Herald Investment Trust Plc – Half-year Report

HERALD INVESTMENT TRUST PLC

(the “Company”)

HALF-YEARLY FINANCIAL REPORT

For the six months ended 30 June 2020

SUMMARY OF PERFORMANCE

^A   Alternative Performance Measure (APM). See Glossary of Terms and Alternative Performance Measures on pages 78-79 of the annual report and financial statements for the year ended 31 December 2019. 

*  At 9 April 1996 being the date funds were first available for international investment.

⁺   The Russell 2000 (small cap) Technology Index was rebased during 2009 following some minor adjustments to its constituents. The rebased index is used from 31 December 2008 onwards.

Past performance is not a guide to future performance.

CHAIRMAN'S STATEMENT

In this challenging environment it is gratifying to be able to report an appreciation of 7.6% in the net asset value per share during the first half of 2020. The Company's overseas investment portfolios contributed positively while the UK portfolio experienced a small negative return. This was nevertheless substantially better than various UK indices. It is evident to us all how much the development of the internet has enabled the economy to function as well as it has in lockdown. Working from home has assisted the majority of the Company's investments to continue trading profitably through the period. The outcome for the full year remains uncertain, but on average the profits of companies owned by the Company will be lower than we expected at the start of the year. A few holdings have been materially damaged, whilst others have actually benefited.

The Company's UK portfolio, which accounts for 47.8% of the Company's net assets, has returned -2.0% versus a total return of -19.8% for the Numis Smaller Companies Index plus AIM (excluding investment companies). Within the UK portfolio, on average the return of technology stocks was mildly positive with BATM Advanced Communications the star performer returning £14.9m. However, the media sector, which accounted for 24% of the UK portfolio, delivered a return of -19.9% (-£27.8m). This loss was nearly offset by an exceptional return of £18.5m in ITM Power, where investors have become increasingly convinced by hydrogen as a source of clean energy.

The Manager participated in twenty-three placings for UK companies during the period of which five were related to a cash shortfall caused by COVID-19, and fifteen overseas. We are aware that a further three companies need to raise money which may prove challenging, and there may well be a couple more. In aggregate these holdings are not material. Fortunately, by value the majority of holdings seem to be trading satisfactorily in spite of the adverse economy.

The North American portfolio represents 25.8% of net assets and its performance has been a sparkling 25.4%, which compares very favourably with the total return of the Russell 2000 (small cap) Technology Index of 6.3% in sterling. In contrast, the large capitalisation index has returned 24.2% reflecting the defensive nature of the scalable large companies, which have attracted investors. The takeovers of Mellanox and Adesto completed at the end of June, realising £22.3m in cash, but there have been no new takeover bids made since COVID-19 emerged. Five9 was the best contributor to performance, appreciating by £9.3m. VOIP (voice over internet) call centres are in demand in a lockdown world. Elsewhere, the performance was broadly based with another seventeen holdings appreciating by more than £1m. In percentage terms Veritone led the field, appreciating by 538%, albeit from depressed levels. Ballard Power appreciated by 130%, reflecting the enthusiasm for hydrogen power, and Bandwidth appreciated by 112%. Fifteen of the North American holdings now have a market capitalisation in excess of $3bn. We do not make new investments in companies above this size, but we retain the holdings if future prospects justify it. These fifteen stocks had an aggregate value of £122m, which is 40% of the total North American portfolio. The aggregate book cost of these holdings is £26m so the average growth multiple has been 4.7x. These stocks delivered a total return of 50.1% in the first half. In part this reflects a success bias, but also demonstrates a material upward rerating of the larger small companies, which is a continuation of the trend seen last year. Valuations are becoming uncomfortably high in this size range

The continental European portfolio (EMEA) returned 11.6% in sterling. The top performers by value, Esker, BE Semiconductor Industries, Nordic Semiconductor and Isra Vision, have collectively returned £7.9m. However, in percentage terms more recent purchases Raysearch Laboratories (+54%) and Nfon (+46%) have delivered better returns.

The Asian portfolio return of 26.2% in sterling was pleasingly strong. As in North America, the performance was driven by the holdings which now have a market capitalisation in excess of $3bn. Combined they account for 35% of the Asian portfolio by market value at the period end and three quarters of the return in the period. The return was particularly driven by the performance of Kingdee International Software, a Hong Kong listed competitor to SAP, which returned 149% (£9.4m). In percentage terms, BASE in Japan appreciated more (218%), and so did Momo in Taiwan (172%). In contrast the Australian segment of the portfolio was flat.

Cash balances are high at the period-end and stand at £134m (11.2%) including short-dated Government bonds which are held as a proxy for cash. This level includes cash received from takeovers at the period end, and the amount due in settlement of other takeovers is now minimal. However, much of the cash has been held in overseas currencies, and sterling weakness has meant that overall the drag from cash relative to the equity returns has been minimal. The Manager prefers to retain a cash buffer to ensure that existing investments can be further funded, to take advantage of opportunities, and to stand ready to exploit any market weakness. Liquidity is still patchy, so a war chest seems appropriate. During the period, 545,000 shares have been repurchased at a cost of £7.6m.

The dividend income has fallen sharply by 48%. It would be wise not to read too much into this figure in the short-term because many companies had to make a decision at the peak of uncertainty and thought it prudent to cancel. Some are likely to consider reinstating dividends later in the year. The figures are small in relation to the capital return and, as an investment trust focused on capital growth, the Company does not typically pay a dividend in any case.

The poorer performance in the UK compared to overseas holdings is disappointing, but there is sensible value even in the media sector, and companies with an overseas exposure will benefit from sterling weakness on a delayed basis, whereas overseas holdings have benefited instantly.

The technology sector is diverse but working from home has accelerated the disruption that the internet is causing. For example, there is an evident upturn in demand for internet shopping, internet bandwidth, internet communications including video conferencing, cloud-based applications and so on. Meanwhile, working from home will further drive the requirement for computer security.

The Manager has always made meetings with companies central to its investment process. Clearly this has not been possible in recent months. The team has undertaken over 500 telephone or video calls with investee and potential investee companies, which is a similar rate to the number of meetings it would have had in previous years, but unfortunately provides an inferior experience for gathering information as compared to physical meetings. It is manageable for a sustained period but is not the team's preferred way of working on a permanent basis.

OUTLOOK

It is perhaps surprising that the overall returns have been positive when COVID-19 has led to economic havoc, and technology is at the eye of the storm in trade tensions between China and the United States. Share price increases have led to the valuation rating of the portfolio rising from a p/e ratio of 21.4x at the start of the year to one of 25.3x Bloomberg estimates. Furthermore, analysts' forecasts rarely reflect share-based compensation so valuations are really higher than they have been at any time other than the internet bubble of 2000. However, there is no comparison with that period as most investee companies are solidly generating cash. In addition, the challenge for investors in finding value anywhere makes these valuations less unattractive, and it is evident that there is more interest in the TMT sector. The caveat is that the economic outlook remains precarious, and forecasts are more uncertain than usual.