Scottish Mortgage Investment Trust — Annual Report 2013

Managers' Review — James Anderson (year ended 31 March 2013)

Context. A low-turnover year: the trust still owned all of its top thirty holdings. Anderson explains why the trust refuses to trim winners merely because they have grown, why 'risk-on, risk-off' macro waves are noise to be ignored, and why China (Tencent, Alibaba) and structural technological change remain the decisive long-term forces.

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Managers' Review

Managers' Review

We made few changes to your portfolio in 2012/13. We still own all of the top thirty holdings of a year ago. Market movements accounted for the bulk of the changes in the rankingsof thesestocks.Overallturnoverhasbeenlittleover1o%. Whilst equity markets have generally moved forward over theyear it has been a frustrating period for patient investors looking for strongly growing companies. Our approach will not changebutthereis littlesignthatthemarketsarewillingtoabandontheirpreoccupation with alternating waves of macroeconomic and political hope followed by renewed angst. In defined as short term share price volatility. Any serious assessment of the long-run competitiveprospectsofindividualcompaniesappearsunlikelyatthecurrent juncture. Whilst ourporfolioisbuilt upon the attractions of individual ThishasmadeChina fertile ground for the superbbusiness model of inditex in whichwe now have a larger holding.in such ways turnmouldedbythedominantforcesintheglobaleconomy.For does theChineseconsumeraideven therural economy of bedraggledSpain. especially critical: Theriseof China (and toa lesserextent otheremerging economies). -The underestimated power of structural technological change. The flaws of the Western financial system. Weseenoimminentreasontoamend thisframework. OurCoreInvestmentBeliefsassetout inlastyear'sRevieware eiteratedinthesectionfollowingtheCaliforniaNote. China tisonthistopicthatwefindourselvesmostoutofsympathywith burrentmarketsentiment.Thedisdainshown toChinese equities wherever theymaybelisted)isbutpartofasustained and continuing antipathytowards thestocksofallthemajor emerging

markets.Brazil,Russia and Indiahavebeensimilarlyunpopular. A luxury goods company, a beneficiary of Chinese consumer his is an extraordinary contrast with the mood fiveyears ago consumption. when theBRiCcountrieswereperceived tobe thesavioursof the lobaleconomy.Whilstwesharesomedisillusionwiththecurrent orogressof Brazil, India andRussia wehave longbelieved that Weremainmostexcitedbytheopportunitiessurroundingthe China is ina class apart.This conviction has grown rather than Chineseinternet.Thiswas thespecificareainwhichwehave shrunkover thelastyear.Growth has migrated fromexportsto been most out of step with the market mood in thelast year. In Homesticdemandandfromthecoaststotheunderdeveloped particularBaidu'ssharepricehasbeenextremelyweak.Asit heartlands.Wageshaverisenashasproductivity.Inflationis begantheyearasourlargestholdingthishasobviouslyhada subdued.Naturallyfurtherprogress is needed inseveral areas substantial impact on ourNAv.We donot intend to retreat from romcorruptiontopollutionbuttheunderlying transformationhas ourbelief inthe company and its management.Baiduhasbeen beenimpressive.WecannotexpectChinatogrowat10%per the booming mobile business. This seems to us to be very annumasithasinthepast.Wedonotwantittodosowiththe dramaticexportsurplusesofthatera.Thecurrenttrendof7% sensible.Ithasbeen characteristicof thelast year that equity growth andburgeoning importdemandcontributefarmore tothe markets aredeeply intolerant of anyinvestment spending by healthoftheglobaleconomythantheunbalancedandimmature companies that crimp immediate profit growth. We find this both boomofthepast. remarkably short term evenbyrecentstandards and deeply disturbing in its implications for corporate behaviour and the Thefuturedriversof theChineseeconomyarereflected in the bortfolio.Asimportshavegrownwehavemaintainedsignificant aplacing of unquoted convertiblepreferenceshares inAlibaba. exposure to international companies that have the skils and vision ThisisChina'sdominante-commerceenterprise.Onitspeak o enable them to flourish in China. PPR's luxury goods have been doublethatoftheentireUSe-commercesectoronCyber vealthyChineseconsumerbutbroadgainsindisposableincome Monday.Alibabatoowillcontinuetoinvestfearlesslyand haveopened upprospectsfor classicmiddleclasspurchases. admirably.ItsreticenceaboutafullIPOreflectsboththis characteristicanditsstrongcash-flows. b8AnnualReport2013

