Herald Investment Trust plc (LON:HRI) annual financial report for the year ended 31st Dec 2019.
Results and dividend
The net asset value (NAV) of the Company at 31 December 2019 was 1,668.1p per ordinary share (2018 – 1,307.9p). This represented an increase of 27.5% during the year. The discount was 11.3% (2018: 17.8%) and the share price increased by 37.7% to 1,480.0p.
The Company made a revenue profit of £31,000 (2018: £58,000) giving net earnings of 0.05p per share (2018: 0.08p) per share. The directors do not recommend a dividend (2018 – nil) for the year ended 31 December 2019.
The financial information set out in this Annual Financial Report does not constitute the Company’s statutory accounts for 2018 or 2019. Statutory accounts for the years ended 31 December 2018 and 31 December 2019 have been reported on by the Independent Auditor. The Independent Auditors’ Reports on the annual report and financial statements for 2018 and 2019 were unqualified, did not draw attention to any matters by way of emphasis, and did not contain a statement under 498(2) or 498(3) of the Companies Act 2006. The Company’s statutory accounts for the year ended 31 December 2018 have been filed with the Registrar of Companies. The Company’s statutory accounts for the year ended 31 December 2019 will be delivered to the Registrar in due course.
The financial information in this Annual Financial Report has been prepared using ‘FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland’ (FRS102), which forms part of Generally Accepted Accounting Practice (‘UK GAAP’) issued by the Financial Reporting Council. The financial statements have also been prepared in accordance with The Companies Act 2006 and with the Statement of Recommended Practice ‘Financial Statements of Investment Trust Companies and Venture Capital Trusts’ issued by the Association of Investment Companies (‘AIC’) in October 2019.
CHAIRMAN’S STATEMENT AND REVIEW OF 2019
At the mid-year, we reported that the net asset value per share (“NAV”) had grown 17.2%. By the year end, the Company’s NAV per share growth had reached 27.5%. The growth in NAV for the year, which compares favourably with wider indices, reflected strong equity markets globally and good stock selection.
Of note was an unusually sharp divergence in performance between larger and smaller companies within our overall smaller companies remit: larger companies performed materially better than smaller ones. To illustrate this, the Company’s investments with a market capitalisation in excess of $1bn at the year end had delivered a total return of 56.5%, with the investments with a market capitalisation below $1bn returning the lower but still good figure of 19.1%.
There is degree to which this divergence reflects success, because the good performers have grown; but the more significant factor this year is a much greater re-rating in the valuation basis. A crude measure of some relevance is the Bloomberg forecast of Enterprise Value to Sales: it is 5.0x on average for the holdings above $1bn, whereas the average for companies below $1bn is 2.8x.
The most significant effect on performance is provided by the UK, which accounts for 52.2% of the Company’s total assets and has a much lower average market capitalisation. The total return from our UK portfolio was 30.2% which compares favourably with the Numis Smaller Companies Index plus AIM (ex investment companies) which returned 22.2%. Nevertheless, this market has not felt like a bull market at all because liquidity has been so poor. Indeed, volumes in AIM technology stocks across the market have fallen 70% over the last year. In a normal market cycle, we would expect the performance to filter down to much smaller companies in 2020 and 2019 should have been a good year for new issues, however it was not. The UK market had a double headwind; firstly political uncertainty which was significantly alleviated by the election because the UK portfolio appreciated 7.8% in December; secondly a withdrawal from illiquid assets, or at least avoidance of smaller companies, partly due to the regulatory shock of MiFID II and other issues. The latter may have an ongoing effect, which we have to monitor closely. However, the performance figures should reassure investors that shrinking markets can still be rewarding.
The North American region has delivered the strongest overall return reflecting a greater skew to the larger end of the remit. The total return from the North American portfolio was 39.5% versus the Russell 2000 (Small Cap) Technology Index (in sterling terms) returning 29.7%. It is interesting to observe that the large capitalisation Russell 1000 Technology Index returned 41.5%, so again smaller companies have materially underperformed their bigger brethren, but it is pleasing to have performed nearly as well as that latter index which is dominated by Apple and Microsoft, when they have performed so well. It is also pleasing that the UK performance, in spite of the microcap challenges has exceeded that of the US Russell 2000 Technology Index. Remarkably there were £62m in takeovers in the Company’s North America portfolio, some of which have not completed, which is extraordinary versus a market value of £218m at the start of the year.
