Scottish Mortgage Investment Trust — Annual Report 2014

Managers' Review — James Anderson (year ended 31 March 2014)

Context. The 2014 review: a year in which markets finally rewarded the trust's convictions — six top-30 holdings doubled, including Tencent, the soon-to-be-quoted Alibaba, Illumina, Facebook and Tesla. Anderson answers Thiel and Levchin's '40 years of stagnation' pessimism directly: 'marked improvement is imminent... the single most important contention that we have at present.'

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Managers' Review

We have made few changes to your portfolio. We still own all but one of the 30 largest holdings of last year. Most have been in place for several years. Rather to our surprise markets have seen fit to reward many of these holdings with substantial share price rises in the last year. Six of the current top 30 have seen their share prices more than double in the last 12 months. Two are Chinese technology companies (Tencent and the soon to be quoted Alibaba) whilst three are innovative Californian ventures in the shape of Illumina, Facebook and Tesla. The last, and perhaps most surprising, member of the group is Fiat. Fortunately all of these were large holdings before the surges in their prices occurred with the frustrating exception of Tesla. In truth the conduct and progress of these companies has changed little. It is beyond us to explain, even in retrospect, why markets chose to recognize their achievements in the last 12 months. Previously informed opinion had been markedly hostile to most of these six and several more strong performers. Facebook is perhaps the clearest example of this dramatic change in market sentiment.

As usual we would like to structure our comments around the three themes that we have stressed for several years. These all still appear vital. In order to turn them into our portfolio of individual stocks we operate according to our Core Investment Beliefs that are set out on page 14.

The Underestimated Power of Technological Change

Last year's report included Tom Slater's contribution describing his months spent amongst Northern Californian capitalists. His reflections have been extremely helpful in allowing us to interpret the waves of innovation and disruption that have emanated from the San Francisco Bay area. Our principal preoccupation this year has lain in our attempts to see how far these have spread into new industries and geographies outside their traditional information technology redoubts. For all the remarkable progress that the last two decades have offered in electronics there has been a lingering feeling of disappointment that innovation has predominately been confined to the electronic world. As the acerbic venture capitalists Peter Thiel and Max Levchin have frequently observed 'if you look outside the computer and the internet, there has been 40 years of stagnation' and that the US innovation system is 'near death'. They exaggerate. But more importantly we think that marked improvement is imminent. We believe that this is the single most important contention that we have at present. On its accuracy or otherwise will our future returns depend.

2013-14 appears to have been the year in which structural change began to transform the healthcare landscape. A year ago we noted encouraging developments in genomic science. Since then the sharp falls in sequencing costs and increases in data scope and utility have prompted a transition from academic to practical enthusiasm. Illumina's considerable lead in the provision of sequencing has similarly translated into significant new machines, strong orders and much broader market opportunities. If the clinical benefits that seem likely to follow do come to fruition then the scale and longevity of the investment opportunity in genomic science ought to be very substantial. Presumably even Mr Thiel would accept that making most forms of cancer a manageable disease would count as beneficial progress.

The car and utility industries have been two of the dullest, least innovatory and most uninteresting sectors in the world for several decades. Some would go further than this. The CEO of US generator NRG has described his utility industry as 'the least innovative industry in America, maybe the world, in history.' The power of the incumbents to block real change has been far-reaching. Only major internal corporate mistakes have been threatening. Many have been made, especially in Detroit, to compensate for the lack of external stimulus. But these industries may now be subject to radical re-shaping. Whilst the combination of inertia and offsetting technological improvements are critical the trigger is the effervescent Elon Musk. Between Tesla and Solar City his companies are directly attacking the incumbents. That Tesla has become a realistic competitor to the internal combustion engine's 130 year dominance and to even the better run luxury car companies is remarkable. The next challenges of building a mass market business and solving the storage conundrums are formidable but seem attainable in comparison with the challenges that have already been met. Increasingly our belief is that our previous unsatisfactory forays into alternative energy were premature and flawed in company selection rather than fundamentally doomed.

China and Emerging Markets

Last year we commented on the disdain shown to Chinese equities amidst generalized antipathy to the once beloved emerging markets. Twelve months on the situation appears little different on the surface. Domestic Chinese equity markets continue to lag. Economic commentators and the international media have picked up on the popular hedge fund mantra that China faces a housing bubble and debt crisis. Robert Peston has shifted his attention away from Europe and towards China in the desperate search for economic catastrophe to fill our screens. Brazil, India, Turkey, Indonesia and Russia have regularly swapped places as candidates for imminent crisis. Russia has now taken a deserved and potentially sustainable lead in this race to the bottom.

