By Annabel Brodie-Smith
Well it had to happen at some stage. After all those market highs, the markets have remembered they can go down as well as up, with the FTSE 100 trading at 7,223, at the time of writing, around 7% off the high of 7,779. Is this a correction or is it the end of the great bull market? That’s the big question that everyone is asking and inevitably no one knows the answer but some commentators think they do!
Interestingly, this short-term posturing is put into perspective by the new logo on this newsletter as we are celebrating 150 years of investment companies’ achievements. It’s 150 years since the launch of the first investment company, Foreign & Colonial Investment Trust, in 1868.
Inevitably, there have been highs and lows along the way including two World Wars, the Great Depression, the tech boom (and bust), the split capital trust crisis and the global financial crisis to name a few.
"Whether the current volatility is a much-needed correction or something more prolonged, it’s reassuring to know that investment companies have seen it all before"
Annabel Brodie-Smith, AIC
Whilst these were difficult times, our history demonstrates the strength and durability of the investment company structure, which is just as relevant for today’s investors. So whether the current volatility is a much-needed correction or something more prolonged, it’s reassuring to know that investment companies have seen it all before.
This month with the end of the tax year fast approaching, we are looking at Venture Capital Trusts (VCTs). VCTs invest in small, high-risk companies which can grow to become household names in the future, helping to create jobs and economic benefits. The Government offers generous tax benefits to compensate for the risks involved. To find out more about VCTs and the tax breaks read our guide.
Ian Cowie, our investment journalist expert is also a VCT investor who gives us his personal insight into VCTs’ investment benefits and risks. As Ian reminds us: “Not every acorn turns into an oak.”
We have an article of VCT managers’ views on their recent investment activity and where they are finding attractive investment opportunities. There is a fascinating article from Andy Gray, manager of Artemis VCT on how he selects companies and what he’s looking for.
Finally, Jonathan Davis, investment company director and former Independent and FT journalist, gives his perspective on the recent market volatility. He has also just published The Investment Trust Handbook 2018, featuring an investment company directory, analytical advice and contributions by a dozen leading investment company experts, including Peter Spiller, Robin Angus, John Baron and many more. It is available as a hardback book or as a (currently free) e-book download.
Have a great month.
Communications Director, AIC
From little acorns
Ian Cowie explains how VCTs can help investors do well by doing good
From little acorns
By Ian Cowie
Venture Capital Trusts or VCTs are becoming increasingly popular, with demand boosted by valuable incentives for investors in these tax shelters and tighter restrictions elsewhere. However, smaller companies and start-ups held within this type of investment trust are potentially higher risk and so the pros and cons of VCTs must be considered with care.
You should never invest primarily for tax breaks, although these can be an important consideration, particularly for high earners and experienced investors. VCT shareholders can qualify for upfront 30% income tax relief, regardless of the individual investor’s earnings; provided the tax paid is sufficient to cover the relief obtained.
For example, initial tax relief can reduce the net cost of £10,000 nominal stock in a VCT to £7,000, even for basic rate taxpayers. Any dividends paid by these funds and any capital gains are tax-free, provided the shares are held for five years.
"Initial tax relief can reduce the net cost of £10,000 nominal stock in a VCT to £7,000"
As I know from personal experience, having invested in Northern 2 VCT and Northern 3 VCT nearly five years ago, this combination of initial tax relief and tax-free dividends can produce double-digit yields. But it is important to remember that dividends are not guaranteed and may be cut or cancelled without notice.
Things to consider
Another important consideration is that VCT shares tend to be priced substantially below their net asset value and many trade at a double-digit discount to NAV. Even after the minimum five-year holding period has elapsed, small companies’ shares may prove illiquid or difficult to sell.
Not every acorn turns into an oak and start-ups or small companies are less likely than large or long-established firms to have big reserves or diversified businesses to help them cope with economic adversity or other setbacks. So it is important to remember that share prices may fall without warning and you might get back less than you invest.
"£483m has flowed into VCTs during the 2017-2018 tax year, compared to £542m in the whole of the previous fiscal year"
Despite those caveats, £483m has flowed into VCTs during the 2017-2018 tax year, compared to £542m in the whole of the previous fiscal year, and several experts forecast a new annual high will be hit before the current tax year ends at midnight on April 5. One reason is tougher taxation of investors elsewhere.
