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Polar Capital Technology held back by widening discount

Polar Capital Technology held back by widening discount – Polar Capital Technology Trust has published results for the year ended 30 April 2021. The 12-month period was one where the sector performed extremely well but gave back some of its returns in the final couple of months. The trust just failed to match its benchmark, returning 45.5% against a 46.4% return for the Dow Jones World Technology Index (in sterling). The shares moved from trading at a premium to trading at a small discount, leaving investors with a return of 33.3%. The trust both issued and bought back shares in the period.

[Shareholders may be disappointed that the trust’s shares did not keep pace with the benchmark. However, the sector rebounded in June and the trust’s NAV is up by about 3.8% since the end of April. The discount is still peculiarly wide, however, at almost 10% last night, which seems a bargain for a trust that is performing so well and has a good track record of share buybacks. We suspect that this might be a short-term phenomenon.]

Ben Rogoff’s manager’s report sets the scene

The technology sector once again outperformed broader market indices as the Dow Jones World Technology Index returned 46.4% during the fiscal year against the MSCI All Country World Index’s +32.6% and the S&P 500’s +32.8%. The sector’s strong returns are testament to the crucial role it played in allowing the world to operate effectively during the covid crisis.

The fiscal year also saw the NASDAQ 100 index finally recover the entirety of its relative underperformance associated with the dotcom peak and in June – after 20 years, 3 months and 3 weeks – was back level with the performance of the S&P 500. However, the technology sector’s outperformance came entirely during 2020, with 2021 proving a more challenging year thus far for the sector as a very different macroeconomic backdrop has put upward pressure on interest rates and downward pressure on growth company valuations. Despite these challenges, the absolute and relative returns delivered by technology subsectors remained impressive and the breadth of the strength was striking. Larger technology companies recovered more quickly coming out of the crisis and the sector’s five largest companies reached a new high as a percentage of the S&P 500’s market cap by late summer (25%). As market breadth improved into the second half of the year and smaller, more cyclically sensitive companies benefitted from a style rotation in 2021, the large cap index (the Russell 1000 Tech) was surpassed by the smaller cap index (Russell 2000 Tech) during the second half of the fiscal year, finishing up +52.7% for the fiscal year against the Russell 1000’s +45.2%.

The software sector continued to ride a wave of digital transformation and further demonstrated its criticality during the covid crisis as companies and consumers made more intensive use of cloud software services to keep their businesses (and lives) going. Long-held ‘digital transformation strategies’ became operational and tactical emergencies. Businesses accelerated their technology initiatives and rapidly adopted collaboration and communication tools including Zoom (FY return: +115%), Microsoft’s Teams (+28%) and Atlassian (+39%). They used software platforms such as Twilio (+198%), HubSpot (+184%) and ServiceNow (+31%) to drive automation. The cloud (flexible, scalable, reliable) sat as the critical infrastructure beneath this acceleration in adoption and innovation, and the major platforms (Amazon Web Services, Microsoft Azure and Google Cloud) saw strong growth in their cloud businesses of +30%, +50% and +55%, respectively. These three cloud titans delivered ~$77bn of 2020 cloud revenue, up +38% from 2019, and should pass through the $100bn mark this year. Security remained an important priority during the period and both Crowdstrike’s (+181%) next-generation endpoint product and Cloudflare’s (+227%) network security offering recorded explosive growth.

Given such strong secular drivers it was perhaps somewhat disappointing that the software sector delivered returns modestly below other major technology subsectors and the broader technology index during the fiscal year, the Bloomberg Americas Software Index, returning +29.5%. This largely reflects the multiple compression that many of the highest growth software names suffered during the growth to value rotation following the February 2021 peak, and the impact of rising rates on long-duration asset valuations. Companies with higher growth rates and multiples generally saw a sharper sell off than those with more modest attributes, with companies showing >40% revenue growth de-rating from February highs of 34x EV/forward sales to ~23x at the end of March. M&A activity returned to the sector headlined by the announcement of Salesforce’s $25.8bn acquisition of Slack and Microsoft’s acquisition of Nuance Communications for $19.7bn. The backdrop for software remains supportive given a McKinsey survey of 800 executives that saw 85% of respondents indicate covid has somewhat or greatly accelerated their implementation of technologies that enable employee interaction and collaboration, and two-thirds have accelerated automation and artificial intelligence initiatives.

