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

ehavemadefewchangestoyourportfolio.Westillownall but heofthe30largestholdingsoflastyear.Mosthavebeenin place for severalyears.Rathertooursurprisemarketshaveseen torewardmanyoftheseholdingswithsubstantialshareprice sesinthelastyear.Sixofthecurrenttop30haveseentheir harepnicesmorethandoubleinthelast12months.Twoare hinesetechnologycompanies(Tencentand thesoontobe quotedAlibaba)whilstthreeareinnovativeCalifornianventuresin the shape oflllumina,FacebookandTesla.Thelast,andperhaps most surprising.memberofthegroupisFiat.Fortunatelyallof these werelargeholdingsbeforethesurgesintheirprices occurredwiththefrustratingexceptionofTesla.Intruththe onductandprogressofthesecompanieshaschangedlittle.Itis beyond ustoexplain,eveninretrospect,whymarketschoseto Bcognizetheirachievementsinthelast12months.Previously nformedopinionhadbeenmarkedlyhostiletomostofthesesix Indseveral morestrongperformers.Facebookisperhapsthe learestexampleofthisdramaticchangeinmarketsentiment. Asusualwewouldliketostructureourcommentsaroundthe hreethemesthatwehavestressedforseveralyears.Theseall stillappearvital.Inordertoturnthemintoourportfolioof ndividualstocksweoperateaccordingtoourCoreInvestment Beliefsthataresetoutonpage14. TheUnderestimatedPowerofTechnologicalChange Lastyear'sreportincludedTomSlater'scontributiondescribing hismonthsspentamongstNorthernCaliforniancapitalists.His eflectionshavebeenextremelyhelpfulinallowingustointerpret thewavesofinnovationanddisruptionthathaveemanatedfrom heSanFranciscoBayarea.Ourprincipalpreoccupationthisyear haslaininourattemptstoseehowfarthesehavespreadinto hewindustriesandgeographiesoutsidetheirtraditional thatthelasttwodecadeshaveofferedinelectronicstherehas peenalingeringfeelingofdisappointmentthatinnovationhas predominatelybeenconfinedtotheelectronicworld.Asthe acerbic venturecapitalistsPeterThielandMaxLevchinhave frequently observedifyoulookoutsidethecomputerandthe ernet, therehasbeen40yearsofstagnation'andthattheUS hovationsystem is‘neardeath'.Theyexaggerate.Butmore portantlywethinkthatmarkedimprovementisimminent.We lievethatthisisthesinglemostimportantcontentionthatwe ive atpresent.On its accuracy or otherwisewill ourfuture returns depend. 013-14appearstohavebeentheyearinwhichstructural notedencouragingdevelopmentsingenomicscience.Since enthesharpfallsinsequencingcostsandincreasesindata opeandutilityhavepromptedatransitionfromacademicto actical enthusiasm.llumina'sconsiderablelead in theprovision sequencinghassimilarlytranslatedintosignificantnew achines,strongordersandmuchbroadermarketopportunities. heclinicalbenefitsthatseemlikelytofollowdocometofruition enthescaleandlongevityoftheinvestmentopportunityin nomicscienceoughttobeverysubstantial.Presumablyeven Thielwouldacceptthatmakingmostformsofcancera anageablediseasewouldcountasbeneficialprogress. lecarandutilityindustrieshavebeentwoofthedullest,least novatoryandmostuninterestingsectorsintheworldforseveral cades.Somewouldgofurtherthanthis.TheCEOofUS neratorNRGhasdescribedhisutilityindustryas‘theleast lovativeindustryinAmerica,maybetheworld,inhistory. lepowerof theincumbentstoblockrealchangehasbeen -reaching.Onlymajorinternal corporatemistakeshavebeen eatening.Manyhavebeenmade,especiallyinDetroit,to mpensateforthelackofexternalstimulus.Buttheseindustries ay now be subject to radical re-shaping. Whilst the combination gger is the effervescent Elon Musk.BetweenTesla andSolar tyhiscompaniesaredirectlyattackingtheincumbents.That slahasbecomearealisticcompetitortotheinternal mbustionengine's130yeardominanceandtoeventhebetter nluxurycar