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.

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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 that 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 were under extreme pressure.

Frequently markets are simply absurd. The notion that we should judge ourselves by endlessly benchmarking ourselves against their erratic behaviour is one that we completely reject. Our task is to build wealth for shareholders over long periods of time with indices simply as a background 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.

Our principal investment contentions

It may be worth repeating once more the three convictions that have dominated our strategy over the last five years. Despite the fragile economic times and the frenetic activity in markets these have remained solid signposts for us. They are that;

• the rise of China (and to a lesser extent other emerging economies) is transforming the global economic scene;
• stock markets underestimate the power of technological change in exaggerated revulsion to the bubble of 1998–2000;
• the Western financial systems are dangerously flawed.

It is, of course, dangerously easy to be sucked into seeing evidence that confirms the ideas that one is advocating and it is almost equally challenging to spot the point at which concepts that are fundamentally valid have simply been pushed too far by overblown market sentiment. Nevertheless we see little reason to retreat from these three contentions. Indeed in each case we appear to have underestimated their importance.

China

It is on this topic that we feel most guilty of feebleness. We have grasped that the mean-reversion of China to a position of global economic leadership was probable. Yet we have underestimated both the awesome pace and scale of this development and the conclusions that this should have forced us towards in stock selection. Whilst we are generally more interested in economic exposures than in location of corporate headquarters 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 commonly used indices.

This is not to say that we have any desire to simply buy exposure to corporate China in general but it is to point to the single most important mental shift that we have gone through in the last year. It is that we think that China is now home to an entrepreneurial fury that is leading to the creation of great individual businesses. In the years ahead we think it probable that individual private Chinese ventures will provide much of the innovation in the world. There has already been a marked structural shift in our portfolio from state owned behemoths such as China Mobile towards youthful and ambitious companies such as Baidu and Tencent within the same telecom and internet space. New Oriental Education (the leading English language school), Ctrip (online travel) and Belle (shoe retailing) are other examples of companies with open-ended growth opportunities, competitive strengths and focused strategies that would have appealed to us wherever in the world they could be found over the last 100 years.

We regularly review threats to continued Chinese progress. A year ago we thought the immediate challenge was preventing the anticrisis stimulus from seeping into speculation. The domestic stock market has shown little sign of this but the coastal housing market has plainly become too buoyant. Fortunately, and in marked contrast to the West, the authorities are prepared both to call incipient 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.

Beyond this immediate concern the next stage of China's rise would be greatly assisted by the focus of growth shifting from the advanced Eastern provinces to encompass the interior as well as from exports to domestic demand. We spent a fascinating three weeks touring China in March to investigate such questions with a particular stress on provinces from Inner Mongolia to Sichuan that do not enjoy the historic coastal advantages and prejudices. We returned more optimistic than when we left. It appears to us that demand has shifted decisively to domestic demand whilst growth in the rural interior seems to be both stronger and sounder than we had feared. We see no sign as yet that the Chinese Communist Party is either unpopular or that it has made major policy mistakes that are likely to prompt serious discontent. Both are entirely plausible causes of friction in the future.

Emerging markets no more?

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 time has come to abandon this phrase. The consequent gain in accuracy and clarity has investment benefits. The phrase has come to be used to denote economic backwardness and high risk. This makes little current sense. We find it hard to see much of urban China as low in wealth (private or public). We think it unwise to think of China and Brazil as high risk when their balance sheets, trade positions and financial structures appear so much more solid than our own. It is a pleasing irony that one of the few countries in recent years to have been reclassified as 'developed' from emerging is Greece. Our own preference would be to assess individual companies, cities and regions at best and individual countries at most. If the investment world demands generalizations then we would suggest a line running from 'rising (super) powers' to 'declining empires' as the most helpful in our work. Where the USA proves to be on this continuum will be critical in the years ahead.

Technological innovation

Where America has remained a land of opportunity in recent years has been in technological innovation. Whilst the British corporate sector has created little of new shareholder or social value over the last 30 years this sad state of affairs 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 Wall Street cannot completely obscure this extraordinary achievement.

On a more mundane but practical level it has also been critical to Scottish Mortgage. Two years ago we wrote that "investing in technology companies involves a willingness to accept both volatility and diverse returns in the search for a select band of companies that will prove to be persistent winners... but the rewards for doing so can be dramatic." Whilst we still need to be cautious in declaring that we have found persistent victors we have certainly had experiences of both diverse returns and apparent victories. It may be coincidence but we have had more and greater victories when investing in (broadly defined) Silicon Valley and (so far) China than elsewhere in the world. Amazon has risen to be our largest holding after fine business and share-price performance. 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 attitudes inculcated by management. This is a company with contempt for the quarterly earnings game, a commitment to continuous innovation (however disruptive) and an intolerance of internal agendas and bureaucracies that makes future success more than normally likely.