Changes to personal allowances
For example, with effect from April 6, 2018, the dividend allowance – or the maximum equity income investors can receive without having to pay tax – will be cut by 60% from £5,000 per annum to £2,000 per annum. That means many income-seeking investors who have not made use of government-approved tax shelters, such as individual savings accounts or VCTs, will pay more tax after April.
Retirement funds are the most valuable way for long-term investors to place assets beyond the grasp of HM Revenue & Customs but pension tax reliefs have already been sharply curtailed.
The maximum investment allowed in retirement schemes has been reduced both in terms of annual contributions and the lifetime allowance.
At first glance, the current maximum pension contributions of between £10,000 and £40,000, depending on the individual’s income, and a lifetime cap of £1m look sufficient for most people.
But rising numbers of serious savers in their forties or fifties - and others looking to catch up with retirement planning using bonuses, redundancy lump sums or the sale of businesses - are hitting their heads on these limits and looking for alternative or supplementary tax-efficient stores of value. The maximum anyone is allowed to invest in a VCT is £200,000 this year.
However, it is important to beware the government changed the rules about which underlying businesses qualify for VCT tax breaks a couple of years ago. For example, management buy-outs are no longer eligible for new VCTs. This means VCTs might have to take higher risks than they used to in order to earn the tax breaks their investors enjoy.
More positively, rising numbers of VCT managers now have substantial track records which you can find and compare on the Association of Investment Companies’ website. They are divided into different groups, depending on the businesses of their underlying holdings. For example, these include VCT Generalists, VCT Alternative Investment Market (AIM) and specialist sub-sectors such as Healthcare & Biotechnology; Media Leisure & Events and Technology.
The benefits of VCTs
In most cases, the closed-end structure of investment companies – as opposed to open-ended funds, such as unit trusts – may prove valuable to shareholders and managers investing in illiquid assets, because they will never be forced to dispose of underlying holdings to raise cash to meet redemptions.
"VCTs enabled companies in which they invested to more than double their turnover – with an increase of £2.2m of revenue for every £1m invested by VCTs – and to create a total of 27,000 new jobs"
This makes VCTs a valuable source of patient capital to fund the expansion or scaling up of smaller companies and start-up businesses that are an increasingly important part of the British economy. For example, according to research by the AIC last year, VCTs enabled companies in which they invested to more than double their turnover – with an increase of £2.2m of revenue for every £1m invested by VCTs – and to create a total of 27,000 new jobs.
So, while it is vital to remember the risks as well as the rewards, VCTs can enable investors to do well by doing good – and trim tax bills while doing so.
Ian Cowie is a columnist at The Sunday Times
The outlook for VCTs
VCT fund managers discuss where they are finding opportunities as investor demand doubles
Demand for VCTs in the 2017-2018 tax year has been very strong. From 6 April 2017 to 31 January 2018 VCTs have raised £483 million, more than double the £221 million raised from 6 April 2016 to 31 January 2017.
However, following changes to the VCT investment rules in the 2017 Budget, new regulations are in place which affect how these funds can be invested.
On 7 February, the AIC held a media roundtable where, Jo Oliver, fund manager of the Octopus Titan VCT, Andrew Garside, fund manager of the Baronsmead VCTs, and Trevor Hope, partner of Mobeus Equity Partners, manager of the Mobeus Income & Growth VCTs, discussed their recent investment activity, the effect of regulatory changes and where they are finding attractive investment opportunities.
Their views have been collated alongside comments from Stuart Veale, managing partner of Beringea and Eliot Kaye, investments director at Puma Investments.
Where are managers finding opportunities?
Stuart Veale, managing partner of Beringea, the manager of the ProVen VCTs, said: “Beringea is currently seeing a strong flow of investment opportunities. Two areas which are proving particularly fruitful at the moment are software as a service, or SaaS, and e-commerce and mobile commerce.
“The ProVen VCTs recently invested in two companies which are linked to both of these sectors. SmartAssistant is a SaaS company whose technology allows its customers to create intelligent, digital advisers. These help shoppers make better purchase decisions when shopping online, on mobile or at point of sale, thereby increasing customer engagement and satisfaction. Beringea also recently provided a further investment into portfolio company Poq, an ‘app-commerce’ company which provides a SaaS platform that enables retailers to build engaging shopping apps for their customers.
“These two companies are typical of the ProVen VCTs’ strategy of investing growth capital into relatively early stage, high growth companies. As they have been pursuing this investment strategy for many years now, they have not had to change their approach following the rule changes introduced in November 2015, unlike VCTs which had previously focused primarily in investing in management buyouts.”