The Company’s total return in Europe was 38.9% with three-quarters of the region’s return by value coming from the three biggest holdings, BE Semiconductor, Data Respons and Nordic Semiconductor. The Asian total return was 29.3% with a particularly strong performance from Taiwan of 51.5%.
Cash has been a drag on the overall return. Cash levels were higher than planned at the start of 2019 reflecting a spate of takeovers, and a further £106m of takeovers have been announced during 2019. In both the UK and North America portfolios, sales exceeded purchases, and modest net cash was invested in EMEA and Asia. There were no completed takeovers in those regions, though by the year end one significant holding, Data Respons, agreed a takeover, which has not yet completed. Reinvestment has been measured and the Manager has taken profits in a number of holdings reflecting full valuations.
During the year share buyback transactions amounted to £20.3m or 2.3% of the equity outstanding at an average price (including costs) of £12.79 per share.
BOARD COMPOSITION AND GOVERNANCE
As anticipated at this time last year, Julian Cazalet retired from the board of the Company at the conclusion of the annual general meeting in April 2019 having chaired the board for ten years. We are very grateful for his leadership and his very substantial contribution to the Company’s success.
Henrietta Marsh joined the board in September, bringing investment management background, with a particular focus on smaller companies, to further strengthen the board’s expertise.
The Company undertook an audit tender process in 2019 and is pleased to report that PricewaterhouseCoopers LLP were appointed as auditor to the Company and have undertaken the 2019 audit.
Valuations are not as attractive as they have been, but the sector is still dynamic, and we believe continues to offer better opportunities than the wider market. The microcap end of the market offers conspicuously more interesting valuations. The closed-end nature of an investment trust makes it an ideal vehicle to access the Company’s target market.
18 February 2020
INVESTMENT MANAGER’S REPORT
After a year of consolidation in 2018, I was confident that 2019 would be better, but candidly I am surprised by quite how strong the market has been. I was particularly apprehensive in the middle of the year when I was aware how dire liquidity was, particularly in the UK and Europe.
As Woodford’s troubles emerged there was a spate of selling as investors tried to reduce holdings in illiquid stocks and the market was scarcely functioning. I feared distressed sellers would deliver a downward dislocation. Fortunately, the Woodford situation occurred against a very strong market background; otherwise, more damage could have been done.
Why, I wonder, has the market been so strong? I believe the main reason is that, while there is a shortage of capital in smaller quoted companies, there is a surplus in the hands of private equity. They are using cheap debt to leverage returns and exploit the anomaly that interest is tax deductible when dividends are not. They continue to pay significant premiums when acquiring quoted companies and gradually the quoted market is moving to their valuation levels. They have gathered assets by performing with leverage, which has worked in an era of declining and very low real interest rates.
From first principles, the ideal environment is for companies to have permanent capital and for investors to have perfect liquidity. That worked in the stock market and for the wider economy as well over extended periods. On the other hand, private equity is temporary capital, with short-term horizons, which while possibly driving markets higher in the short-term, will over time tend to undermine economies as more ownership goes into its hands.
The move to private equity ownership has been helped by the huge increase in costs and distraction from spiralling regulation in public markets, which is particularly onerous for developing businesses. For example, I estimate that of the 131 UK listed investments in the portfolio each has spent an additional £50,000 on investor relations by appointing a joint broker, commissioning independent research or, in extremis, employing an individual to do investor relations. On average Herald owns 4.2% of the outstanding capital of its UK holdings, so the share of those costs borne by our investors is c£275,000. This is a hidden cost not disclosed to investors. At the same time, we now have 17 holdings with no broker coverage, a further 64 with access to only one broker (including our largest US holding Pegasystems) and a further 62 holdings with access to research from only two brokers. This anecdote perhaps explains why MiFID II research payments are so confusing and challenging for us and why some investors and brokers are disappearing from the smaller companies’ scene.
