At the Annual General Meeting in 2012 shareholder approval was obtained for a simplified investment policy. This did not change the investment objective but provides a clear and appropriate set of up to date investment restrictions in line with the Financial Conduct Authority and HM Revenue and Customs current requirements.
The portfolio was managed under and in accordance with the old policy and restrictions in the year to 30 April 2012 and up to 4 September 2012 when the change was approved by shareholders.
Asset allocation
Technology may be defined as the application of scientific knowledge for practical purposes and technology companies are defined accordingly. While this offers a very broad and dynamic investing universe and covers many different companies, the portfolio of the Company (the “Portfolio”) is focused on companies which use technology or which develop and supply technological solutions as a core part of their business models. This includes areas as diverse as information, media, communications, environmental, healthcare, finance, e-commerce and renewable energy, as well as the more obvious applications such as computing and associated industries.
The Board has agreed a set of parameters which seek to ensure that investment risk is spread and diversified.
The Board believes that this provides the necessary flexibility for the Investment Manager to pursue the investment objective, given the dynamic and rapid changes in the field of technology, while maintaining a spread of investments.
The Company uses the Dow Jones Global Technology Index (total return, Sterling adjusted, with the removal of relevant withholding taxes) as the Benchmark against which Net Asset Value (NAV) performance is measured for the purpose of assessing performance fees. From 1 May 2013 the benchmark was calculated using a net basis which adjusts the Benchmark income element to reflect withholding taxes which would be suffered by a UK based investor.
However, the Benchmark is neither a target nor an ideal investment strategy. The purpose of the Benchmark is to set a reasonable return for shareholders of PCT above which the Investment Manager is entitled to a share of the extra performance it has delivered.
Risk diversification
PCT will at all times invest and manage its assets in a manner that is consistent with spreading investment risk and invests in a Portfolio comprised primarily of international quoted equities which is diversified across both regions and sectors. PCT will satisfy the following investment restrictions:
- PCT’s interest in any one company will not exceed 10 per cent. of the gross assets of PCT from time to time, save where the Benchmark weighting of any investee company in PCT’s portfolio exceeds this level, in which case PCT will be permitted to increase its exposure to such investee company up to the Benchmark ‘neutral’ weighting of that company or, if lower, 20 per cent. of PCT’s gross assets.
- PCT will have a maximum exposure to companies listed on emerging markets (as defined by the MSCI Emerging Markets Index) of 25 per cent. of its gross assets from time to time.
- PCT may invest in unquoted companies from time to time, subject to prior Board approval. Investments in unquoted companies in aggregate will not exceed 10 per cent. of the gross assets of PCT (measured at the time of acquisition of the relevant investment and whenever PCT increases the relevant holding).
In addition to the restrictions set out above, PCT is subject to Chapter 15 of the UK Listing Authority’s Listing Rules which apply to closed-ended investment companies with a premium listing on the Official List of the London Stock Exchange. In order to comply with the current Listing Rules, PCT will not invest more than 10 per cent. of its total assets at the time of acquisition in other listed closed-ended investment funds, whether managed by the Investment Manager or not. This restriction does not apply to investments in closed-ended investment funds which themselves have published investment policies to invest no more than 15 per cent. of their total assets in other listed closed-ended investment funds. However, PCT will not in any case invest more than 15 per cent. of its total assets in other closed-ended investment funds. PCT must not conduct any trading activity which is significant in the context of its group as a whole.
Borrowing, Cash and Derivatives
The Company may borrow money to invest in the Portfolio over both the long and short-term. Any commitment to borrow funds is agreed by the Board and the AIFM.
The Company’s Articles of Association permit borrowings up to the amount of its paid up share capital plus capital and revenue reserves but any net borrowings in excess of 20% of the Company’s net assets at the time of drawdown will only be made with the approval of the Board.
The Investment Manager may also use from time to time derivative instruments as approved by the Board such as financial futures, options, contracts-for-difference and currency hedges. These are used for the purpose of efficient portfolio management. Any such use of derivatives will be made in accordance with PCT’s policies on spreading investment risk as set out in this investment policy and any leverage resulting from the use of such derivatives will be subject to the restrictions on borrowings set out above.
