Trust 23 complete magazine

READING THE SIGNALSTom Slater talks technology stocks

WAITING FOR THE SUNRISECan ‘Abenomics’ save Japan?

ON THE SAME TRACKJohn Kay and James Anderson on restoring trust between companies and investors

inside

SPECIAL REPORT CORPORATE

GOVERNANCE

Special Report

10 RESPONSIBLE OUTLOOK Heather Connon on improving business stewardship

15 A STRONGER RELATIONSHIP Rebuilding trust between companies and investors is vital, says Professor John Kay

Features

17 MATADOR ON THE MOvE Spain is determined to fight recession, writes Stephen Womack

20 FIGURE OF INFLUENCE Peter Tasker on the legacy of Japan’s Viscount Takahashi

22 REACHING FOR GROWTH? ‘Abenomics’ could save Japan, says Ben McLannahan

25 THE MANY COLOURS OF CAPITALISM Jonathan Gregson on different approaches to this system

30 HANDS-FREE HIGHWAY Self-driving cars are coming – Baillie Gifford investigates...

Editor: Heather FarmbroughSub-Editor: Bernie Deehan Design: Touch www.thetouchagency.co.ukPrint: J Thomson Colour Printers www.jtcp.co.uk

Trust is a financial promotion. It has been printed on Arctic Volume paper which was sourced from well- managed forests independently certified according to the rules of the Forest Stewardship Council ® TT-COC-002242

All editorial queries should be directed to: Stuart Conlan, Baillie Gifford Savings Management Limited, Calton Square, 1 Greenside Row, Edinburgh EH1 3AN.

Images © Getty Images unless otherwise stated.

Trust is also online at www.bgtrustonline.com Cover image shows The Dish at Stanford University, California © Getty Images

The articles in this issue were written between April and May 2013

HEATHER FARMBROUGHis the editor of Trust and a freelance journalist. She has worked as a stockbroker, a fund manager and a journalist on the Financial Times.

DAvID SMITHis economics editor and an assistant editor and policy adviser for The Sunday Times. His latest book is Free Lunch: Easily Digestible Economics.

PHILIP COGGANis the Buttonwood columnist and capital markets editor of The Economist. His next book on democracy is out in September.

JONATHAN GREGSON is a freelance journalist and editorial consultant of First Magazine. He has been a city reporter at The Sunday Telegraph and has written three books on South Asia.

This issue’s contributors

Regulars

04 IN BRIEF Baillie Gifford’s website goes mobile and other news

06 SPONSORSHIP & EvENTS Our support of literary events, author interviews, and the next Private Investors’ Forum

07 WEST COAST WONDERS Tom Slater talks to Heather Farmbrough about investing in US tech companies

28 INTERvIEW Gerald Smith and Tom Walsh share their plans for The Monks Investment Trust

32 DAvID SMITH David Smith ponders the fall in global productivity

34 BOOK REvIEW Philip Coggan on James Owen Weatherall’s book The Physics of Finance

35 THE TRUSTS Information about Baillie Gifford’s trusts, how to invest and important risk details

HEATHER CONNONhas been a financial journalist for 25 years, writing for the Observer, The Independent and the London Evening Standard, among many other publications.

STEPHEN WOMACK is a financial journalist and former personal finance correspondent for the Daily Mail and Mail on Sunday. He has also written for The Times and the FT Group.

I am very pleased to welcome you to this issue of Trust magazine. At Baillie Gifford, we’ve been following closely the extraordinary success of many technology companies based in the San Francisco Bay Area. Scottish Mortgage is a long-term investor in some of these firms, and deputy manager Tom Slater speaks about getting to know them better. Indeed, the importance of good dialogue and relationships between companies and investors is at the heart of our special report on corporate governance. In this report we speak to James Anderson, manager of Scottish Mortgage and Michael MacPhee, manager of Mid Wynd. We also interview Professor John Kay, author of The Kay Review. I’m also delighted to introduce you to Tom Walsh as the new deputy manager of Monks, in an interview with him and manager Gerald Smith on page 28. I hope you enjoy reading all the articles in this issue.

LINDSEY GREIG Chief Executive, Baillie Gifford Savings Management Limited

Lindsey Greig is responsible for customer support for personal investors and intermediaries.

Welcome Contents

www.bgtrustonline.com [email protected] and 0800 917 2112

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PETER TASKER is a founding partner of fund manager Arcus Investments and also a writer of non-fiction and novels. His website is www.petertasker.asia

BEN MCLANNAHANis the Tokyo correspondent for the Financial Times, and he has written for the FT’s Lex column, Institutional Investor and The Economist Group.

JENNIFER HILLis a freelance journalist, writing forTheIndependent and City AM amongothers. She is the former deputy Money editor of The Sunday Times and personal finance editor of The Scotsman.

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Going Mobile

Following the successful redesign of the Baillie Gifford website last year, we have now launched a mobile optimised version. You can use your smartphone to easily access a range of information while on the move, allowing you to view and compare information about Baillie Gifford funds, find out how to invest, check daily fund prices and performance information and watch investment films and interviews. To log on from your mobile device, simply search for the www.bailliegifford.com website as you would on your desktop computer. The site will automatically detect that a smartphone is being used and will display the mobile optimised version. Tom Barrett, head of digital communications at Baillie Gifford, said: “With so much of our lives now being conducted on the move, our new mobile optimised site offers up-to-date information on all of Baillie Gifford’s trusts.”

A new offer with our Share PlanOpen a Baillie Gifford Investment Trust Share Plan between 1 July and 30 September 2013 and you will also receive a £10 Amazon Gift Card.* The Share Plan offers you access to the global stock market through a range of investment trusts. You can choose to invest in any combination of the eight trusts managed by Baillie Gifford. Invest from £250 as a lump sum or from £30 each month and there is no maximum limit. Your investments can be managed conveniently online,(subject to certain restrictions) and you can switch between the eight trusts whenever you wish.

*Terms & conditions apply. New Share Plan customers only. For more details visit www.bailliegifford.com or call the Client Relations Team on 0800 917 2112.

Top marks for Trust

Trust has won ‘Best Newsletter’ for the third year running at the annual Best Information to Shareholders Awards 2013, run by the Association of Investment Companies (AIC). The accolade once again rewards a magazine written for investors and those keen to learn more about our exciting and diverse industry, within a fresh and captivatingly designed medium.

“We are thrilled that Trust has won this award for the third consecutive year,” said Stuart Conlan, marketing manager at Baillie Gifford. “We are passionate about producing a top quality magazine with engaging and interesting articles for our readers. This award is independent recognition of our efforts.”

Reducing fees, maintaining values Baillie Gifford has reduced its investment management fees for four of its specialist investment trusts: Baillie Gifford Japan Trust, Shin Nippon, Edinburgh Worldwide and Pacific Horizon. The annual fee, which covers investment management and administration costs, has been cut to 0.95 per cent on the first £50m of the trusts’ net assets, and 0.65 per cent on net assets over £50m. This change is expected to reduce the ongoing charge expense for each trust. James Budden, director of retail marketing and distribution at Baillie Gifford, said: “We reduced our fees because we are committed to the long-term future of the trusts we manage and want them to remain competitive.”

The views expressed in Trust should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The articles contain information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research. Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions.

The information contained within Trust has been compiled with considerable care to ensure its accuracy at the date of publication. However, no representation or warranty, express or implied, is made to its accuracy or completeness. Nothing in this information or elsewhere in Trust shall exclude, limit or restrict our duties and liabilities to you under the Financial Services and Markets Act 2000 or any conduct of business rules that we are bound to comply with. Any telephone call you make to us may be recorded for training or monitoring purposes.

RISK WARNINGS AND IMPORTANT INFORMATION Visit the mobile site

www.bailliegifford.com


Before our interview, I asked Tom Slater to send me a list of the meetings he had with companies in the San Francisco Bay Area in the USA last autumn. It reads like a Who’s Who of the West Coast, with Facebook and LinkedIn (both held by Scottish Mortgage Investment Trust PLC), as well as Expedia, Twitter, Netf lix, PayPal and Dropbox. Spending two months in the area – focusing mostly on Palo

Alto, home to many leading technology companies – gave Tom the chance to see a wide variety of people. “It was great to be able to spend some time talking with Dr Catherine Mohr, director of medical research at Intuitive Surgical, which designs and builds the da Vinci robot for minimally invasive surgery, and to really understand where the company thinks it can go in 10 years’ time with its technology.

