Scottish Mortgage Investment Trust — Annual Report 2011

Managers' Review — James Anderson (year ended 31 March 2011)

Context. "The global economy has seldom been stronger. The pace of economic change has never been greater." The 2011 review frames the China transition (from low-cost exporter to consumer of first resort), defends conviction through the European sovereign crisis, and restates the case for judging performance only over five-year-plus horizons.

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Managers' Review

Managers' Review

The global economy has seldom been stronger. The pace of economic change has never been greater. We suspect that this will for investors. Preoccupation with unpredictable short term oscillations in economies and markets has opened upa deep gulf between the crucial determinants of economicprogress and speculative behoviour.It seemsmost unlikely that thefuture of theglobol economy and of intelligent siock selection lies in on obility to ponlificate about Greek,lrishcndPortuguese debt.One of the virtues of a global investment trust with access to long term capital ought tobe its ability lo transcend suchfashions. What happened in the year under review? Once again the inexorable development of China is our starting? point.It seems to us that the transition from alowcost exporting behemoth to a consumer of first resort and a crucible for innovative corporate models was the key story of last year. Whilst we suggested last year that this might eventually happen we are surprised by just how fast the change appears to be occurring.in the course of 2010 China became the home of the world's fastest computer, the world's fastest train and theworld'slargest genome sequencinginstitute. Most importantly of all the startling results obtained by the Shanghai region in the OECD backed PISA educational survey revealed just how quickly China is upgrading its human capital. This demands that ourmental models of the Chinese economy need constant revision. This is directly relevant for our portfolio. After a year of extraordinary share price performonce our largest holding is now the Chinese internet search companyBaidu.lt and our sixthlargest equity posifion characteristics of the Chinese internet. Such companies are offering challenges to the US business models that have been so dominant in Whilst the continuing ascent of the Chinese economy has been the dominant feature of the last year the greatest surprise has been the less sophisticated economies.Foryears it has been popular to belile the virtues of the sober Germon approach in contrast to the

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consider it ikely that Germany can enjoy growth rates above 3% for several years to come as the recovery broadens into increased capital expenditure and even consumplion. We think that German industry has potiently priced itself back into internalional competitiveness, reoriented its trade towords rising nations and established enviable brand leadership in key seciors. Meanwhile governments of both leff and right have maintained national fiscol order whilst the populace has resisted the lure of property inflation. ThatmanyGerman bankshavefailed to operatewith similar sense is a persistent failure but one thatis unlikely to undermine overall prosperity. It seems to us that much of this follows the model of the revival of Scandinavion economies in the last 10 years after tough economies are now thriving.This too appears sustainable.As yet we have been more successful in identifying individual corporate successes in Sweden (Alas Copco once ogoin} and Denmark Whilst the current prospecis of China and Germany justify this approach we suspect that the next decade will require a gradual retreat from such convenient labels.ScotishMorigagehas spent much of the last decade shifing from an indulgent home-market bias. As late as 2005 our four largest holdings were all UK listed companies (none of which we now own nor regret selling). We have succeeded in moving to a genuinely global perspective but the comparative simplicities of this beneficial change are now showing signs of fraying. At one level there has always been @ potential weakness: the fund management industry has a tendency to link national economic circumstances and corporate performance more tightly than underlying reality permis. Such institulional biases are containablebut thefuture seems likely to hold more serious challenges to our current investment methodology.

Corporate prospects are simulianeously becoming more local and more global. This statement requires explanation. We are finding that an increasing percentage of our investment ideas and holdings are concentrated ina smaller and smaller number of cities or ctmost frequently achieved in a limited number of locations combining openness lo innovation,educalional prowess, socialliberolism cnd access to supporive finance. If we can understand the way this process seems toworkand identifythe20-30cities that arethekey exemplars then we stand a belter chance of investing successfuly. Thisdoesnot mean thatwewillignore otherlocationsbut it does seeking refuge in outmoded generalizations such os'emerging markets.' In specific terms it is why we are in the process of opening a Shanghairesearch office.lt is also why if this experiment proves successful wewouldbe more likely tolook toreplicateilinSan Francisco rather than in amore immediately obvious candidate cily Whilst the origins of corporate wealth may well be dominated by a comparatively smal number of cilies the speed and power of technologicol change is likely to overwhelm such considerations.lf in fields as diverse as genetics, robotics, dota availability, nonoiechnology and synthetic biology then the importance of geography may be subsumed in greater challenges. Companies, societies ond indeed humanity will be intensely strained by the pace of change. Geographic boundaries may become relatively meaningless. Machines are not concerned by geography. It will almost certainly be another blow to believers in conventional tisk metrics. It will eventuolly defy belief that largeness cnd sofety were once closely equcted.Tragically BP and Tokyo Electric Power should have given pause for thought amongst proponents of this notion in 2010-11 but there is little sign of such open-mindedness. Our emphasis on the ferocious pace of change may well cppecr