Changes to investment policy
Any material change to the investment policy will require the approval of the Shareholders by way of an ordinary resolution at a general meeting. PCT will promptly issue an announcement to inform Shareholders and the public of any change of its investment policy.
The Board monitors the portfolio’s exposure to different geographical markets, sub-sectors within technology and the spread of investments across different market capitalisations. Cyclical changes in markets and new technologies will bring certain sub-sectors or companies of a particular size or market capitalisation into or out of favour.
Market parameters
Notwithstanding the ability to invest up to 100% of the portfolio in any one market, with current and foreseeable investment conditions the Portfolio will be invested in accordance with the objective across worldwide markets within the following geographical and market parameters:
- North America up to 85% of the Portfolio
- Europe up to 40% of the Portfolio
- Japan and Asia up to 55% of the Portfolio
- Rest of the world up to 10% of the Portfolio
The Board has set specific upper exposure limits for certain countries where they believe there may be an elevated risk.
Cash
From time to time PCT may hold cash or near cash equivalents if the Investment Manager feels that these will at a particular time or over a period enhance the performance of the Portfolio. The management of cash is through the purchase of appropriate government bonds, money market funds or bank deposits depending on the Investment Manager’s view of the investment opportunities.
Gearing
On 30 September 2020, the Company had drawn down the two, two-year fixed rate, term loans of JPY 3.8bn and USD 36m from ING Bank N.V. Both loans fall due for repayment on 30 September 2022. The JPY loan has been fixed at an all-in rate of 0.90% pa and the USD loan has been fixed at an all-in rate of 1.1% pa. The Company has repaid the two, two-year loan facilities with ING Bank N.V of USD 23.3m and JPY 5.2bn dated 2 October 2018.
Fund Manager Commentary As at 31 August 2021
Market review
Global equity markets advanced for the seventh consecutive month in August. The MSCI All Country World advanced 3.6% while the S&P 500 gained 4.1% and the DJ Euro Stoxx 600 2.9% (all returns in sterling terms).
Robust market performance was supported by a strong US jobs report at the start of the month combined with dovish commentary by Fed Chair Powell at Jackson Hole. Receding concerns around the coronavirus Delta variant as new global cases plateaued (after reaching 650,000 in mid-August) also provided some respite, although trends continue to vary significantly by country with all eyes on countries such as the UK and Israel as they open up and China, Japan and Australia as they battle resurgent outbreaks. Vaccination programs continue to make good progress with the EU reaching the goal of fully vaccinating 70% of its adult population, despite the slowing pace of inoculations.
Powell’s speech at Jackson Hole certainly calmed investor nerves about an imminent tapering of asset purchases, although the possibility that this could begin this year remains. On the two goals set for this process to start, there has been “clear progress towards [the] maximum employment” objective, while the economy had already passed the “substantial further progress” test on its inflation objective. Powell also struck a dovish tone that helped drive equity markets higher as he stressed tapering was not a signal for eventual rate hikes and warned that monetary policy should not respond to transitory inflation pressures.
Economic activity indicators continue to indicate varying challenges to the ongoing macroeconomic recovery. August provided another set of weaker-than-expected China PMIs as the composite PMI dropped to 49.9, which marks the first sub-50 reading since February 2020. The official manufacturing PMI was relatively resilient in falling modestly to 50.1 versus 50.4 last month, but the non-manufacturing PMI was a big miss, at 47.5 versus 52.0 expected, and down from 53.3 last month. Multiple factors are likely behind the slowdown including imposing lockdowns to control the spread of the Delta variant, flooding in some regions and the ongoing regulatory changes that have impacted business and consumer spending.
Several key industrial commodities gave back some of their strong year-to-date gains during the month, including oil which posted its first monthly decline since March. Brent fell 4.0% as concerns over slowing demand in China and new restrictions imposed due to the Delta variant weighed on sentiment.