“For us, this kind of information is very valuable. Being a sizeable and supportive shareholder (the company makes up 2.4 per cent of Scottish Mortgage’s portfolio), I think we can have a dialogue that other investors can’t.” I suggest to Tom that the best way to get a company to trust you, enough to allow you to understand it properly, is to be a long-term shareholder. “Yes, I think that’s true,” he

Win tickets to the book event of the year

The Scottish Mortgage Investment Trust Book of the Year will be announced at the Lennoxlove Book Festival in East Lothian on 2 November 2013. The finalists will each receive £5,000 and the overall winner will receive a further £25,000. The voting is split between a judging panel and the public, so you can consider your favourite book from the shortlist by visiting www.scottishbookawards.com when the list is announced in September. The public vote will be open from October. We are offering Trust subscribers the chance to win an invite to the awards ceremony and entry to other events taking place at the Lennoxlove Book Festival. The prize includes two nights’ bed and breakfast accommodation at Letham House Hotel in East Lothian, entry to the awards ceremony and drinks reception, and roving tickets to events taking place at the Festival on 2 November 2013. For further information and to enter the prize draw, visit www.bgtrustonline.com/sponsorship

Hear the views of fund managers at our London forum

Baillie Gifford is holding its next Private Investors’ Forum on the afternoon of 10 September 2013 at London’s exclusive private members venue, The Hurlingham Club. The theme of the event is ‘Investment Trusts – the Active Investment Choice.’ After a buffet

lunch, there will be presentations from Sarah Whitley (Japan Trust), Dominic Neary (SAINTS), Tom Walsh (Monks) and Mark Urquhart (Edinburgh Worldwide). Don’t miss this opportunity to broaden your investment knowledge and meet some of our investment trust managers. For more information and to pre-register for tickets, visit www.bgtrustonline.com/forum Speakers may be subject to change.

Sponsorship & EventsTrust Online:wise words on the web

Go online and you can read our interviews with leading writers from many different fields who have appeared at UK literary events sponsored by Baillie Gifford each year. We’ve recently spoken to BBC News Europe editor Gavin Hewitt, economist Paul Ormerod, sociologist and political scientist Colin Crouch, journalist and politician Adam Fergusson, and academic Colin Mayer. You can read these interviews at Trust Online by visiting www.bgtrustonline.com – simply click on Articles and then Person to Person. You can also read our talks with Gavin Esler, Dylan Evans, Paul Mason and Jonathan Fenby, which took place in March at the Words by the Water Festival in Keswick and The Independent Bath Literature Festival. Make sure to keep an eye on Trust Online as future interviews will take place at the Henley Literary Festival and The Times Cheltenham Literature Festival, and we will post our conversations from the Ways With Words Festival at Dartington Hall online too.

TOM SLATER, DEPUTY MANAGER OF SCOTTISH MORTGAGE, TALKS ABOUT THE ATTRACTION OF SAN FRANCISCO’S TECHNOLOGY COMPANIES WITH HeatHer FarmbrougH

Wonders of the West Coast

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agrees. “We’ve been big shareholders in some internet companies for quite a long time and built up relationships. It is interesting when successful f irms get tired of the Wall Street game and say, ‘What’s the point of going to talk to big firms who are just trading in our shares?’ They are starting to think about what they want from a shareholder base and are looking for patient capital.” Scottish Mortgage is certainly patient: it has a very low annual turnover in shares of the companies it holds – a little over 10 per cent last year – and has several large, long-term shareholdings. This leads to quite a distinctive approach. “If you’re going to be a long-term shareholder, then you’re interested in quite a different set of information from those people who listen to the quarterly earnings calls and analyse every quarter’s numbers,” says Tom.

“We want to have a different conversation with these companies, and very often it’s with quite different people in those organisations.” When companies ask Tom if he would like a chat after the quarterly earnings figures have been published, the answer is usually “No, thanks”. As he explains: “It’s just another way to consume the same kind of information as everybody else, and if we’re doing that, then it’s self-defeating almost because that information will be captured in share prices and we can’t hope to have an advantage.”

vENTURING AFIELDScottish Mortgage can and does sometimes invest in unlisted companies, such as Chinese e-commerce group, Alibaba. In Palo Alto, Tom also met some venture capital f irms. Although the nature of these businesses is very different from Baillie Gifford’s work, there are some similarities between fund managers and venture capitalists – such as the investment of time and effort in understanding businesses, and backing a management team and staying with it. And he wanted to look at some companies that are moving away from venture capital toward a stock market listing, and get to know some of those towards the end of the pipeline.

Spotting up-and-coming companies is one thing, but valuing them is another, particularly a technology based company breaking new ground. How does Tom and his colleague, James Anderson, manager of Scottish Mortgage, deal with this? “We just acknowledge the uncertainty,” he replies. “We don’t keep trying to do spreadsheets that will calculate profits over the next two years. It’s more about trying to identify companies where the market is big enough for them to grow into a multiple of their current size, and to think about the factors that might enable them to achieve that. What advantages do they have that other people can’t steal? How much capital might they need?” In any case, you might ask how you can define a technology company since the spectrum of businesses they operate in is so broad – healthcare, social networking and advertising, retail, recruitment and infrastructure, and so on. Tom suggests that a common factor is their propensity to disrupt other businesses, and he notes

that many of the successful ones have founders that still largely own the companies. He concludes that markets still underestimate the importance of technology as an investment theme. Investing in all companies, particularly technology ones, is risky, especially in the early stages. This does not worry Tom: “It comes back to a tolerance of failure. We will be wrong about some companies, but we just have to accept that the returns we’ll get from the ones we’re right about should exceed the losses from the ones we’re wrong about. “Understanding that we can’t

be right about everything, and that we can’t outperform every quarter and get every one of these things right, gives us f lexibility to invest in some businesses that offer the potential for long-term rewards. We can be patient and wait for breakthroughs.”

To find out more about Scottish Mortgage visit www.scottishmortgageit.com

This interview took place in May 2013. Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested. Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates.

The Trust’s risk could be increased by its investment in unlisted investments. These assets may be more difficult to buy or sell, so changes in their prices may be greater. Currently Scottish Mortgage does not have a material holding in unlisted investments.

SCOTTISH MORTGAGE GOES WESTHoldings in West Coast technology companies

NAME SUB SECTOR % FUND

AMAzON.COM General Retailers 8.0GOOGLE Software & Computer Services 3.7ILLUMINA Pharmaceuticals & Biotechnology 3.7SALESFORCE.COM Software & Computer Services 2.8APPLE Technology Hardware & Equipment 2.6INTUITIvE SURGICAL Health Care Equipment & Services 2.3FACEBOOK Software & Computer Services 1.0LINKEDIN Support Services 1.0EBAY General Retailers 1.0WORKDAY Software & Computer Services 0.5OPENTABLE General Retailers 0.4

source Baillie Gifford at 31 May 2013

Being a sizeable and supportive shareholder I think we can have a dialogue that other investors can’t

TOM SLATER

THE RESEARCH YARD AT STANFORD UNIvERSITY

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“We must create cultures in which business and finance can work together to create high-performing companies and earn returns for savers on a sustainable basis.” These are the words of Professor John Kay in the introduction to The Kay Review of UK Equity Markets and Long-term Decision Making, which was published in July 2012. This view will chime with that of many in the financial world, from City bankers to individual savers. Sir Adrian Cadbury said much the same thing when he introduced the country’s first report on corporate governance more than two decades ago; in the interim there have been at least half a dozen other reports on various aspects of business stewardship, yet the scandals in this area have simply got worse. The recent financial crisis is undoubtedly the worst failure of governance in decades, with banks such as Northern Rock, Royal Bank of Scotland and HBOS collapsing or needing government rescue while developed economies labour under the costs of these bail-outs. The banking industry’s already poor reputation has been further tarnished by scandals such as the LIBOR inter-bank lending rate fixing and the mis-selling of payment protection insurance, which is costing the industry billions in compensation and fines. There have been plenty of other examples of corporate malfeasance in recent years, such as the fraud and false accounting at Enron and WorldCom, the uncovering of a giant Ponzi scheme run by the well known financier Bernard Madoff, the bursting of the technology bubble at the turn of the century, and the fraud at Olympus in Japan and Parmalat in Italy. The list is long. The key question, therefore, is whether the new regulations and guidelines emerging from this latest financial crisis will be any more successful in preventing future collapses and scandals. Much of the focus so far has been on pay and incentives, particularly in financial organisations: the European Union plans to cap bankers’ bonuses at twice the level of salaries. In the UK, meanwhile, the Prudential Regulation Authority – which has taken over part of the responsibilities of what was the Financial Services Authority – states in its principles that banks should have in place “sufficient controls to minimise incentives for excessive risk-taking,

Responsible outlookHeatHer Connon LOOKS AT WHETHER NEW EFFORTS TO IMPROvE BUSINESS STEWARDSHIP WILL SUCCEED WHERE EARLIER ONES FAILED

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for example remuneration structures that reward careful and prudent management”.

