Some thoughts on Herald Investment Trust (HRI). The write-up is my contribution to an investment group in which I am a member. We meet every month or two (currently virtually, but previously face to face) to discuss shares. Each meeting sees everyone chip in with their research.
The write-up was prompted by a group member saying this trust had performed very well and yet owned 300-plus shares. Contrary to Buffett’s advice, diversification seems to have worked out well for Herald’s portfolio. Mind you, the trust does seem dependent on multi-baggers to succeed! What do you think? I would welcome any feedback or extra info on Herald.
Offers exposure to unusual/higher-risk strategy: focused on TMT smallcap companies, often with funding requirements.
Genuine long-term investor: buys and holds, with exits often through takeovers.
Many multi-bagger holdings: ‘investor of last resort’ can lead to bargain buys.
Fund size leading to extra diversification: vast majority of holdings are sub-1%. Can HRI operate at scale?
Performance very acceptable: but gains driven in part by re-ratings while the Nasdaq has offered similar sector returns with no active-manager risk.
I like HRI’s long-term mindset:
“The Company has consistently invested in early stage companies, often providing primary development capital, then holding investments for long periods , regularly providing further capital when needed.” (AR 2020)
Of the 20 largest holdings as at December 2020:
- 9 have been portfolio members since 2010 or before;
- 4 since 2011;
- 2 since 2012;
- 1 since 2014;
- 2 since 2015;
- 1 since 2016, and;
- 1 since 2018.
What happened to the ‘class of 2010’ is impressive. Of the 20 largest holdings as at December 2010:
- 10 were acquired;
- 9 remained portfolio holdings at December 2020, and;
- 1 was sold.
The 19 positions that were held or acquired could of course have been trimmed during the intervening 10 years.
But the impression given is a genuine long-term buy and hold approach.
Turnover within the portfolio seems much more likely to be forced by acquisitions rather than by conventional ‘sell’ decisions.
Hunting for multi-baggers
Performance is supported/driven by multi-bagger stocks:
"The evolving nature of technology means there is a wide divergence of performance between winners and losers, but the winners can be spectacular. " (AR 2020)
The earlier table showed the 20 largest holdings had a book cost of £68m and a December 2020 valuation of £422m – i.e. the initial investment was multiplied 6.2x.
Examples of recent multi-baggers:
a) "I do gulp at the valuation of ITM with a market capitalisation of £2.8bn, and minimal revenues, we have realised gains of £11m during the year. We did participate in funding rounds in 2012, 2014, 2016, 2017 and 2019 as well as one in 2020. In the 5 rounds prior to this year I invested in aggregate £4.0m at an average price of 30.1p, and a further £1.5m at 235p in September. The funding rounds in 2016 and 2017 were at 15p and 17p *respectively when the company was friendless, and which were at a lower price than the 50p level in 2012." (*AR 2020)
Buying as low as 15p – share price now 386p having seen 700p earlier this year.
b) "Ilika develops solid state batteries. We invested in three funding rounds in 2014, 2015 and 2018 an aggregate sum of £2.1m, at prices of 60p, 73p and 20p in that order, and a further £1.1m at 40p in March 2020. I am astonished it has closed the year at 200p." (AR 2020)
Buying at 40p, now at 200p.
c) "We were fortunate to acquire most of the Avesco holding at distressed levels in June 2009 at the height of the financial crisis at 22p . The take out value of 650p was most welcome, and the premium on the price the day before the takeover was 125%" (AR 2016)
Buying at 22p and selling at 650p.
Sometimes the only investor – contrarian opportunities?
HRI seems happy to invest where others are hesitant. The fund may therefore be able to invest at bargain prices in companies keen to raise cash. The 2017 report states:
"There is a surprising level of entrepreneurialism in the UK relative to other countries, as well as skills. In a world awash with cash the area of conspicuous value is small companies that need cash***, because debt funding is not available*** . That is part of the reason why the UK continues to be a surprisingly large element of this global fund."
a) "In percentage terms, Zoo Digital appreciated the most (by 550%). The patient support that we gave to the company during a technical transition has been rewarded. In the darkest period, only Zoo’s chief executive and Herald supported the company with cash to enable the company to survive . Although still a small company, based in Sheffield, it has an impressive customer list with Netflix adding to long standing customers such as Disney and Warner." (AR 2017)
b) "This is the nature of long-term early stage investing, but had we not invested the company [ITM Power] would not have existed for the more recent gains . This provides an emphatic example of the long-term support and funding that we provide for early-stage companies."(AR 2020)
c) "The most significant takeover was Statpro , in which the Company had an 11% stake. We went above our customary 10% threshold when they could not draw on their overdraft facility when Kaupthing went bankrupt. We, along with Statpro’s Directors, provided emergency funding … the company would not have floated and survived if we had not provided it with necessary capital." (AR 2019)
Plenty of companies have been asking for money:
"We have been made insiders for secondary fund raisings over 100 times in 2019 and we have participated in 62 placings with an aggregate value of £40m. There were other occasions when we would have participated or invested more had there been more co-investors as we are disciplined in ensuring that we generally do not exceed 10% ownership of the outstanding share capital." (AR 2019)
A strategy involving frequent placing participation does allow HRI to obtain meaningful stakes in microcaps.
