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 December 2021
Market review
Global equity markets advanced in December to finish the year on a high as the MSCI All Country World advanced +1.9% while the S&P 500 gained +2.4% and the DJ Euro Stoxx 600 +4% during the month. The strong close to an eventful year led to a full-year return of +19.6% for the MSCI All Country World versus the S&P 500 at +29.8% while the DJ Euro Stoxx 600 modestly underperformed at +18.2% (all returns in sterling terms).
It is now two years since COVID-19 began to reshape the world we live in. Thankfully, the introduction of vaccines and anti-viral treatments during 2021 provided us with some much-needed light at the end – hopefully – of the proverbial tunnel. Unfortunately, late November delivered another setback in the form of the Omicron variant which has subsequently engulfed the world due to its mind-blowing transmissibility. During the three previous COVID-19 waves, peak new cases were between 700,000-900,000; in early January new cases are reported to be 2.5 million daily with the US alone exceeding one million.
While the combination of an apparently less deadly variant and greater immunity (natural or via vaccines) may have broken the link between infection and death, the sheer volume of cases and the ability of Omicron to at least partially evade previous immunity threatens significant worldwide disruption. Initially this caused panic, leading to the US 10-year Treasury to fall to 1.34% while the VIX Index (an option-implied measure of market volatility) exceeded 30. Since then, a more optimistic view has emerged with this ‘weaker’ variant the potential bridge between pandemic and endemic phases. This led equity markets to fully recover into year end. Commodity markets also rebounded strongly, and oil prices came close to recovering all their earlier losses with WTI Oil gaining +14.2%. The US 10-year Treasury yield also recovered sharply, ending the year around 1.5% and surging towards a post-pandemic peak of 1.7% during the first week of 2022. This likely reflects the potential for a strong post-pandemic rebound with ongoing supply constraints.
In addition, there was a notable and incrementally hawkish shift from several central banks, with the US Federal Reserve (Fed) moving to double the pace of its tapering from $15bn to $30bn, with the termination of QE purchases now forecast for March instead of June, while the new dot plot graph indicates the FOMC expects three rate hikes in 2022. Beyond this, the median dot also envisages three additional hikes in 2023 and two in 2024, bringing the Fed Funds just below the FOMC’s estimate of the longer-term neutral rate. In the accompanying statement, the FOMC Committee acknowledged inflation had exceeded target for some time and emphasised that lift-off would be tied to the economy reaching full employment.
The FOMC minutes – released on 5 January – reiterated this more hawkish tone, with the committee noting “it may be warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated” and "some participants... noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate".
The ECB also announced a reduction in its bond purchases. Purchases under the Pandemic Emergency Purchase Program (PEPP) will be reduced and will end in March, although the regular Asset Purchase Program (APP) will continue until there are plans to raise interest rates. For the time being, however, the ECB does not foresee any rate hikes in 2022. The Bank of England raised its benchmark interest rate from 0.1% to 0.25%, making the UK the first of the G7 economies to experience a rate rise since the start of the pandemic. Evidence of a very tight labour market and persistent inflation pressures were cited as key influences behind the decision.
While we would not be surprised to see higher interest rates, the possibility remains that inflationary pressures (and bond yields) may peak earlier in 2022 than expected. Leading economic activity indicators that remain in expansion territory are fading from recent highs with Omicron likely to further dampen near-term expectations. The US manufacturing ISM survey showed a 2.4-point decline at the headline level to 58.7 in December, disappointing consensus expectations of a milder fade to 60 and leaving the index at an 11-month low. The underlying sub-indices promisingly indicated that supply-chain strains are easing as the prices paid sub-index slumped to 68.2 from 82.4. This marked the lowest prices paid index reading since November 2020 and is notable because ISM prices were one of the first early signals of supply-chain strains and led the surge in consumer prices.