PAY POLICYThere are also moves to control executive pay outside the financial sector: voters in Switzerland recently backed the idea of giving shareholders a binding vote over executive pay – with the threat of prison for directors of companies that fail to comply. In the UK, the government has said it will make the current voluntary vote on pay mandatory. Michael MacPhee, manager of Mid Wynd International Investment Trust PLC, is in little doubt about the effect of these changes. “If a system can be gamed, it invariably will be. Rules alone do not work. Bonus payments based on simple returns on equity or absolute profits or volume increases led us to shadow banking systems, derivatives, rapidly expanding leverage, and complexity beyond the wit of those engaged in inventing it and beyond the vision or understanding of their regulators.” The Kay Review says incentives matter but they are not the only factor affecting performance: “Most people have more complex

ACTION SPEAKS LOUDERJENNIFER HILL ExPLORES SOME OF THE BENEFITS OF ACTIvE INvESTMENT

Many academic and empirical studies have shown that the average active manager has underperformed the index, after fees, over most periods of time. However, these studies have a central flaw: they refer to the ‘average’ manager. The case for truly active management rests on avoiding being average and performing at an above-average level. Research published in January 2013 by investment managers Vanguard shows that less than 25 per cent of actively managed US equity mutual funds outperformed their relevant style benchmarks over the past 20 years. Yet the study concludes that low-cost active talent can achieve outperformance and that investors, if they stick with a disciplined approach, can be successful using actively managed funds. James Budden, marketing director at Baillie Gifford, agrees: “A quarter of active managers beat the index, whereas 100 per cent of passive managers are most likely to fail as charges must still be taken, reducing any returns made. What you want is a cost-conscious, high-performing active manager, because fees matter, and you may want to stay with them for the long term as trading in and out costs money.” While passive funds blindly buy an index, good active managers have the benefit of being able to select and invest in businesses with world-class management teams that stand to make solid profits for shareholders over the long term. “The best managers of companies are those with whom a fund manager is aligned,” says James. “If governance issues do arise, active managers can exercise a benevolent and beneficiary interest.”

Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested. Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates.

“If a system can be gamed, it invariably will be. Rules alone do not work” MICHAEL MACPHEE, MANAGER OF MID WYND INTERNATIONAL INvESTMENT TRUST PLC

goals, but they generally behave in line with the values and aspirations of the environment in which they find themselves.” Refocusing those values and aspirations is crucial, but James

Anderson, manager of Scottish Mortgage Investment Trust PLC and an adviser to the Kay Review, asks: “How far, in the last 20 years, have the malign objectives of institutional investors and short-

term shareholders influenced companies and altered their behaviour? “I think the incentives set by capital markets go a long way towards explaining the serious issues faced at BP [the Gulf of Mexico oil spill in 2010] and GlaxoSmithKline [accused of market abuse by the Office of Fair Trading]. Did GSK seriously believe that changing their research organisation every five years, which has led to problems with drug safety, was nothing to do with the demands of the capital markets?”

POSITIvE SUGGESTIONSThe Kay Review places emphasis on increasing trust, improving communication between companies and investors, and shifting the focus of stock markets from the short to the long term (see Professor Kay interview, p15). These goals can be met, suggests the review, by abolishing quarterly reporting of earnings, urging companies to consult their investors about boardroom appointments, and encouraging the development of a more long-term attitude of stewardship and strategy rather than simply governance. The report puts the onus for change on investors as well as companies, asking fund managers to align their own remuneration with the long-term performance of their investments rather than short-term results, and recommending the establishment of an investors’ forum to help them engage directly with companies. This may look like an ambitious plan given that the average holding period for stocks in both the US and the UK was last recorded to be around seven

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A stronger relationship

PROFESSOR JOHN KAY ExPLAINS TO HeatHer FarmbrougH WHY OvER-EMPHASIS ON THE SHORT TERM HAS ERODED TRUST BETWEEN COMPANIES AND INvESTORS

Equity markets are not working as well as they should be, according to Professor John Kay’s report, The Kay Review of UK Equity Markets and Long-term Decision Making, published in July 2012. It concludes that domestic equity markets are no longer a significant source of funding for new investment by UK companies. His review concluded that the over-reliance on the short term – in terms of both company earnings and performance (usually linked to a benchmark) – has been corrosive. Businesses tend to under-invest and corporate strategies focus too much on restructuring, financial engineering or mergers and acquisitions at the expense of the underlying business.

Many professional asset managers, who are now the major shareholders in UK quoted companies, are forced to take an increasingly short-term approach in an attempt to beat the market, undermining the trust between investors and companies. Most investors, quite understandably, want share prices to be as high as possible, but isn’t there tension between this goal and the simple fact that these prices can’t be high all the time if the company is being run honestly? “Yes,” says Professor Kay. “If you manage to persuade yourself that the share price is the best possible indicator of the value of a company then an awful lot of things flow from that. The world in which those running companies were not very interested in the share price hasn’t existed for about 50 years, and in many ways, or certainly at least from this point of view, it was better. “In financial services we have moved away from a

JAMES ANDERSON, MANAGER OF SCOTTISH MORTGAGE INvESTMENT TRUST PLC

“Why do we not pay more attention to the serious underlying issues facing businesses?”

months, which hardly counts as long term. However, this average is skewed by active trading from hedge funds and others seeking to exploit small, short-term stock price movements – which are estimated to account for as much as 40 per cent of trading in Europe and 70 per cent in the US. Other investors, such as Baillie Gifford, are there for the long term. James Anderson thinks there are lessons to be learnt from companies in Sweden and Korea, where the equity markets are dominated by long-term owners: in Sweden, for example, the Wallenberg family’s holding company, Investor, owns stakes in a large number of firms that it holds for long periods. The long-term results from companies in these countries have been excellent, says James, reflecting their stable ownership structures that encourage beneficial relationships between company executives and shareholders.

FAIR SHARE James believes that shareholder forums could be a useful new model for dialogue between companies and their owners. “These are not to interfere with

the day-to-day running of the company but would be occasional events where there can be co-operation,” he says. “The aim is to see shareholders as long-term investors, rather than simply as holders of shares whose purpose is to outperform the rest of the market. “We need a change of philosophy. It does seem peculiar that, rather than looking at share ownership as allocating capital in the interests of companies and the country, it is translated into relative performance. It is not relative performance that pays for your pension or gives you a return on your investment. Why do we not pay more attention to the serious underlying issues facing businesses?” He also thinks that the model being developed by technology companies on the west coast of the United States could hold useful lessons for the way businesses are run elsewhere. In these companies, the founders and key executives retain large stakes and eschew the kind of earnings guidance and quarterly reporting that characterise more traditional US companies. Baillie Gifford’s philosophy is to invest for the long term and

to build lasting relationships with the managements of the companies in which it invests. Important factors are stable and experienced management, ownership including that of founders or families, the structure of executive remuneration and the quality of the long-term relationship with shareholders. “My experience in 25 years of investing is that what works over the long term, 10 years plus, is where the company’s management treats investors as partners,” says Michael MacPhee. “The same holds true the other way around, so investors should not just sell at the first sign that something is going wrong. If you invest in the right way, you invest in people who you know and trust.”


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Matador on the moveSPAIN MAY HAvE BEEN HIT HARD BY THE RECESSION, BUT STEPHEN WOMACK FINDS A COUNTRY PICKING UP SPEED WITH A STRING OF ECONOMIC REFORMS

relationship culture to one based on transactions and trading. If we want an efficient financial services sector we have to shift that back.” This has caused the widespread erosion of trust in financial intermediaries and the financial system as a whole, argues Kay, who is a director of The Scottish Mortgage Investment Trust PLC. His report was the result of the government asking him to look at whether British equity markets were fulfilling their purpose in helping British companies to perform by providing finance, and in helping savers to benefit by holding shares in these companies, directly or indirectly. The report calls for a more efficient system of rewarding companies, savers and intermediaries financially; it also recommends a renewed emphasis on relationships all along the equity investor chain, rather than trading transactions just being carried out between anonymous agents. It also argues that asset managers need to develop their role as stewards. An asset manager’s role as steward is most effective if their institution holds

concentrated portfolios with fewer but significant holdings in companies. As Professor Kay explains: “If you own 2 per cent of a company, and you do things that improve performance, 98 per cent of the benefit goes to other people. When the 2 per cent becomes 12 per cent the maths look a lot better, and when it’s 12 per cent it means asset managers can do things other than simply trying to outguess each other, which is in large part what they are doing at the moment.” Professor Kay is calling for cultural rather than regulatory change. But surely he can’t put the clock back? “People say that,” he replies, “but I ask, ‘Why not? Why can’t we?’”


Many professional asset managers are forced to take an increasingly short-term approach in an attempt to beat the market

THINGS ARE BEGINNING TO MOvE AGAIN IN MADRID

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THE RISE OF INDITEx

Inditex (the parent company of clothing chains such as Zara and Massimo Dutti) has been one of Spain’s great success stories. The first Zara store opened in 1975 in A Coruña in Galicia; Inditex now has more than 6,000 stores in 86 markets around the world. The company has transformed the traditional retail model by organising its sourcing, manufacturing and logistics to respond rapidly to customer demands. As James Anderson, manager of Scottish Mortgage Investment Trust PLC says, “The management regards itself less as a retail business than a logistics one.” Inditex manufactures its own goods in response to trends, and very little inventory is ordered in advance. Two deliveries per week are made to each store from Spain. Inditex can tap into a well-educated, dynamic, relatively low-cost labour force and, in common with other Spanish exporters, has been helped by the combination of falling real wages and rising output per worker since the financial crisis.