In the Eurozone, the composite index may have peaked as the August reading retraced slightly to 59.5 from 60.2 in July. It was noteworthy that the Eurozone services sector surpassed the reading for manufacturing for the first time since the start of the pandemic, which had hit services particularly hard. Presently, all readings remain in expansion territory and suggest the European recovery is in good health.
US jobs data improved as the US jobs report for July, released in early August, showed non-farm payrolls were up 943,000, the strongest in 11 months. Positively, the June number was also revised higher to show 938,000 new jobs as the unemployment rate dropped to 5.4%. This strength was somewhat offset by a weak August reading, which saw a jobs gain of just 235,000, about 500,000 below consensus as the Delta variant led to weakness in COVID-19-sensitive sectors including leisure. The US economy, like China, has passed the peak in its leading economic indicators, although the majority of data points remain firmly in expansion territory, supportive of continued robust economic conditions. In August, the US ISM manufacturing PMI unexpectedly rose to 59.9 (versus 59.5 in July) despite headwinds caused by both labour and material shortages. That said, there was softer economic data too – July retail sales/housing starts weakened and the August University of Michigan Sentiment Survey produced notable downside surprises.
Technology review
The Dow Jones Global Technology Index returned 5.2% in sterling terms during August, outperforming the broader equity market. The sector continued to benefit from concerns that economic growth has peaked with sustainable secular growth more valued by investors. Likely aided by continued inflows, large caps outpaced small caps, the Russell 1000 Technology Index returning 5.0% driven by mega-cap strength, while the Russell 2000 returned 3.5%. This brings the YTD performance gap to 28% for the large-cap index versus 12% for the small-cap index. The Bloomberg Americas Software Index outperformed during the month, rising 4.8%, benefitting from a strong earnings season and sustained demand for digital transformation. The semiconductor and internet subsectors lagged, the Philadelphia (SOX) Semiconductor Index returning 1.9% while the NASDAQ Internet Index gained 2.3%.
Company results in the software sector remained robust during the month. Salesforce.com delivered a strong report and offered encouraging guidance while operating margins expanded y/y and management raised its FY22 margin outlook slightly. Management attempted to assuage investor concern around M&A synergies, disclosing Tableau was involved in nine of the top 10 deals, and Slack Connect grew 200% y/y. Workday also reported strong Q2 results beating expectations and raised FY22 FCF guidance by $300m to $1.5bn. Management remain confident that new bookings growth will accelerate from here. Snowflake, which provides cloud-based data storage and analytics services, grew product revenue 104% y/y ($41m q/q from $36m q/q last quarter) raised guidance to 91-93% product revenue growth in FY22. Snowflake is advancing its position beyond a cloud data warehouse, as evidenced by early traction in new areas including Snowpark (modern data pipelines), security analytics, machine learning and data exchange.
Cybersecurity results have also remained strong. End-point cyber security provider Crowdstrike Holdings delivered a strong quarter with annual recurring revenue (ARR) growth of 70% y/y and raised full-year revenue growth guidance to 60% y/y, slightly below high investor expectations (despite delivering strong operating leverage (FCF margin in H1 was 30%). However, we modestly reduced our position on valuation grounds.
Elsewhere, some of the big winners from 2020 such as Zoom Video Communications (Zoom) and Peloton Interactive (Peloton) continued to struggle despite solid results due to uncertain H2 demand/guidance. Zoom posted solid results with revenues growing 54% y/y, but full-year guidance was only raised modestly, implying continued deceleration (flat q/q in Q3 and Q4). Management commented that churn was increasing in the SMB segment and that sales cycles were reverting to more normal pre-pandemic buying patterns. On the positive side, Zoom Phone reached two million seats while up-market growth remained robust, with 131% growth in >$100k customers.