One of the most challenging issues for us is that the success of Amazon, Apple, Google, Nintendo and Baidu has been such that these giants are increasingly clashing with each other as there are comparatively few other pools of profit left to destroy. We are wary of coming to definitive views as to 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 almost instant geographical reach of innovation and the highly appealing returns that the winning companies can mean that we are willing to accept such clashes as an inevitable drawback of businesses with great growth opportunities.

As already noted we have seen our technology investments spread into China but we also believe that we need to widen our interest beyond traditional sector boundaries. We suspect that the combination of scientific progress, venture capital interest, demographic demands and financial imperatives mean that healthcare will be a prime focus of future technological innovation. We do not believe that that the traditional big pharmaceutical companies will lead this sweeping change. A good, if thus far rare, example of what we are looking for comes in our purchase of Intuitive Surgical which is the world leader in robotic surgery. It has thrived on scientific collaboration from Stanford, research support from the US armed forces, better clinical outcomes and a claim to reduce healthcare costs. It now has 90% of the world market for such systems. We hope that we will be able to report on more holdings of this type in future years.

Western finance: still rotten?

The machinations of the Western financial sector continue to trouble us. Last year we remarked that we saw no evidence of "less complexity or reduced avarice." Sadly this still appears to be the case in the investment banking world. What improvements there have been seem to be coming from outside pressures. Capital requirements are somewhat less indulgent than in the past, the intellectual mood does appear to have shifted against extreme market fundamentalism and governmental and legal activism is at least plausible. We regard it is inevitable that any process of reregulation will have flaws but we still believe that this is a small price to pay if the systemic risks to the world economy posed by excessive gearing, illconsidered risk analysis and untrammelled greed in the financial sector can be brought under control. This is not populism. It is necessary for the proper functioning of our financial system. We will continue to have limited holdings in the Western financial system until this occurs and what we do have will be concentrated in those rare institutions (notably Banco Santander, Progressive Insurance and Berkshire Hathaway) in which we have faith in the ethics and seriousness of the management. We feel no need to be tempted by the morass of unreformed financial institutions.

Conclusion and Outlook

We are all aware of the shocks that the global economy has been prey to in recent years. We doubt, however, that there has been sufficient rethinking of the investment landscape as a consequence of what we have seen and should have learnt. Our attitudes to and understanding of risk needs to be rethought. This has transforming consequences. The idea that risk should be defined as volatility around an index and that it can be measured has always seemed exceedingly presumptuous. Nevertheless from heavily leveraged investment banks to the most staid of investment trusts this has generally been the default position of risk managers and hence asset allocation. This has led most equity portfolios to a concentration on large Western companies 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 mortgage debt that has so haunted the bond markets). We doubt that 'Western' or 'large' will prove synonyms for either 'safe' or 'wealth-creating' in the decades ahead. We are convinced though that the world offers a wealth of opportunities. We think that the global economy is more solidly based, indeed more exciting, and more capable of dragging untold millions out of poverty than at any stage in history.

Naturally events and accidents can occur and stock markets will always be prone to vigorous oscillations but we tend to see such occurrences as distractions from a fundamentally optimistic picture. If this is right and if the Managers carry out their task competently then the prospects for Scottish Mortgage shareholders ought to be bright indeed.

China Trip Note

James and I recently returned from overlapping trips to China with our colleague, Wanyi Yao. We were trying to increase our understanding of the huge changes that are occurring in the region through meetings with companies, government officials, academics and entrepreneurs. We spent time in the megacities of Beijing and Shanghai as well as travelling to the western centres of Chongqing and Chengdu, the plains of Inner Mongolia and the provincial capitals of Anhui, Liaoning and Zhejiang.

There is a lot of concern in financial markets that the Chinese economy is experiencing an unsustainable boom at present. We do not share these misgivings. We believe the pace of fixed asset investment is not the result 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 to anyone who has spent a day there that the road network can barely support current usage. The subway system is to be expanded from the current six lines (which serve a municipal population of twenty two million people) to nineteen lines by 2020. This necessary investment in mass transit is mirrored in at least ten other major Chinese cities.

As we drove along the expressway from Shanghai to Hangzhou, we could see the pillars that are being erected for the new high speed rail link between the two cities. The scale of this infrastructure investment is astonishing, with concrete pillars standing fifteen meters tall supporting a concrete base for the track and stretching for thousands of kilometres. In fact, seventeen thousand kilometres of high speed rail links are currently under construction. Such investment projects underpin our confidence in prospective demand for many of our global industrial holdings such as iron ore producer, Vale or engineering company, Atlas Copco.