Managers' Review

Technology WeareappendinganotebyTomSlaterdescribinghisextended stayinSiliconValleylastautumn.Itdescribesareasofpotential interestinthefuture.Itmaybeworthaddingafewwordson The greatest currentdevelopments.Heretoothedominantcharacteristicis encouragement of extremeimpatienceandintoleranceofeventhemostmodestand the year has been the continued progress in riseanddramaticfallofApple(withalossapproachingS30obnin genomic science. capitalization overthelastsevenmonths) althoughit ishard to patternhasbeenreplicatedfromthehigh-profilelurchesin gyrations in cloud-computing company Rackspace. The only priceswings(albeitwithquitesufficientvolatilityaroundresults). ThisisremarkableasAmazonismorededicatedtothepursuitof muchdeferredrewardsthananyotherquotedcompanyinour experience.Itispossiblethatithasashareholderbasethattries to match thispleasingperspective. The greatestencouragementof theyearhasbeen the continued orogressingenomicscience.Pricesforsequencingcontinueto plunge,diagnosticimprovementsarefollowingandgradually hewworld.llumina continues tolead thistechnology.Weare bleasedithaspreserveditsindependence. WesternFinancialFlaws Thereislittlesignthatbankshavebecomelesscomplex,less greedyorlessdangerous.Managementmodestyremainsrare. Conclusion Regulatorychangeshavebeenpiecemealandhardly Althoughthelast12monthshaveseenamodestimprovementin distinguishedbytheirownsimplicity.Allweareleftwithisthe stockmarketstheatmosphereremainsacutelynervousand nopethatthecombinationof thesavagelessonof2008/9and a confidencelow.Onlythosestocksandthosecountriesperceived gradualpushformoreequitywithinthebankshasdampenedthe to be the safest and most stable have enjoyed consistent rallies. mminent threats. Even in America politics and economic data points continue to Dverthelastyearmoreattentionhasbeenpaid totheflawsof frayemotions.Thecorporatesectorhasasyetprovenunwillingto governmentfinances thanthoseofbanks.Attimesconventional re-invest its extraordinary cash riches-perhaps unsurprisingly nterpretationsappearedlackingincommonsense.Ithasalways giventhesuspicioninvestorshaveshownwhenanysuch Seemed improbablethattheECBandGermanywerewillingto ambitions have been mooted.At the same time prior optimism walkawayfromthecontinuedexistenceoftheeuro.Thatitwas Delieved tobesoappears toustoowemoretothelurid ofunderperformanceandredemptions.Yetallthisseemsto maginingsoftheLondonestablishmentthantoseriousanalysis. neglect substantial improvements.America is recovering - beenshowntobelowerthanoncefeared.Chinahastransformed and political sectors isself-defeating inpractice.That it appears itselfandindoingsoassistedtheglobaleconomy.Aboveallthere aretrulygreat,growingandsustainablecompanies availabletous bbvious.Structuralreformaccompaniedbythepursuitofgrowth atalluringprices.Eventuallythiswillmatter. ather than consolidation appears the appropriate policy in almost allthedevelopedworld JamesAnderson ManagerofScottishMortgage 10 May 2013 ScottishMortgageInvestmentTrustPLC09

Managers' Review

Alibaba Group China's dominante-commerce enterprise. Tencent Atlas Copco Tencent's'WeChat'logo. Swedishengineeringexcellence. Intuitive Surgical Inditex Continued advance in diagnostic ZaraHighStreetStore. technologyandroboticsurgery techniques. 2012 Intuitive Surgical,Inc. Our portfolio is built upon the attractions of individual companies. 10AnnualReport2013

