Herald Investment Trust has announced its annual results for the year ended 31 December 2016. During the year, the Trust’s NAV increased by 22.8% to 1,083.2p per share, whilst the share price increased by 18.4%. This reflected a widening of the discount, over the year, from 15.5% to 18.5%. The Trust says that during the period the Numis Smaller Companies Ex Investment Companies Index Plus AIM increased by 9.1%, the Russell 2000 (small cap) Technology Index (in sterling terms) increased by 49.8% and the trust’s comparative index increased by 21.7%.
Following the EU referendum result in the UK, Herald benefited from cash balances intentionally held in overseas currencies as sterling depreciated sharply. The total appreciation on the portfolio was £144.5m in 2016. Of this return currency gains represent some £41m.
The portfolio saw significant takeover activity during 2016. Of the fifteen takeovers, six were in the US, eight in the UK and one in France. The aggregate takeout value was £64.0m and the average holding period from first purchase was 8.2 years. The Trust’s chairman, Julian Cazalet, says that most of the UK takeovers were towards the end of the year and that it felt as though no decisions were made before and immediately after the Brexit vote but, as business carried on normally after the vote, buyers’ confidence returned. The level of takeovers was not as high as it was in 2015 (£92.3m), but it reportedly remains above the long-term trend.
Takeover activity reflects the natural lifecycle of the Company’s investments. One of our aims has always been to provide development capital to early stage quoted companies, and it is inevitable that as they mature, some are acquired. However, there is another phenomenon. The number of takeovers is now exceeding the number of new issues: investors are withdrawing capital from the quoted sector. Instead there are flows of capital into private equity and venture capital. Private equity is able to use more efficient capital structures with more financial leverage, and lower taxes. In addition, the level of regulation in quoted markets is increasingly burdensome for companies and investors alike. Investors in private companies also have the advantage of investing without the limitations of insider rules.
Fortunately, there are some counterbalancing positives. Firstly, large companies driven by quarterly reporting are investing less in new products and are happier to acquire smaller companies when they have reached profitability. This leaves a larger gap for entrepreneurial companies to fill. Secondly, both private equity and large corporations are paying significant premiums to quoted market valuations. Thirdly, many professional investors are abandoning smaller quoted companies, and brokers are less energetic about promoting secondary market activity due to reduced commissions. Together these factors create opportunities for a research-driven company like Herald. Finally, private equity is in general not a good quality owner because its time horizon is determined by the life of their fund. This can cause forced exits, bringing companies back to the market at a later stage of development. There could in due course be a flood of IPOs at exciting valuations.
In terms of portfolio composition, the UK continues to be the largest proportion of the portfolio but, as a percentage, has fallen to 57% of net assets. The return on the UK portfolio was 16.0%. As such, the UK was a drag on the overall return of the fund although, acording to the Trust, its performance exceeded the Numis Smaller Companies Index (inc AIM but exc investment companies) which grew by 9.1%. The North American return was 38.4% in sterling terms. The trust says that, whilst this was an impressive number in absolute terms, it lagged the Russell 2000 Technology Index in sterling which returned 49.8%. The trust says that all of the relative underperformance occurred in the fourth quarter, and reflects its exposure to the smaller companies in the Russell 2000 Index and companies too small for this index. The Asian portfolio appreciated by 21.65% which the trust says was largely related to currency. Europe was reportedly the star region, rising 56.7% in sterling, though it is a small proportion of the trust’s portfolio. The trust held net cash throughout the year, which it says reflects caution around political uncertainties and held back performance overall. The trust’s cash balance increased in Q4 as cash came in from takeovers. The trust closed its remaining £25m of interest rate swap as it was offered favourable terms to close.
The chairman says that the share price discount has remained at a frustratingly wide level, but broadly in line with UK smaller companies investment trusts and that, hHelped by the strong cash flows from takeovers in 2015 and 2016, the Board and the Manager have been purposeful in share buybacks (£23.5m), representing 4% of the outstanding capital, but overall volume has been limited. He says that the illiquidity in the Trust’s shares mirrors the illiquidity in the underlying portfoli and that, in his view, this in part this reflects the fact that commission levels have been driven down to such a low level that it does not pay brokers to broke stocks actively. The burden of marketing is now moving even more to companies including the Trust itself. Marketplaces adapt, but at the moment in the UK the regulatory shock of the impending introduction of MiFID II has led to dire illiquidity, and commensurately wide discounts for smaller company trusts in general. He says that it will be interesting to see how markets evolve over the next two years and that, in 2017, the board intends to be more active in marketing and broker engagement.