Even a casual observer of Europe over the last four years will know that Spain’s economy has had more than its fair share of troubles. The nation’s finances have been devastated by a property collapse and deep recession. The official unemployment rate shows that, in February, one worker in four was without a job. And last year

Kave and a team of colleagues recently met with companies, politicians and academics in Spain to look behind the headlines and form a clearer view of the work going on to rebuild the nation’s finances. “One of the reasons for the recession in Spain is that the economy is taking some tough medicine,” he says. “We’re trying

wage agreements and to negotiate local deals on pay and conditions. Firms also have more flexibility to make redundancies, allowing them to adapt their workforces to the real conditions in the economy. This helps businesses lay-off staff. But it also means they are more willing to hire employees, knowing they will not be stuck with an extra wage bill for

the European Union was forced to offer Spain up to €100bn of support to help bail-out the country’s struggling banks. But appearances can be deceptive. Kave Sigaroudinia, a senior portfolio manager with Baillie Gifford, says: “Our approach has always been to take a step back and look at what is happening on the ground, not at what the stock markets are flapping about on any one day.”

to look at where that medicine gets you to in five years’ time.” And while there is still a significant amount of work to be done, there are signs that some of the changes will free up Spain’s stronger and better-run businesses, allowing them to grow rapidly. One turning point has been the relaxation of labour market laws last year. This allows Spanish companies to opt out of national

years if things go wrong. Gayle Allard, professor of economic environment and country analysis at IE Business School in Madrid, says the overall reform package is “not only the most ambitious ever attempted in Spain; it is the most dramatic recorded anywhere in the OECD [Organisation for Economic Co-operation and Development] in the postwar period”. Professor Allard says that while

in the short term the pain of reform may hurt Spain, in the longer term it is necessary. There are already signs that a more competitive labour market is helping the country. International car makers, for example, are taking advantage of lower costs to switch production to Spain. Volkswagen, Renault and Ford have all announced investments in their Spanish plants in recent months. VW is spending €785m updating a plant near Pamplona, Renault said it will be hiring 1,300 new people for its Spanish plants, while Ford has invested just over €1.1bn increasing capacity at its site near Valencia, and is consulting on switching production of Mondeo and Galaxy cars from Belgium to Spain.

ON TRACKSpain’s exports have already surpassed their pre-crisis level. Industrial champions, such as train maker CAF, are finding they can compete well in international markets. The firm, which manufactures the trams shortly to be seen on the streets of Edinburgh and Birmingham, has an order-book just shy of €5bn, with almost 85 per cent of this destined for export markets. Construction and infrastructure services firm Ferrovial now earns more than half its revenues from outside Spain, including a one third share in Heathrow Airport and work constructing London’s Crossrail.Spain’s property and construction sectors have suffered a painful contraction. But, from the perspective of new investment, the outlook is brighter. Kave says: “If you look at the fundamentals there is now a lot to be positive about. With housing starts down 90 per cent between 2007 and 2011, new supply is at rock bottom and there is really only one way to go from here.”

Spain’s banks have also had to digest some painful medicine. They had been weighed down by bad loans granted to property developers during the nation’s real estate boom. After a prolonged period where banks were effectively in denial about the problems, Spain’s government finally forced the industry to tackle the issue in 2012. The worst performing banks were nationalised; others were forced to merge. Bondholders, including many retail investors, have been forced to take losses of up to 61 per cent on their holdings. A ‘bad bank’, called Sareb, has been set up to take over distressed assets. Kave says: “This process has forced the banks to confess to their sins and open up to independent auditors. It has triggered a seismic restructuring that will see more than 50 banks eventually dwindle to perhaps 10.” In time he thinks this could create huge opportunities for the surviving banks, which will have far greater control over prices and should be able to lend at higher margins. “It is a once-in-a-generation opportunity,” says Kave. “On a five-year view, Spain’s banks could be very exciting as an investment and we are putting a lot of research into the sector.” Spain’s people and its businesses are by no means out of danger yet. There is more pain to come and hardships ahead. But there are reasons for optimism too that make Spain worth a second look for long-term investors.


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Spain’s exports have already surpassed their pre-crisis level. Industrial champions such as train maker CAF are finding they can compete well in international markets


Japan is reigniting the interest of investors and it’s all thanks to ‘Abenomics’, the reflationary policy package initiated by prime minister Shinzo Abe (see article, p22). But Abenomics has a strong link to the past – it echoes the policies of Takahashi Korekiyo, who was Japan’s finance minister during an influential period between 1931 and 1936. Viscount Takahashi (pre-war Japan had a British-style honours system) is seen by many as Japan’s equivalent of John Maynard Keynes. He was not, however, a scholar or a trained economist. According to Richard Smethurst’s splendid biography, From Foot Soldier to Finance Minister, Takahashi probably had no formal education at all. Takahashi was born in 1854, when Japan was still a closed country under the moribund shogunate (a feudal military government). At the age of 10 he went to work as a houseboy at a British merchant in the port of Yokohama. Two years later he travelled to California to further his English, only to be tricked by his homestay family and sold into indentured servitude.

Upon his return to Tokyo, at the age of 15 he was given a teaching position at a government school but “succumbed to the demon sake” and quit to live with a geisha. Perhaps it was this experience that inspired the Keynesian parable that he published years later: “If someone goes to a geisha house and calls a geisha, eats luxurious food and spends 2,000 yen, we disapprove morally. But if we analyze how that money is used, we find that the part that paid for food helps support the chef’s salary, and is used to pay for fish, meat, vegetables and seasoning… The farmers, fishermen and merchants who receive the money then buy clothes, food and shelter… From the individual’s point of view it would be good to save his 2,000 yen, but when seen from the vantage point of the national economy, because the money works 20 or 30 times over, spending is better.” In keeping with the turbulent times, Takahashi moved from responsible government jobs – he was Japan’s first patent commissioner – to rather more dubious activities, such as leading a group of brawling, hard-drinking Japanese miners to the high Andes. Proof of his talents came with the outbreak of the Russo-Japanese war in 1904. During extended stays in New York and London, Takahashi negotiated a series of bond issues that allowed capital-short Japan to procure modern British weaponry. The results were spectacular – the Russian fleet was sunk and Japan enjoyed the first victory of an Asian power over Europeans since the era of the Mongols.

Takahashi’s economic ideas were by this point already well formed. He believed that the government’s role was to create the conditions for growth, not direct the allocation of capital. He opposed increases in military spending and maintained that Japan’s prosperity was best secured within the Anglo-American world order. In subsequent decades, Takahashi was prime minister once, minister of finance five times and is the only governor of the Bank of Japan to have his portrait featured on a banknote. Like the UK, Japan was forced off the gold standard by the First World War. Also like the UK, it made a disastrous decision to return to gold at the pre-war parity in 1930, on the cusp of global depression. By then Takahashi had retired from public life to tend his bonsai, but he answered the call of duty. Economic conditions were desperate and unemployment was soaring. Takahashi immediately took Japan off the gold standard and closed the public deficit through bonds underwritten by the Bank of Japan. In today’s terms, he

depreciated the currency and combined fiscal stimulus with quantitative easing. The result was a rapid return to growth and a stabilisation of the debt-to-GDP (gross domestic product) ratio as government revenues soared. Share prices doubled. According to US Federal Reserve chairman Ben Bernanke, Takahashi “brilliantly rescued Japan from the Great Depression through reflationary policies”. But there was to be no happy ending. So successful was the reflationary programme that it was soon time to implement an exit strategy. Takahashi had been critical of the Japanese army’s uncontrolled adventurism in China, so it was clear that military expenditure would bear the brunt of his imminent fiscal squeeze. Early one snowy morning in February 1936, fanatical army officers staged a coup d’état in central Tokyo. A detachment of soldiers marched from their base in Roppongi to Takahashi’s residence and shot and hacked him to death as he slept. It is a tribute to Takahashi’s stature that he was a prime assassination target at the age of 81. The coup was soon crushed, but the militarists were now dominant and Takahashi’s successor immediately doubled their budget. The result was inflation and war. Yet Takahashi may well have the last laugh. If Abenomics works and other countries follow suit, he will still be having a significant impact on our world today.