But beneath the furore there is evidence of changing perspectives and greater differentiation. Much of this stems from the corporate sector. Whilst we would endorse the economic and political case for optimism over Chinese prospects the argument has been advanced much more powerfully by the remarkable growth and achievements of the Chinese internet companies. Tencent, Alibaba and Baidu have begun to command global respect for their innovation, popular appeal and sheer scale as well as their stock market success. Thus it is hard to know whether to admire Alibaba more for its ability to grow at well-over 50% whilst already producing more traffic than Amazon and eBay combined, to envy their ability to make in-roads into financial services in a manner their western brethren struggle to achieve or to watch in amazement as US analysts compete to come up with the most dramatic sum in potential market capitalization for its forthcoming flotation.

Unfortunately we see little of similar attraction in the other major low income economies. It is a relief to have only modest Brazilian exposure. Sales of once large holdings such as Petrobras seemed painful at the time but sadly now appear thoroughly justified in retrospect. Beyond the economic and political difficulties that Brazil and its peers face our greatest disappointment has been how few individual companies have convinced us of their appeal even at much lower prices and ratings. The modest exceptions to this depressing conclusion have been in building small holdings in Magnit (an impressive grocery chain well-removed from the Putin circle) and BIM (a discount retailer with tentacles well-beyond Turkey's fascinating but puzzling economic and political growth pains). For us China and its great innovative companies stands out from its presumed rivals ever more dramatically.

The Western Financial Systems and its Flaws

Whilst technology and China move on at pace there is little evidence that our financial system is other than stuck. The sad majority of banks remain complex, greedy and unrepentant. Fund managers still appear reluctant to exert their full influence over the managements in question. Hedge funds in aggregate appear ever more impatient and collusive. All too often major companies appear effectively without committed owners.

What is welcome is that piecemeal reform has made the potential returns from investment banking gradually appear less alluring relative to equity requirements. But as with other similarly troubled industries the best hope of serious structural reform must surely come from new competitors from outside the traditional finance industry. We need the help of great and disruptive technology companies in finance as in healthcare and energy.

Conclusion

It is reasonable to expect that after the last year that many of our stocks would experience share price set-backs. This has already been the case in recent weeks. In the long-run it is better that this is so. It is never comfortable to see our holdings in the portfolios of momentum players and hedge fund princes. It is pleasanter to see them reappear amongst their preferred shorts and the objects of the habitual scorn of the Financial Times and Barron's.

Meanwhile, the overall tone of markets has reverted to the nervous jumping at available and imagined shadows that has been so prevalent since 2008. From Cyprus twelve months ago to Ukraine now and from the assumed implosion of the Eurozone to the presumed terrors implied by Federal Reserve monetary tapering anxiety and gloom remains deeply fashionable. This mood has its troubling asset allocation analogy in the ceaseless search for low volatility and the determination to 'de-risk' the future by replacing active equity ownership with such splendid prospective investments as governments bonds, gold and forests. The only consolation is that this makes our own task easier as the competition to assess and own companies for the long-term weakens by the day.

But above all we would like to stress that we are excited by the opportunities available. Excitement is usually perceived to be akin to naivety. If that is so then we plead guilty. We are fascinated by the changes in the transforming global economy and thrilled by the opportunities for rapid, highly-profitable and long-lasting growth that are available to the great companies that it is our responsibility to identify and own.

James Anderson Tom Slater

Berlin Trip Note

You can do anything you want in Berlin. Only crossing empty roads without the permission of the little green electric man with a jaunty hat who is one of the sole survivors of the unlamented East Germany evokes discontent. This observation is hard to avoid and hence unoriginal. Yet it is important. It conveys both the tolerance that is so refreshing a contrast with too much of Berlin's past and the whiff of the 1920's that it still carries. But it also illustrates the marked contrast between Berlin and the bourgeois sensibilities of West Germany's recent centres of power and corporate responsibility. For all that Berlin is the seat of Federal authority and the key to decisions that are central to European politics and economics it is equally and profoundly a metropolis that has little in common with the rest of the country. Perhaps this is also true of London but Berlin has no confidence at all that it is a model, powerhouse and guide for the rest of the country. Such view would, it scarcely requires saying, be risible in Munich, Stuttgart or Frankfurt even if Berlin was confident enough to propound it.

My plan to work in Berlin for an extended period was initially prompted by the wish to understand better the motivations behind the political power that it carries (often reluctantly). It has long seemed strange and exploitable that markets pay such exorbitant attention to the posturing of the London financial and media establishment whilst barely contemplating or caring what Berlin thinks — or more importantly does. This appears to us to be a practical example of persistent market inefficiency.