companies isremarkable.Thenextchallenges of ildingamassmarketbusinessandsolvingthestorage nundrumsareformidablebutseemattainableincomparison ththechallengesthathavealreadybeenmet.Increasinglyour lief isthatourpreviousunsatisfactoryforaysintoalternative ergywereprematureandflawedincompanyselectionrather anfundamentallydoomed. hinaandEmergingMarkets styearwecommentedonthedisdainshowntoChinese uitiesamidstgeneralizedantipathytotheoncebeloved ferentonthesurface.DomesticChineseequitymarkets ntinuetolag.Economiccommentatorsandtheinternational ediahavepickeduponthepopularhedgefundmantra that inafacesahousingbubbleanddebtcrisis.RobertPestonhas iftedhisattentionawayfromEuropeandtowardsChinainthe sperate search for economic catastrophe to fill our screens. azil, India,Turkey, Indonesia and Russia haveregularly swapped acesascandidatesforimminentcrisis.Russiahasnowtakena servedandpotentiallysustainableleadinthisracetothe ScottishMortgageInvestmentTrustPLC09

rategicReport Chinamovesonatapace. Butbeneaththefurorethereisevidenceofchangingperspectives andgreaterdifferentiation.Muchofthisstemsfromthecorporate sector.Whilstwewouldendorsetheeconomicandpoliticalcase foroptirmismoverChineseprospectstheargumenthasbeen advancedmuchmorepowerfullybytheremarkablegrowthand achievementsoftheChineseinternetcompanies.Tencent, AlibabaandBaiduhavebeguntocommandglobalrespectfor theirinnovation,popularappealandsheerscaleaswellastheir stockmarketsuccess.Thusitishardtoknowwhethertoadmire producingmoretrafficthanAmazonandeBaycombined，toenvy theirabilitytomakein-roadsintofinancialservicesinamanner theirwesternbrethrenstruggletoachieveortowatchin amazement as US analysts competetocomeupwith the most dramaticsuminpotential marketcapitalizationforitsforthcoming flotation. Unfortunatelyweseelittleofsimilarattractionintheothermajor lowincome economies.It isarelief tohaveonlymodestBrazilian exposure. Sales of once large holdings such as Petrobras seemedpainfulatthetimebutsadlynowappearthoroughly justified inretrospect.Beyond theeconomic andpolitical 10AnnualReport2014 fficultiesthatBrazilanditspeersfaceourgreatest sappointmenthasbeenhowfewindividualcompanieshave onvincedusoftheirappealevenatmuchlowerpricesand tings.The modest exceptions to this depressing conclusion avebeeninbuildingsmallholdingsinMagnit(animpressive ocerychainwell-removedfromthePutincircle)andBiM(a scountretailerwithtentacleswell-beyondTurkey'sfascinating utpuzzlingeconomic andpoliticalgrowthpains).ForusChina nd itsgreatinnovativecompaniesstandsoutfromitspresumed ralsevermoredramatically. heWesternFinancialSystemsanditsFlaws ThilsttechnologyandChina moveonatpacethereislittle videncethatourfinancialsystemisotherthanstuck.Thesad ajority of banks remain complex,greedy and unrepentant.Fund anagersstillappearreluctanttoexerttheirfullinfluenceoverthe oreimpatientandcollusive.Alltoooftenmajorcompanies opeareffectivelywithoutcommittedowners. hatiswelcomeisthatpiecemealreformhasmadethepotential turnsfrominvestmentbankinggraduallyappearless alluring lativetoequityrequirements.Butaswithothersimilarlytroubled dustriesthebesthopeofseriousstructuralreformmustsurely omefromnewcompetitorsfromoutsidethetraditionalfinance dustry.Weneedthehelpofgreatanddisruptivetechnology ompanies in finance as in healthcare and energy. onclusion isreasonabletoexpectthatafterthelastyearthatmanyofour ockswouldexperiencesharepriceset-backs.Thishasalready eenthecaseinrecentweeks.Inthelong-runitisbetterthatthis so.Itisnevercomfortabletoseeourholdingsintheportfolios thehabitualscornoftheFinancialTimesandBarron's. eanwhile,theoveralltoneofmarketshasrevertedtothe