Figure of influenceTHE PAST MAY BE PROLOGUE FOR JAPAN’S ECONOMY, SAYS Peter tasker, AS HE OUTLINES THE LEGACY OF FORMER FINANCE MINISTER vISCOUNT TAKAHASHI

Takahashi believed that the government’s role was to create the conditions for growth, not direct the allocation of capital

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Sarah Whitley is more impressed with Japan’s economic picture than she has been for a long time. As manager of The Baillie Gifford Japan Trust PLC since 1991, she has seen the country’s economy and stock market go through a few cycles, including Japan’s ‘hot’ market between 2005-2006, when the reformist zeal of then prime minister Junichiro Koizumi led to Tokyo’s stock price index doubling to levels only reached again this spring. The world’s third largest equity market has been on a roll since mid-November 2012, when it became clear that prime minister Shinzo Abe’s pledge to rid Japan of deflation would carry his Liberal Democratic Party to victory in the lower house in December’s elections. Abe’s plan – which observers have termed ‘Abenomics’ – comprises three strands: fiscal stimulus via government spending, monetary stimulus using central bank policy, and structural reforms to improve Japanese economic growth. By mid-May 2013, Japan’s Topix index of shares had jumped 71 per cent since Abe’s November announcement of the plan, as foreign investors bought into the market. Rising markets, in turn, have lifted consumer confidence, spurring hopes that broader expectations of growth will eventually overcome the mild but persistent deflation that has sapped the country’s spirits for much of the past 15 years. “Things have happened, and they’ve happened more quickly and more decisively than anyone could have hoped for in November,” says Sarah. Few expect the pace of gains in stocks to continue. At the time of writing, Sarah says valuations of Japanese equities no longer look as extraordinarily low as they did last autumn when the market was at post-tsunami, post-crisis lows with

plenty of scope to catch-up once the gloom lifted a little. But many investors share Sarah’s conviction that Japan’s prospects remain encouraging – especially if the yen remains on a weakening trend. “If you look at long-term graphs, we’re just crawling up from the bottom,” she says. “We haven’t yet had time for the weaker yen to feed through to higher profits, for example. This year there could be over 50 per cent growth in earnings.”

TAKING STOCK Despite Japan’s high-octane market, Sarah is running the portfolio as she has always done – seeking out innovative, shareholder-friendly companies trading at attractive valuations, then holding on to them.

Last November, she began buying shares in the Mazda Motor Corporation. Although they have done well, she intends to hold on to them for longer, arguing that the company’s Skyactiv series of fuel-saving technologies – highly efficient petrol engines coupled with lightweight steel frames, which the company wants to introduce to every car it sells by 2015 – is reason enough to stay involved. “That, plus the cheaper yen, adds up to something very interesting,” adds Sarah. She also bought shares in Japan Tobacco (JT), one of the top three international tobacco companies in the world by sales. It has proved to be a good performer, having demonstrated a commitment to

Reaching for growth?ben mCLannaHan ExPLORES HOW ‘ABENOMICS’ – THE DYNAMIC STRATEGY OF JAPAN’S PRIME MINISTER TO BOOST THE ECONOMY – MAY WELL TURN ROUND THE COUNTRY’S FORTUNES

SHINzO ABE DURING A BUDGET COMMITTEE SESSION

DAWN BREAKS OvER TOKYO

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The many colours of capitalismimproving earnings through a combination of share buybacks and price rises. And now that Japan’s government has cut its holding in the company from 50 per cent to the minimum 33 per cent required by law, JT has “full control of its balance sheet”, says Sarah. Sarah’s faith in another company, Don Quijote, the country’s largest discount-store operator, has also been rewarded, with the stock roughly doubling between August 2012 and April this year. “After the earthquake [of March 2011], it was well supplied and a lot of people ended up staying as customers. We feel it has the potential to be a national discount chain, and, longer-term, it will have appeal in the rest of Asia.”

GROWTH PLAN As an experienced Japan-watcher, Sarah has high hopes for the so-called “third arrow” of Abe’s stimulus package, to accompany monetary and fiscal reform: a new national growth strategy, including deregulation in many areas such as employment and utilities, as well as other structural reforms such as increasing labour-force participation, particularly among women. So far, Abe’s circle of advisers has mostly steered clear of delicate

matters that involve more decision-makers, require a larger amount of co-ordination, and may take much more time to implement. On immigration, for example, Abe’s Industrial Competitiveness Council has proposed creating a special zone within the Tokyo metropolitan area that would be subject to less stringent residence qualifications for highly skilled foreigners, such as engineers. But there has been little discussion on allowing in more relatively unskilled workers – such as nannies and nursing-home assistants – that could help to mobilise large swathes of Japan’s existing labour force, for example by freeing up well-educated Japanese women to work. For now, though, foreign investors appear to be continuing to invest in Japanese stocks, trusting that Abe’s desire to seal control of the upper house of parliament in July’s elections will ensure that he keeps Abenomics

on course at least until then. By mid-April net inflows from abroad into Japanese stocks stood at almost $65bn since the beginning of the year, which was more than six times the total for the rest of Asia combined. Is this a false dawn? Sarah thinks not, noting that Japan has experienced several periods of rapid change over short periods, such as the political and social revolution of the Meiji Restoration from 1868 to 1912, and the nation’s rebuilding after World War II. “What has struck us is the uniformity of purpose, from both the government and the corporate side,” says Sarah. “Everyone is all together, for the first time in 20 years. It feels real to me.”

Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested. Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates. The Baillie Gifford Japan Trust invests in smaller companies and single currencies. Such investment is generally considered higher risk as changes in share prices may be greater, and the shares may be harder to sell. Smaller companies may do less well in periods of unfavourable economic conditions.

‘Abenomics’ comprises three strands: fiscal stimulus via government spending, monetary stimulus using central bank policy, and structural reforms

Apart from a few isolated cases, such as Cuba or North Korea, most countries have adopted some form of capitalism. But there are many variations, ranging from the ‘Anglo-Saxon’ model (typified by the UK and the United States) to a distinctly more ‘Chinese’ approach to capitalism. All of these systems share the belief that markets provide the best means of allocating resources, but what varies widely is the way in which these models are moulded and the end purposes they are intended to serve. In the US, for example, the concept of the American Dream still reigns supreme, where the individual can achieve wealth and success through hard work; in France, the model is rooted more in the idea of solidarité, with people working collectively for common interests and social cohesion. Colin Mayer, professor of management studies at Oxford’s Saïd Business School and author of the book Firm Commitment, sees the main distinction between different kinds of capitalism being in the nature of corporate ownership. “In the UK and US, large corporations are generally held on stock markets by a broad shareholder base – pension funds, insurers and individuals,” he says. “In continental Europe far more are family-owned, as is true of Korea and many other Asian economies. In Japan, however, controlling ownership is more through bank and corporate cross shareholdings, while in China it lies with the state and provinces.”

Those differences, he says, explain much about how each strand of capitalism has developed, although different cultures, regulatory environments and politics have also played their part. “Anglo-American ownership structures encourage risk-taking, and prior to 2008 their banks engaged in this to a degree that was good in the short term for managers, key employees and possibly shareholders,” says Mayer. “But it was detrimental to depositors and ultimately to tax-payers.”

STATESIDE vIEWNowhere is risk taking, along with entrepreneurial spirit and innovation, more revered than in the US. Share ownership is high, and with it comes a widespread distrust of ‘big government’ and tolerance of corporate lobbying – from local county level to Capitol Hill. Wealth creation is embraced and the role of leverage to maximise returns is more widely accepted than in any other country. And thanks to the three-decade-long credit super-cycle that ended in 2008, low interest rates, easy access to credit and rising asset prices encouraged more and more Americans to jump on the bandwagon. Dr Tim Morgan, global head of research at wholesale inter-dealer broker Tullett Prebon, points out that while the US economy grew by 128 per cent in real terms between 1980 and 2011, total debt grew by 390 per cent between 1981 and 2009 – much of this to fuel short-term consumption. Additionally, due to globalisation and

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JonatHan gregson ExPLORES THE WAYS DIFFERENT COUNTRIES HAvE ADOPTED THIS SYSTEM

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source Morningstar. Share price, total return. Past performance is not a guide to future performance.

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PAST PERFORMANCE – % CHANGE TO 31 MARCH EACH YEAR

Japan Trust

Topix 500 Index


outsourcing, much of that economic activity shifted from globally marketable products to internally consumed services. As more money went to hairdressers, gardeners or gym fees, for example, and less into producing exports, debt-laden Americans became the consumers of last resort. It is hardly surprising then that the bubble burst first in the US in the form of the sub-prime mortgage crisis. Since then, the US has been more proactive than most in addressing these weaknesses. Bailed-out banks and corporations have paid back the government. Quantitative easing (QE) seems to be spurring a recovery. But it is largely a jobless recovery, with unemployment still above 7 per cent and inequality continuing to increase.