The internet sector was well-positioned for the covid crisis and the NASDAQ Internet Index returned 52.2%. The ecommerce sector was an early beneficiary of government stay-at-home orders as many consumers were forced to move a huge portion of their spending online. According to Mastercard $1 in $7 of global retail spending occurred online in 2019, which moved to $1 in $5 in 2020. The Adobe Digital Index predicts that the pandemic has “permanently boosted online spend by 20%” and 2022 will be the first trillion-dollar year in e-commerce. The US Census Bureau reported that US retail ecommerce sales grew 32% y/y through the third and fourth quarters of 2020, a striking acceleration from the 13-15% consistent y/y growth since 2013, reaching 14% of total retail sales (double 2015’s penetration rate of 7%). Much of this growth represented a genuine expansion of the ecommerce TAM, as 21% of UK shoppers shopped online for the first time, and PayPal (+94%) added more users in the second quarter of 2020 than they had in the entirety of 2016.

Online advertising saw a similar dynamic as companies still needed to find customers in an online-dominated world. This strength persisted through the year and December 2020 quarter growth rates were higher than 2019 levels for all major online advertising platforms. Facebook’s (+45%) advertising revenues held up well throughout, growing +10% y/y in Q2 and +20% y/y in Q3, as a pause in some macro-sensitive advertising was offset by strong direct response spending among Facebook’s 10m (mainly) small business advertisers. Alphabet (+59%) initially held up less well given higher (10-15%) exposure to the travel vertical and saw revenue growth turn negative in Q2, but then rebounded strongly in 2021 as broader ad spending recovered. The most significant dynamic in the internet advertising space during the year was the rise of the historically ‘second tier’ social platforms such as Snap (+220%) and Pinterest (+192%), which saw material acceleration in both user growth and monetization, only to get caught in the high-growth/high-multiple selloff this year.

Digital entertainment also saw a material increase in both penetration and usage during the covid crisis as the digital transformation of leisure accelerated with similar intensity to the digital transformation of work. Netflix (+11%) added 26m net new subscribers in the first half of 2020, more than double the 12m added over the same period the year before and reached 200m subscribers exiting the year. This did, however, represent some degree of ‘pull forward’, and Netflix sold off on the back of a disappointing subscriber guide for 2021. New categories of entertainment emerged and rapidly scaled during 2020, such as Peloton’s (+184%) home connected fitness products, which delivered +232% revenue growth in the September quarter and guided to 2.275m subscribers by June 2021, from just 0.25m in June 2018. Match Group (+82%) saw usage hold up well during lockdowns and video dating become a routine activity as around half of Hinge users have now been on a video date. Food delivery platforms initially delivered strong returns as they responded to high consumer demand at the same time as much-needed market consolidation took place, but then struggled in the expectation of challenging year-on-year comparators and stiffer offline competition as restaurants reopened.

Regulatory scrutiny of the major platforms intensified over the year and culminated in Federal Trade Commission (FTC) vs Facebook vs and Department of Justice (DOJ) vs Alphabet lawsuits, which represent the most significant regulatory actions against Big Tech since DOJ vs Microsoft in the 1990s. The heightened scrutiny was not limited to the US, however, as Ant Financial was forced to suspend its November IPO following a last-minute regulatory change which indicated that Ant would need to bring its credit tech business into the financial regulatory framework and set up a financial holding company (which would significantly increase the capital requirement and reduce both the growth and return of the business). Regulatory pressure has continued to intensify in China during 2021.

Despite the weaker macroeconomic backdrop for much of the fiscal year, semiconductor companies also delivered strong returns as the Philadelphia Semiconductor Index (SOX) rose +53.7%. The first half of 2020 (SOX: +17%) as challenging as supply chains were disrupted and US/ China trade tensions provided a meaningful overhang for the sector. The semiconductor space was, however, the best-performing technology subsector in the second half of the calendar year (SOX: +28%) as tight supply (and associated price increases), improving demand in automotive, smartphone and personal electronics (driven by work from home) and macroeconomic optimism combined to push both estimates and multiples higher. Advanced Micro Devices (AMD) (+42%) had another standout year as it cemented its technological lead over Intel at 7nm. TSMC (+93%), which has been integral to AMD’s technological advancement and has extended its position as the world’s leading foundry, also delivered strong results. Intel (-13%) had an annus horribilis despite strong PC and datacentre demand driven by the shift to remote working and cloud computing, as their 10nm manufacturing process was pushed out yet again. Nvidia (+87%) benefitted to a far greater degree on the back of strong cloud, gaming and AI-related demand. 2021 proved more challenging as the sector’s cyclical exposure to an improving economy was tempered by concerns around component shortages and peak demand. A succession of large M&A deals arrived as NVIDIA bid $40bn for ARM (private), AMD announced the acquisition of Xilinx in a $35bn all-stock deal and Marvell snapped up InPhi for $9bn. This consolidation reflects the enormous scale and resources required to compete at the leading edge of the semiconductor market.