Europe seen from Berlin

There still appears to be no evidence that the Berlin government has any intention of deserting the Eurozone. Moreover events in the last year have considerably encouraged the German establishment in adhering to existing European policy. Domestically the two anti-Euro political parties have respectively collapsed (the FDP) and failed to enter the Bundestag (the AfW). Only the Federal Court in Karlsruhe has any significant potential qualms about monetary assistance as even the Bundesbank appears to accept the Merkel, Schauble and Draghi mix of policies.

The dominant view in official Berlin is that the European periphery has begun to see the benefits of its traumatic experiences of recent years. It is generally added that this has been less about inflexible German backing for austerity than about a necessary reform process bringing greater economic flexibility and political honesty to bear on structurally troubled countries.

Inevitably it is the fortunes of Spain and Italy that are of dominant interest. There is little patience for the notion that the problems of either country are primarily the result of Eurozone membership. Global economic crisis would have shown up their serious weaknesses whatever the institutional framework. The question is instead whether that membership gives two critical partners the impetus to make structural reforms that they would otherwise have refused to confront. This is not an obviously unfair critique. If the current policies can be maintained for a reasonable period then sustained growth is thought to be achievable in both countries. The remarkable decline in long-term interest rates in peripheral Europe and the indications of modest economic growth returning in Southern Europe have created confidence that the turmoil has been worthwhile. There are many who would like to see a similar reform dynamic in France and regret that such seems unlikely. Perhaps speculation that Mrs. Merkel would eventually like to move to Brussels might help to advance such a cause.

Berlin does not admire finance. In this it captures both the local ethos and the national consensus. The 2008-9 crisis removed any temptation to emulate the Anglo-American model. There is little appetite to allow its interests to dominate Europe. If there is one policy that unites the different geographical and political strands of the broad German establishment it is that the German economy and its companies must be kept out of the hands of speculators and in those of families and foundations. The return of Deutsche Bank to industrial sense from its unrewarding venture into finance capital is eagerly awaited. This requires the retirement of its Goldman Sachs trained Chairman.

Energy policy has been the most evident failure of the German government in recent years. What probably amounts to over €100bn of solar subsidies have failed to lower overall national emission levels, to sustain a local industry of global value or end Russian gas imports. European energy policy under a feeble German Commissioner has only exacerbated the situation. The domestic decision to ban nuclear power has been the cause of many of these unintended miscalculations.

It is, however, doubtful that major change is imminent. There is full awareness that powerful and successful companies such as BASF must have competitive energy prices. At the same time there is a strong conviction that in the long-term alternative energy sources will be both economically rewarding and environmentally necessary. The required fiscal, industrial and political compromises are to be endured in the meantime. There is little sympathy for Mr. Putin but nor is there much belief that his danger should be equated with that of the Soviet Union. This is hardly surprising in a city that has learnt to differentiate between serious and very present danger and mutual political posturing. Talk about the deteriorating conditions in Ukraine seems less apocalyptic when strolling across what was once the death strip of the Berlin Wall.

The Berlin Economy

Although this is the capital of Europe's most powerful economy there is much local emphasis on the comparative poverty of Berlin. It sees itself as 'poor but sexy' in the words of the long-standing Mayor. This is backed by a deep suspicion of what are perceived as the rich, privileged, conservative, hierarchical and complacent cities of recent German economic leadership. Berlin has very little in common with Munich from wealth to local politics to conceptions of urban beauty. This predates the division of East and West Berlin. An extraordinary surge of manufacturing activity in late 19th century Berlin left a radical political heritage and cramped living conditions more redolent of Glasgow or Philadelphia than princely and agricultural Munich. The aging radicals who fled to West Berlin to avoid military service and to riot in 1968 reinforced an entrenched suspicion of capitalism that

Brecht would have been proud of and that the economic collapse of the East only reinforced. This has many admirable consequences. There are audiences of thousands ready to boo Deutsche Bank available at any time of the day or (preferably) night. There is a willingness to think critically and radically that has little in common with the persistent, incremental and successful family capitalism of rich Germany.

The consequences of the complex history of Berlin have combined in an entirely unpredictable manner to create an extraordinarily vibrant and innovative local culture. Here is a city with a population lower than in 1914 but with a dense urban geography dating from before then. Much of the housing stock after the fall of the Wall was far too decrepit to appeal to short-sighted speculators. Nor could they see that ramshackle factories and breweries were ripe to serve as unique artistic spaces, night-clubs and cafes in a manner quite obvious to any aspiring member of the creative class.