Managers' Review

California Note The model of capitalism that exists on the West Coast of the United States has produced several of the largest holdings in our portfolio. I spent the autumn there visiting existing holdings, thinking about the emerging technologies and meeting early stage companies that may become significant in future years. distributing theirproducts.It seemsvery unlikely that there willbe remainsthemostimportantcentreforthegenerationandgrowth ofnewtechnologycompanies.Theinfluenceofsuchcompanies jsincreasingrapidlyinbothgeographicreach andeconomic Payments impact.Thepersonal computerreached the upperincome tier of Avarietyofventure-fundedcompaniesareseekingtoreinventthe thedevelopedworld.Overthecomingdecade,computersinthe way we pay for goods and services. The underlying idea is that if formofsmartphonesarelikelytobeinthehandsofbillionsof mobilecomputingdevices become widespread,consumers may users.Thislevelofubiquitytransformstheopportunitysetfor use online methods to pay for goods in the offine world. This wouldbeattractivetoretailersasitwouldgivethemmore this change that is impressive.The way consumers access informationabout theircustomersand allowthemtobettertarget nternet services is moving at astonishing speed.It is plausible theiradvertisingbudget.However,theuserexperienceofswiping thatwithinthenexttwoyearsthemajorityofaccesswillbefrom a payment card is straightforward and well understood. To mobiledevices. changebehaviour,thekeywillbeprovidingsufficientincentive. Severalideasarebeingpursued,themostpromisingofwhich TodayintheWesternwordtherearefourdominantplatformsin seemstometobetheeliminationofphysicalcheckoutandthe theconsumerinternet:Amazon,Google,FacebookandApple. Wecurrentlyownsharesinallofthem.Whilstalotiswritteninthe currentlyhaveexposuretothelargestonlinepaymentsbusiness mediaabouttheskirmishesbetweenthesecompanies,itappears in theworld,PayPal.This is aremarkablebusinesswhichhas ousthattheircorebusinessesencounterlimitedcompetition. continued to growrapidly despite its already significant scale and a relatively lackluster pace of product development. The huge oeenhighlysuccessful innavigatingtheshifttowardsmobile investment in infrastructure that has beenrequired togetPayPal toitscurrentbaseof12omusersin190countriesnowrepresents py their founders.From IBM toMicrosoft toHewlettPackard to asignificantassetand amajorhurdlefornewplayers.Followinga ntel it is striking that long periods of dominance in technology changeinleadershipthereseemstobeamarkedacceleration in navecoincidedwiththereignsoffounder-managers.Inthe the pace of product development at PayPal.Thisleaves it well consumerinternetinparticular,havingaCEOwhoisverycloseto placed tobenefit fromfuturegrowth inits addressablemarket oroductdevelopmentseemslikelytobeacriticalfactorasuser despitetheemergenceofnewandinnovativecompetition. Dehaviourcontinuestoevolvesoquickly. Enterprise perspectiveonsomeof themost interesting areasofearlystage The technologies thathave beencreated by the recent wave of op of the big four consumerplatforms.This allows them to fortheenterprisemarketplace.Thelatestconsumerwebsitesare nstagram,a mobile photo sharing service recently acquired by potential in a corporate setting. Whilst most of the existing acebook,providesanexample.Priortoacquisition,itsuserbase enterprise software companies arebuilt around providing systems grewfrom10mpeopleto30minsixmonths.lItservedtheseusers ofrecordinareassuchasaccountingorhumanresources,the withjust 13 employees and a modest amount of capital.This nextgenerationofbusinessesareutilisingthedatathatexists brofileisn'tunusualforabreakthroughconsumerinternetservice outsideofsuchastructuredenvironment.Inexpensivestorage techniquesmean thathugevolumesofdatacanberetained and E-commerce thetechnologiestomakethemostofthisinformationarestarting E-commerceremainsanareaofactive interestforearlystage to emerge.Typically,Amazonhas beenat the forefront of undingandnewbusinessmodelsareemerging.Howeverthere understandingtheimplicationsofthesechanges.Itisnow $eemslittlethatmightchallengethedominanceofAmazoninthe commonplacefor newtechnologycompaniestooutsourcetheir istributionofanyitemwithauniversalproductcode.Amazon's computing infrastructure to Amazonrather than investing in eputationforinvestinglargesumsof moneyoverlongperiodsof servers ordata centres.Similarty.Rackspace israpidlybecoming imeinordertoreinforceitsdominancehasinformedthe the world's largest IT department providing an outsourced service oehaviouroftheventurecapitalcommunity.whichisunwillingto for those companies thatnolongerwant suchdistractions. unddirectcompetitors.Instead thenewgenerationof Thehistoriccorefunctionsofenterprisesoftwarearealsobeing -commercecompaniesarefindingotherwaystoserve challenged bycompanies employingmore modernapproaches. ustomers.Theyaredesigningandsourcingtheirowngoods. Dften they arecollapsing inefficientlegacysupplychainsby Peoplesoftandlistedonthestockmarketrecently.Itscentrally- cuttingoutintermediatelayers.Theyarere-inventingphysical hostedsoftwareisaccessedviaawebpagetodeliveraccounting etailmerchandisingonlineanddevelopingalternativewaysof and humanresources systems. Centralisation allows for much ScottishMortgageInvestmentTrustPLC11