Managers' Review

characteristic to search for in our investment process isa management mentalily andbusinessmodelflexibility ihat can thrive amidstrapidly changing conditions.From Jeff Bezos and his conscious policy of improvements at Amazon lo the re-thinking of sourcing policies that hcs so aided the dramatic internalional expansion of Inditex(Zarc] we think thar such altitudes are thekey tobuilding competive advantage Over the years chead. Relying on lecdership inertia will fail. The combination of mancgerial excellence with ccceleraling months. We have come to the view that cloud computing now has the ability both to cut costs and improve service levels across he corporate and government sectors os expanded upon in the TripNole that follows this Review.This development is very likely to be at the cost of traditional hardware and software giants butpresentsvery substantial opportunities for new entrants. We have graduallybeen building a holding in salesforce.com.li seems to us to be the single compony with thebreadth ofproduct and ambitionthatmight make it the dominant companyin theindustry over thenextdecade.We think that the very myopic. We also admire the efforts of Rackspace to make itself the highest service option within cloud outsourcing. lt has done this principally by thoughtful motivation of employees including by share options that are spread much more broadly thanis commonly the case. A year ago we argued that heathcare was ripe for sweeping change. We also expressed frustralion thai we had made limited progress in identifying companies that could lead this transformation. We conlinue to view the historic pharmaceutical and medical supply companies as likely to be casuallies rather than beneficiaries of this earnings and with many of the supposed clinical advances of the last decade looking increasingly questionable we think problems abound. Internally these companies are viclims of their own immense

Managers' Review

Surgeon console used for robotic surgery. To our relief we are now starting to find attractions in a different group of healthcare companies. We have continued to add to our holding in Intuitive Surgical (the robot surgery leaderl.lt may make the human surgeons seem quaint and redundant as the years go by. We have recently starled buying llumina which is the dominant supplier of tools for the genomics industry. This is a field where progress in science and priceis so rapid that we think it is mistaken to worry thaf thus far it has not delivered significant clinical benefis continuing innovation and prepared to spend boldly in pursuit of As should have become apparent we are increasingly disillusioned by the dominant preoccupations and methodologies of the financial services indusiry.We donotbelieve that following the endlesstwists and turns ofmacroeconomic gyrations, quarterly earnings ormarket sentiment offers good odds of success.This is speculation not investment. It surprises us how litle ihe chaos of recent years has delighted if others think that they canplay these gamesmore inclinations on the comparatively predictable forces of technological change and the reemergence of great civilizalions.Since we believe still more stronglyin the increasing power of these twin forces than last year we once again suggest that the probobility is that if the Managersprovereasonably competent then the long term

James Anderson

1Annual Report 2011

A global leader in gene sequencing systems. 20 1 , I1. mro Ikg, AI nghes *sserve The most complex order management system that exists today, operating a vast supply chain and distribulion infrastructure, can be used with great ease. if you have ever shopped on Amazon.com retailing consumer goods and is paving the way for a sea change in the ITworld.The longstanding idea of delivering IT services rermotely [known as Cloud Computing] is finolly turning in to realiy and in the process is creating some exciting investment opportunities. With these changes in mind I went to Arizona and California to develop our thinking as to who the beneficiaries could be. The trip also provided an opportunity to meet a number of people from other holdings on the west coast of the United States, a part of the world that boasts some of the most innovative companies we can invest in. Salesforce.com is based in downtown SanFrancisco with offices looking out onto the Bay Bridge and cable car station. It was entrepreneur,author andphilanthropist.Benioff set out toattack the behemoths of the enterprise sofiware market such as SAP, Microsoff and his former employer, Oracle. His approach has been lo use the Internet to deliver a service, as opposed to the traditional approach of selling software and an expensive implementation package.The computer hardware requirements and the associated in-house hos altracted 83,000 customers. The compuler power required to support this customer base is around 3% of what would be required using α traditional hardware/software opproach. We cannot predicthow much enterprisetechnology spending could one day find its way onlo salesforce.com's platform but recent developments have seen the company expanding well beyond its original sales management remit and the opportunity exists to become many times

Whilst the cost savings from this technology change represent a the potenlial for unleashing crealivity on a much wider scale that through the Internet and the supporting IT infrastructure con be outsourced, small businesses wih a good idec con achieve astonishing scale in a very short time.I met a number of young businesses which ore not yet listed but moy,in the future,make it into Scoltish Mortgage's portfolio.Their achievements are quite different from what we have seen before. Take Groupon, which is a local advertising and group shopping business. It had four hundred growth would not have been possiblewithout therapid spread of an idea through the Internet combined with the ability to outsource all the infrastructure required to support such a huge subscriber base to One striking aspect of the move to cloud computing is the way users are taking malters into their own hands.It is no longer necessory to means limited upfront spending and the cost of experimentation is vostly reduced. This should provide a boost to productivity ond it also prompts us to change cur mental model of how compelition in costs for customerswould mean incumbent ITprovidershod an enduring competitive advantage.This now seems much less clear and was, in part, behind the decision to sell our holdings in SAP We think ihat in cloud compuling.os in mony creos, we can leorn from walching the cctions of those corporate leaders whose opinions we respect. It come as no surprise that Jeff Bezos, CEO of Amazon, was one of thefirst toidentifythisidea and the opportunitiesit