ervousjumpingatavailableandimaginedshadowsthathas eensoprevalentsince2008.FromCyprustwelvemonthsago Ukrainenowandfrom theassumed implosionof theEurozone thepresumedterrorsimpliedbyFederalReservemonetary oodhasitstroublingassetallocationanalogyintheceaseless archforlowvolatilityandthedeterminationto'de-risk'the ture by replacing active equity ownership with such splendid ospective investments asgovernments bonds,gold and forests. heonlyconsolationisthatthismakesourowntaskeasierasthe ompetitiontoassessandowncompaniesforthelong-term eakensbytheday. utaboveallwewouldliketostressthatweareexcitedbythe oportunities available.Excitement isusuallyperceived tobe akin naivety.If that is so then weplead guilty.We arefascinated by 9changesinthetransformingglobaleconomyandthrilledby e opportunitiesforrapid,highly-profitableandlong-lasting owththatareavailabletothegreatcompaniesthatitisour sponsibilitytoidentifyandown. mesAnderson omSlater

Alibaba Group China'sdominante-commel Inditex Flagshlp store in the Champs-Elysees in Paris. Tencent Kering Tencent's QQ logo. Aworldleaderinfashion. Our portfolio is built upon the attractions of individual companies. Strategic Report erceenterprise. Chinesewebservicescompany. WholeFoods Desserts at the Bakery Department. ScottishMortgageInvestmentTrustPLC11

rategicReport Berlin Trip Note pu can do anythingyouwant inBerlin.Only crossing empty adswithoutthepermissionofthelittlegreenelectricmanwitha untyhatwhoisoneofthesolesurvivorsoftheunlamentedEast ermanyevokesdiscontent.Thisobservationishardtoavoid nd henceunoriginal.Yetit isimportant.It conveysboththe blerancethatissorefreshingacontrastwithtoomuchofBerlin's astandthewhiffofthe1920'sthatitstillcarries.Butitalso ustratesthemarkedcontrastbetweenBerlinandthebourgeois ensibilitiesofWestGermany'srecentcentresofpowerand orporateresponsibility.ForallthatBerlinistheseatofFederal uthorityandthekeytodecisionsthatarecentraltoEuropean oliticsandeconomicsitisequallyandprofoundlyametropolis hathaslittleincommonwiththerestofthecountry.Perhapsthis $alsotrueofLondonbutBerlinhasnoconfidenceatallthatitis model,powerhouseandguidefortherestof thecountry.Such viewwould,it scarcelyrequires saying,berisible inMunich, StuttgartorFrankfurtevenifBerlinwasconfidentenoughto propound it. Myplan towork inBerlinfor anextendedperiodwas initially oromptedbythewishtounderstandbetterthemotivations Dehindthepoliticalpowerthatitcarries(oftenreluctantly).lthas ongseemedstrangeandexploitablethatmarketspaysuch exorbitantattentiontotheposturingoftheLondonfinancialand mediaestablishmentwhilstbarelycontemplatingorcaringwhat Berlinthinks-ormoreimportantlydoes.Thisappearstoustobe practicalexampleofpersistentmarketinefficiency. EuropeseenfromBerlin little TherestillappearstobenoevidencethattheBerlingovernment nasanyintentionofdesertingtheEurozone.Moreovereventsin helastyearhaveconsiderablyencouragedtheGerman establishmentinadheringtoexistingEuropeanpolicy.Domestically FDP)andfailedtoentertheBundestag(theAfW).OnlytheFederal CourtinKarlsruhehasanysignificantpotentialqualmsabout theMerkel,SchaubleandDraghimixofpolicies. Thecomplex historyofBerlin createsan extraordinarily vibrant and innovativelocal culture. 