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Herald benefits from defensive positioning

HRI : Herald Investment Trust - Investing in the future Herald Investment Trust - Shifting sentiment

Herald Investment Trust (HRI) has announced results for the year ended 31 December 2018. During the year, HRI’s NAV fell by 4.9%, while its share price fell by 8.2%, reflecting a widening of the discount during the period. HRI says that this compares against a fall in the Numis Smaller Companies Index plus AIM (ex. investment companies) index of 18.1% and an increase Russell 2000 (small cap) Technology Index of 4.7% (all figures in sterling terms). Most of the damage was done in the final quarter but HRI benefitted from a defensive positioning of its portfolio as its manager felt valuations had got ahead of themselves.

Herald was ahead at the half way stage

At the half way stage of the year, HRI’s NAV had risen some 9.6% but the sharp correction in markets during the last quarter of 2018 saw the trust’s Nav performance for the year move into negative territory. Commenting on the results, the trust’s chairman, Julian Cazelet, said “It is always disappointing to report negative returns, but the portfolio had been positioned defensively, reflecting the manager’s belief that some valuations had become somewhat too ambitious. The performance relative to the wider market is quite pleasing, since the wider market (captured by the FTSE All Share Index) depreciated by 9.5%.  We enter 2019 more comfortable that valuations now offer scope for good absolute performance once again”.

[QD comment: QuotedData has recently published an update note on Herald – Click here to read it]

Investment manager’s commentary

Katie Potts, HRI’s investment manager, has provided commentary on the various markets in which HRI invests as well as her outlook. There is plenty of detail on individual companies and it makes good reading. We have included this below.

“In 2018 we were intent on maintaining cash and even accumulating higher cash levels. This was helpful in the fourth quarter when there was a correction, which led to a decline in net assets per share of 4.9%. We are beginning to believe that cash may be a drag moving forwards, albeit there remain some macro imponderables. The intention is to slowly reinvest as opportunities arise, and to maintain the borrowing facility in case a good buying opportunity emerges.

There has been a wide divergence in performance between stocks. A few have disappointed at the trading level, while others have just been de-rated. The subset of the technology sector that has experienced downgrades has mainly been exposed to volume markets, such as mobile phones and automotive. This has hit the semiconductor sector in particular where increases in capacity combined with lower growth in demand have led to price cuts and margin pressure. This has affected holdings such as IQE and BE Semiconductor Industries, both of which performed outstandingly in previous years. We had reduced our positions, but not enough. However, the appeal of the sector is that it is not homogeneous, and in all markets, there are some that grow. For most of our holdings there has been no discernible weakness versus expectations.

The US economy, and consequently the global economy, has benefited from tax cuts which have provided a tailwind to corporate profits. However, this has been offset by the Federal Reserve moving towards normalising interest rates, which the market worried about in the fourth quarter. This, as much as the tariff war, has spooked the markets. Of concern is that the UK has hardly started to normalise interest rates with the Bank of England fearful over slowing the economy around Brexit uncertainty. The housing market already recognises that easy money will not endure forever. However, the macroeconomic environment is less relevant to the technology sector than almost all others. We continue to be in an exciting phase where companies have to adapt or be disrupted. In addition, cybersecurity, data protection (GDPR) and regulation all require compulsory expenditure for Governments and businesses alike.

Technology disruption is also seeing winners and losers within the sector. The legacy companies are evident – IBM, HP, Oracle, Blackberry to name a few. In particular, processing power and storage is migrating to the big datacentre companies dominated by Amazon Web Services and Microsoft Azure, followed by Google and Alibaba. These companies are disintermediating the branded companies such as HP and IBM.

There was a twenty-year period when food retailers outperformed food manufacturers as powerful buying chains squeezed manufacturers margins compared to the weaker buying power of the corner shop. This is happening in computer infrastructure. For Waitrose see Microsoft, for Tesco see Amazon Web Services and for Aldi see Alibaba?

Interestingly IBM was the legacy mainframe computer company that survived the move to client server PC based computing, but is now floundering. Microsoft and Intel were the winners in the PC world. Microsoft has conspicuously succeeded in being the legacy PC company to survive the transition to the datacentre world. The jury is out on Intel, only because its near monopoly position in microprocessors for PCs and servers is now being challenged by AMD and GPUs, and it is being squeezed by the ‘supermarket’ buying power of the big four datacentre companies.

