Scottish Mortgage Investment Trust — Annual Report 2012

Managers' Review — James Anderson (year ended 31 March 2012)

Context. Anderson borrows Jeff Bezos's discipline — every Amazon annual report reprints the 1997 shareholder letter — and reviews how Scottish Mortgage's own approach has evolved: long-termism, global concentration, the willingness to look wrong for years. Closes: "Pessimism is very popular. We do not share it."

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Managers' Review

Managers' Review

Each year the Amazon Annual Report incorporates the original Mortgage are more distant and our thoughts are far less profound than thoseof Jeff Bezos we think thisis an admirablediscipline. What follows is therefore a summary of how our investment approach has evolved over the last decode. We should be prepared to be judged by it in the years ahead. ssas sa ji jo y pas oi w sa py the competitive advantage of companies they are notoriously sandomness and mean-reverting characteristics of most such data. If this does not suffice then attentionturns toa discussion of the high packages that the fund manager enjoys. Sometimes the procedural details of the investment process are outlined with heavy emphasis on risk controls. Litfe attention is given to either the distinctiveness of the opproach or the strategic advantages the manager might enjoy in order tomake imitation improbable.We thinkweshould try to do periods of at least five years that the compelitive advanlages and managerial excellence of companies becomes apparent. It is these characteristics that wewant to identify and support. We own companies rather than rent shares. We do not regard ourselves as experts in forecasting the oscillations of economies Or the mood swings of markets. Indeed we think that it is hard to excel in such areas as this is where so many market participants focus and where so litle of the value of companies lies. Equally Bailie Gifford is more likely to possess competive advantcges for the good of shareholders when it adopts a long terrm think about our own business over decades not quarters.Such stability may not be exciting but it does encourage patience in

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this most impatient of industries. We only judge our investment performance over five year plus time horizons.In truth it takes at least a decade to provide adequate evidence of investment skill. The investment management industry is ill-equipped to decl with us lofight thesedangers.We crebesieged bynews,data and opinion.The bulk of this informationis of litle signiicance but it imploresyou to rapid and usually futile action.This canbe particularly damaging at times of stress.Academic research argues that most individuals dislike financial losses twice as much as they take pleasure in gains.We fear that for fund managers this relationship is close totenfold.Internal and externalpressures make the avoidance of loss dominant. This is damaging in a porifolio context. We need to be wiling to accept loss if there is an equal or greater chance of (almost] unlimited gain. We are very dubious about the value of routine information. We have litle confidence in quarterly earnings and none in the views of investment banks. We try to screen out rather than joyous opportunities to hear views, perspectives and visions thai plus in stock selection. Hfolding sizes reflect the potential upside and its probability (or otherwise) rather than the combination of the market capitolization and geographical location of the company and its headquarters.We do not have sufficient override stock selection. We do not have enough confidence in ourmarket timing abilities to wish toadd orremove gearing at frequent intervals. We do, however, have strong conviction that our portfolio should be comparatively concentrated, and

Provider of private education in China. that it is of litleuseto shareholders totinker around the edges of indices. We think this eventually produces better investment results and it certainly makes us more committed shareholders in companies.We suspect that selecting stocks on the basis of the past (their current market capitalization)is a policy designed to protect the security of tenure of assetmanagers rather than to build thewealth of shareholders.Companies that are large and established tend tobeinternally complacenl and inflexible.They are offenvulnerable toassault by more ambitious andvibrant We are Growth stockinveslors.Such has been the preference differentials that investors find it very hard to acknowledge the extraordinary growth rates and returns that can be found today. The growth that we are particuiarly interested in is of an explosive nature and offen requiresminimol fixed assets or indeed capital.We think of it as'Growth at Unreasonable Prices'rather than the traditional discipline of'Growth at a Reasonable Price'. We need to be willing to pay high multiples of immediate earnings because the scale of future potential and returns can be so dramatic. On the slocks that flourish the valuation will have turned out to be derisorily low.On the others Webelievethat it is ourfirst dulyto shareholderstolimit fees. Both the investment management fee (equivalent to O.32%) and the TER (O.51%] are low by comparative standards but at least adequate in absolute terms.We think that the malign impact of high fees is frequently underestimated. The difference between α TER of O.5% and one of 1.5% may not appear great but if the perspective is altered to think of costs as a percentage of expected annual returns then the contrast becomes obvious If annual returns average 1O% (sadly they have not in recent years} then this is the diference between removing 5% of your returns or 15% each year. Nor do we believe in a performance fee.Usually it undermines investment performance.lt increases