12Annual Report2014 edominantviewinofficialBerlinisthattheEuropeanperiphery sbeguntoseethebenefitsofitstraumaticexperiencesof centyears.ltisgenerallyaddedthatthishasbeenlessabout exibleGermanbackingforausteritythanaboutanecessary ormprocessbringinggreater economic fexibility andpolitical nestytobearonstructuralytroubledcountries. evitablyitisthefortunesofSpainandItalythatareofdominant erest.Thereislittlepatienceforthenotionthattheproblemsof hercountryareprimarilytheresultofEurozonemembership. obaleconomiccrisiswouldhaveshownuptheirserious aknesseswhatevertheinstitutionalframework.Thequestionis petustomakestructuralreformsthattheywouldotherwisehave used toconfront.This is not anobviouslyunfair critique.If the rrentpoliciescanbemaintainedforareasonableperiodthen stainedgrowthisthoughttobeachievableinbothcountries. eremarkabledecline in long-term interest rates inperipheral SouthernEuropehavecreatedconfidencethattheturmoilhas enworthwhile.Therearemanywhowouldliketoseeasimilar ormdynamicinFranceandregretthatsuchseemsunlikely. rhapsspeculation that Mrs.Merkelwould eventually like to ovetoBrusselsmighthelptoadvancesuchacause. rlindoesnotadmirefinance.Inthisitcapturesboththelocal losandthenationalconsensus.The2008-9crisisremoved ytemptationtoemulatetheAnglo-Americanmodel.Thereis eappetitetoallowitsintereststodominateEurope.If thereis 9policythatunitesthedifferentgeographicalandpolitical andsofthebroadGermanestablishmentitisthattheGerman onomyanditscompaniesmustbekeptoutofthehandsof eculatorsandinthoseoffamiliesandfoundations.Thereturn DeutscheBanktoindustrialsensefromitsunrewardingventure financecapitaliseagerlyawaited.Thisrequirestheretirement itsGoldmanSachstrainedChairman. ergypolicyhasbeenthemostevidentfailureof theGerman vernmentinrecentyears.Whatprobablyamountstoover

little TheEastSideGalleryoftheBerlinWall. E10obnofsolarsubsidieshavefailedtoloweroverallnational amissionlevels.tosustainalocalindustryofglobalvalueorend Russiangasimports.Europeanenergypolicyunderafeeble GermanCommissionerhasonlyexacerbated thesituation.The domesticdecisiontobannuclearpowerhasbeenthecauseof manyoftheseunintendedmiscalculations. It is,however,doubtful that major changeis imminent.There isfull awarenessthatpowerfulandsuccessfulcompaniessuchasBASF musthavecompetitiveenergyprices.At thesame time thereis a strongconvictionthatinthelong-termalternativeenergysources willbebotheconomicallyrewardingandenvironmentally necessary.The required fiscal, industrial and political compromises aretobeenduredinthemeantime.ThereislittlesympathyforMr. Putinbutnoristheremuchbeliefthathisdangershouldbe equatedwith thatof theSovietUnion.This is hardly surprising in a citythathaslearnttodifferentiatebetweenseriousandvery presentdangerandmutualpoliticalposturing.Talkaboutthe deterioratingconditionsinUkraineseemslessapocalypticwhen strollingacrosswhatwasoncethedeathstripoftheBerlinWall TheBerlinEconomy thereismuchlocalemphasisonthecomparativepovertyof Berlin.Itsees itself as‘poorbut sexy'in the words of thelong- perceived as the rich, privileged, conservative, hierarchical and complacent citiesofrecentGermaneconomicleadership.Berlin hasverylittleincommonwithMunichfromwealthtolocalpolitics toconceptionsof urbanbeauty.Thispredatesthedivisionof East andWest Berlin.Anextraordinarysurge of manufacturing activity inlate19thcenturyBertinleftaradicalpoliticalheritageand cramped living conditions moreredolent of Glasgow or radicalswhoffed toWestBerlintoavoidmilitaryserviceand to riot in1968reinforced anentrenchedsuspicionofcapitalism that echtwouldhavebeenproudofandthattheeconomiccollapse theEastonlyreinforced.Thishasmanyadmirable eutscheBankavailableatanytimeofthedayor(preferably) ght.Thereisawillingnesstothinkcriticallyandradicallythathas leincommonwiththepersistent,incrementalandsuccessful milycapitalismofrichGermany. econsequencesofthecomplexhistoryofBerlinhave traordinarilyvibrantandinnovativelocalculture.Hereisacity ographydatingfrombeforethen.Muchofthehousingstock