Polar Capital Technology (PCT) has released its half year results for the six months ending 31 October 2022 and, over this period it has reported a NAV return of -9.1% and share price return of -7.2%, compared to the -8.9% of its benchmark, the Dow Joes World Technology Index.
PCT’s discount was 9.6% as of its half-year end, narrowing from the 11.5% discount it reported at its previous financial year end (30 April 2022). This was in part the result of 2.9m shares the board repurchased over the six-month period, representing 2.3% of the total issued capital. PCT traded on a 9.7% discount as of 09 December 2022.
The largest individual detractor to PCT’s performance relative to its benchmark was its underweight position in Apple, although the market rotation away from growth towards value stocks during the period proved more costly in aggregate. Fortunately, the impact of this ameliorated PCT’s underweight allocation to Asia, while its average cash position of 4.7% and NDX put options were positive contributors.
PCT also benefited from select stock level outperformance. Robust data centre spending growth benefited its holdings of both Arista Networks and Pure Storage. While strong earnings progress helped chipmakers Lattice Semiconductor and ON Semiconductor. Other examples include Enphase energy, which benefited from higher energy prices; as well as Axon Enterpise an E lnk, which benefited from the demand for public security software.
The six-month period was another active one for PCT. The management team, led by Ben Rogoff, raised cash by c.3%, while also increasing PCT’s underweight to mega-cap technology stocks (>$100bn market cap) from -14.8% to -24.1%, in favour of large caps ($50-$100bn market cap). This partially reflected the team’s decision to modestly reduce their US exposure in favour of Japanese, European and Latin American stocks that had previously underperformed.
At a sector level, the team reduced their exposure to e-commerce, advertising and social media companies, citing the impact of higher interest rates. Specific companies included DoorDash, Etsy, and Snap. They also further reduced their remaining exposure to work from home beneficiaries, selling both Twilio and Zoom. Higher risk-free rates and wider high-yield spreads saw the team reduce exposure to longer-duration companies and/or those with weaker balance sheets, including Coupa Software, Ocado and Seagate Technology.
The proceeds were invested into the next-generation of infrastructure software companies, such as Confluent and Gitlab, and payment-related assets, including Adyen, Bill.com, Flywire and GMO Payment Gateway, following significant valuation compression. They also took advantage of lower growth stock valuations within medical technology, buying DexCom and Intuitive Surgical.
Much of the team’s concerns about the near-to-medium term outlook are macro-economic in nature, the most prominent downside risk for the market being uncontrolled inflation. In addition to the other prevailing risks like a tighter labour market. The team comment that monetary policy may still surprise to the upside or remain restrictive for longer than markets are currently anticipating. They do offer some upside risks which can offset the pessimism, such as the fact that we may already be at peak inflation. They also believe that strong household and consumer finances could limit a potential downturn.
At a sector level, the team highlight that the technology sector will have to contend with the combination of higher risk-free rates, slowing growth and some margin degradation which makes for a more challenging immediate outlook for the technology sector. The magnitude of the multiple compression also reflects a sharp reversal in sentiment around the ‘inevitability’ of technology disruption which reached a zenith during the pandemic. The stronger US dollar has also weighed on the sector, as worldwide IT spending this year is now expected to grow by only 0.8% year on year in 2022, compared to 4% anticipated in April. However, the team no longer have the same concern about next-generation valuations that they did a year ago prior to the Fed pivot, with the valuation compression seeing next-generation stocks give up all and more of their pandemic rerating. As such the team see much improved risk/reward in this group of stocks and have been moving the portfolio in this direction, companies such as infrastructure software firms Confluent and Gitlab.
Ben comments that: “Even if technology stocks have struggled to live up to their pandemic billing, we remain believers in the primacy of technology and excited about humankind’s ability to innovate and reimagine industries. This – above all else – should provide a fertile backdrop against which to invest.”
[QD comment: “The relative concentration of the technology sector is an issue for tech investing, as is reflected in PCT’s half year results, given the impact its underweight to Apple had on PCT’s relative performance. In practice, it is effectively impossible for active technology managers to have the same mega-cap weightings as their benchmarks while maintaining an appropriate level of diversification. The question we believe investors need to ask themselves is whether we are now past peak inflation (the primary factor behind the selloff) and market valuations are already accounting for higher discount rates, in which case PCT’s discount offers an attractive entry point into a market which may become more bullish towards technology stocks. Or, is there more downside to come given the wide array of prevailing risk factors (economic recessions, geopolitical risks, China’s COVID-19 responses to name a few). If one is of the same mindset of PCT, it may thankfully be the former.”]