Polar Capital Technology

Investing in global tech, PCT targets global leaders at favourable points in their development cycle…

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Polar Capital Technology

Summary

Polar Capital Technology (PCT) aims to maximise long-term capital growth through investment in a diversified portfolio of technology companies from across the globe. Led by Ben Rogoff, PCT enjoys a deep pool of fund managers and analysts specialising in technology companies, assessing companies from around the world.

Portfolio construction is benchmark aware, but willing to diverge to access what the team regard as the best growth opportunities. As we discuss under Portfolio, this includes an assessment of the ‘hype’ cycle surrounding the development and adoption of a technology and its integration into everyday life. Ben and the team look to invest in companies at the stage where they are reliably growing sales, and where operating margins are expanding, leading to potentially exponential earnings and free cash flow growth.

This tends to lead to a slightly larger-cap skew within PCT when compared to peers in the closed and open-ended universes. With the trust intended as a core technology equity holding, this is somewhat a consequence and an intention of the investment process and portfolio construction.

Returns, in line with the technology sector, have been strong, but PCT’s managers have been able to add value over a broader technology benchmark, as we highlight under Performance. Despite this, the trust has recently moved out to a Discount of over 5.6% (as at 30/09/2020). This is in contrast to the generally ebullient attitude to technology stocks in recent months, and the trust has frequently traded at a premium, allowing the board to grow the trust through issuance.

Kepler View

In our view the managers of PCT have demonstrated good portfolio and risk management. On a relative basis, PCT is perhaps best understood as a core proposition offering active but benchmark aware exposure to large-cap technology. It is also likely to be slightly less exposed to the US than most peers. We regard the managers’ recognition of the risks in Chinese companies, from both geopolitical and corporate governance perspectives, as a positive. PCT’s focus on presently profitable companies should potentially leave it relatively less vulnerable should valuations be challenged by rising discount rates.

Conversely, rumbling noises in the US Congress about potential antitrust actions against the tech giants could prove a headwind to relative returns compared to peers focussed on smaller companies. This latter point should be an important concern for all tech investors on an absolute level, as the presmued monolithic end-state of being for these companies would become imperilled. However, whilst there are noises surrounding this issue, the zeitgeist as yet seems to remain in favour of the technology goliaths, and the proposals mooted in Congress do not appear yet to carry majority support.

Bearing this in mind, with the biggest challenge to tech’s dominance seemingly likely to be regulatory, PCT’s discount of c. 5.6% looks attractive at this time for exposure to fairly tangible growth at a time when such a thing is in scarce supply globally. However, fees remain reasonably high given the scale of assets.

bull bear
Specialist access to profitable, rapidly growing companies Regulatory risks to the tech giants appear to be growing
Present discount looks attractive if bullish on the technology sector Charges are relatively high, especially considering scale of assets under management
Deep and experienced management team Slightly lower growth tilt than ATT, and could accordingly lag in a bull market

Portfolio

Polar Capital Technology (PCT) aims to maximise long-term capital growth through investment in a diversified portfolio of technology companies from across the globe. Lead manager Ben Rogoff is assisted by a deep analytical team of technology specialists focussed on specific areas, who each seek to identify strong growth opportunities through a mixture of bottom-up stock analysis and top-down cycle analysis. The resultant portfolio tends to skew more towards larger cap companies than many peers, most notably Allianz Technology Trust (ATT).

Ben and the team look to understand the ‘hype’ cycle of technology, aiming to position their portfolio amongst developing technologies which are positioned to undergo exponential growth. They believe that technology investments go through different stages of investor and consumer interest. Typically, the technological products held within PCT will typically have mass applications and have a tangible route to integration to everyday life amongst consumers. Essentially, the team are looking to identify ‘the next Google’, a product or service which can become so ubiquitous and essential that we scarcely even notice it.

It is with a process initiated with a thematic overview of the dynamic shifts in real world adoption of technologies that the team seeks to distil an investment universe of over 4,000 stocks into a focussed portfolio representing what they deem some of the strongest growth opportunities. The team are looking for secular growth themes, and to play these in as pure a manner as possible, and looking to access these as they start to move towards demonstrating growing profit margins and accelerating growth.

This includes eschewing venture-capital style holdings in very early stage investments, especially those which are unlisted or pre-revenue generation. Whilst the managers are avowedly growth-biased, they are looking for growth opportunities at the inflection point where cash flow generation starts to become exponentially greater. This tends to involve economies of scale, with operational costs that are relatively fixed after a certain scale is reached on products or services where revenue growth remains unimpeded.