Managers' Review

Zara's, via del Corso, Rome flagship store. presented. To understand how Amazon's web services business works, it is necessary to step back and think about the infrastructure underlyingthe cloud computing model.Businesses shut down their computer servers ond run their applications on pooled equipment in out the many parallels with the period one hundred years ogo when compcnies stopped producing their own power cnd plugged into the newly buill electric grid.The economies of scale and efficiency that this process produced have direct relevance to the changes in computing weare seeing today.The centralised power plants of the eleciric grid have an equivalent in the vast data cenlres that are required to supply the computing power for cloud-based applications.Amozon has alrecdy developed the software and services lo run such facilities bosed onmore than a decade of work infrastructure requires.We are seeing a trendforyoungbusinesses with no legacy IT systems, such as gomes producer Zynga and thaninvesting timeand energyinbuilding their own IT departments. The other big player in the provision of cloud infrastructure is also held within Scottish Mortgage's portfolio. Rackspace has laken a different approach from Amazon. Where Amazon provides the nuts and bolis for a customer to build their own system,Rackspace has focused on providing a high level of service. Some companies will embrace thisnew modelandbe comfortableusing online tools to build their services,but others willfind it more challenging and require assistance. It is this second group of business which Rackspoce is targeting. Excellent customer service has been something of a rarily in the IT business: even Apple's inspirational wrongly, rather than admiting there were problerms with: his product. I Rackspace is able to deliver consistently in this areo then its

Scottish Mortgageinvestment Trustplc11

Managers' Review

Ground mounted solar panels at Toledo Zoo, Ohio. Whilst the principal focus of the trip was on cloud computing, this was also an opporlunily tofollow up on outslanding queslions al some of our other hoidings. Google's headquarters {also known as looking out over San Francisco boy. The quirky campus with its free bicycles, solar panels and life size replica of SpaceShipOne houses one of the most innovative engineering businesses we have seen in as the migration of advertising dollars towards online formats continues and thereremains a large gap between consumption of online media and the associaled adverlising spend.lts culture seems very unusual in the corporate world in that it is prepared to experiment with new technologies and businesses without fearof failure, even when that failure is very public. Amongst the company's experiments has been the development of an operating system for mobile phones and thishasturned out tobeprescient.Google's

Tomsla

market share in smortphones has surged from a negligible level two years ogo to around 1/3rd of the US market today.As the Internet moves increasingly away from deskiop computers to mobile devices, Google looks very well placed to build o new and complermentary The application of technologydriven productivity gains to industries that have historically seen a slower pace of evolution is throwing up some very inleresting opporlunities. One such area is renewable energy.We have found it challenging to identify renewable energy businesses that posses sustainable competitive advantages but think one such is First Solar. As befits a solar panel manufacturer,First Solar is located in the Sonoran Desert, Arizona. Since 2004, the company has reduced the cost of solar energy generation by over 20% per onnum. The compounding effect of this is powerful, with a cumulative cost reduction over that period of 75%. With this kind of progress, you do not have to look very far into the future to see an end to subsidies for this technology and, with it, a tipping point in usage.The solar industry is also achieving far greater acceplance with mainslream utilities,as illustrated by theimminent construction project at Gila Bend, Arizona. This will be the largest solar plant to date with an output of 280MW, enough to power 77,000 homes.

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fertiliser which is then used by nearby farms. However, this may wellbe dwarfed by First Solar'splanned installation in Ordos,China,witha memorandum of understanding signed for a 2GW plant, equivalent in output to a large coal or We think the shift to cloud computing will become one of the more important trends in technology over the coming years. This should create significant opportunitiesforanumber of companies,many of which are located in theSanFranciscobay area.innovalion continues to increase the cddressable market for many technology businesses and we think this is a fertile area for identifying attractive

Tom Slater

Thirtylargest E

2011 000.3 172,596 167,061 104,138 101,279 84,357 83,026 72,557 63,624 58.576 49,369 40,716 39.726 38,235 37.832 36,542 35.449 34,450 34,334 33,629 32,561 32,095 32,088 31,988 29,751 28,929 27,922 27,200

Kghm

26,560 25,660 25,614 1,607,864 64.3 *Absolute cndrelativeperformancehasbeencolculared ona totclreturn basis overheperiod1Apl terms; relative performonce is ogcinst the benchmark:FTSE All World Index (in stering terms]. Past performance isnol a guide tofutureperformance. 2010 '000 118.2 101.4 77,278 25.5 15.8 120,009 11.7 47,517 65.3 52.5 83,831 84,691 14.7 30,900 56.4 44.3 47.030 24.0 14.4 30,640 58,268 47,770 40.9 30.0 29,280 13.7 26,050 13,744 10.7 34,118 37,503 24,781 15.4 30,731 71,659 10.7 37,106 43,022 30,747 32.0 21.8 24,441 11.9 29,384 41.9 31.0 21,336 72.8 59.4 16,773 27,916 15.5 24,694 65.1 52.3 34,170 108,260 21.6 12.2 21,398 64.3 1,315,047 ver the period1April 2010 to31 March 2011.Absolute performance is in sterling

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