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

The global economy has seldom been stronger. The pace of economic change has never been greater. We suspect that this will only accelerate over the next decade. This has profound implications for investors. Preoccupation with unpredictable short term oscillations in economies and markets has opened up a deep gulf between the crucial determinants of economic progress and speculative behaviour. It seems most unlikely that the future of the global economy and of intelligent stock selection lies in an ability to pontificate about Greek, Irish and Portuguese debt. One of the virtues of a global investment trust with access to long term capital ought to be its ability to transcend such fashions.

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 a low cost 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 the world's largest genome sequencing institute. 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 our mental models of the Chinese economy need constant revision. This is directly relevant for our portfolio. After a year of extraordinary share price performance our largest holding is now the Chinese internet search company Baidu. It and our sixth largest equity position in Tencent are representative of the dynamism, scale and national characteristics of the Chinese internet. Such companies are offering challenges to the US business models that have been so dominant in the second half of the last century.

Whilst the continuing ascent of the Chinese economy has been the dominant feature of the last year the greatest surprise has been the extraordinary revival of the German economy. This has received remarkably little attention amidst the travails of far smaller and far less sophisticated economies. For years it has been popular to belittle the virtues of the sober German approach in contrast to the glitz, leverage and inequalities so beloved of Anglo-American finance capitalism. We do not think this is merely a moment of simple cyclical optimism. Fortified by a recent visit to Berlin we consider it likely that Germany can enjoy growth rates above 3% for several years to come as the recovery broadens into increased capital expenditure and even consumption. We think that German industry has patiently priced itself back into international competitiveness, reoriented its trade towards rising nations and established enviable brand leadership in key sectors. Meanwhile governments of both left and right have maintained national fiscal order whilst the populace has resisted the lure of property inflation. That many German banks have failed to operate with similar sense is a persistent failure but one that is unlikely to undermine overall prosperity.

It seems to us that much of this follows the model of the revival of Scandinavian economies in the last 10 years after tough struggles against debt and competitiveness problems. These economies are now thriving. This too appears sustainable. As yet we have been more successful in identifying individual corporate successes in Sweden (Atlas Copco once again) and Denmark (NovoZymes) than in Germany itself.

The decade ahead

Thus far we have described the world in traditional national terms. Whilst the current prospects of China and Germany justify this approach we suspect that the next decade will require a gradual retreat from such convenient labels. Scottish Mortgage has spent much of the last decade shifting 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 a potential weakness: the fund management industry has a tendency to link national economic circumstances and corporate performance more tightly than underlying reality permits. Such institutional biases are containable but the future seems likely to hold more serious challenges to our current investment methodology.

Dominant cities

Corporate prospects are simultaneously 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 in a smaller and smaller number of cities (or at most regions). Dramatic corporate success seems to be much more frequently achieved in a limited number of locations combining openness to innovation, educational prowess, social liberalism and access to supportive finance. If we can understand the way this process seems to work and identify the 20-30 cities that are the key exemplars then we stand a better chance of investing successfully. This does not mean that we will ignore other locations but it does require us to comprehend the cultures of these cities rather than seeking refuge in outmoded generalizations such as 'emerging markets.' In specific terms it is why we are in the process of opening a Shanghai research office. It is also why if this experiment proves successful we would be more likely to look to replicate it in San Francisco rather than in a more immediately obvious candidate city like Rio de Janeiro.

Cloud computing

The combination of managerial excellence with accelerating technological progress has taken us in some new directions in recent months. We have come to the view that cloud computing now has the ability both to cut costs and improve service levels across the corporate and government sectors as expanded upon in the Trip Note that follows this Review. This development is very likely to be at the cost of traditional hardware and software giants but presents very substantial opportunities for new entrants. We have gradually been building a holding in salesforce.com. It seems to us to be the single company with the breadth of product and ambition that might make it the dominant company in the industry over the next decade. We think that the market preoccupation with a high immediate multiple of earnings is very myopic. We also admire the efforts of Rackspace to make itself the highest service option within cloud outsourcing. It has done this principally by thoughtful motivation of employees including by share options that are spread much more broadly than is commonly the case.