HOME AFFAIRSThe UK’s version of capitalism shares many of these US characteristics – at least since the Thatcherite reforms of the 1980s. Free markets, privatisation, ‘light touch’ regulation, more flexible work practices and a shift towards financial services and away from manufacturing – these are all distinctly ‘Anglo-Saxon’ policies. The total indebtedness level in the UK is the worst among the countries that form part of the Organisation for Economic Co-operation and Development, says Dr Morgan, with debt soaring by 95 per cent from 1998 to 2012 against a backdrop of real gross domestic product growth of just 30 per cent. Professor John Van Reenen, director of the Centre for Economic Performance at the London School of Economics (LSE), says the crucial difference is that the UK has a much more generous welfare state than either the US or the new middle income economies. The UK system therefore shares some characteristics with the European ‘social

model’ of capitalism, which combines free market wealth creation with redistribution, welfare and social goals. The Scandinavian variant, says his LSE colleague Dr Robert Hancké, “allows markets to do the work with high taxes allowing redistribution”. The state provides services such as healthcare and education to all, while taxation reduces some of the inequalities of earnings. Dr Hancké says Germany, the Netherlands and Austria focus more “on a balance between capital and labour, with workers’ collective rights recognised as in boardroom representation, though the unemployed have very few rights”. Capitalism in France and southern Europe is “very state-centred, with high taxes, governments partly owning ‘national champions’ or, as in Italy, the state being in effect an employment machine”. The weakness of these models, says Hancké, is their inflexibility and unattractiveness to risk-taking capital. Van Reenen succinctly describes China’s variant as “a capitalistic system with the Communist Party hierarchy overlaid on top”. It is characterised by “much greater state involvement, whether that be through its five-year plans, maintaining the renminbi-dollar peg, or channelling the country’s surplus into state-run companies”. China’s export-driven model, he says, “has been very successful, it is open to foreign direct investment and is increasingly integrated into the rest of the world’s trading system. A key advantage is China’s huge internal market”. But while Van Reenen says that many developing countries are looking to emulate China’s success, he does not believe the level of control exercised by the state is an advantage over the long term: “There has been greater suppression of wages than elsewhere, but now workers are demanding higher rewards. Inequality is still rising.

“There is a need to innovate and not just copy others; but, while the Chinese recognise this, state control and political repression are not conducive to creativity or innovation. Popular demands for a more effective welfare state combined with disgust at levels of corruption are fuelling social tensions. It is hard to see the current Chinese model as sustainable over the next 20 years.” Mayer says of China: “Questions are being asked about whether state domination can continue or whether a different ownership structure will emerge. But it will certainly not be a shift to the Anglo-Saxon model.” Family ownership plays a much larger part elsewhere in Asia, such as in South Korea as mentioned earlier, but also in other countries such as Taiwan, Singapore and India.Its strength is the close alignment of the interests of investors and management; its weakness is when the patriarch is gone, which often triggers a succession crisis and the break-up of previously thriving concerns. In Japan the system of defensive cross-shareholdings between big corporates and banks endures after more than 20 years of deflation. Attempts by prime minister Shinzo Abe and the Bank of Japan to jump-start the economy through massive QE in the hope of raising both asset values and overall inflation may work. It might, however, encourage other highly indebted countries to follow the same course, triggering a ‘race to the bottom’ as inflation erodes their debts while keeping their currencies competitive. “Some nations such as the UK are trying to cut back on government expenditure,” observes Mayer. “Others are looking to monetise public debt. Through QE they may eventually inflate their way out of government deficits. Levels of inflationary pressure are still modest, but

they could well accelerate in the near future.” For long-term investors, the choices are becoming more difficult. The pool of ‘safe’ assets becomes more restricted as one sovereign bond issuer after another (including China) is downgraded. Those that are left offer negative yields in real terms. As strategy consulting firm Bain & Company’s Macro Trends Group points out, money creation and a propensity to save means that global capital has tripled over the past two decades to $600 trillion by 2010. Financial assets now stand at nearly 10 times the value of all goods and services the world produces. Moreover, the main causes of this ‘environment of capital superabundance’ (as Bain calls it), namely financial innovation, high-speed computing and reliance on leverage, are still in place. And the growth of total global capital is expected to expand by half again to nearly $900 trillion by 2020 as China, India and others add to the stockpile. While there are many shades of capitalism, globalisation means they all face similar challenges. Money printing on an unprecedented scale is taking us all into uncharted territory. Uncertainty increases the urge to save, but there is more capital chasing fewer assets that can be qualified as ‘safe’ or ‘productive’. Negative real interest rates distort markets and encourage a ‘search for yield’, pushing investors into higher-risk categories. Caught between fears of deflation and the possibility of hyper-inflation, central bankers, regulators and governments must perform a delicate balancing act. The mechanisms of capitalism remain, but in future they are likely to be subject to ever-tighter controls.

GERMANY, THE NETHERLANDS & AUSTRIA

A balance between capital and labour, with workers’ collective rights recognised

CHINA

A capitalistic system with the Communist Party hierarchy overlaid on top

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HEATHER FARMBROUGH This year you’ve brought in Tom as deputy manager to strengthen your team, but last year was a difficult one for Monks, wasn’t it?

GERALD SMITH Yes, it was. In the financial year to April 2013, we achieved some capital appreciation in line with our objectives, but not very much. We don’t have a formal benchmark as such, but we do look at how our performance compares with the FTSE World Index and I’m afraid that it lagged well behind.

HF Why?

GS Stock selection was the main factor. We have around 100 stocks in our portfolio and some will always do better than others – but several did disappoint. These included temporary power generation company Aggreko, a large holding that had performed well in the past (and whose holding we have since reduced), and French car maker Peugeot, a relatively recent acquisition that has not worked out. There were also some negative themes such as our purchase of gold shares at the end of 2011. When Tom became deputy manager in January 2013, I asked him to review these holdings. Tom, would you like to comment?

they telling you a good story but selling their own shares? We need to pay closer attention to whether management’s objectives are aligned with those of long-term shareholders. HF With Tom on board, have you changed the way Monks is run?

GS No, not really, but Tom is a very useful contributor to the investment process, both in terms of reviewing existing holdings and in decision-making. I haven’t said, “This is your bit of the portfolio,” but he has had an impact on what we hold. He has also helped to draw up a range of checklists for us to use, a series of points that we must ensure we don’t overlook. Our fundamental investment approach remains the same – to look for companies that will grow, to keep an open mind and not be afraid of going against the market.

HF You were also cautious last year about markets. How did this affect performance?

GS Early last year I certainly was cautious and did not want to be fully invested. We wanted to have some insurance in case markets had a big correction and to have cash coming in, rather than going out. When the markets recovered, this proved to be a drag on performance. The impact, though, was not as great as stock selection.

HF Are you more optimistic now?

GS Yes I am, and I have reduced our level of insurance. We’re pretty happy with the portfolio as it now stands. Tom, would you like to add anything?

TW Yes, we have a number of exciting growth stocks. Nanoco, for example, was one of our smallest holdings when bought in 2010 but it has grown and made a significant contribution. It’s a UK company with a patented

technology to manufacture quantum dots, tiny luminescent semiconductor crystals that provide a very pure and efficient light without using cadmium, which is toxic.

GS Another one that started off as a small holding and became more significant is Seattle Genetics in the US. When we first bought it, the biotech area was out of favour and Seattle Genetics had an unproven technology. They now have licensed drugs using conjugated antibody technology to deliver toxins directly to cancer cells, without attacking healthy cells.

HF As an investor, why would I buy shares in Monks?

GS Wearing my shareholder’s hat, what do I expect from my holding in Monks? Capital appreciation is important, but so is capital preservation during times of distress because history shows that mitigating losses in these periods enhances long-run returns.

HF Tom, what has been your impression of Monks since coming in?

TW Monks has a differentiated portfolio, sometimes idiosyncratic but with an emphasis on growth. There are a lot of very interesting companies in the portfolio – the more you scratch the surface, the more interesting many of them become.

This interview took place in May 2013. Gerald Smith is manager of The Monks Investment Trust PLC and Tom Walsh is the deputy manager.


TOM WALSH Yes. The investment case for gold was based on two broad premises: gold’s attractions as an asset class in the light of worries about the global economic outlook, and the attraction of the smaller gold mining companies as a means of gaining exposure to the commodity. I think the concerns about the economic outlook were entirely sound – something unpleasant might have happened in the eurozone and markets could have fallen sharply. However, economies muddled through, markets went up and the gold price fell. The mining companies’ operating performance has also generally been poor and this compounded the problem.

GS I think also that I did not pay enough attention to the ability of the various management teams to execute mining projects – this is because I was concentrating on the potential to grow reserves and the possibility of takeovers. We have had to think about what we might have missed.

HF What kind of thing might you have missed?

GS Management will naturally tend to put across a positive view of things, so we need to talk to other people in the industry and look more closely at what management is doing, particularly with regard to its investments. Are

MONKS INvESTMENT TRUST MANAGER, GERALD SMITH, AND RECENTLY APPOINTED DEPUTY MANAGER TOM WALSH DISCUSS THE PORTFOLIO WITH HeatHer FarmbrougH

An interesting mixGERALD SMITH

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Monks

FTSE World Index

PAST PERFORMANCE – % CHANGE TO 31 MARCH EACH YEAR

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source Morningstar. Share price, total return. Past performance is not a guide to future performance.