Similarly, audit fees are leaping, and it seems too much time is spent counting the blades of grass without intelligently viewing the lawn. We are jealous of the minimal scrutiny of the private equity world, but maybe in time investors will realise that minimal regulation is not ideal either. Wealth managers are facing ever increasing costs, which now have to be paid out of after-tax income when previously more of the cost was ascribed to capital. None but the richest investors can now afford tailor-made advice. When costs were pro-rata to dealing more of the cost was born by big investors and less by small investors.
In recent years the stock markets in the UK and the US have not provided the stable quality ownership that they did in the past and have not supported the UK technology sector. The quality long-term owners of defined benefit pension schemes and insurance companies have disappeared and the ebbs and flows of open-ended funds make them unstable shareholders for small companies. As allocations to quoted UK equities have fallen, investors have too easily accepted takeovers and failed to provide capital for companies to grow. In this challenging environment for smaller public companies, Herald has been a steadfast supporter of technology businesses. We have been made insiders for secondary fund raisings over 100 times in 2019 and we have participated in 62 placings with an aggregate value of £40m. There were other occasions when we would have participated or invested more had there been more co-investors as we are disciplined in ensuring that we generally do not exceed 10% ownership of the outstanding share capital. I am sure flows into passive investments are driving up some valuations; for liquidity reasons they should not and generally do not invest in smaller companies, but it is another slug of capital no longer available for small quoted companies. Clearly, they do not participate in new issues, nor in pricing shares efficiently.
On a more positive note there is relative value in the smallest companies. Capital is still hard to find where it is needed most, which is for emerging companies who have not yet reached profitability where venture capital has significantly lower cash to deploy compared to leveraged private equity. Furthermore, US investors, appreciating the value in the UK, are beginning to appear on the share registers of the smaller UK quoted companies, which may be the lifeline needed. I am reassured that the SEC has extended the exemption which allows US brokers to sell research to European firms by three years. There are therefore the building blocks in place, of attractive valuations and increasing capital availability, for a positive investment environment.
I remember when I started in the City during Thatcher’s reign the atmosphere was “we need small companies to create wealth, added value jobs, taxes and future big companies”, and there was an enthusiasm to allocate capital accordingly. It is within the Government’s powers to direct UK savings to alleviate the disastrous decisions made over the last twenty years: after all, they provide a subsidy to pensions, ISAs and private equity. Now that we have left the EU, there is an opportunity for government to create a really positive environment for innovation and growth.
The UK portfolio has returned 30.2%, outperforming the Numis Smaller Companies Index plus AIM (ex investment companies) (the “Numis Index”) by 8%. The return from stocks with a market capitalisation exceeding $1bn was 77.3% which has driven the outperformance and was over 60% better than the smaller UK companies in the Company’s portfolio. I note that fully listed UK stocks returned 54.5% and AIM stocks delivered 21.6%, so the bigger stocks in AIM contributed very strongly and I conclude that neither AIM nor politics is the issue, but rather the flight of capital from illiquid smaller companies. Of the top 73 holdings in the Company with a market capitalisation of over $1bn only 17 are in the UK with a market value of £185.4m but a book cost of only £41.7m. Therefore, on average, they have risen 4.5x, many having started as microcaps in the portfolio.
The number of takeovers in the UK was eight with an aggregate value of £38.1m which is a lower rate than recent years, being only 8.1% of the UK portfolio at the start of 2019. The most significant takeover was Statpro, in which the Company had an 11% stake. We went above our customary 10% threshold when they could not draw on their overdraft facility when Kaupthing went bankrupt. We, along with Statpro’s Directors, provided emergency funding. We first invested in May 2000 in an early stage IPO when it was a struggle to find value in the technology bubble. I am sorry to see the company go, but pleased to say the return over the life of the holding is 1,018.5%. Of the cumulative £13.8m total return over the history of the holding, £9.2m was in 2019 with the takeover premium. People detached from investing may ask “why did you not buy them at the beginning of 2019”? Two reasons. Firstly, an 11% stake would not have been available and, secondly, the company would not have floated and survived if we had not provided it with necessary capital. Unfortunately, there are not enough other long-term investors around. I suspect there were few technology investments made in May 2000 that delivered that sort of return, albeit over nearly 20 years. Scisys was another company where Herald was the largest outside shareholder with an 8.2% stake. It is under offer, as is Sophos.