Managers' Review

greaterefficiency.Becauseallusersarerunningthelatestversion ElectricityConsumption of the software, support costs are lowered and development Whilst much of the innovation we invest inis implemented by cyclesareshortened.Salesforce.comhasachievedasimilarfeat software companies,there are exceptions.The efficiency with whichcomputersuseelectrical powerhasbeendoublingevery application of its software tomanage online marketing. eighteen months for thepast sixty years equating to a 100-fold improvement every decade. It is this progress that has enabled computers from 1991, its fully charged battery would last 2.5 seconds. In recent years, the contribution of one of our holdings. ARM,to microprocessor designs has been increasingly important to this trend. Its designs are used in over 9o% of mobile phone handsets as they offer the best trade-offs betweenperformance andpowerconsumption.Theirtechnologycontinuestodrive downpowerrequirementsand the implicationsof thisprogress continuing arefascinating.Universitylaboratories arealready producingsensorsthatuse60microwattswhenactive.In metropolitanareas,thisamountofpowercanbeharvestedfrom ambientradio andTV signals.Without theneed forbatteriesyou get sensors that run indefinitely. Such distributed computing increasing the efficiency with which we use existing resources. Wearecontinuallytryingtoimproveourinvestmentapproach. Healthcare WhilstwebaseourselvesinEdinburgh,inparttogetawayfrom Healthcareseems like anindustryripefordisruption through centres,spendingtimeinthepartsoftheworld thatare producing great companies is a fabulous opportunity to learn.We unionisedworkforceareoff-puttingtotheventurecapitalist community.whichcreatesadificultfundingenvironmentfor start-ups.WhilstIntuitiveSurgicalisnominallyahealthcare downtochanceandthebestwecanhopeforistodiversifyour portfolio.Engaging with the entrepreneurs who are out there company,it isheadquartered inSiliconValley,itsresearchand developmentisleadbyanengineer,notadoctor,anditsrobots viewoftheworld.Theydon'tleavethingstothechance runovera millionlinesofsoftwarecode.Todate,these outcomesofnormaldistributionsandbelievethattheymustbuild instrumentshaveemployedartificialintelligencetorecreateopen Surgeryusing minimally invasive techniques.Thefuture might look thefutureforthemselves.Mostwillfail(experimentationand failureisabadgeofhonour)butthereturnsthataccruetothe quitedifferent.Developmentsindiagnostictechnologymeanthat clinical targetswill getsmaller.Targetingnervesorvesselswill winners can be very large. Our belief is that by developing our equireprecisionbeyond theabilitiesofmosthumansurgeons. knowledgeofthepotentialwinnersatanearlierstageoftheir development cyclewe will be able to do a better job at investing inthemforourshareholdersinthefuture. bebeyond thescopeof thehumaneyeandnewvisualisation techniquesarerequired.Overthecomingdecadeweshould anticipatethatthesetechnologieswillexpandtherealmofwhatis Tom Slater surgicallypossible. DeputyManagerof ScottishMortgage 10 May2013 12 Annual Report 2013