17.5% of the portfolio is normally in companies yet to become profitable (Youtube interview)
Sometimes the only investor – not enough support?
HRI added to that Statpro takeover that "Unfortunately, there are not enough other long-term investors around." (AR 2019)
Which can mean some of HRI’s investments are ‘abandoned’ by the market and succumb to low-ball offers:
"We had confidence in the company [ Servicepower Technologies ] 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. To our 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. This colourfully illustrates the state of UK capital markets. Cash everywhere except where it is needed. UK investors are particularly poor at investing in break-even or loss making businesses. The take out valuation was little more than one times revenue. Such a low valuation is very unusual in US markets, so we were reluctant sellers on this occasion. We wish there were more like minded long term co-investors ." (AR 2016)
HRI’s portfolio is becoming more diversified. Perhaps future returns will not be as great as past returns as extra holdings are added.
Portfolio holdings have risen from 252 for 2016 to 271, 285, 288 and 324 for 2020 – i.e. up 28%
HRI focuses on sub $3bn companies, and in practice invests in much smaller firms:
“We do not make investments when the market capitalisation exceeds $3bn…we wish to retain our focus on earlier stage investments for new positions.” (AR 2020)
“We have always focused on providing development capital to emerging companies but 25% of the Company’s net assets now exceed $3bn market capitalisation through so much capital appreciation. In addition, the scale of the Company makes it more challenging for new investments to make a meaningful impact on performance.”
HRI’s largest portfolio position during the last 10 years was Imagination Technologies at 5.3% for 2011. The largest position thereafter has ranged from 2.6% to 3.9% (3.2% for 2020).
The chart below shows the top 20 holdings representing a steadily smaller proportion of the portfolio as total assets increase:
For 2020, the 20th holding represented 1% of the portfolio. The average weighting for a holding outside the top 20 was 0.2%.
Can HRI operate the present strategy with, say, assets of £3b versus £1.5b today? Not sure. "What is HRI’s asset ‘capacity’? " would be my first question to management.
Lots of companies means lots of research
Management company HIML employs 20 people, so presumably each employee monitors 15-20+ companies. Research process involves lots of meetings with managements:
"Analysis entails a prolific number of meetings with companies, either at Herald’s offices, site visits or at conferences globally, as well as broker-hosted meetings. In addition, Herald relies on independent industry research and published company filings, statements, presentations, websites and broker research. " (AR 2020)
I liked this:
"This [MIFID] exercise has focused our minds on how few investors attempt to invest globally in small companies as we do. In overseas markets, we are often the only foreign investor to visit individual companies ." (AR 2017)
Lead investor Katie Potts is 62, so retirement/succession planning could be a medium-term issue.
The reports are peppered with some welcome forthright views.
On the environment:
“I recognise the aims of the Extinction Rebellion demonstrators sleeping in the street in which I live but I arrogantly believe that we at Herald have done and will do far more to help alleviate global warming through appropriate investment of primary capital in emerging technologies .” (AR 2020)
On board diversity:
“There is one issue where I am firmly at odds with the regulatory pressures and that is the requirements for board diversity. In short there are simply not enough experienced women in the sector and of suitable calibre to fill a third of board posts in the TMT smaller companies space in which we invest and we have seen instances of unsuitable candidates being appointed and doing real damage.” (AR 2020)
On share options:
"When I hear companies justifying 5% dilution each year to keep good staff I shiver, and think of adverts in 2007 for 125% mortgages. It is a bubble and many valuations do not reflect the viciousness of this dilution ." (AR 2016)
Performance and rerating
A useful table from the 2020 report:
HRI’s portfolio P/E has risen from c17x to c31x during the last 7 years – an 82% re-rating.
Share price was 2,245p on 31 Dec 2020 and 685p on 31 Dec 2013 – a 228% gain.
Portfolio earnings are therefore up 146% in 7 years, which helped trigger the 82% re-rating.
With the portfolio P/E at c31x, HRI may not benefit from a further 82% re-rating during the next 7 years.
Note the small-print that the portfolio P/Es exclude loss-making companies.
The 2010 report showed P/Es at much more modest levels:
Had you wanted to back ‘tech’ 10 years ago, a Nasdaq 100 ETF could have been a plausible alternative and would have outperformed HRI:
The relative performances over 5 years or less are much closer, although the Nasdaq ETF has no active-manager risk.
The Nasdaq is essentially a 50:50 split between 8 big names (Apple, Microsoft, Amazon, etc) and a 92 long-tail positions of 2% or less. So an equal mix of ‘proven quality’ and ‘potential future multi-baggers’.
Both HRI and the Nasdaq ETF have trounced the FTSE 100.