Peloton’s FY21 results were in line with expectations but FY22 guidance proved more mixed. Management expects to grow Connected Fitness Subscribers by 1.3 million during the fiscal year, an acceleration from 1.2 million in FY21 (against fears of one million or below). This positive news was undermined by a c20% Peloton Bike price cut and a significant increase in spending to support subscriber acquisition, which led to EBITDA guidance well below consensus. While the company has positioned this as an offensive rather than defensive initiative designed to increase their subscriber base more quickly using a lower price point, the use of price at this stage of penetration somewhat challenges the Apple parallel (premium price, mass affluent customer) while creating additional H2 uncertainty resulting in us reducing our position.
In the video game subsector, Activision Blizzard reported strong Q2 results, with net bookings down 8% y/y against a very difficult comparison (first lockdown), and raised full-year guidance, driven by ongoing strength from the Call of Duty franchise and King (bookings +15% y/y). That said, market sentiment on the sector is rock bottom, despite engagement remaining resilient during the reopening. The company remains on a yellow card due to an ESG issue – a lawsuit from the DFEH (Department of Fair Employment and Housing) in California related to claims of discrimination and harassment, focused on the Activision Blizzard studio. While management has now taken meaningful steps to address these issues, we are monitoring their progress here as well as uncertainty around forthcoming game releases tied to this disruption. Elsewhere, ROBLOX continues to perform better, modestly missing Q2 bookings’ expectations due to softness in June, but daily active users (DAUs) were +29% y/y and bookings +35% y/y against a very tough comp. Trends also improved in July, which had the highest levels of users and engagement to date, along with strong DAUs outside US/Canada +42% y/y and DAUs over the age of 13 +46% y/y, reaching near parity with those under 13.
The gaming industry (along with dating and music) could be genuine beneficiaries of the regulatory pressure mounting against Apple and Alphabet’s app store take rates. South Korea recently became the first country to ban monopolies on app store payments, allowing app makers to use other companies to process payments for them. In the US, a bipartisan Senate bill called The Open App Markets Act would also require app store owners to allow third-party in-app payment systems and ‘sideloading’ of apps, meaning they do not need to be downloaded from an official app store. This comes ahead of the Apple versus Epic ruling, which is expected soon.
In the internet sector, Zillow Group reported a solid quarter and strong guide for Q3 with a record 3,805 homes purchased as the iBuying business continues to ramp up. While adjusted EBITDA guidance for Q3 was below expectations due to higher product and marketing investments, the Zillow 2.0 business model appears to be gaining traction. Despite the reopening of the economy, meal-kit provider HelloFresh continues to fire on all cylinders, and reported revenue growth of 67% y/y cc. The company added 400,000 customers in the quarter, taking the total to 7.7 million, +83.7% y/y. Management have increased fulfilment investments to meet demand, with spending set to increase 45-55% in 2021 from expectations for 20-25% set at the start of the year.
In the travel subsegment, TripAdvisor reported in line, while Q3 guidance was for a meaningful sequential improvement. The US market remains the key driver, with the hotel metasearch revenues nearly achieving 2019 levels, while Europe has been accelerating since May and helped push EBITDA back into positive territory. Airbnb posted a strong quarter with gross booking value (GBV), revenue and EBITDA all ahead of expectations. Room nights were almost flat on 2Q19, while GBV/revenue were up 37%/+10% respectively as price recovers faster than volume. North America was once again the key region supported by a significant rebound in Europe, with early signs of recovery in cross-border and urban/city, two historic strengths of Airbnb. However, Q3 guidance for room nights was down sequentially and expected to remain below 3Q19 levels near term due to concerns around the coronavirus Delta variant.
In semiconductors, shortages did not stop NVIDIA reporting revenue growth of 68% y/y with all key operating metrics modestly above consensus estimates. Gaming demand continues to outstrip supply and gaming GPUs were selling at a c50% premium to manufacturers’ suggested retail price in August. Data centre revenue growth is accelerating (with inference revenue doubling), more than offsetting lower demand from cryptocurrency. In contrast, Infineon Technologies modestly missed top line estimates impacted by manufacturing constraints which limited its ability to grow revenue despite the semiconductor shortage. Customer/channel inventories are at historic lows, however, with chips being shipped from fabs straight into the end applications resulting in book-to-bill at 2.4x (up from 2.1x last quarter).