Managers' Review

Our Core Investment Beliefs Whilstfundmanagersclaimtospend muchof theircareers assessing the competitive advantage ofcompanies they are Thetendencyistociterecentperformanceasevidenceofskill despitetheluck,randomnessandmean-revertingcharacteristics ofmostsuchdata.If thisdoesnotsuffice thenattentionturnstoa discussionofthehigheducationalqualifications,hardworkand :Sometimestheproceduraldetailsoftheinvestmentprocessare outlined with heavy emphasis on risk controls.Little attention is given to either thedistinctiveness of the approachor thestrategic advantagesthemanagermightenjoyinordertomakeimitation improbable.We think we should try to do better than this. -We arelong term in ourinvestment decisions.It isonlyover periodsof at least fiveyears that the competitive advantages We areGrowthstockinvestors. andmanagerialexcellenceofcompaniesbecomesapparent. It is these characteristics that we want to identify and support. We own companiesrather thanrent shares.We do not regard sufficientconfidenceinourtop-downassetallocationskillsto ourselvesasexpertsinforecastingtheoscillationsof wish tooverride stockselection.We donot haveenough economiesorthemoodswingsofmarkets.Indeedwethink confidenceinourmarkettimingabilitiestowishtoaddor that it ishard to excel in such areasas this is where somany remove gearing at frequent intervals.We do,however,have marketparticipantsfocusandwheresolittleofthevalueof strong conviction that our portfolio should be comparatively companies lies.EquallyBaillieGifford ismore likelytopossess concentrated, and that it is of little use to shareholders to tinker competitiveadvantagesforthegoodofshareholderswhenit around theedgesofindices.Wethinkthisproducesbetter adoptsalongtermperspective.Wearea100yearold investmentresultsanditcertainlymakesusmorecommitted Scottish partnership.We think about ourown business over decades not quarters.Such stability may not be exciting but it onthebasisofthepast(theircurrentmarketcapitalization)isa doesencouragepatiencein thismost impatient of industries. policydesignedtoprotect thesecurityof tenureofasset Weonlyjudgeourinvestmentperformanceoverfiveyearplus managers rather than to build the wealth of shareholders. timehorizons.Intruthittakesatleast adecadetoprovide Companies that are large and established tend to be internally adequateevidenceofinvestmentskill complacent and inflexible.They are often vulnerable to assault The investment management industry is ill-equipped to deal bymore ambitious andvibrantnewcomers. withthebehaviouralandemotionalchallengesinherentin -We are Growth stock investors.Such has been thepreference today'scapitalmarkets.Ourtimeframeandownership forValueandthesearchtoarbitrageawayminorrating structurehelpustofight thesedangers.We arebesieged by differentialsthatinvestorsfinditveryhardtoacknowledgethe news,dataandopinion.Thebulkofthisinformationisof little extraordinarygrowthratesandreturnsthatcanbefound significancebutitimploresyoutorapidandusuallyfutile today.Thegrowththatweareparticularlyinterested inisof an action. This can be particularly damaging at times of stress. explosivenatureandoftenrequiresminimalfixedassetsor Academicresearcharguesthatmostindividualsdislike indeedcapital.Wethinkofitas‘GrowthatUnreasonable financiallossestwiceasmuchastheytakepleasureingains Prices'ratherthanthetraditionaldisciplineof'Growthata Wefear thatforfund managers thisrelationship is closeto ReasonablePrice'.Weneed tobewillingtopayhighmultiples tenfold.Internal and externalpressures make the avoidance of ofimmediateearningsbecausethescaleoffuturepotential lossdominant.Thisisdamaginginaportfoliocontext.We andreturnscanbesodramatic.Onthestocksthatflourish needtobewillingtoacceptlossifthereisanequalorgreater the valuation willhave turned out to be derisorily low. On the chanceof(almost)unlimitedgain. others we willose money. We arevery dubious about thevalue ofroutine information. Webelievethatitisourfirstdutytoshareholderstolimitfees We have little confidencein quarterly earnings and none in the Boththeinvestmentmanagementfee(equivalentto0.32%) views of investmentbanks.We trytoscreenoutratherthan incorporatetheirnoise.Incontrastwethinkthattheworld standardsbutatleastadequateinabsoluteterms.Wethink offers joyous opportunities tohearviews,perspectives and visionsthatarebarelynoticedbythemarkets.Fromouroffice underestimated.The differencebetween ongoing charges of inShanghaitofuturistsinCaliforniathereismoreinthe perspectiveis altered to think of costs as a percentage of Joumaldescribe. expected annual retums then thecontrastbecomes obvious. Weareglobalinstockselection,assetallocationand attribution. We are active not passive - or far worse- index years) then this is the difference between removing 5% or plusinstockselection.Holdingsizesreflectthepotential 15%ofyourreturnseachyear.Nordowebelieveina upside and its probability (or otherwise) rather than the performance fee. Usually it undermines investment performance.It increasespressure and narrowsperspective. locationofthecompanyanditsheadquarters.Wedonothave ScottishMortgageInvestmentTrustPLC13

ThirtyLargestHoldingsand TwelveMonthPerformance at31March2013