The star performers have been GB Group and Future which both returned more than £20m during the year and have been strong long-term performers, dwarfing the disappointments from M&C Saatchi and LoopUp.
There are currently a few unlisted holdings with an aggregate value of £15.1m. Some are unlisted securities which are convertible into quoted ones (35.7% of £15.1m) and others are previously quoted companies that have delisted (11.2% Fusionex and Celoxica). There are two further private companies which are also held within Herald Ventures, Natilik and Antenova, accounting for 19.8%. Both are profitable and paying dividends. The board has approved a limited scope to invest in private companies and we have a natural flow of opportunities. If we believe better returns can be achieved here, we would consider asking directors and shareholders for greater flexibility but have no current plans to do so. The remaining private investment is the holding in the management company.
Since inception the UK has been the core driver of the Company’s performance, but over the last five years the UK has lagged the returns from North America and Europe. Even so, the total return in the UK has been 105.5% over that period, while the Numis Index has returned 52.4% and the AIM Technology Index a similar amount.
The North American portfolio’s return (in sterling terms) was 39.5%, some 10% ahead of the Russell 2000 Technology Index. Smaller companies in the US materially underperformed the Company’s overall return for many years post the technology bubble of 2000, but have outperformed from 2014. The Company’s North American portfolio has returned 171.4% (in sterling terms) over the last five years, with the Russell 2000 Technology Index returning 135.4% over the same period: 36.0% ahead. The total return of the large company Russell 1000 Technology Index has returned 181.4%.
I should be thrilled if we can sustain that degree of outperformance, but a legitimate question is why we have not had a higher US weighting. There were two factors: takeovers and valuations.
At the beginning of 2015, the value of the North American portfolio was £144m and, by coincidence, the aggregate value of US takeovers in the last five years has also been £144m. Of that, £62m is the value of takeovers in 2019 alone, including Mellanox and Fitbit which have not yet completed. Some 20.4% of the North American portfolio at the start of 2019 has been acquired in the last year. The significant takeovers were Attunity (£17.3m), Mellanox (£16.8m), Amber Road (£9.4m), Hydrogenics (£6.7m) and Quantenna (£5.4m). We took an initial position in Attunity in 2014, and the Company cornerstoned a secondary offering in December 2017 investing $4.75m, which I had the confidence to do having known the management with a modest holding for three years. The take-out price of $23.5 per share, by private equity house Thoma Bravo seems a good return in just over a year, but one of my colleagues saw them at a Gartner conference recently and exclaimed on his return that we were robbed, because revenues had grown 100%.
We are sad to be losing Mellanox as well. The total return has been 9x the initial book cost and the exit valuation is somewhat disappointing. It takes time and patience to find similar opportunities.
As well as losing some holdings to takeovers in North America, we took profits in some where we believed that the stocks had run too far. In aggregate we sold £67m of North American stocks, offset by £30m of purchases. The cash from sales and takeovers has come in with the market at elevated levels, and we believe that there will be better buying opportunities in the US. Private equity is sweeping up value, but some of the momentum stocks in the SAAS (software as a service) area were on uncomfortably high valuations with EV/sales values as high as 30x. There is a resourcing bubble in California and stock-based compensation, meaning free shares, are being liberally doled out, but normally stripped out of “adjusted EPS” numbers. There were signs in the second half that the market is beginning to worry about this too and valuations have corrected a little. Analysts almost never take account of share-based payments in earnings forecasts, which means there is a material overstatement of earnings and therefore understatement of the P/E ratio. This is a particular problem in the software sector, but not in semiconductors. I am therefore unsurprised that semiconductors have performed relatively well.
There are 22 stocks in the portfolio with an aggregate value of £170m which exceed $3bn market capitalisation, which is the level above which we do not make new or further investments. Of these, 13 are in North America with an aggregate value of £95.5m which is an anomalously large proportion (37%) of the North American portfolio. The aggregate cost base for these holdings is only £19.3m, so the average return is nearly 5x. In addition, £14m profit has been realised already. The star performers have been Pegasystems, Mellanox, Descartes and Five9. LivePerson and Hydrogenics are smaller companies which have contributed strongly this year.