Managers' Review

The latest version of the iPad. The three contentions that we have outlined in the past remain intact. ·The rise of China (and to a lesser extent other emerging economies] is transforming the global economic scene. Stockmarketsundereslimate the power of technological change in exaggerated revulsion to the bubble of 1998-2000. ·The Western financial systems are dangerously flawed. We have seriously underestimated this force.lt is more powerful than we thought and far broader in its application than we suspected. investment world. The opportunities in front of us are likely to be even more dramatic than in the recent past.This is because the very pace of change is in itself accelerating. It is very hard to grasp the implications of this.The minds ofnormalhuman beings,let alone those of fund managers with their Preoccupation with the immediate, have difficully in coping with change that is exponential rather than linear and where the guidance offered by the past is so modest. Apple is perhaps the simplest example of this process asits devices are so dominant and as so much of its story is visible. In product terms this has taken us from the original Apple computer retailing at the equivalent of US$2,500 in today's prices without a monitor, power supply or even a casing to an iPad with at least 10,OOOx as much processing power for a fith the price. In 2001 it took 91 weeks to sell one million iPods. In 2011 it took 24 hours to seli one million iPhone 4Ss. For the company this willtranslate into sales of over US$15Obn this fiscal year {with China now running at 20% of sales] with near 40% operating margins and US$ 1 1Obn in cash. From the share price lowsbeforethereturn of Steve Jobs in1997a market value of below US$1.5bn has become US$550 bn. Identifying and holding such extraordinary companies is ourprimary task. Doing so holds far greater rewards than any amount of market prognostication. Whilst we have owned Apple since early 2009 we feel that we deserve more criticism than praise for our actions. Not

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Managers' Review

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Enzyme manufacturer's stadardization tanks inNorth Carolina. just did it take us several years to buy the shares but we were also quick to take profis in 2011. Our holding ond our profis should We hope that we own several companies that can follow the same path as Apple but are at a much earlier stage of development. As suggested earlier they are businesses with substantial growth opportunities,minimal or negative capitalrequirements from ayoung age cnd what wethink are sustainable competive advantages.This often translates into formidable margins cnd return on capital. Their advantages lie in network effects or in mare traditional dominance by scalebut thelackof capital intensity is in common.We think that such companies are exiremely unusual in the history of capitalism. The markets are very uncomfortable in dealing with their existence andcharacteristics.They are hard tofit into the establishedvalualion frameworks - particularly those that stress the relationship between the capitalization of a company and the value of its fixed assets. Although most of these companies are American (or specifically WestCoastAmerican} there is litle theoreticalreason that this need be so. The main exceptions are currently Chinese which is intiguing. Our two lcrgest holdings conlinue to be Baidu and Amazon.Both li into the descriplion above. They also reflect our strong preference for companies that are led by their share-owning founders. Baidu has continued togrow dramatically but the room to expand still seems open-ended. It has only 321,000 paying customers. There are approximately 40 million small businesses in China. Mobile search is growing very rapidly and advertising is becoming critical to the Chinese consumption surge.Amazon may be an even less mature margins.lt has so many opportunities to invest that despite very fovourcble cash-flow dyncmicsit con consume all the cosh it generates.As long as it isinvesting in activities where itscompetitive position oughi io be powerful and returns improving then we are content tobe verypatient investors in such a visionfor all the