The all-important pace of change

Whilst the origins of corporate wealth may well be dominated by a comparatively small number of cities the speed and power of technological change is likely to overwhelm such considerations. If the current rates of exponential change continue (or even accelerate) in fields as diverse as genetics, robotics, data availability, nanotechnology and synthetic biology then the importance of geography may be subsumed in greater challenges. Companies, societies and 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 risk metrics. It will eventually defy belief that largeness and safety were once closely equated. 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 appear abstruse and abstract but we are already finding that the most critical characteristic to search for in our investment process is a management mentality and business model flexibility that can thrive amidst rapidly changing conditions. From Jeff Bezos and his conscious policy of intense low cost experimentation to exploit technological improvements at Amazon to the rethinking of sourcing policies that has so aided the dramatic international expansion of Inditex (Zara) we think that such attitudes are the key to building competitive advantage over the years ahead. Relying on leadership inertia will fail.

New directions in healthcare

A year ago we argued that healthcare was ripe for sweeping change. We also expressed frustration that we had made limited progress in identifying companies that could lead this transformation. We continue to view the historic pharmaceutical and medical supply companies as likely to be casualties rather than beneficiaries of this development. With healthcare providers finally proving less generous, with research budgets ever more squeezed to maintain earnings and with many of the supposed clinical advances of the last decade looking increasingly questionable we think problems abound. Internally these companies are victims of their own immense bureaucracies. We own none of them.

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 leader). It may make the human surgeons seem quaint and redundant as the years go by. We have recently started buying Illumina which is the dominant supplier of tools for the genomics industry. This is a field where progress in science and price is so rapid that we think it is mistaken to worry that thus far it has not delivered significant clinical benefits. Again these are both companies that are convinced of the need for continuing innovation and prepared to spend boldly in pursuit of continued leadership.

Conclusion

As should have become apparent we are increasingly disillusioned by the dominant preoccupations and methodologies of the financial services industry. We do not believe that following the endless twists and turns of macroeconomic gyrations, quarterly earnings or market sentiment offers good odds of success. This is speculation not investment. It surprises us how little the chaos of recent years has deterred others from such highly competitive pursuits. We are delighted if others think that they can play these games more successfully than history suggests. Instead we base our investment inclinations on the comparatively predictable forces of technological change and the re-emergence of great civilizations. Since we believe still more strongly in the increasing power of these twin forces than last year we once again suggest that the probability is that if the Managers prove reasonably competent then the long term prospects should be bright.

California/Arizona Trip Note

The most complex order management system that exists today, operating a vast supply chain and distribution infrastructure, can be used with great ease. If you have ever shopped on Amazon.com then you have already done it. Interacting with computer software through a web browser is a model that has application well beyond retailing consumer goods and is paving the way for a sea change in the IT world. The longstanding idea of delivering IT services remotely (known as Cloud Computing) is finally turning in to reality 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 San Francisco with offices looking out onto the Bay Bridge and cable car station. It was founded in 1999 by its larger-than-life CEO Marc Benioff, a serial entrepreneur, author and philanthropist. Benioff set out to attack the behemoths of the enterprise software market such as SAP, Microsoft and his former employer, Oracle. His approach has been to use the Internet to deliver a service, as opposed to the traditional approach of selling software and an expensive implementation package. The benefit for consumers is that they can dramatically reduce their computer hardware requirements and the associated in-house management expertise. Eleven years later, salesforce.com's model has attracted 83,000 customers. The computer power required to support this customer base is around 3% of what would be required using a traditional hardware/software approach.

We cannot predict how much enterprise technology spending could one day find its way onto 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 larger than it is today.

Whilst the cost savings from this technology change represent a major opportunity to increase efficiency in the corporate sector, it is the potential for unleashing creativity on a much wider scale that seems most exciting. When a company interacts with its customers through the Internet and the supporting IT infrastructure can be outsourced, small businesses with a good idea can achieve astonishing scale in a very short time. I met a number of young businesses which are not yet listed but may, in the future, make it into Scottish 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 subscribers in November 2008. It now has over 65 million. This growth would not have been possible without the rapid 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 another company (in this case, Amazon.com's web services operation).

