector and in geographical terms of a small portion of the North-West Coast. All the arrogance of Harvard and greed of Well Street On a more mundane but practical level it has olso been critical lechnology companies involves c willingness to accept both volatlity cnd diverse returns in the search for a select band of companies thal will prove to be persistent winners... but the rewards for doing so can be dramatic.'Whilstwe stillneed tobe cautious in declaring that we have found persistent victors we have cericinly had experiences of both diverse returns and opparent victories. It may be corincidence but we have hadmore and greater victories when investing in [broadly defined) Silicon Valley and (so for) China than elsewhere in the world. Amazon has risen to be our largest holding cffer fine business and share-price perforrmance.This is the first time since 1983 that a US stock has been our largest holding. Our admiration for Amazon lies partly in the scale of the business opportunity but still more in the atitudes inculccted by management. This is o company with contempt for the quarterly earnings game, commitrment lo internal agendas and bureaucrocies that makes future success more One of the most challenging issues for us is that the success of Amazon, Apple, Google, Nintendc and Baidu has been such that comparatively few other pools of profit left tc destroy.We are wary of coming to definitive views as lo the likely course and consequences of these internecine struggles as we have great respect for the abilities of all involved. The combination of the increasing pace and complexity of technological change,the almosl instant geographicol reach of innovalion and thehighly appeoling returns that the winning companies earn mean that we are willing to accepl such clashes as an ineviable drawback of businesses with greal growth opportunities.

Scottishmortgageinvestmenttrustplc9

Managers' Review

Aleading retail bank in a country,Turkey, As already noted we have seen our technology investments spread beyond traditional sectorboundaries.We suspect that the combination of scienific progress, venture capitl interest,demographic demands and financial imperatives mean that healthcare will be a prime focus traditional big pharmaceutical companies willead this sweeping change.A good, if thus far rare, exarmple of what we are looking for comes in our purchase of Intuitive Surgical which is the world leader in robotic surgery.lt has thrived on scientific collaboration from Stanford.research support from the US crmed forces, better clinical outcomes ond a claim to reduce healthcare costs. It now will be able to report on more holdings of this type in future years. Us.Last year weremarked that we saw noevidence of‘less case in the invesiment banking world. What improvements there have been seem to be coming from outside pressures. Capital requirements are somewhat less indulgenl than in the post, the intellectual mood does appear to have shiffed against extreme market fundamentalism and governmental and legal octivism is al ieast plausible. We regard it is inevitable lhat any process of reregulation will have flaws but we sillbelieve that this is a small price to poy if the systemic risks to the world economy posed by greed in the financial sector can be brought under control. This is not populism. lt is necessary for the proper functioning of our financial system. We will continue to have limited holdings in the Western financial syslem until this occurs and what we do have will be concentrated in those rare institutions (notably BancoSantander, Progressive Insurance and Berkshire Hathaway) in which we have

Jamesan

faith in the ethics and seriousness of the management. We feel no need tobe tempted by the morass of unreformed financicl institutions.

10Annualreport2010

Brazilian railway operator which is improving We are all aware of the shocks that the giobal economy has been prey to in recent years. We doubt, however, that there has been sufficienl rethinking of the investment landscape as a consequence of what we have seen and should have learnt. Our atitudes to and understanding of risk needs to be rethoughr. This has transforming consequences. The idea thal risk should be defined as volatiliy cround cn index and that it can be measured has always seemed exceedingly presumptuous. Nevertheless from heavily leveraged investmentbanks to the most stcid of investment trusts this has generclly been the default position of risk managers and hence asset allocotion.This has led most equity porfolios to c concentration on large Western componies as the perceived safe default choice without much thought as to the underlying exposures of these entities (rather similar to the automatic trust in AAA rated mortgoge debt that 'large' will prove synonyms for either'safe' or'weaith-creating' in the decades ahead. We are convinced though that the world offers a solidly bosed, indeed more exciting, and more capable of dragging untoldmillions out of povery than at any siage in history.Naturally evenls ond accidents can occur and stock markets will always be prone fovigorous oscillations but we iend to see such occurrences as distractions from a fundamentally optimistic picture.If this is right and if theManagers carry out their taskcompetently then the prospecls for Scottish Mortgage shareholders ought to be bright indeed.