Furthermore, with the growth in server applications powerful computing can be accessed on battery powered phones and tablets, which do not use X86 architecture, but are ARM based. The companies mentioned here are all larger than this Company’s small capitalisation remit, but they are hugely relevant to the small company world. The ability to rent scalable processing power, storage and software is collapsing the cost, and more importantly the capital requirements for small companies. We see this as a driver to global economic growth akin to collapsing oil prices.

It is only in the last few years that the consumer, the enterprise and Government have all been networked, and soon vehicles will be too.  The network roll-out for higher speeds continues but is ex-growth. The applications used on the network are far from mature. Faster, cheaper processing power is enabling artificial intelligence to be used commercially, which will have further profound disruptive effects. 

UK

The UK portfolio declined 8.7% on a total return basis. The two worst performing stocks were IQE and Bango, which last year were the best. In 2017 IQE appreciated £29.8m and in 2018 it declined £11.5m. Fortunately, we had been aggressively taking profits on rising prices so that during 2017 we had realised cash of £19.2m and profits of £15.3m, and a further £5.1m of cash and £3.8m of profit in the first quarter of 2018 in 27 separate trades, albeit offset by an investment of £2.9m to support the fundraising to ensure they could invest in additional capital equipment for demand expected from Apple.

The level of expected demand from Apple has reduced, however, and so has IQE’s share price. The business remains the world leader in manufacturing compound semiconductor wafers, and now has a strong balance sheet. These wafers will be used in the forthcoming 5G phones and infrastructure, and we expect the demand for VCSELs, which are used in the iPhone’s facial recognition product, to grow albeit at a slower rate now that Apple has demonstrated that the market for £1,000 smartphones is more limited than hoped.

As a user I am a convert to the belief that facial recognition will be more widely adopted, but the overall phone price must lower, and it will do so as component prices such as DRAM fall. As an investor focussed on smaller companies in the supply chain of large companies such as Apple, it is evident that it is brutally tough in requiring the supply chain to build capacity in excess of any potential demand, and then subsequently has the whip hand on pricing.

Bango appreciated £15.4m in 2017, and fell £13.7m in 2018. Unfortunately, we were not as successful at taking profits realising only £0.5m. The shares were too high, but there were not willing buyers. It is a microcap company with only two customers of significance – Google and Amazon, but very valuable ones they are.

The potential scale of those players makes it difficult to value. We were surprised by how strong both shares were, but in IQE’s case there was massive private client buying. Not only did that enable us to sell shares too expensively, but it concerned us that a new phenomenon became more evident – that of private client buying influenced by internet chat boards. This buying was not across the board but very stock specific. But private investor demand of this nature, combined with the disappearance of the institutional investor, had made us cautious for the market overall.

There were also some positive returns. There were five stocks that appreciated in excess of 100% collectively returning £10m. Two of these were struggling companies where the return came from the takeover premium. In both cases, Lombard Risk and Earthport, we were losing faith in management’s ability to deliver, and were happy to see them go.

In addition, Elektron, Brave Bison and Versarien rose 145%, 144% and 121% respectively. In terms of materiality Versarien is the most relevant. It appreciated £4.5m during the year. We have significantly reduced the position having started to sell in 2017, and have now realised £9.5m in cash and £8.2m in gains. The company has a graphene product, and an energetic entrepreneurial management team, but again private clients have elevated the price to a level that we could not resist selling.

Craneware appreciated £6.4m with an encouraging rise in revenue and profit expectations. This has been a good long term performer but after upgrades at over £30 per share we were torn between wanting to own the shares long term, and worrying about the valuation being ahead of itself. We sold a little, but the market has resolved the issue with the share price markedly correcting in the fourth quarter.

ZOO was a star performer in 2017 and appreciated a further £6.8m in 2018. When the company was in financial difficulties, we increased Herald’s stake to 20% and provided funds through a convertible loan to provide survival funding. It is therefore rewarding to have been able to reduce our holding materially towards a more normal percentage ownership withdrawing £4.6m, and still having a material unrealised gain. BATM has been a sleeper for a while, but has an exciting ARM based networking solution so appreciated 80% and £4.9m.

There were several IPOs that we were prepared to participate in towards the end of the year, but there were insufficient co-investors. On the other hand, we did not participate in the Avast IPO because it exceeded our size threshold of $3bn market capitalisation, but it subsequently fell sufficiently, and we were pleased to take the opportunity to acquire a stake. 