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Hands-free highway SELF-DRIvING CARS ARE BECOMING A REALITY – BAILLIE GIFFORD DISCUSSES THE vARIOUS CHANGES THEY MIGHT BRING

Three US states – California, Florida and Nevada – have already legalised the testing of self-driving cars. These vehicles travel autonomously and navigate using cameras, sensors, lasers and other technology. “Many of the really tricky issues were solved as long as 20–30 years ago,” says Hamish Dingwall, technical analyst at Baillie Gifford, who led a recent brainstorming session that looked at the economic, technological, industrial and social implications of the vehicles. The most difficult technological issues were visual, such as how

the car would distinguish between a plastic bag floating across the road and a rock, or detect a tree with branches that may overhang the vehicle. Professor Ernst Dickmanns and his team at the University of the Federal Armed Forces Munich resolved many of these visual issues by using algorithms. By the late 1990s, they were sending re-modified, self-driving Mercedes-Benz and Daimler-Benz cars around the Paris autoroutes and German autobahns at speeds of up to 110mph.

Google’s self-drive cars have been out on the streets of Palo Alto, California, while Tesla is working on its own autopilot system for these vehicles. Toyota, Audi and Volkswagen are also developing their own self-driving models. PRACTICAL ISSUESThe discussions at Baillie Gifford threw up a lot of questions, not least what the cars will be used for – supermarket deliveries, car pools, international travel or for older people? Also, how willing will passengers be to get into a car with no driver? The conversation covered other areas too, such as whether the

technology will lead to small electric-buggy style vehicles or larger, potentially mass-transit systems. And some questioned what effect such vehicles may have on people’s independence. Implications for journey times and fuel consumption were considered, as was the question of what people would do with their additional leisure time, and whether self-driving cars would be a status symbol for many owners. For some sectors of the economy, the cars may bring added benefits. Solicitors will be needed to draft new laws, for example, though the implications for insurance companies are less clear. Who is liable if a self-driving car causes an accident?

The theory, of course, is that computer-controlled cars are less prone to errors than humans. We have fly-by-wire aircraft, so why not cars? As to whether our roads and urban infrastructure will have to be modified, Hamish thinks probably not: the cars will have to adapt to the environment, rather than the other way round. But probably the most critical factors are technological. Is the technology worth the effort and, if so, how soon will these cars be an everyday reality? “The surprise that came out of the discussion was how fast this could happen,” observes Hamish. “The pace of technological change is increasing, usually faster than we expect.”

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businesses fail but are replaced by new and more dynamic ones, has been held back. Many firms cite caution and uncertainty as reasons for hoarding cash rather than investing in new plant and equipment. Yet many people report that they are working even harder than before the current recession. Pre-crisis, for example, an estate agent may have been able to effortlessly generate three sales a day. Now he or she has to work hard for three days to get one sale. The agent has not become lazy – quite the opposite – but output per worker (the estate agent) or per hour or day has gone down.

QUESTION OF CAPITALDr Ben Broadbent, a member of the Bank of England’s monetary policy committee, argues that the problem stems from capital having been misallocated. Following the crisis, the damaged financial system is not pushing funds in the direction of high-growth, high-productivity newer firms. But he suggests that, over time, this should happen as the health of the financial system improves. The current low-productivity period could thus give way to one where productivity surprises on the upside. It may, in other words, be all right in the end. There is, however, another possibility, and it is much less reassuring. Remember Solow’s observation about computers and productivity? We expect technological and other improvements to raise productivity over time. But what if we have lost the ability to raise productivity – and therefore growth – through technological innovation? In a provocatively titled paper, Is US Economic Growth Over?, Professor Robert Gordon of Northwestern University in the US offered a series of reasons why future productivity growth will be more elusive than in the past, top among them the faltering pace of innovation. Though he was describing the US, his argument could apply to many other economies. Perhaps Japan over the past two decades is a living example of this viewpoint. However, it is genuinely too early to say. For the moment, all we can speculate is that weak productivity is mainly the result of temporary factors. But we cannot discount the possibility that a more fundamental change has occurred. We have to hope that is not the case.

DaviD smitH ON THE REASONS WHY OUTPUT IS SLOWING DOWN GLOBALLY

There are two famous quotes about productivity, both from Nobel prize-winners. The first comes from United States economist Paul Krugman: “Productivity isn’t everything, but in the long run it’s almost everything.” By this he meant that productivity – output per worker – is the ultimate driver of wealth and prosperity. The other comes from fellow US economist Robert Solow: “You can see the computer age everywhere but in the productivity statistics...” This quote outlined his productivity paradox, which was the puzzle of how huge progress in information technology, replacing manual clerking tasks and other routine work, had not had a bigger impact on productivity. Keep those two in mind. We may, however, also have to add a third quote to the list, along the lines of: “Whatever happened to productivity?” The global financial crisis, it seems, has killed it off. In the UK, the puzzle is that a weak economic recovery has been accompanied by a strong rise in employment. Part of the answer may be that growth is being under-recorded. A bigger part, however, is that productivity growth has been unusually weak. There was no obvious productivity problem before the financial crisis: output per worker grew by an average of 2.3 per cent a year over the 2000/07 period. But the crisis changed that. At the end of 2012, UK output per worker was a mere 0.5 per cent up on its average in 2009, the recession low-point, while output per hour was 0.3 per cent down. Also at the end of 2012, what the Office for National Statistics (ONS) describes as “market-sector” productivity (i.e. excluding government) was at its lowest level since 2005.

STRANGE PATTERNJoe Grice, the ONS’s chief economist, has described the unusual nature of this situation. “Generally, labour productivity shows a rising trend… declines in productivity have not characterised previous recessions and recoveries in the UK,” he wrote in a 2012 ONS research paper. “In both the early 1980s and early 1990s

“Among mature economies, the United States, the Euro area, and Japan have seen labor productivity growth virtually stalling, as uncertainties prevented businesses to invest more rapidly and bringing new products and services to the market,” said the CB in its brief. “Major emerging economies, such as China, India, Brazil and Mexico have also experienced slowing productivity growth.” So what has happened to productivity growth? If the CB is right, weak productivity is mainly the result of the uncertainties that have held back investment and innovation. The normal process of creative destruction that follows a recession, in which unproductive

episodes, there was little or no initial fall in productivity and then a substantial recovery. Sixteen quarters after the start of these episodes, productivity had risen by approximately 14% in both cases.” So something odd is happening, and not just in the UK. The Conference Board (CB), an international business association, monitors global productivity. Its 2013 Productivity Brief, published earlier this year, showed that global productivity growth slowed to 1.8 per cent in 2012, the weakest rate since 2001/02 with the exception of the 2008/09 crisis, “as lower investment and less innovation make workers less productive”. The CB predicted little improvement for 2013.

Whatever happened to productivity?

Major emerging economies such as China, India, Brazil and Mexico have also experienced slowing productivity growth

CAR MANUFACTURE IN MExICO

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OTHER BOOKS THAT BAILLIE GIFFORD IS READING

•The Signal and the Noise: Why So Many Predictions Fail – But Some Don’t by Nate Silver

•How Asia Works by Joe Studwell (see review at www.bgtrustonline.com)

•Simpler: The Future of Government by Cass Sunstein

•Moonwalking with Einstein: The Art and Science of Remembering Everything by Joshua Foer

Graduate in physics these days and you probably won’t end up working on the Large Hadron Collider. You are much more likely to be hired by an investment bank or hedge fund to exploit your theoretical expertise. It is all very different from the days when, as J K Galbraith described it, success in finance could be achieved with “a nicely conformist nature, a good tailor and the ability to articulate the currently fashionable financial cliché”. In his well-written new book, James Owen Weatherall shows how the worlds of physics and finance have gradually come together, starting with Louis Bachelier, a French academic, who noticed that share prices seemed to behave like dust particles in a beam of light, moving randomly in all directions. Although individual share prices might be unpredictable, he said that in aggregate price movements seemed to fit the normal distribution, or bell curve, with most results in the middle. These statistical properties had two important consequences. First, they seemingly made markets easy to model; second, they seemed to suggest that markets were “efficient”, in the sense that they were difficult to outperform. Both assumptions had their negative effects; the use of simplistic models made investment banks too blasé about risk, with disastrous results in 2008, while the efficient market hypothesis caused central bankers such as Alan Greenspan to ignore bubbles, on the grounds that they could not outguess the wisdom of crowds. However, as Weatherall explains, there were also pricing anomalies that the efficient market hypothesis could not explain, anomalies that could be exploited by smart people with the right trading programme. A few

mathematicians or physicists could become rich, and, hired by Wall Street, the right physicist could create a complex structured product that only the bank, not the client, could understand. Weatherall explains this well in a book that is much less daunting than its title suggests; there are no equations and little that a moderately intelligent reader would find impossible to follow. However, that also means some of his stories may be familiar to readers Of course, he is right that the executives of investment banks probably did not understand the products their geeks were devising. But the geeks got the high salaries, so they must bear some responsibility for the mess that followed. Perhaps the most intriguing element of the book appears in the final chapter, where the author recounts how a few physicists began to wonder in the last decade whether their expertise might be applied positively to the field of economics, given the discipline’s failure to predict the crises of recent years. Perhaps, given the endlessly recycled debates on austerity and quantitative easing, the physicists should try again.