As an output of this, PCT tends to be marginally more exposed to slightly more mature and larger companies than many peers. We can see the practical effect in the chart below, which shows the rolling R2 of PCT to large-cap US technology stocks, relative to the R2 of a selection of trusts who would often be considered peers in terms of stylistic and sector preferences, and in utilising a global investment mandate. We have also shown PCT’s R2 to large-cap US technology stocks relative to that of a global technology index to US large-cap tech. When the line is above 0, PCT has demonstrated closer performance alignment with US large-cap tech stocks than the comparative investment vehicle, and vice versa. As we can see, PCT has been consistently more aligned with larger companies than peers, but less so than a broad global technology allocation. As PCT is typically underweight the US market relative to ATT, we think this particularly demonstrates the larger cap bias of PCT.

rolling 12-month r2 to large cap tech Index relative to peers and index

Source: Morningstar

As well as being an output of the stock selection process and investment philosophy, this is also somewhat a desired outcome for the managers. Ben, Nick and the team aim to ordinarily have an active share to the benchmark of around 50%, noting that PCT is intended to be a core technology product (and, as such, at times complementary to some other similar investment vehicles). Although they allocate actively away from the benchmark, they are very much benchmark-aware and note that larger companies (and hence, larger constituents of the benchmark) often retain some of the best growth opportunities.

Indeed, Ben has highlighted that the favourable tailwinds seen for technology and growth investing in recent years somewhat suggests that any technology company which has not already attracted significant investor interest is unlikely to be an overlooked gem, but instead is more likely to be an unattractive technology and investment proposition. Accordingly, the top ten holdings are currently, and likely to remain, largely familiar names.

top ten holdings

Holding %
Apple 10.1
Microsoft 9.3
Alphabet 5.7
Facebook 5.2
Alibaba Group Holding 3.6
Tencent 3.4
Amazon 2.8
Advanced Micro Devices 2.5
Samsung Electronics 2.5
TOTAL 47.6

Source: Polar Capital, as at 28/08/2020

Although stock selection emphasises growth potential and awareness of the growth cycle, the team are cognisant of valuation considerations. Price targets are set for a range of assumptions, and position sizing will in part reflect their assessment of the relative probabilities of the gamut of assumptions input against the potential rewards. They note that presently sector level valuations seem relatively elevated compared to history, and that this is true at a look-through level to PCT’s portfolio and the relative valuation they are currently paying for their preferred companies compared to sector level valuations. However, they also note that the growth premium relative to the sector remains consistent with that typically seen historically.

Geographically PCT tends to be underweight the US market, both relative to the index and to most comparable peers. However, the US market remains the dominant market globally for technology companies and as such is likely to remain a majority of PCT’s portfolio; it is presently c. 71%, as at 28/08/2020.

More so than the geographic location of a listing, Ben and the team are interested in the business operations and quality of product a company holds. They are looking for companies that either are or can become global leaders, and prefer to avoid companies that they perceive to be regional attempts to replicate global winners (notably avoiding Wirecard, for example). Accordingly their exposure to a market such as Japan is likely to be primarily focussed on such areas like robotics, where Japanese companies are global leaders, through holdings such as Keyence, as opposed to attempts to play domestic themes.

Whilst the team believe that the US and China will remain the dominant players in global technology going forward, they are nonetheless aware of the current risks and opportunities that could arise from the deterioration of relations between the US and China. They have this year initiated a position in Ericsson in recognition of the increased opportunities likely to arise from the forced withdrawal of Huawei from many markets where Ericsson now holds a competitive advantage.

Aside from such growth opportunities, Ben also notes that there is an increasing divergence in the relative outlook for different subsectors within technology. Longer term thematic opportunities still remain strong in areas such as software, cloud computing and artificial intelligence, but areas such as hardware producers are experiencing notably slower (or negative) sales growth as global businesses scale back investment.

Although antitrust measures, potentially reducing the ability of some leading tech companies to operate at scale and raising the spectre of possible forcible break-ups, remain a potential risk, Ben notes that he does not anticipate a change in how competition authorities primarily assess whether companies are in breach of antitrust law. In the US in particular, the present position is largely that so long as the price is reduced to the end consumer, there is no abuse of market position taking place. Ben and the team maintain that this is the tangible result of the growing dominance of many of the tech giants.

At an absolute level, portfolio risk is somewhat managed through use of options. A limited amount of protection is on occasion used to ‘tail-hedge’ extreme negative market level outcomes, typically employed when option protection is relatively cheap to acquire. When we spoke with Ben, there was a very small amount of portfolio protection through deeply out-of-the-money put options on the NASDAQ Index. However, the team had held a greater number of put option contracts (which reward the holder in a period of market declines) in early 2020, having observed an unusually low volatility environment in the preceding months (thus making option protection cheaper to incorporate). Whilst this did not offset market level downside wholly, it positively benefitted returns on a relative basis during the period of market drawdown.