erthefalloftheWallwasfartoodecrepittoappealtoshort- ghtedspeculators.Norcouldtheyseethatramshacklefactories dbrewerieswereripetoserveasuniqueartisticspaces. ght-clubs andcafesinamannerquiteobvioustoanyaspiring emberofthecreativeclass. oreover,theanti-capitalistethosmadeitinevitablethateven wlyfashionableareaswouldstillremainstockedwithasocial xtureunthinkableinmoreconventionalworldcitiesfrom anghaitoNewYork.AfterallevennewlyenrichedPrenzlauer ergrefusestoletownersaddbalconiesasthiswouldmeanthat ceswouldrisetoofar.ButevenifPrenzlauerisoutofreachfor anypriceis theingredientthatmakesBerlinunique.Rental stsareapproximately7o%belowLondonlevels.Educational stsarelow,universitystandardsarerisingsharplyand portunities for foreigners to gain admission arepleasinglyhigh. tertainmentischeapandveryplentiful.Ithasthereforebecome navenfortheyoungofalmostanywhere,lookingforalmost ythingfromajobtosocialwelfaretofreedom. eironyisthatthisidealisticandostensiblyanti-capitalistbrew aywellhavecreatedthenearperfectingredientsformodern onomicdevelopment.It hastranslated into a flurry ofyouthful, irky,highlyskilledandintenselymulticulturalstart-upsthatis omedeffortstocreatealternativeSiliconValleys(ormere undabouts)Berlinmayjusthavedonesoviaserendipity.Heavy dustrywillnotreturntorecreate19thcenturyBerlinbutfrom ftwaretohealthcarethepotentialreplacementsarestartingto herge. yet this dynamism is comparativelyhard to channel into the ottishMortgageportfolio.But it is becoming easier.Wehave a ldinginKinnevikwhichisamajorbackerinturnofRocket ernetandZalando.Rocketisprobablythemostinteresting nturecapital groupanywhereoutsideSiliconValley.It isturning lovation intoanindustrial processfromadown atheelbuilding centralBerlinwhilstZalandohasbecomeoneoftheworld's gestinternetclothingretailerfromanequallymodest mmunist era structureamilefurthereast.Over the coming arswewouldhopeandexpectthatwecanfindmore portunitiesofsimilarpedigree.Someofthesemaybe quotedventures.Thisrefectsourbelief thatfrom the tastrophesofthe2othcenturyBerlinisrapidlybecomingthe ost important key to understanding European economic, social d politicalprospects inthe 21st century. mesAnderson ScottishMortgageInvestmentTrustPLC13

rategicReport he Managers' Core Investment Beliefs Vhilstfundmanagersclaimtospendmuchoftheircareers ssessingthecompetitiveadvantageofcompaniestheyare otoriouslyreluctanttoperformanysuchanalysisonthemselves. hetendencyistociterecentperformanceasevidenceofskill espitetheluck,randomnessandmean-revertingcharacteristics fmostsuchdata.Ifthisdoesnotsufficethenattentionturnstoa iscussionofthehigheducationalqualifications,hardworkand xoticremunerationpackagesthatthefundmanagerenjoys ometimestheproceduraldetailsoftheinvestmentprocessare butlinedwithheavyemphasisonriskcontrols.Littleattentionis idvantagesthemanagermightenjoyinordertomakeimitation mprobable.Wethinkweshouldtrytodobetterthanthis. Wearelongterminourinvestmentdecisions.Itisonlyover periodsofatleastfiveyearsthatthecompetitiveadvantages andmanagerialexcellenceofcompaniesbecomesapparent. Itisthesecharacteristicsthatwewanttoidentifyandsupport. Weown companiesratherthanrentshares.Wedonotregard ourselvesasexpertsinforecastingtheoscillationsof economiesorthemoodswingsofmarkets.lndeedwethink thatitishardtoexcelinsuchareasasthisiswheresomany marketparticipantsfocusandwheresolittleofthevalueof companies lies.EquallyBailie Gifford is more likelytopossess competitiveadvantagesforthegoodofshareholderswhenit adoptsalongtermperspective.Wearea100yearold Scottishpartnership.Wethinkaboutourownbusinessover decadesnotquarters.Suchstabilitymaynotbeexcitingbutit