The high levels of takeovers in the Company’s North American market investment universe has been reflected in a sharp decline in the number of listed technology companies because takeovers have exceeded IPOs. At the beginning of 2019 the number of stocks in the Bloomberg Communications and Technology sectors in the United States with a market capitalisation >$20m and <$3bn was 616 and this had fallen to 535 by the year end, albeit the number of companies above $3bn market capitalisation had grown from 235 to 267. The trend in recent years has been for venture backed companies to have more fund raising rounds pre-IPO. The much discussed “Unicorns” such as Uber, Airbnb, Slack, WeWork et al were private companies raising money with rounds at >$1bn valuation.
It is interesting that some of these have crawled to market in a dull way or failed to IPO. Those private valuations were too high. Furthermore, Spotify and Slack pioneered an introduction to the market without a fund raising. Slack’s share price, for example, reached $38.6 when it first listed and traded at $22 at the year-end. It still has a market value way above our smaller companies remit at $12.4bn, which is eye-watering compared to forecast sales of $622m for the year to March 2020 and a huge loss-making margin of over 20% of EBIT. Presumably some of the stock has been acquired by passive investors? These late stage venture investors must be careful to leave something on the table to attract public investors or exits will be difficult. Examples like this may make the pre-IPO fashion fade, while leveraged private equity will stumble when interest rates rise.
The European portfolio had a tricky year in 2018 led by the semiconductor downturn (including the largest holding BE Semiconductor Industries), but 2019 has seen a good recovery. The total return for 2019 was 38.9% and over 5 years it has been 181% in sterling terms, which makes it the best performing region. Data Respons is a Norwegian holding acquired in 2014 and a French company Akka has agreed to acquire it. It is a pity to lose a holding with a known and respected management team, but it has helped short-term performance.
The Asian portfolio has returned 29.3% in sterling terms this year and 78.3% over 5 years. Within the year, the Kosdaq IT Index in Korea rose 6.3%, the larger company TWSE Electronics Index in Taiwan increased 40.8% and the Mothers General Small Companies Index in Japan was up 8.9%. Performance across the Asian indices was disparate between countries and between the first and second half of the year.
In general, China and Hong Kong equity markets had a volatile and challenging year due to the negative impact on GDP of Trump’s tariff war with China and the civil disturbance in Hong Kong. The Australian market had a stellar start to the year rising around 50% in sterling terms by mid July 2019 before giving up a decent proportion of these gains by the year end. By contrast the TWSE Electronic Index (the “TWSEE Index”) had modest gains in the first half but rose strongly in the second half to return 40.8% for the full year – one of the highest returns from any index worldwide. The Taiwanese portfolio holdings surpassed the TWSEE Index with a 51.5% return in the year. The stock market excitement in Taiwan is focused around two concepts; firstly the adoption of 5G wireless technology increasing the demand for Taiwanese hardware and semiconductors and secondly demand for components from Chinese companies desperate to switch away from American suppliers as a result of the US-China trade war. As with all concepts the reality can disappoint and with a number of the Taiwanese holdings near record valuations there is a temptation to realise some gains. The biggest contribution in the year came from Realtek, a Taiwanese semiconductor company that benefitted from strong demand for its RF semiconductors, particularly for use in wireless audio earbuds.
The approach within the Asian portfolio is to continue to diversify away from the hardware business models common in Korea and Taiwan by unearthing opportunities and allocating capital to interesting small companies in countries such as Australia and Japan, both of which have a good flow of IPOs coming to market.
We remain enthusiastic about the outlook for investing in the technology sector. Cloud computing and ubiquitous connectivity will continue to drive disruption across different sectors, creating opportunities for technology companies. Although we expect trade tensions and regulatory concerns to continue to cause short-term volatility, ultimately the sector is among the few which is investing heavily in innovation, creating high value employment and bringing benefits to consumers, enterprises and governments around the world and generating attractive returns in the process.