Jo Oliver, fund manager of the Octopus Titan VCT, said: “Octopus Titan VCT looks to invest in companies led by talented teams with global ambitions, such as Secret Escapes or Tails.com. We are seeing a fantastic pipeline of investment opportunities thanks to the UK’s thriving and vibrant entrepreneurial landscape. More and more investors are keen to play a part in that.”
Trevor Hope, partner of Mobeus Equity Partners, the manager of the Mobeus Income & Growth VCTs, said: “Mobeus is seeing a large volume of investment opportunities from across the UK with an increase not only in software related technologies but also in engineering and advanced manufacturing opportunities.”
VCT investment activity
Eliot Kaye, investments director at Puma Investments, the manager of the Puma VCTs, said: “We recently invested £3.75 million in Sweat!, an innovative fitness business set up by Virgin Active founder, Frank Reed.
"We recently invested £3.75 million in Sweat!, an innovative fitness business set up by Virgin Active founder, Frank Reed"
Eliot Kaye, Puma Investments
“The money will be used to support Sweat!’s planned roll-out of five new gyms in the next twelve months and includes an option for us to make a further equity investment of up to £2.5 million after twelve months. As with all our investments, we’re focused on supporting high-quality management teams and growth companies and we’re excited by Sweat!’s prospects.”
Trevor Hope, partner of Mobeus Equity Partners, the manager of the Mobeus Income & Growth VCTs, said: “Midlands-based Biosite Systems has developed a unique fingerprint algorithm which works with low grade fingerprints (a feature of the construction industry) to provide access control for workers coming on site. Around this, Biosite has developed a software system that allows customers to utilise the data collected from the access control platform to manage their workforce as well as providing broader security services including integrated CCTV, fire alarms and guarding. Mobeus has invested £4 million into the company after its origination team approached the company to discuss investment opportunities.”
The effect of regulatory changes
Andrew Garside, fund manager of the Baronsmead VCTs, said: “The VCT industry is looking forward to a period of stability and a renewed focus on investing in small, high-growth companies. VCT fund managers have been kept busy in recent years coping with significant change to the scheme’s regulations. The November 2015 Budget changes triggered a significant shift in investment strategies for most VCTs in 2016. This was followed by the useful Patient Capital Review through 2017, which resulted in further changes. It appears that the industry and the Government’s main sponsor, HM Treasury, are aligned on the intent for the scheme and it would be welcomed if we could all enjoy a period of stability in the rules. The fund managers can then turn all their efforts to what they excel in - investing for the long term in small, high-growth companies and supporting their continued success.”
Stuart Veale, managing partner of Beringea, the manager of the ProVen VCTs, said: “The changes to the VCT rules announced in the November 2017 budget were designed primarily to ensure that VCT investment is focused exclusively on entrepreneurial, high-growth companies. As Beringea has invested exclusively in these types of businesses for many years, these changes will not have any impact on Beringea’s investment strategy. The ability to invest up to £10 million p.a. in ‘knowledge intensive companies’ from 6 April 2018, compared to £5 million as at present, will be helpful in enabling Beringea to deploy more investment into these types of companies.”
"The changes to the VCT rules announced in the November 2017 budget were designed primarily to ensure that VCT investment is focused exclusively on entrepreneurial, high-growth companies"
Stuart Veale, Beringea
Trevor Hope, partner of Mobeus Equity Partners, the manager of the Mobeus Income & Growth VCTs, said: “Mobeus, as a manager of four VCTs with over £250 million of capital, welcome the changes to the rules regarding investing in knowledge-intensive companies (KICs), allowing for a greater lifetime investment of up to £20 million in an individual company. This provides VCTs with the opportunity to continue to provide patient capital to companies creating rich intellectual property whilst also allowing VCTs to back their ‘winners’ for longer.”
Eliot Kaye, investments director at Puma Investments, the manager of the Puma VCTs, said: “Following the Patient Capital Review and the government’s Budget statement, it is good to see that Venture Capital Trusts remain a viable and valuable source of funding for smaller and growth companies, whilst continuing to retain their attraction to investors. The government obviously has to balance competing priorities, but we’re pleased the value of these schemes to businesses and investors has been recognised and reaffirmed.”
Outlook for VCTs
Trevor Hope, partner of Mobeus Equity Partners, the manager of the Mobeus Income & Growth VCTs, said: “The outlook for the VCT sector is positive with growth capital required to provided support to SMEs as they navigate the uncertainties and opportunities which will be presented by Brexit.