doesencouragepatienceinthismostimpatientofindustries. Weonlyjudgeourinvestmentperformanceoverfiveyearplus timehorizons.Intruthittakesatleastadecadetoprovide adequateevidenceofinvestmentskill. The investment management industry is il-equipped to deal withthebehaviouralandemotionalchallengesinherentin today'scapitalmarkets.Ourtimeframeandownership structurehelpustofightthesedangers.Wearebesiegedby news,dataandopinion.Thebulkof thisinformationisof little significancebutitimploresyoutorapidandusuallyfutile action.Thiscanbeparticularlydamaging at timesof stress. Academicresearcharguesthatmostindividualsdislike financiallossestwiceasmuchastheytakepleasureingains. Wefearthatforfundmanagersthisrelationshipiscloseto tenfold.Intemal andexternalpressuresmake the avoidanceof loss dominant. This is damaging in a portfolio context. We needtobewillingtoacceptlossifthereisanequalorgreater chanceof(almost)unlimitedgain. Weareverydubiousaboutthevalueofroutineinformation. We havelittleconfidenceinquarterlyearningsandnone inthe viewsof investmentbanks.We trytoscreenoutratherthan incorporatetheirnoise.Incontrastwethinkthattheworld offers joyous opportunities to hear views, perspectives and visionsthatarebarelynoticedbythemarkets.Thereismore intheinvestmentworldthantheFinancialTimesorWallStreet Joumaldescribe. Weareglobalinstockselection,assetallocationand attribution.Weareactivenotpassive-orfarworse-index plusin stockselection.Holding sizes reflect thepotential upsideanditsprobability(orotherwise)ratherthanthe combinationofthemarketcapitalizationandgeographical locationofthecompanyanditsheadquarters.Wedonothave 14AnnualReport2014 VeareGrowthstockinvestors. sufficientconfidenceinourtop-downassetallocationskillsto wishtooverridestockselection.Wedonothaveenough confidenceinourmarkettimingabilitiestowishtoaddor removegearingatfrequentintervals.Wedo,however,have strongconvictionthatourportfolioshouldbecomparatively concentrated,andthatitisoflittleusetoshareholderstotinker aroundtheedgesofindices.Wethinkthisproducesbetter investmentresultsanditcertainlymakesusmorecommitted shareholdersincompanies.Wesuspectthatselectingstocks onthebasisofthepast(theircurrentmarketcapitalization)isa policydesignedtoprotectthesecurityoftenureofasset managersratherthantobuildthewealthofshareholders. Companiesthatarelargeandestablishedtendtobeinternally WeareGrowthstockinvestors.Suchhasbeenthepreference forValueandthesearchtoarbitrageawayminorrating differentialsthatinvestorsfinditveryhardtoacknowledgethe extraordinarygrowthratesandreturnsthatcanbefound explosivenatureandoftenrequiresminimalfixedassetsor indeedcapital.Wethinkofitas'GrowthatUnreasonable Prices'ratherthanthetraditionaldisciplineof'Growthata ReasonablePrice'.Weneedtobewillingtopayhighmultiples ofimmediateeamingsbecausethescaleoffuturepotential andreturnscanbesodramatic.Onthestocksthatflourish thevaluationwillhave turnedouttobederisorilylow.Onthe otherswewillosemoney. Webelievethatitisourfirstdutytoshareholderstolimitfees. Both the investment management fee (equivalent to 0.32% falling to 0.30% as of 1 April 2014) and ongoing charges ratio (0.5%)arelowbycomparativestandardsbutatleastadequate inabsoluteterms.Wethinkthatthemalignimpactofhighfees is frequently underestimated.Thedifferencebetween ongoing but if theperspectiveis altered tothinkof costsasa percentageofexpected annualreturnsthenthecontrast becomesobvious.lIfannualreturnsaverage1o%(sadlythey havenotinrecentyears)thenthisisthedifferencebetween removing5%or15%ofyourreturnseachyear.Nordowe believeinaperformancefee.Usuallyitunderminesinvestment performance.Itincreasespressureandnarrowsperspective.