The concept of IT as a utility has been talked about since the mid 1990s. However, it was with the wide acceptance of opensource software post 2000, the availability of mobile data networks in the mid-2000s, the launch of Amazon’s AWS in 2006 and the launch of the Apple App store in 2008 that the pieces of the puzzle were in place for the concept to go mainstream. Today we call that utility model “Cloud Computing.”
We are 10+ years into the adoption of Cloud Computing. The size of the market is very large but growth rates remain robust. Gartner Group estimate Public Cloud revenues to grow from $227bn in 2019 to over $350bn in 2022 (source: Gartner). Moreover, we see the adoption of Cloud Computing disrupting about $1tr of the current annual spending on legacy systems.
The move to Cloud Computing is disproportionately beneficial for smaller companies. It gives them access to a global resilient IT infrastructure at arguably less than 1% of cost of having to build it themselves, and the added benefit that they can flexibly scale their businesses up and down efficiently and with low risk. Additionally, this allows small companies to target niche markets around the world efficiently.
In the same way that the internet democratised information flow and we are still grappling with its second and third order effects, Cloud Computing and Ubiquitous Connectivity continue to democratise software development across different end markets with changing second and third order effects.
Investing in technology gives us a front seat to see the ripples and aftershocks of seemingly unconnected small innovations which often combine to create tectonic shifts across different industries. Regardless of the source of the innovations, smaller companies and the entrepreneurs behind them tend to be the first ones to exploit the nascent opportunities throughout global supply chains.
With time and relentlessly excellent execution, leaders emerge to dominate fragmented, newly created markets. This has been the story of most of the tech titans of today, e.g. Microsoft, Apple, TSMC, Google, Facebook, Amazon, ASML and SAP. We have seen this pattern repeated again and again over the last three decades. We do not see any sign of it changing in the foreseeable future.
In a world of limited resources and growing environmental and social concerns, it is worth highlighting that a number of the technology companies have taken it upon themselves to be standard-bearers, raising the environmental and social bars for all. For example, Apple is using 100% renewable energy for all of the electricity used by its facilities around the world and is striving to make products using 100% recycled and renewable materials.
Apple imposes its own exacting standards on all of its suppliers and the suppliers of their suppliers. Apple’s lead in this area has spurred others such as Google, Microsoft, Amazon to also up their efforts. So although the US government, driven by corporate lobbies, drags its feet on environmental commitments, this has not stopped the leading US technology companies from rapidly raising standards across their supply chains around the world. This leads small companies which are customers and/or suppliers of the large companies to also become progressively more environmentally efficient.
“We’re sourcing 100% renewable energy for all the electricity used at our facilities in 43 countries around the world. Two thirds of this renewable energy comes from Apple-created projects.”
“We take responsibility for our entire carbon footprint. That includes the emissions beyond our direct control, like those from sourcing materials, making our products, and our customers using their devices.”
“Partners across our supply chain are installing or investing in sizable solar projects and purchasing clean energy directly from renewable projects or from their utility. As of April 2019, 44 manufacturing partners in 16 countries have committed to 100% renewable energy for Apple production”
Apple Environmental Responsibility Report, 2019
The technology sector will be significantly affected if Coronavirus continues to disrupt manufacturing in China. Although the direct exposure to Chinese companies is minimal, the indirect effect could be significant. In particular, a handful of holdings in each region manufacture products there, either with Chinese operations, or through subcontractors and suppliers, and many more companies use PCs and servers which are at least in part manufactured there. However, the knock-on effects will be felt in many sectors if the cessation of production is prolonged, and at this stage that is uncertain.
We remain confident that there is growth in the sector above that of the wider economy and that much of the sector now has non-cyclical spending. In particular, the recurring revenues associated with IT infrastructure and applications, used by corporations, the consumer and governments alike, have the defensive characteristics of utilities without the regulatory issues, which benefit so many companies within our universe. However, the geopolitical uncertainties, the illiquidity associated with smaller companies and valuation levels which will be vulnerable when interest rates rise, means that we prefer to keep higher than normal cash levels to ensure we can exploit buying opportunities, which will inevitably occur. For reassurance, valuations are in general not in bubble territory and the difficulty which central banks have in raising interest rates means there is a good chance that valuations could rise further.
18 February 2020