Jamesanderson

2Ppr

China giving it amarket share of around 20% Jomes and I recently returned from overiapping trips to China with our colleague, Wanyi Yao. We were trying to increase our understanding of the huge changes that are occurring in theregion through meelings with companies, governmenl officials, academics and enlrepreneurs. We spent time in the megacities of Beijing and Shanghai as welil as Iravelling to the western centres of Chongqing and Chengdu,the plains of Inner Mongolia and the provinciai capitais of Anhui, liaoning and Zhejiang. There is a lot of concern in financial markets that the Chinese economy is experiencing an unsuslainable boom at present. We do not share the resulf of a housing bubble but a necessary consequence of the process of urbanisation. In Beijing, for example, there is a requirement for huge further investment to ease congestion. Car ownership in Beijing is less than 20% of the level seen in the United States but it is quite clear lo onyone who has spent o day there that the road nelwork can barely support currenf usage. The subway system is to be expanded from the current six lines which serve a municipal This necessary investment in moss fransit is mirrored in at least ten As we drove along the expressway from Shanghai to Hangzhou, we could see the pillars thal are being erected for the new high speed rail link between the two cilies. The scale of this infrastrucfure tall supporing a concrete base for the track and streiching for high speed rail links are currently under construction. Such inveslment of our global industrial holdings such as iron are producer, Vale or It is apopularmisconception ihat theChinesecuthorities are not concerned about climate change. lt was quite clear from meetings with state controlled companies such as Shonghai Electric (which has been funding a rapidly growing wind turbine manufacturer or longyucn Power (China's largesi windfarm operalor) that the Chinese government is taking this issue seriously.Thetariff structure cnd investment incentives are being put inplace to support ahuge

Managers' Review

2Ppr

PPR owns luxury brands with excellent potenticl in newer markets including Gucci andBattega Veneta. University of Science and Technology in Hefei highlighted that funding is clso flowing intoresearch on the development of the electricity grid to cope with greater porlicipolion from renewable sources. Perhaps even more importantly, a trip to one of the country's fifty four high lechnology zones showed hat there is a clear understanding within government thatChinese companies have to increaseresearch cnd development spending and move into higher value sectors of ihe econorny. Given the growth opportunity in their domeslic market. they see green energy as an area in which they can be world leaders. The desire lo shift economic focus from commodity industries was in the financial sector where the pace of change seems to be ccceleraling. We were struck by the thoughtful and open manner of the government officials responsible for this. Perhaps one big cs likely to be atracted to a career in government as they are fo private sector employment.Therefore those responsible for finonciol regulation may be better placed to idenlify and prevent industry excess.One of the lessons that the Chinese have taken from the receni crisis is that the financial seclor has to serve the real economy and that the connection between the two must be maintained as they grow. Therefore they are happy to encourage the development of new financial producis but only if they support the development of new and strategically important induslries.Perhops this is a lesson which wehave not yet fully understood here in the UK. Whilst consumption remains c relalively small part of the China's economy. there is lile evidence that as Chinese society becomes Because ihe overall population is large, even having a small proportion of people with meaningful disposable incomes already translates into huge spending power.Wehad an interesting meeting with Gucci China la subsidiary of the fund's holding in Pinaulf- PrintempsRedoute)and the development of their business illustrates this well. Gucci now generctes I5% of global revenues in China having entered the market in 1997. One of the interesting facets individucl brands cnd the corollary of this may wellbe that successful brands have a larger opportunity in China. The scale of demand for luxury products appears to be leading to higher prices than elsewhere