Apple (+63.7%) enjoyed another strong year of performance as the iPhone segment unexpectedly returned to strong growth (+11%) in Apple’s June quarter as demand for iPhone 11 held firm and the new mid-range iPhone SE proved popular. The 5G iPhone 12 launch in October was successful and demand for the higher end devices surprised positively as consumers spent some of their covid savings on the best new phones. This culminated in strong results in the most recent quarter with revenue +54% y/y (on a $58bn base), driven by robust performance from iPhones, iPads, iMacs and Services. Apple continues to benefit from stay-at-home demand and demand from the strong 5G upgrade cycle, most notably in China, which grew +87% y/y.”

With regard to the trust’s performance

The Trust modestly underperformed its benchmark, with the net asset value per share rising 45.5% during the fiscal year versus 46.4% for the Dow Jones World Technology index. Stock performance was ahead of index in every region and market capitalisation tier. However, this was more than offset by our average cash position

of 4.6% which dragged on performance by c300bps on a relative basis. In addition, NASDAQ put options (which

served us well during the prior fiscal year) accounted for a 171bp drag as the market powered to new highs. We believe that the cash and put positions should not be viewed in isolation because by ameliorating downside risk during market setbacks (as per Q1’20), they positively influence stock selection and embolden overall portfolio construction.

At the stock level, strongest relative performance was delivered by covid beneficiaries although this was first half weighted. These included ecommerce companies such as Zalando (+97%) as well as digital payment platforms such as PayPal (+94%). Software companies able to support remote work also delivered outstanding returns including Zoom (+115%) and Twilio (+198%). A number of cloud software vendors also experienced sustained strength including next-generation security vendors Cloudflare (+227%) and CrowdStrike (+180%). Other outstanding performers included Peloton (+184%) due to surging sales of its connected home gym equipment, while Pinterest (+192%) and Snap (+219%) both benefited from increased users, engagement and advertising on their social media platforms. Alternative energy stocks also delivered incredible performance, benefiting from sharply lower riskfree rates during the first half of the year, accelerating EV adoption and a growing list of countries announcing their intention to achieve carbon neutrality. Earlier gains were sustained following President Biden’s victory in November and his subsequently announced Green New Deal. The portfolio benefited from some remarkable performance in a number of smaller positions with EV exposure including Tesla (+313%) and BYD (+198%), as well as renewable energy plays such as SolarEdge (+115%) and Ceres Power (+215%). The Trust also benefited from continued underperformance of incumbents such as Cisco, IBM and Oracle where we have zero exposure. Not only do we perceive them to be negatively impacted by technology change, but accelerated cloud adoption during the pandemic had a disproportionate impact on legacy vendors as IT budgets migrated away from on-premise solutions. In addition, the Trust benefited significantly from travails at both Intel (manufacturing issues / market share loss) and SAP (cloud transition) where we had limited exposure and which we exited early during the fiscal year.

As previously discussed, liquidity and our NASDAQ put options represented the most significant drag on performance during the period as markets moved sharply higher. At the stock level, Apple (+64%) proved the most significant detractor to relative performance as our largest underweight position cost c.120bps. However, our largecap Internet exposure proved more costly with overweight positions in Amazon (+27%) and Netflix (+11%) struggling on slowing growth concerns, while underweight positions in both Alphabet (+59%) and Facebook (+44%) were headwinds given the advertising recovery during the second half. In addition, the portfolio was negatively impacted by a number of travel-related stocks such as Visa and Mastercard (cross-border transactions) as well as Uber which were challenged by covid-related lockdowns. As ever, there were also a few genuine disappointments such as FLIR Systems, Ping Identity, LiveRamp and Ciena all falling short of expectations, but these were largely contained to the portfolio tail.

Having begun the year with a number of core themes mapping well to beneficiaries of the pandemic, we gradually moved the portfolio to better position it for a ‘new normal’ backdrop in which a staggered reopening of economic activity would take place. We reduced exposure to those companies likely to prove non-recurring beneficiaries of the move to WFH, such as PC-exposed stocks, and added to those we felt would benefit from more lasting changes, such as food delivery and exercise at home. We also took profits in a number of areas including software where multiple expansion left us uncomfortable. During the second half of the year, we began to selectively add to more cyclical names as our confidence in eventual vaccine deployment and subsequent economic recovery increased. This process continued following the encouraging vaccine phase 3 clinical trial results and we rotated further towards some of these more economically sensitive stocks. This was still focused on those exposed to our core investment themes, epitomised by our decision to add exposure to electric vehicle (EV) largely via semiconductor and component companies such as ST Micro, Infineon and Aptiv. The final third of the year saw us add selectively to growth stocks beyond software before retrenching as markets became more speculative in nature, evidenced by retail participation, SPAC issuance and the inexorable rise of Tesla (which we sold in February). Growth stocks came under sustained pressure into our year end as higher risk free rates weighted heavily on valuations; we reduced / exited a number of our lower conviction names (some with more difficult comparisons looming) in favour of more cyclical stocks including Applied Materials, Micron and Seagate.”

PCT : Polar Capital Technology held back by widening discount

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