It is a popular misconception that the Chinese authorities are not concerned about climate change. It was quite clear from meetings with state controlled companies such as Shanghai Electric (which has been funding a rapidly growing wind turbine manufacturer) or Longyuan Power (China's largest windfarm operator) that the Chinese government is taking this issue seriously. The tariff structure and investment incentives are being put in place to support a huge construction programme in green energy generation. A visit to the University of Science and Technology in Hefei highlighted that funding is also flowing into research on the development of the electricity grid to cope with greater participation from renewable sources. Perhaps even more importantly, a trip to one of the country's fifty four high technology zones showed that there is a clear understanding within government that Chinese companies have to increase research and development spending and move into higher value sectors of the economy. Given the growth opportunity in their domestic market, they see green energy as an area in which they can be world leaders.

The desire to shift economic focus from commodity industries was articulated by many of the people we met. This was most noticeable in the financial sector where the pace of change seems to be accelerating. We were struck by the thoughtful and open manner of the government officials responsible for this. Perhaps one big difference from Western countries is that the brightest graduates are as likely to be attracted to a career in government as they are to private sector employment. Therefore those responsible for financial regulation may be better placed to identify and prevent industry excess. One of the lessons that the Chinese have taken from the recent crisis is that the financial sector 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 products but only if they support the development of new and strategically important industries. Perhaps this is a lesson which we have not yet fully understood here in the UK.

Whilst consumption remains a relatively small part of the China's economy, there is little evidence that as Chinese society becomes wealthier, the propensity to spend will be lower than anywhere else. Because the overall population is large, even having a small proportion of people with meaningful disposable incomes already translates into huge spending power. We had an interesting meeting with Gucci China (a subsidiary of the fund's holding in Pinault-Printemps Redoute) and the development of their business illustrates this well. Gucci now generates 15% of global revenues in China having entered the market in 1997. One of the interesting facets of the market is that consumers appear to be much more loyal to individual brands and the corollary of this may well be 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 in the world.

Whilst in Beijing, we met the former leader of Google China, who left 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 in technology. It quickly became clear that there is no shortage of new ideas and the interest that this particular venture has generated suggests great potential enthusiasm. For example, the fund has had over one hundred thousand CVs over the few months since its formation, suggesting that many potential employees have been looking for a way into this industry. As the entrepreneurial ecosystem starts to build and capital becomes more readily available, we think the creativity that is unleashed will form the foundation of many exciting new businesses.

After visiting a local hospital and health bureau in north eastern China, we met the senior researcher of the State Council who drafted China's Healthcare Reform White Paper. Over the next three years, the government will invest the equivalent of £85bn in healthcare, aiming to provide basic health insurance to all (it was interesting to discover that healthcare insurance coverage is already over 90% in urban China). These headline figures are likely to understate the true level of investment as they do not capture the spending of local government. Whilst we have yet to find attractive potential investments in this area, a visit to an unlisted pharmaceutical company in Chengdu, which is seeing explosive volume growth in the drugs it sells, was illustrative of the opportunities which are being created. The huge commitment to healthcare and the associated increase in spending levels will be an important new driving force for the Chinese economy. The increase in healthcare infrastructure investment will directly promote economic growth and the implementation of reform will improve the health of citizens and social security, thereby stimulating consumption and sustaining economic growth in the long term.

With questions about rural reform in mind, we travelled westwards to one of the largest and most populous agricultural provinces — Sichuan. Whilst rural development has been ongoing since the 1970s, this time the direction is quite different and the success (or otherwise) of the policy will have far-reaching consequences. State sponsored land privatisation in selected villages in Sichuan is underway which should create wealth for rural inhabitants as well as increasing agricultural productivity through a move to large-scale farming. One consequence of this may be an increase in the number of migrant workers relocating to urban areas, which has positive implications for productivity growth. Sichuan already exports over twenty million migrant workers to the coastal provinces of eastern China. However, as further urbanisation takes place, megacities are reaching saturation point and therefore the strategic development of smaller cities and towns is of increasing importance. From an investment point of view we are questioning whether large banks with existing rural networks are the best way to facilitate rural reform and benefit from these changes. There are implications for a wide range of businesses from the domestic real estate developers to our holding in John Deere, the farm machinery business.

In summary, we remain very enthusiastic about the prospects for growth in Chinese infrastructure investment and domestic consumption. A great deal of progress is being made in fields as disparate as renewable energy, financial services, healthcare, agricultural reform and early stage technology investment. We believe markets continue to underestimate the importance of the changes that are taking place and this is throwing up many exciting opportunities for us as long term investors.