We remain committed to AIM but have purposefully reduced the weighting in the portfolio from a high of 44% of the Company’s net assets at the end of 2017 to 35% at the end of 2018. The attraction is that there are some dynamic companies, and new ones continue to appear, but our caution emanates from the withdrawal of so many institutional investors. Index tracking funds are growing but do not invest in small companies and, in particular, they do not make the capital allocation decisions in order to provide primary funding of companies requiring capital, which is an important raison d’etre for public markets, and requires judgment and not machines.

We are proud of the fact that we have invested £417m since the Company’s inception in primary capital in the UK, and an additional sum of £52m overseas, to provide development capital which is about 5x the outside capital ever raised by the Company, so capital has been productively recycled. The market has become too dependent on marginal buying from private clients, some of which is speculative and some IHT exemption driven. Liquidity is an issue; fund managers of scale cannot get adequately sized positions, particularly when coping with cash inflows and outflows. This has led to takeovers exceeding new issues, and shrinking the addressable market.

The other cloud that has made us so cautious and led to us withdrawing money from the UK is the unknown effects of the numerous regulatory changes. In 2018 sales from the UK exceeded purchases by £60m. The exercise stimulated me to consider the long term cash flows, and overall sales in the UK portfolio exceed purchases by £167m from inception in 1994, with a market value of £468m at the year end.

North America

The North American total return in sterling terms was 11.7% versus the Russell 2000 (small cap) Technology Index (in sterling terms) return of 4.7%, and the NASDAQ return of 3.1% in sterling terms. At one point in the year the return exceeded 30%, so the fourth quarter correction was as vicious as any region but North America had performed better previously. The US is a particularly momentum driven market with gyrations more extreme than elsewhere. Nevertheless, the outcome is satisfactory.

We were net sellers in the UK, and we were also net sellers in North America by £13m in 2018 and by £44m over the last three years. This reflects in part takeovers of £27m in North America in 2018, £61m over the last three years and £131m over the last six years, which is material in relation to a portfolio valued at £218m at the year-end.

This year there have been six takeovers in the North American portfolio, of which the significant ones have been Barracuda, Callidus and Web.com. There have been a healthy number of IPOs in the US. We have tracked thirty one. We do not normally participate in NASDAQ IPOs led by the global players, because we are irrelevantly small clients, and get poor allocations in hot IPOs and filled in the difficult ones, and prefer to look in the aftermarket. We do however want a vibrant public market, and remain frustrated that institutional cash flows continue to move in the direction of private equity, and their valuations seem higher than public ones. We prefer to be in the cheaper market, but do not want the move to private equity and tracking funds to strangle markets to death.

The star performer of the year was Attunity, which appreciated 199% during the year, from a good-sized position, so the appreciation was £10.2m. We acquired a small position in 2014, and bought some more in 2015, but the shares languished although regular meetings with the company reassured that underlying progress was better than the share price. When they had a secondary offering in December 2017 we were the cornerstone of a $23m fund raising, investing $4.75m in a share issue that was a struggle.

Value is more evident in the smaller companies with offerings made by smaller brokers. We are better networked into these brokers following the opening of our New York office three years ago. Alteryx and ACM Research appreciated 149% and 120% respectively. Alteryx’s IPO was in 2017, but we invested six months after the IPO following a meeting with management at which we were impressed. We did participate in the IPO of ACM Research from a smaller broker. In both cases the position was small because we are always resistant to committing large amounts of capital until we have got to know the company and its management over a period of time.

By value Five9, Mellanox, Fabrinet and LivePerson were all strong contributors.

The smaller brokers in the US were hit by Sarbanes Oxley, which raised the cost for a small company to be public, and the fact that venture capital is providing follow on rounds to a much later stage.

The latest twist is MiFID, which has hit them hard. Although MiFID has not been implemented globally, some of the large multinational players are applying the same rules. It is evident that some of the technology boutiques important to us have been hit hard. As in the UK it is difficult to know quite how great the pain is, because nobody wants to say they are losing for obvious reasons, but the number of quality individuals choosing to leave the industry, and the continuing drift of lay-offs, tells its own story.

Tracker funds are even more significant in the US market but do not make the investment judgement required for investing in IPOs. It was interesting to see Spotify come to the market by way of an introduction without the expense of fund raising fees to investment bankers, because venture capital had provided sufficient capital, and index trackers can provide an exit. The price has subsequently performed poorly.