Scottishmortgageinvestmenttrustplcit

Managers' Review

IThe view from the foot of Huangshan Whilst in Beijing, we met the former leader of Google China, who leff to start up an incubator fund focused on technology companies. In some areas, such as Internet gaming.the Chinese are the pioneers of new business models and this was an opportunity to see whether this reflects a growing culture of innovation and startup investment inlechnology.It quicklybecome clear that there is no shorlage of newideas and the interest that this particularventure has generated suggesis greal potenlicl enthusiasm.For example the fund has had over one hundred thousand CVs over the few months since its formation,suggesting that many potenticlemployees have been looking forc way into this industry.As the entrepreneurial ecosystem slarts to build and capital becomes more readily available, we think the creativity that is unleashed willform the foundation of After visiing a local hospital and healh bureau in north eastern China,we metthe senior researcher of the State Council who drafted China's Healthcare Reform White Paper. Over the next three yecrs, the government will invest the equivalent of 85bn in heathcare, aiming to provide basic health insurance lo ailit was interesting to discover that healthcare insurance coverage is already over 90% in urban China).These headlinefigures are likelyto understate the true level of inveslment as they do not capture the spending of local government. Whilst we have yet to find airactive potentiol investments in this area, a visit lo on unlisted phcrmoceutical company in Chengdu,which is seeing explosive volume growth in the drugs it sells, was illusirotive of ilhe opportunilies which are being created. The huge commitment to healihcare and the associated increase in spending levels willbe animporlant new driving force for the Chinese economy. The increase in healthcare infrastructure investment will directly promote economic growth and theimplementation of reform

Tomslat

will improve the health of citizens and social security, thereby stimulating consumplionand sustaining economicgrowth in the

1Annualreport2010

colleague Wanyi Yao in China this year. With questions obout rural reform in mind, we travelled wesiwards to one of the largest and most populous agricultural provinces -Sichuan. Whilst rural development has been ongoing since the 1970s, this time ihe direclion is quite different and the success (or otherwise] of the policy willhave farreaching consequences. State sponsored land privatisation in selected villages in Sichuan is underway which shouid create weolth for rural inhabilants as well as increasing agriculural productivity through a move to large-scale farming. One consequence of this rnay be an increase in the number of migrcnt workersrelocating to urban areas,which hospositive implications for productivity growth. Sichucn clready exports over wenty million migrant workers to the coastalprovinces of eastern China. However, as further urbanisation takes place, megacilies are of smcller cities and lowns is of increasing importance. From cn investment point of view we are questioning whether large banks with existing rural networks are the best way tofacilitate rural reform and benefi from these changes. There are implications for a wide holding in John Deere, thefarm machinery business. In summary,we remain very enthusiastic about ihe prospects for growth in Chinese infrastructure investment and domestic consumption. A great deal of progress is being made in fieids as disparate os renewcble energy, financial services, healthcare, agricultural reform and early stage technology investment.Webelieve markets continue to uncerestimale ihe inporlance of the changes that are taking place and this is throwing up many exciting opportunities for us as long

Tomslater

Thirtylargeste

Thirty Largest Equity Holdings and Equity Performance as at 31 Ma 2010 '000 120,009 108,260 84,691 83,831 77,278 71,659 58,268 47.770 47,517 47,030 43,022 42.768 40.303 37,503 37,106

Kghm

34,170 34,118 30,900 30,747 30,731 30,640 30,322 29.708 29,384 29,280 28.323 27,916 26,050 25.658 25,553 1,390,515 ↑Absolute ond relative performance has been colculated on a total return basis over the period 1Ap terms; relative performance is against the benchmark: FTSE All World Index [in sterling terms] * Figures relale lo partperiod returns where the equity has been purchased during the period. Past performance is not a guide to future performance. 2010 2009 '000 000.3 120,009 75.4 18.2 62,512 108,260 56.2 87,056 84,691 95.3 31.6 34,179 83,831 104.5 37.8 60,044 77,278 220.7 116.2 5,357 71,659 13.1 49,315 58,268 138.4 60.7 41,632 47.770 54.0 44,751 47,517 104.9 38.1 18,132 47,030 74.2 17.4 27,478 43,022 36.8 31,826 42.768 112.7 43.3 20,617 40.303 14.7 22,523 37,503 36.2 27,523 37,106 35.3 27,640 34,170 34,118 30,900 155.3 7,566 30,747 51.4 18.094 30,731 146.5 66.2 11.542 30,640 25,693 30,322 119.9 48.2 37,111 29.708 149.8 68.4 12.167 29,384 47.6 20,254 29,280 50.0 28,276 28.323 111.1 42.3 7.019 27,916 26,050 25.658 25,553 136.5 59.4 10,903 390,515 64.4 739,210 over the period 1 April 2009 to31 March 2010. Absolute performance is in slerling

Scottishmortgageinvestmenttrustplci3