The team also use call options on certain major index constituents to manage risks on relative performance to the index. For example, when we spoke with Ben, PCT had call options on Intel. Ben and the team have a relatively cautious outlook on the growth prospects for Intel in the near future. However, they do believe there are management decisions which Intel could (but are unlikely to) make which would be likely to be rewarded with very significant share price upside. Rather than hold significant exposure to Intel shares which they deemed to be unlikely to prove rewarding, they held a very limited exposure through call options which, if the explosive upside scenario were to occur, would offer greater upside than a conventional long position in the shares. The team intend to limit the costs of using any such hedges to c. 100bps a year.

Gearing

PCT does not currently have any net gearing in place (as of 31/08/2020). The board has recently announced the renewal of two loan facilities, but the effect of cash also held within PCT is that the trust remains ungeared on a net basis.

The loan facilities currently drawn down include $36m at a fixed rate of c. 1.335% p.a., and a ¥3.8bn facility at a fixed rate of 0.9%. Using current exchange rates as at 02/10/2020, we estimate these equate to c. £55.3m of gross borrowing in total, representing around 1.78% of current assets.

We estimate that, based on the historic rates, the weighted average cost is approximately 1.1% p.a. The board appears to have negotiated a substantially cheaper loan rate on the USD loan facility from what was previously in place, though the rate has risen on the Yen loan facility. Still, the overall effect has been to reduce the cost of gearing notably.

PCT has fairly consistently operated at a net cash or ungeared level. There is some underlying gearing undertaken through the use of derivatives contracts, specifically calls, but these are more generally utilised for portfolio management as opposed to an attempt to generate additional upside through the use of leverage.

Returns

PCT has delivered NAV and share price returns of c. 580% and 556.8% respectively over the ten years to 30/09/2020. This equates to annualised NAV returns of c. 21.1% over this period, an exceptional return. In part this has been due to sector tailwinds, with the technology sector enjoying a very robust decade of performance. Nonetheless, PCT has still outperformed the iShares Global Technology ETF (a passive investment product tracking the global technology sector), which would have delivered returns of c. 542.1% over the same period (we further note that PCT’s benchmark - the Dow Jones Global Technology Index - would have delivered c. 508.7% over this period).

Similarly, this represents outperformance of the wider peer group (AIC Technology & Media). However, the AIC peer group is very thin, we would only consider Allianz Technology Trust (ATT) to be a like-for-like comparator amongst the peer group. PCT has strongly outperformed the open-ended IA Technology & Telecommunications sector, which has seen average returns of c. 380% over this same period. However, PCT has underperformed relative to ATT, which has seen NAV and share price returns of c. 681% and 735% respectively.

cumulative ten-year returns vs peers and index

Source: Morningstar

When we look at relative returns to a global technology ETF over this period, however, we see that much of the ten-year outperformance has been a phenomenon of roughly the past four and a half years or so.

relative returns to passive global technology exposure

Source: Morningstar

We think this can at least partially be attributed to a tendency on the managers’ part to underweight US technology companies. Whilst, as highlighted under Portfolio, PCT tends to tilt more towards larger cap technology stocks than many of its (closed and open-ended) peers, the managers have been fairly consistent in underweighting the US as a geographic region. The impact of this has been varyingly positive and negative, as can be seen in the graph below where we look at the rolling relative returns of PCT and of the iShares Global Technology ETF against the US large-cap Index. Periods where global technology outperforms US large cap has tended to coincide with outperformance by PCT, and vice versa.

pct nav and global tech index rolling 12-month returns relative to us large cap tech index

Source: Morningstar

Returns over the past 12 months to 30/09/2020 have remained very strong, with PCT delivering NAV and share price returns of c. 46.4% and 47.1% respectively. This represents outperformance again of the iShares Global Technology ETF, which would have produced returns of c. 37.2% over this same period. The open-ended IA Technology & Telecommunications sector saw average returns of c. 34.8% over this same period, whilst ATT generated NAV and share price returns of c. 59.9% and 58.1% respectively.

PCT’s recent returns have been boosted by increasing sector and stock dispersion, with areas perceived as ‘structural growth’ winners, notably technology, the main beneficiaries thus far. The managers of PCT have noted that these divergences also exist within the broader technology sector itself, with poor headline sales growth driven by the underperformance of subsectors such as networking and hardware, whilst areas such as software and semiconductors continued to grow strongly. Valuations have now reached elevated levels within the technology sector as a whole in the opinion of the managers, as we noted under Portfolio, but they note that the underlying growth in their preferred companies and subsectors remains supportive.