Moreover, the anti-capitalist ethos made it inevitable that even newly fashionable areas would still remain stocked with a social mixture unthinkable in more conventional world cities from Shanghai to New York. After all even newly enriched Prenzlauer Berg refuses to let owners add balconies as this would mean that prices would rise too far. But even if Prenzlauer is out of reach for many price is the ingredient that makes Berlin unique. Rental costs are approximately 70% below London levels. Educational costs are low, university standards are rising sharply and opportunities for foreigners to gain admission are pleasingly high. Entertainment is cheap and very plentiful. It has therefore become a haven for the young of almost anywhere, looking for almost anything from a job to social welfare to freedom.

The irony is that this idealistic and ostensibly anti-capitalist brew may well have created the near perfect ingredients for modern economic development. It has translated into a flurry of youthful, quirky, highly skilled and intensely multicultural start-ups that is entirely accidental and much the better for being so. After all the doomed efforts to create alternative Silicon Valleys (or mere Roundabouts) Berlin may just have done so via serendipity. Heavy industry will not return to recreate 19th century Berlin but from software to healthcare the potential replacements are starting to emerge.

As yet this dynamism is comparatively hard to channel into the Scottish Mortgage portfolio. But it is becoming easier. We have a holding in Kinnevik which is a major backer in turn of Rocket Internet and Zalando. Rocket is probably the most interesting venture capital group anywhere outside Silicon Valley. It is turning innovation into an industrial process from a down at heel building in central Berlin whilst Zalando has become one of the world's largest internet clothing retailer from an equally modest communist era structure a mile further east. Over the coming years we would hope and expect that we can find more opportunities of similar pedigree. Some of these may be unquoted ventures. This reflects our belief that from the catastrophes of the 20th century Berlin is rapidly becoming the most important key to understanding European economic, social and political prospects in the 21st century.

James Anderson

The Managers' Core Investment Beliefs

Whilst fund managers claim to spend much of their careers assessing the competitive advantage of companies they are notoriously reluctant to perform any such analysis on themselves. The tendency is to cite recent performance as evidence of skill despite the luck, randomness and mean-reverting characteristics of most such data. If this does not suffice then attention turns to a discussion of the high educational qualifications, hard work and exotic remuneration packages that the fund manager enjoys. Sometimes the procedural details of the investment process are outlined with heavy emphasis on risk controls. Little attention is given to either the distinctiveness of the approach or the strategic advantages the manager might enjoy in order to make imitation improbable. We think we should try to do better than this.

— We are long term in our investment decisions. It is only over periods of at least five years that the competitive advantages and managerial excellence of companies becomes apparent. It is these characteristics that we want 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 little of the value of companies lies. Equally Baillie Gifford is more likely to possess competitive advantages for the good of shareholders when it adopts a long term perspective. We are a 100 year old Scottish partnership. We think about our own business over decades not quarters. Such stability may not be exciting but it does encourage patience in 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 deal with the behavioural and emotional challenges inherent in today's capital markets. Our time frame and ownership structure help us to fight these dangers. We are besieged by news, data and opinion. The bulk of this information is of little significance but it implores you to rapid and usually futile action. This can be 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 to tenfold. Internal and external pressures make the avoidance of loss dominant. This is damaging in a portfolio context. We need to be willing 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 little confidence in quarterly earnings and none in the views of investment banks. We try to screen out rather than incorporate their noise. In contrast we think that the world offers joyous opportunities to hear views, perspectives and visions that are barely noticed by the markets. There is more in the investment world than the Financial Times or Wall Street Journal describe.

— We are global in stock selection, asset allocation and attribution. We are active not passive — or far worse — index plus in stock selection. Holding sizes reflect the potential upside and its probability (or otherwise) rather than the combination of the market capitalization and geographical location of the company and its headquarters. We do not have sufficient confidence in our top-down asset allocation skills to wish to override stock selection. We do not have enough confidence in our market timing abilities to wish to add or remove gearing at frequent intervals. We do, however, have strong conviction that our portfolio should be comparatively concentrated, and that it is of little use to shareholders to tinker around the edges of indices. We think this 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 asset managers rather than to build the wealth of shareholders. Companies that are large and established tend to be internally complacent and inflexible. They are often vulnerable to assault by more ambitious and vibrant newcomers.

— We are Growth stock investors.

Such has been the preference for Value and the search to arbitrage away minor rating 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 particularly interested in is of an explosive nature and often requires minimal 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 stocks that flourish the valuation will have turned out to be derisorily low. On the others we will lose money.

— We believe that it is our first duty to shareholders to limit fees. Both the investment management fee (equivalent to 0.32% falling to 0.30% as of 1 April 2014) and ongoing charges ratio (0.5%) 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 ongoing charges ratio of 0.5% 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 10% (sadly they have not in recent years) then this is the difference between removing 5% or 15% of your returns each year. Nor do we believe in a performance fee. Usually it undermines investment performance. It increases pressure and narrows perspective.