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Work at the Shanghai robotics factory. We have grown accustomed to the extraordinary pace of change in the electronics andtelecommunications industries.As wenoted last year similar developments are now working their way into industries of established players.Whilst opposifion can still slow progress it is unlikely to be able to do more than delay transformation once the relevant technologies acquire sulficient momentum. We have applied this idea to the alternative energy cnd healhcare sectors. So far this has proven a significant error in the first case and seems quile promising in the latter. We have now sold First Solar but not before it was one ofour worstinvestment decisions.Whilst the cost of solar energyhas fallen even more sharply than we believed likely, the competitive cdvantage once enjoyed byFirst Solar has been eaten away by the power of Chinese competition and by the acvent of Healthcare requires reform. It is costly, inefficient and frequently fails to provide the best available medical outcomes. Whilst improving this situation will be the task of decades it is possible the pace of '1 think thebiggest innovationof the21stcenturywill be the intersection of biology and technology. A new era is beginning.' Genome sequencing appears to be the critial scientific advance enabling sucha newera.ltscosts are alsofallingat around twice the pace of the famed Moore's Law that has transformed large shareholdinginlluminawhichis the established leaderin this technology. We have recently supported the company in its (thus far) what has becomea largeholding in IntuiiveSurgical,whichis not just the dominant leader in robotic surgery but is also the firsl pure robotics company in any field of activity to become highly profitable

It is fashionable to be gloomy about Chinese prospects. We are nol. We think that the transitionfroma low cost,lowvalued added export behemoth to a domestic empire driven first by infrastructure cnd increasingly by consumption is further and rmore smoothly odvanced than was believed possible.Productivity has risen impressively. The trade surplus is largely a memory. Naturally there will be pauses and blockages. Whilst we think the authorities have been right to clamp down on an overlyexuberant housing market before it assumed bubble proportions this could not prevent local excesses nor does it prop up growth. As productivilyrises and process of evolution still more complex. But such concerns are minor compared with the scale of the achievement and of the remaining potential. We think China has the human capital, the patience and the competing multiplicity of cities cnd regions to continue its rise. Growth may, indeed should, slow but we doubt it willcollapse. We see no eventual reason why China should be poorer than Britain. We are encouraged that we can find enough individual companies of imagination and innovation and with strong compelive moats that this admiration is a matter of practical importance. We have already discussed Baidu but arguably Tencent has been even more prescient in developing the Chinese internet with its focus on social aspects and on mobile. China's return to prominence has been distinguished more by the absence of dramatic disruptions than by their presence. Whilst American ascent was marked by internal and external wars, booms and busts, the last thirty years of Chinese progress has been remarkable in its consistency. The current comparative serenity in the face of a troubled Western economy equally appears remarkable. In contrast India, Brazil and Russia all appear to be struggling with these changed condilions. Inffation, deficits, uncompetiive industries and politicalfailings have combined invaried guises to trigger significant produclivity and growthdisappointments.China is very

Managers' Review

We do not have much to add to the daily media Preoccupation with the systemic fall-out from the catastrophic implosion of the bloated world of finance in 2008-9. But some comment is probably required. At one level we are moderately encouraged. Both the American and German economies show signs of gradually overcoming the damage inflicted by finance. Given that it is now 7 years since the U.S. property bubble initially burst and that American animal spirits are hard to repress entirely in perpetuity this is pleasing but perhaps not surprising.In Germany finance ond housing were more concerned that Spain still has several years of working through a fearsome housing bust than we are that the age-old infelicities of the Italian state will entirely undermine a population of cautious shares in Fiat Auto as an improved generation of manogers can combine with the allure of Ferrari to revive the company. Less Berlusconi with Mario Monti is also a managerial improvement. Such notes of comparative optimism may be unusual amongst the concern at the continuinginabilityof the financial sectortoreform itself. Whilst modest and piece-meal measures have lessened the returns and attraction of invesiment banking there is no evidence that a culture of stability, restraint and modesty has yet been embraced by the industry or been enforced by regulators. Whilst the shock of the crisis and the generosity of taxpayers may defer disaster, the serious threats to thehealth of theWestern world.

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Managers' Review

1Ppr

Among many others,PPR's luxury brands include Gucci, Bottega about than tofear. Innovation combined withglobalizationhas unparalleled returns and growth opportunities.We think that this process is far from complete.We think that it is underestimated and misunderstood by markets.Whilst we hopewe are aware of the dangers of overconfidence,we are also convinced that impatience and fear have alltoo often exerted too great an influence on markets. At times over the last year, most notably in late 2011, it has seemed to us that the flight to presumed safety has been as exaggerated as the rush towards technology stocks in 1999-2000. Market distortions can just as easily result in undue depression as in overvaluation. Indeed given the difficulf recent experience of market participants, this currently seems more probable than an outburst of excessive optimism. Pessimism is very popular. We do not share it.

Jamesanderson

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