Asia

The Asian portfolio declined 11.2% (IRR, total return in sterling terms). In comparison, the Kosdaq IT Index in Korea declined 22.8% and the larger company TWSE Electronics Index in Taiwan declined 6.8%. Generally, the Asian indices across the region had a difficult year, with some of the smaller companies indices particularly impacted, for instance the Tokyo Stock Exchange Mothers Index being amongst the weakest falling 28%.

In the first half the momentum in Asian stock markets remained very strong, continuing the trend from the prior year. Globally, monetary policy remains loose with interest rates very low. In this environment any areas where there was good newsflow proved irresistible and there was a great deal of excitement amongst retail technology investors. This was most clearly illustrated by the euphoria (particularly widespread in Asia) that surrounded Bitcoin which peaked close to £18,000 in December 2017, but then collapsed to lows near to £3,000.

Asian technology companies in general were highly sought after with great excitement in the press regarding concepts such as cloud computing, artificial intelligence, machine learning, robotics, autonomous vehicles and 3D machine vision. We believe that the continuing advances in computing power, sensing and networking are increasing the opportunity for technology to become ubiquitous and alter the working and leisure environment for a growing proportion of the world’s population.

However, at the end of the first half the excitement had clearly run ahead of the reality and markets were vulnerable to bad news – this was duly delivered in the form of the accelerating US-China trade war, fears of monetary policy tightening, softer demand for smartphones, pc’s and servers and weakness in semiconductor prices – particularly memory.  Given the hardware skew and cyclical nature of the Asia technology sector, the business models of Asian technology companies were particularly vulnerable.

The worst performing stocks within the Asian portfolio were generally semiconductor companies or capital equipment suppliers to semiconductor companies, for example Wonik IPS, RichWave Technology, Eugene Technology, PSK and Innox saw declines of between 38-54%. The better performing names came from a broader range of business models including software, hosting, payment and internet platforms with four holdings rising over 50%, the best being Bravura – an Australian financial software company – up over 110%. There has been a deliberate effort to diversify the portfolio from an over reliance on the volatile hardware business models prevalent in Korea and Taiwan with an increased emphasis on unearthing new opportunities in other markets such as Australia and Japan. 

EMEA

The European element of the portfolio has always been small, but over the long term has performed well. Unfortunately, this year has been challenging. BE Semiconductor has provided a total return of £17.4m and remained the biggest holding in the portfolio at the start of 2018, but in 2018 the return was a £5.7m loss. However, the position had been significantly reduced with £17.4m cash and £7.8m profit already realised on share sales by the beginning of April 2018, which significantly reduced the damage. BE Semiconductor is an extremely well-managed company, but is a capital equipment supplier to a cyclical semiconductor industry. There was a major cancellation of an order believed to be in excess of $20m from Apple, but that is the nature of the sector. The stock accounted for a third of the European portfolio at the start of the year, and declined 42%.

The best performing stock in the year was Link Mobility, which benefited from a takeover by private equity. Management are staying with the business, but believe funding for acquisitions will be easier to find through private equity owners. The private equity power has even extended to this Norwegian company.

Outlook

Several references have been made to regulatory changes. Metaphorically this is what keeps me awake at night, not the quality of the portfolio, not the US/China trade war, not Brexit, not politics, but the trends in public markets.

If recent trends persist then quoted markets, for small companies anyway, will cease to exist. The private investor will be marginalised, and private equity will own everything. We discuss this challenge ad nauseum. Wise elder counsel tells me the darkest hour is always just before dawn.

“Asset allocators will realise that P-E valuations have become too high and their returns will deteriorate, and that there might be volatility in public markets but at least there is liquidity and regulated public scrutiny. They will become forced sellers, and public market investors will get bargains. Remember hedge funds were flavour of the month at one time. The market will adapt to regulatory changes and realise commissions or spreads have to be higher, so that the market can function again and provide liquidity and provide capital for companies. The regulator will realise that it has heaped too much cost throughout the chain of financial advisors, fund managers and brokers at the expense of the poor old private investor that they are trying to protect and become more practical.”

We can but hope.

Nevertheless, we are considering allocating a small portion of the portfolio to private companies because we are aware the market is changing and want to ensure access to the best opportunities.

The good news is that you can make money out of shrinking markets, as has been demonstrated in this fund over the last decade if not the last year. Most importantly of all, the sector continues to offer exciting emerging companies. It is evident to all how pervasive technology change is for the consumer, corporates and Governments alike.”

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