One striking aspect of the move to cloud computing is the way users are taking matters into their own hands. It is no longer necessary to commission a colleague in the IT department to buy in hardware and software and configure it before one can start experimenting. Instead, users with limited technological knowledge can immediately deploy powerful software. The subscription nature of these services means limited upfront spending and the cost of experimentation is vastly reduced. This should provide a boost to productivity and it also prompts us to change our mental model of how competition in technology works. We had previously believed that high switching costs for customers would mean incumbent IT providers had an enduring competitive advantage. This now seems much less clear and was, in part, behind the decision to sell our holdings in SAP and Cisco.

We think that in cloud computing, as in many areas, we can learn from watching the actions of those corporate leaders whose opinions we respect. It came as no surprise that Jeff Bezos, CEO of Amazon, was one of the first to identify this idea and the opportunities it presented. To understand how Amazon's web services business works, it is necessary to step back and think about the infrastructure underlying the cloud computing model. Businesses shut down their computer servers and run their applications on pooled equipment in remote locations. Nicholas Carr in his book "The Big Switch" draws out the many parallels with the period one hundred years ago when companies stopped producing their own power and plugged into the newly built electric grid. The economies of scale and efficiency that this process produced have direct relevance to the changes in computing we are seeing today. The centralised power plants of the electric grid have an equivalent in the vast data centres that are required to supply the computing power for cloud-based applications. Amazon has already developed the software and services to run such facilities based on more than a decade of work for its own website. It is able to deliver performance, reliability and security on a very large scale which is what cloud-based infrastructure requires.

We are seeing a trend for young businesses with no legacy IT systems, such as games producer Zynga and movie distributor Netflix, choosing to use Amazon's services rather than investing time and energy in building their own IT departments.

The other big player in the provision of cloud infrastructure is also held within Scottish Mortgage's portfolio. Rackspace has taken a different approach from Amazon. Where Amazon provides the nuts and bolts for a customer to build their own system, Rackspace has focused on providing a high level of service. Some companies will embrace this new model and be comfortable using online tools to build their services, but others will find it more challenging and require assistance. It is this second group of business which Rackspace is targeting. Excellent customer service has been something of rarity in the IT business: even Apple's inspirational leader, Steve Jobs, suggested we were holding our telephones wrongly, rather than admitting there were problems with his product. If Rackspace is able to deliver consistently in this area then its addressable market should be substantial.

Whilst the principal focus of the trip was on cloud computing, this was also an opportunity to follow up on outstanding questions at some of our other holdings. Google's headquarters (also known as the Googleplex) is a leafy 60 acre complex in Mountain View looking out over San Francisco bay. 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 recent years. We think Google's growth potential remains significant as the migration of advertising dollars towards online formats continues and there remains a large gap between consumption of online media and the associated advertising spend. Its culture seems very unusual in the corporate world in that it is prepared to experiment with new technologies and businesses without fear of 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 this has turned out to be prescient. Google's market share in smartphones has surged from a negligible level two years ago to around 1/3rd of the US market today. As the Internet moves increasingly away from desktop computers to mobile devices, Google looks very well placed to build a new and complementary stream of profits.

The application of technology-driven productivity gains to industries that have historically seen a slower pace of evolution is throwing up some very interesting opportunities. One such area is renewable energy. We have found it challenging to identify renewable energy businesses that possess 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 annum. 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 acceptance with mainstream utilities, as illustrated by the imminent 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.

However, this may well be dwarfed by First Solar's planned installation in Ordos, China, with a memorandum of understanding signed for a 2GW plant, equivalent in output to a large coal or nuclear generation facility.

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 opportunities for a number of companies, many of which are located in the San Francisco bay area. Innovation continues to increase the addressable market for many technology businesses and we think this is a fertile area for identifying attractive growing businesses.