The semiconductor sector underperformed during August, despite very strong results overall, with upside limited by both supply constraints and concerns that we are approaching the peak of a very unusual cycle. Demand in some end markets does appear to be slowing. In the PC market, Chromebook sales doubled in 2020 as schools switched to remote learning and, while sales are still expected to grow in 2021, Chromebook makers subsequently cut component orders by 20% in August. Concerns also increased following a report from DRAMeXchange that market expectations are for memory prices to drop up to 5% in Q4. However, inventories in other markets like automotive remain extremely lean.
Outlook
Environmental, social and governance (ESG) issues represent an important challenge for the technology sector, but also a great opportunity. The sector may have contributed to ESG issues, but it also has the singular capacity to alleviate many of them by providing the innovation at scale required to meet today’s existential challenges. Technology is having a beneficial impact on the environment via electric vehicles supporting greener mobility and AI-based optimisation increased energy efficiency across the built environment. The shift towards a hybrid world provides a glimpse into a lower-carbon future associated with lower-frequency, long-distance travel and the transformation of more activity from relatively carbon-intensive ‘atoms’ into less carbon-intensive ‘bits’.
Technology investment is crucial to meet the challenges associated with climate change: more than one third of the cumulative CO2 emissions reductions seen in the Sustainable Development Scenario (2070) derive from technologies currently at the prototype or demonstration phase, and a further 40% derive from technologies that have not yet moved beyond early adoption. There are also negative technological impacts including energy-intensive cryptocurrency mining and hazardous waste biproducts of semiconductor supply chains. We look forward to providing investors with more information about the sector’s ESG impact and more detail concerning the integration of ESG within our own investment process during Q4.
Economists have been reducing their second half growth expectations as the Delta variant has impeded the handoff from goods to services consumption and crimped the labour market recovery in some COVID-19-exposed areas. Against this backdrop, technology companies are themselves having to navigate reopening headwinds that could temporarily challenge growth, but we remain confident in the long-term secular tailwinds enjoyed by our portfolio companies and the richer opportunities that the evolution to a hybrid world offers many of them. Digital transformation remains a corporate imperative and meeting with our companies gives us increased confidence that it remains early in its lifecycle. However, valuations remain challenging in some of the highest growth subsectors, and we believe conservatism is appropriate when analysing some companies on TAM-based valuations given their potential vulnerability to a sharp deterioration in the risk environment.
Selected mega-cap companies continue to benefit from solid growth/earnings, safe haven and premium ESG rating status (and associated fund flows) while a narrow group of perceived long-term winners (high profile/momentum stocks) trading at very high revenue multiples continue to lead. While both these groups have contributed to absolute returns, they also represent a style headwind for our growth-centric but valuation-sensitive approach. Our experience tells us that periods characterised by narrower leadership and weaker market breadth often presage higher future volatility. As such, we are likely to remain relatively conservatively positioned for now with our unbridled enthusiasm for technology centrality in a hybrid world gated only by elevated valuations that leave little room for adverse near-term developments, either at the macro or micro level.
We strongly believe the recent acceleration and broadening of technology adoption will continue to provide a powerful tailwind for the Trust. Near term, however, we see a complex macro backdrop with the prospect of Fed tapering, the consequences of the fading fiscal impulse, an uncertain labour market recovery, inflationary pressures, supply constraints and the still unknown path of the virus and potential for future variants. We could certainly see increased volatility tied to these factors, especially during the challenging early October preannouncement season (ahead of third quarter results). That said, we expect technology results to remain robust suggesting the sector and perhaps the market could just grind higher (aided by record liquidity) as we continue to climb the proverbial wall of worry.
Ben Rogoff
Ben joined Polar Capital in May 2003. He is lead manager of Polar Capital Technology Trust plc and is a Fund Manager of the Polar Capital Global Technology Fund and Polar Capital Automation and Artificial Intelligence Fund.
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