“However, as investment strategies focus on earlier stage companies VCT funds and their shareholders must expect a greater volatility in returns.”
"Investor demand is rising for access to the growth potential of some of the UK’s most dynamic smaller companies, as well as the tax benefits that VCTs can offer"
Jo Oliver, Octopus Titan VCT
Jo Oliver, fund manager of the Octopus Titan VCT, said: “There has never been a more exciting time for VCTs - it’s been a great fundraising season. Investor demand is rising for access to the growth potential of some of the UK’s most dynamic smaller companies, as well as the tax benefits that VCTs can offer.
“This appetite was boosted by the Chancellor’s endorsement of VCTs as a vital source of support for early stage companies, the backbone of the UK economy, back in November.”
Eliot Kaye, investments director at Puma Investments, the manager of the Puma VCTs, said: “It’s important not to see investing in a VCT-backed company as only having an all-or-nothing outcome. Many good, solid businesses rightly qualify for investment through these schemes because they are unable to access capital from traditional sources. VCTs can continue to plug the funding gap faced by SMEs, support innovative enterprises and deliver high-quality returns for our investors. We can do more to highlight the funding options for entrepreneurs and raise awareness of the benefits these schemes offer investors.”
Andy Gray, manager of Artemis VCT, discusses why the Alternative Investment Market offers a 'sweet spot' for investors
“Come back and see me when your market cap is £100m”. A phrase commonly heard by the management teams of smaller companies. To some degree, risk, liquidity and time-management make this understandable but we believe an investment “sweet-spot” exists between early stage start-ups and more well established listed businesses.
These are businesses that exhibit strong potential but are currently too small to attract the attention of mainstream institutions and could benefit from expansion funding available from AIM focussed VCTs.
With careful stock selection the rewards can be high but what are the characteristics we look for? Let us run through the main questions we ask ourselves using the example of our current largest holding. Yu Group listed on AIM in March 2015 and is an independent supplier of gas and electricity focused on the small business sector.
"We believe an investment 'sweet-spot' exists between early stage start-ups and more well established listed businesses"
Andy Gray, Artemis VCT
The first metric we look for is evidence of customer demand. In other words, revenue. Without a meaningful sales base we consider the business a start-up and therefore too risky to commit our shareholders’ capital to. At the time of the company’s IPO Yu Group had over £8.4 million of contracted annual revenue for the 2016 financial year. Customers clearly valued their offer.
Profit & opportunity
However, what about profit? Whilst a "nice to have" rather than a "must have" given their stage of development we do need to have confidence that it will be delivered in the not too distant future.
A business that cannot live within its means is always reliant upon investors to continue providing funds and we know from experience that investor fatigue can kick in.
Yu Group was forecast to be broadly break-even in 2016 with profits expected to grow significantly in 2017 and beyond.
"We typically back founders who have their own capital at stake rather than asymmetric incentive schemes of managers"
Andy Gray, Artemis VCT
Next up is opportunity. How big is the prize if the company is successful and is it sufficiently attractive to compensate for the risks in pursuing it?
According to OFGEM approximately 90% of SMEs are customers of the Big Six, of which circa 40%, equating roughly two million accounts, have not considered changing supplier in the past five years.
Account switching is an observable trend in the domestic market but the rationale applies equally to small businesses. British Gas’s business division alone had almost £8 billion revenue in 2015. Good enough.
Finally, and most importantly, management. Do we believe the management team have the necessary skills, leadership and drive to enable the company to capitalise on the opportunity?
We typically back founders who have their own capital at stake rather than asymmetric incentive schemes of managers. Yu Group itself was founded by Bobby Kalar and he astutely surrounded himself with an experienced management team, both executives and non-executives. He still owns over 60% of the company today.
A long-term view
Once we make the decision to invest, we have a long-term time horizon. Our investment in Abcam for example dates back to 2005 and we maintain a sizeable holding today. That said our judgement is often tested on the journey. Growing pains are somewhat inevitable but so too are poor investment decisions so we need to distinguish between the two.
The VCT rules themselves are a valuable discipline in this regard. Without the option of selling and buying back in later, we are forced to take a view as to whether the issues the company are facing are short term in nature or more deeply rooted. Sitting it out on the side-lines until the picture is clearer is not an option.
A willingness to "look through" short term difficulties has been incredibly rewarding over the years. Keywords Studios had a profit warning barely two months after its IPO. Had we sold we would have missed the subsequent 14-fold share price rise.