12-month returns vs peers and index

Source: Morningstar

Dividend

PCT is avowedly focussed on capital growth as a driver of total returns, and has historically not paid a dividend. This is partially a reflection of the management style, with the managers preferring to identify companies where free cash flow can be reinvested into the business to continue to drive growth, as opposed to companies where, in the absence of sufficient investment opportunities for their business, management prefers to return capital to shareholders.

Whilst the board has a regulatory obligation to pay out at least 85% of net investment income as a dividend in order to maintain investment trust status, charges are taken from the income account. The net effect is that investment income per share has tended to be slightly negative, and as such no dividend is required to be paid. This reduces the headwind of costs on reductions in capital gains generated.

Management

Ben Rogoff took over lead management of PCT in 2006, and was subsequently joined by Nick Evans as co-lead manager in 2008. They are further supported by Fatima Iu, Xuesong Zhao and Alastair Unwin as fund managers, with a further four specialist technology analysts. Team members are each focussed on specific areas and subsectors. This same team also runs the open-ended Polar Capital Global Technology and Automation & Artificial Intelligence funds.

The technology investment trust was managed by the company’s founders and was Polar Capital’s first portfolio. Polar Capital manages over c. £8.9bn in strategies focussed on technology, with over 149 years experience amongst the deep analytical team.

Discount

PCT currently trades on a discount of c. 5.6%, as of 30/09/2020. As can be seen in the graph below, this is an unusual but not anomalous level of discount on this product when we look at the previous ten years. PCT has traded at a wider discount on c. 14.8% of daily readings over this period. By contrast, it has traded at a premium to NAV on c. 20.9% of daily readings, and has displayed a median discount of c. 2.1%. The recent widening in the discount since both NAV and the share price peaked on 02/09/2020 has resulted from share price declines in excess of those experienced by NAV, and a lack of commensurate recovery in share price returns even as NAV has rallied somewhat.

With no notifiable shareholders disclosing sales or purchases in the period since 02/09/2020, we attribute the widening discount to a marginal tendency towards risk aversion from smaller investors in the subsequent period.

The board has been active in issuing shares when the trust trades at a premium, though have a policy of not issuing shares when PCT trades at a discount to NAV. In the current financial year, from 30/04/2020 to 30/09/2020, the board has issued a total of 2,749,000 shares at a weighted average premium of c. 2.1%. We estimate this raised c. £53.8m in total.

PCT’s board also has the authority to buyback shares if the trust is trading at a discount. However, they have acknowledged that a certain level of discount volatility is to be expected given fluctuations in market sentiment and the specialist nature of the trust. As such, we would posit that buybacks are only likely to materialise if the discount has stayed wide for a persistently long period against a positive backdrop for NAV.

As opposed to the general peer group, we think a more pertinent comparator on discounts is relative to ATT. As can be seen in the graph below, since 2017 PCT has consistently traded a discount relative to ATT, but this is quite wide at present (c. 5.6% wider discount in PCT than in ATT as of 30/09/2020) compared to what has historically been seen. Over the three years to 30/09/2020, PCT on average traded at a discount c. 2.5% wider than ATT. On occasions when the discount has been wider than this, PCT shares have on average outperformed ATT shares by c. 4.1% over the subsequent 12 months, though we note that there is a wide dispersion in these returns.

discount/premium

Source: Morningstar

Charges

PCT presently has ongoing charges of c. 0.93%, compared to a peer-group average of c. 0.96% (Source: JPMorgan Cazenove). The management fee is calculated on a tiered basis. The first £800m of assets are charged at 1% p.a., with assets between £800m-£1.6bn charged at 0.85% p.a. Assets between £1.6bn and £2bn are charged at 0.80% p.a., whilst all assets above this level are charged at 0.70% p.a.

On current net assets of c. £3.0bn (Source: The AIC), we estimate the weighted management fee to be c. 0.83% p.a. currently.

A performance fee may also be charged dependent on outperformance above the benchmark. This is dependent on performance at financial year end (30th April), and equates to 10% of any outperformance of the benchmark (subject to a cap of 1% of NAV in any one year). Underperformance must be made good before a fee is paid.

PCT has a KID RIY of c. 1.74%, compared to a peer group average of c. 1.75%, though we would caution that calculation methodologies can vary.

ESG

Polar Capital now incorporates an ESG scoring and analytical framework across the various funds and trusts they manage. This seeks to rank each holding on a variety of factors, and make an assessment of the relative to similar companies. The team will review the report on these factors on an ongoing basis, and any change in a company’s ESG rating will be subject to an investigation by the relevant analyst.

Although the process is not an explicitly ESG strategy, the team seek to use their analytical framework and output on ESG matters to engage with companies and their managements with a view to improving the behaviour of the companies they hold. The team also exclude all companies involved in the production, manufacture or marketing of controversial weapons.

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