In terms of outlook, the chairman says that the latest trading news from portfolio companies is generally sound and that, although valuations are not at the bargain levels of the financial crisis, they are cheap compared to bonds and corporate activity is occurring at substantial premiums.
Looking at individual holdings, Seven appreciated more than 100% during the year, of which the two most significant were Avesco and IQE. Katie Potts, the Trust’s manager says that IQE recovered from aberrantly low levels, while Avesco was the most significant takeover. The trust acquired most of its Avesco holding at distressed levels in June 2009 at the height tof the financial crisis at 22p. As such, Katue says that The take out value of 650p was most welcome, and the premium on the price the day before the takeover was 125%. Katie says that they endeavour not to own more than 10% in any one company, in order to have some discipline over liquidity but that Avesco was an exception. The Trust’s holding crept up to 12.5% when Avesco bought back the shares of one investor Herald’s blessing. Servicepower Technologies was another company where the Trust’s stake crept over 10%, because the Trust bought some cumulative convertibles which were held longer than anticipated, and the accrued coupon converted to ordinary shares at a very low price. The takeover led to an appreciation for the year of 209%. However the shares had fallen prior to the takeover because the company was cash constrained to the point that the manager put in a short term loan. Katie says that they had confidence in the company longer term and would have liked to have stood our corner in a fund raising, but with an 11.5% stake were reluctant to invest alone. She says that, to their frustration, the directors rationally on their part did not want to be diluted at a derisory valuation, so chose to exit the company before it was fully ripe. A Canadian company made a first offer at 5p, which was 100% higher than the price at which the shares had been languishing, and a counter offer came in at 6p. The take out valuation was little more than one times revenue.
At the other end of the spectrum, Katie says that Alternative Networks was the lemon of the year losing £2.4m in spite of a 17% premium on a takeover at the year end. Katie says that it is a pity it limped off the market, because it has historically been a good performer, and yielded nearly £8m in profit and dividends.
There were nine companies in the US portfolio that appreciated by more than 100% in sterling terms. These were Akoustis Technologies, Apigee (bought and sold during the year), Energous, Mentor Graphics, KEYW, Boingo Wireless, Amber Road, Impinj and Fabrinet. (Interestingly Akoustis, Apigee, Boingo, and Energous are not in the index). The most significant by value was the longest held, Mentor Graphics. Katie says that the largest holding in the portfolio – Silicon Motion Technologies – performed satisfactorily, appreciating 64% in share price terms, but profit taking at higher levels helped give a total return of £7.8m during the year. Poor performers were Hydrogenics and Adesto which are both early stage companies.
In Europe, Ordina, BE Semiconductor Industries (BE Semi) and Devoteam all appreciated by more than 100%. Katie says that, by value, the star was BE Semi which was initially purchased in 2011. She says that they would also have done well owning more semiconductor equipment manufacturers on the US market, but BE Semi was the preferred play in this sector, which is highly cyclical. Second was Isra Vision, a German listed company that has been held since 2004 and appreciated by 83.5% (£2.2m during the year). The star performers have all been long term holdings which Katie says have enjoyed multiple expansion.
In Asia, Innox in South Korea appreciated more than 100% and made the biggest individual positive contribution to the Asian performance. PSK and Soulbrain, two other South Korean companies, also performed well. Katie says that Innox and Soulbrain are likely beneficiaries of the move to the use of flexible AMOLED displays in smartphones and PSK is a leading supplier of capital equipment into the DRAM and 3D NAND memory industries. The worst performance came from 21Vianet, an internet data centre services provider in China, where the combination of a failed takeover and weak trading caused the share price to more than halve.
Herald benefits from sterling depreciation and modestly beats comparative index : HRI