"A willingness to 'look through' short term difficulties has been incredibly rewarding over the years"
Andy Gray, Artemis VCT
We have repeatedly found that the once the £100m market cap threshold has been crossed wider investor interest picks up significantly. The resulting impact on the share price makes it rewarding for those willing to bear some of the earlier stage risks, such as AIM focussed VCTs, as the business scales up.
Slow and steady
In the face of recent market volatility, Jonathan Davis explains why a calm approach is best
No matter how much wise advice they receive in advance, few investors find their first encounter with a sharp market sell-off a comfortable experience. The stock market decline that seemed to materialise out of nowhere this month is, so the market historians tell us, the fourth quickest 10% decline in the Dow Jones Industrial Average since Charles Dow started measuring share price performance more than 120 years ago. That makes it a particularly short and sharp “correction”, a correction being the term that market pundits these days use to describe a 10% fall in the overall level of the stock market (not to be confused with a “bear market”, a fall of 20% or more).
How best to react to such a sudden movement? Mark Dampier, Head of Research at Hargreaves Lansdown, says that the best thing you can do if markets take a sudden downwards lurch is to switch off your laptop, leave the newspaper in the wastepaper basket, and go sailing, or whatever your favourite pastime is. That may sound flippant, but it is actually wise advice, for a number of reasons.
The golden rule about market declines of this rapidity is not to panic. Alarmist headlines in the media disguise the fact that immediate explanations of what has caused sharp market setbacks tend to be of an apocalyptic nature and frequently wrong. Don’t be bounced into doing anything hasty; the chances are that you will regret it. Assuming you have made your investments for a sound reason, a spot of market turbulence does nothing to invalidate your reasoning.
The second thing to do, assuming you have not headed out to the beach, is to put what has happened in context. The recent falls follows a more or less unprecedented period of calm in the markets, with no setback of more than 5% being seen for more than two years. J.P.Morgan famously said, when asked what the stock market would do next, “it will fluctuate”.
"The golden rule about market declines of this rapidity is not to panic"
Until this month the market has been defying that characterisation, lulling many investors – though not, I am happy to say, the readers of the Investment Trusts Handbook – into a false sense of security.
In fact share prices have been rising at a faster pace than normal in the last few months, with many investors becoming over-confident about the prospects for economic growth and company earnings. A lot of professional traders have been betting heavily – many with borrowed money – that so-called market volatility would remain low. Such overconfidence always comes at a price. It has been a very profitable trade for some time, but they have now had their fingers badly burnt as volatility has returned with a vengeance. (In this year’s handbook veteran investment company investor Peter Spiller warns specifically against the risk of putting money into many types of ETF).
Once the immediate storm has settled down, what does do no harm is to review your portfolio when episodes like this occur to see whether it has performed markedly differently to what you expected. Investment companies are by their nature diversified - that is one of their strengths - and a portfolio of investment companies investing in different asset classes will add a further layer of diversification that should protect you against the worst of the storm. If it has failed to do that job you may need to review how your portfolio is structured, as a different mix of assets may be warranted.
It is true that one of the advantages that investment companies enjoy is the ability to use gearing (or borrowing) to enhance returns. That cuts both ways – helpful when markets are rising (which they do three years out of four) and potentially a negative when they sell off. But the fundamental principle remains: diversification is the only effective way to reduce the risk of excessive exposure to market swings.
Yes, there are some good reasons for thinking that the stock market is now in the later stages of what has already been an exceptionally long positive bull market, dating back to 2009. The discounts at which many investment companies trade had narrowed to historically low levels before this month’s sell-off, a signal that the markets may have a short-term run ahead of themselves. Bond yields have been rising. Calmly monitoring and adjusting the risk of your portfolio in the light of such new circumstances is never wrong – indeed sharper market falls often create attractive new entry points for investment companies that had been trading at rich prices - but trying to time the market when it is moving around so fast invariably and categorically is.
The Investment Trusts Handbook 2018, featuring an investment company directory, analytical advice and contributions by a dozen leading investment company experts, including Peter Spiller, Robin Angus, John Baron and many more, is available as a hardback book or as a (currently free) e-book download. Link here.
The Investment Trusts Handbook's editor, Jonathan Davis, a former columnist in The Independent and Financial Times, and a qualified professional investor, welcomes ideas and suggestions for next year’s edition. Email: firstname.lastname@example.org.