Philip Coggan’s latest book is Paper Promises: Money, Debt and the New World Order.

The Physics of Finance, Predicting the Unpredictable: Can Science Beat the Market? by James Owen Weatherall (Short Books, £12.99, Paperback)

The Physics of Finance Predicting the Unpredictable: Can Science Beat the Market?Philip Coggan reviews James Owen Weatherall’s book

BOOK REvIEW

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RISK FACTORS AND IMPORTANT INFORMATION

• The information given in this publication is based on Baillie Gifford’s understanding of current tax law and HM Revenue & Customs practice, which may change at any time. • The trusts are listed on the London Stock Exchange

and are not authorised and regulated by the Financial Conduct Authority.

• The trust directors and the staff of Baillie Gifford & Co may hold shares in the trusts, or may buy or sell such shares.• Baillie Gifford does not provide investment advice,

nor should the contents of this publication be taken as investment advice.

• If you have any doubt about the suitability of aninvestment, please contact an authorised intermediary for advice.

opportunities for our clients through

extensive and exhaustive independent

research – and we are fully committed to

our clients’ long-term investment success.

Read on for a guide to the eight investment

trusts we manage, and for information

about the investment plans we offer.

Since 1909, Baillie Gifford’s success

has been built on finding investment

A view to invest

Investment trusts are listed companies whose principal purpose is to invest in other companies, with the aim of making money for you, the shareholder. Your money is combined with that of other investors to provide a spread of risk through a wide range of shares. One of the main benefits to shareholders is that your money is being professionally managed by

our investment fund managers. This means that you don’t have to worry about when to buy or sell individual shares in companies. Baillie Gifford manages a range of eight global and specialist investment trusts – some aim to provide an income that will grow over time, some have a complete concentration on capital growth.

SCOTTISH MORTGAGE INvESTMENT TRUST PLCManaged by: James AndersonDeputy Manager: Tom SlaterSector: Global GrowthTrust aims: a low cost global portfolio designed to maximise overall returns.Total Net Assets: £2,224mwww.scottishmortgageit.com

THE MONKS INvESTMENT TRUST PLCManaged by: Gerald SmithSector: Global GrowthTrust aims: long-term capital growth from an internationally diversified equity portfolioTotal Net Assets: £992mwww.monksinvestmenttrust.co.uk

THE SCOTTISH AMERICAN INvESTMENTCOMPANY P.L.C.Managed by: Patrick EdwardsonDeputy Manager: Dominic NearySector: Global Growth and IncomeTrust aims: to increase capital and grow income in order to deliver real dividend growth.Total Net Assets: £326mwww.saints-it.com

EDINBURGH WORLDWIDE INvESTMENT TRUST plcManaged by: Mark UrquhartSector: Global GrowthTrust aims: capital growth from a concentrated global portfolio.Total Net Assets: £186mwww.edinburghworldwide.co.uk

MID WYND INTERNATIONAL INvESTMENT TRUST PLCManaged by: Michael MacPheeSector: Global GrowthTrust aims: to achieve growth in both capital and income by investing on a worldwide basis. Total Net Assets: £69mwww.midwynd.co.uk

Our monthly Investment Trust Bulletin contains investment reports, performance data and holdings information for all of the trusts we manage. Copies can be obtained by contacting us, or downloaded at www.bailliegifford.com. The website also contains up-to-date analysis, performance and prices as well as the latest Report & Accounts for each trust.

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SPECIALIST INvESTMENT TRUSTS

The Baillie Gifford Japan Trust PLCManaged by: Sarah WhitleySector: JapanTrust aims: seeks capital growth through investment in medium to smaller Japanese companies.Total Net Assets: £209mwww.japantrustplc.co.uk

Pacific Horizon Investment Trust PLCManaged by: Mike GushSector: Asia Pacific excluding JapanTrust aims: seeks capital growth through investment in the Asia Pacific region (excluding Japan) and of the Indian Sub-continent.Total Net Assets: £140mwww.pacifichorizon.co.uk

Baillie Gifford Shin Nippon PLCManaged by: John MacDougallSector: Japanese Smaller CompaniesTrust aims: seeks capital growth through investment in small Japanese companies.Total Net Assets: £94mwww.shinnippon.co.uk

FURTHER INvESTMENT INFORMATION

For more information about how to invest with Baillie Gifford visit www.bailliegifford.comor call us on 0800 917 2112.

All data as at 31 May 2013.

CLIENTS DEPARTMENT AT BAILLIE GIFFORD


Following our instincts.

SCOTTISH MORTGAGE INVESTMENT TRUST

*For a limited period and new Share Plan customers only. Terms & Conditions and minimum investment amounts apply. Please refer to our website or the application pack that we will send you for full details. Your call may be recorded for training or monitoring purposes. Baillie Gifford Savings Management Limited (BGSM) is the manager of the Baillie Gifford Investment Trust Share Plan and the Investment Trust ISA and is wholly owned by Baillie Gifford & Co, which is the manager and secretary of The Scottish Mortgage Investment Trust PLC. Your personal data is held and used by BGSM in accordance with data protection legislation. We may use your information to send you information about Baillie Gifford products, funds or special offers and to contact you for business research purposes. We will only disclose your information to other companies within the Baillie Gifford group and to agents appointed by us for these purposes. You can withdraw your consent to receiving further marketing communications from us and to being contacted for business research purposes at any time. You also have the right to review and amend your data at any time.

SCOTTISH MORTGAGE wAS ORIGINAlly lAUNCHEd TO pROVIdE lOANS TO RUbbER GROwERS IN MAlAySIA IN THE EARly 20TH CENTURy.

Our flagship fund, the Scottish Mortgage Investment Trust searches out investment opportunities from the bottom-up rather than taking a lofty, top-down view of the markets. And time is the key. We always view results in a five year context and are absolutely committed to maintaining a measured and considered long-term approach. Some might call it our natural instinct.

The Scottish Mortgage Investment Trust is managed by Baillie Gifford and is available through our Share Plan and ISA.

Please remember that changing stock market conditions and currency exchange rates will affect the value of investment in the fund and any income from it. You may not get back the amount invested.

Open a Share Plan to receive a £10 Amazon gift card*.

For more information call us on 0800 917 2112 or visit www.scottishmortgageit.com

baillie Gifford – long-term investment partners

RISK FACTORS AND IMPORTANT INFORMATIONAny investment in an investment trust involves risk. You should be aware of the following risk factors that apply to all of the investment trusts and to investment in the Share Plan, Children’s Savings Plan and ISA:

• The Investment Trusts managed by Baillie Gifford & Co are listed UK companies. As a result, the value of their shares, and any income from them, can fall as well as rise and investors may not get back the amount invested.• The trusts invest in overseas securities, changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up.• All the trusts can borrow money to make further

investments (sometimes known as ‘gearing’). The risk is that when this money is repaid by the trust, the value of the investments may not be enough to cover the borrowing and interest costs, and the trust will make a loss. If the trust’s investments fall in value, any borrowings will increase the amount of this loss.

• You should note that tax rates and reliefs maychange at any time. The value of any tax benefits will depend on your individual circumstances.

Details of the other risks associated with the investment trusts and ways to invest in them are in the information we will send to you.

All data as at 31 May 2013.

Baillie Gifford aims to make investing in global stock markets as simple as possible. Our investment trust plans are designed to be flexible, accessible and cost-effective ways to invest directly in the investment trusts we manage.

INvESTMENT TRUST SHARE PLANA flexible, cost-effective and simple way to invest in a spread of shares for the long-term.

• No initial charge*• No annual management charge*• Flexible investment options: lump sum investments from £250 and monthly savings from £30

CHILDREN’S SAvINGS PLANA straightforward way to invest over the long term for children.

• Can be opened for any child under 18• Comes with no initial charge or annual management charge*• Can be a bare trust or a designated account: lump sum investments from £100 or monthly savings from £25

INvESTMENT TRUST ISAYou can choose to open a new stocks and shares ISA or you can transfer the management of your existing ISAs.

• Invest a lump sum from £2,000 (with a minimum of £1,000 per trust) or from £100 a month per trust (subject to investment limits)• Invest up to £11,520 in a stocks and shares ISA this tax year• Transfer existing ISAs with a minimum value of £2,000• No initial charge and an annual management charge of £32.50 plus VAT*

* Charges are subject to review in April each year. Other charges include a withdrawal charge of £22, the dealing price spread, and a stamp duty cost of 0.5 per cent on purchases. Investment trusts also incur costs in managing and administering their portfolios (including dealing costs).

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Trust 23 complete magazine

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