The eurozone manufacturing PMI fell slightly during December, to 58 down from 58.4 in November, its lowest reading in 10 months. In a similar fashion to the US survey, the highlight of the December survey centred on supplier performance which indicated alleviating pressures on supply chains. The average input lead times lengthened to the weakest extent since February. In China, the official manufacturing PMI reached a five-month high of 50.3, marking a second month above 50 as headwinds from the policy-induced downturn in production and power cuts continued to fade. Both inventories and input price sub-indices continued to improve in the month with no evidence of supply-chain disruption from the Omicron variant being visible.
Technology review: performance
The technology sector underperformed the broader market in December, the Dow Jones World Technology Index declining -0.5% during the month. Large-cap US tech continued to outperform into the year end, the Russell 1000 Technology Index declining -0.4%. December proved a microcosm of 2021 in terms of diverging subsector performance with the SOX Semiconductor Index returning +1%, while the NASDAQ Internet Index and Bloomberg Americas Software Index suffered declines of -6.5% and -3.6% respectively.
Encouragingly, the technology sector had another strong year in 2021 (after a phenomenal 2020), the Dow Jones Global Technology Index gaining +28.1% supported by strong underlying growth in revenue and earnings, as well as dollar strength – the trade-weighted dollar rising c6.4% during the year. Having been at the heart of the response to the COVID-19 pandemic, the sector lagged the broader market during the reopening phase, however. Strong headline returns led by the largest companies also belied bifurcated subsector returns. For the calendar year, the NASDAQ Internet Index declined -4.3%, the Bloomberg Americas Software Index returned +27.6% while the Philadelphia Semiconductor Index (SOX) returned +44.1%, providing a tailwind for more value-oriented investors. Large caps materially outperformed, the Russell 1000 Technology Index returning +38.4%, while the small-cap Russell 2000 Technology Index returned +15.1%.
Technology review: fundamentals
There were some notable off-season reports during December. In the software subsector, guidance has proved a little more conservative relative to heightened market expectations, with foreign exchange (FX) headwinds and margin pressure as companies expect travel and other expenses to partially resume going forwards.
Salesforce.com reported revenue and current remaining performance obligation (cRPO) growth modestly above consensus, as well as strong operating margins. However, next-quarter guidance was below consensus expectations, mostly related to FX headwinds and a deceleration at earlier acquisition MuleSoft. Adobe results were largely in line, although net new annual recurring revenue (ARR) modestly missed guidance due to lower traffic on Black Friday/Cyber Monday. Guidance was more disappointing (hopefully conservative) with FY22 revenue expected to be $17.9bn (below consensus at $18.2bn), only +13% y/y, although this included a c200bps headwind from one fewer week and a c100bps headwind from foreign exchange. Operating margin pressure is also evident as guidance implies a -150bps y/y contraction. We had been reducing our position into the print in both stocks and reduced further afterwards.
Coupa reported revenue, billings and EPS above sell-side consensus estimates, although organic billings growth decelerated to +26% y/y, on a tough comparison, shy of buy-side expectations. Management took a typically conservative approach to next-quarter guidance, calling for billings of $290m (versus consensus at $317m), up +14% y/y on an organic basis. Management noted that while they are helping customers address acute supply-chain issues near term, they are also starting to engage in deeper supply-chain transformation conversations which should yield much larger deals in time.
Database platform provider MongoDB delivered a stellar set of results with revenue growing +50% y/y (10% higher than expected), Atlas cloud accelerated for the fourth quarter in a row to +84% y/y and a 900bps y/y improvement in operating margin. Growth has re-accelerated not only due to the secular growth of modern applications being built in the cloud, but also potentially winning the broader industry debate as to whether Mongo’s document model is sufficiently performant and scalable to handle mission-critical workloads. This comes at the expense of the alternative view in the market, often touted by Amazon Web Services (AWS), that customers should employ special-purpose databases that are tailored to the class of applications being built. It seems customers are increasingly standardizing their product development initiatives on MongoDB's platform.
Work management software provider Smartsheet also reported results and guidance that were better than expected, benefitting from accelerating traction with large enterprise customers and its Advance offering (premium digital asset management and skills-based resource management capabilities). Initial FY23 billings growth guidance of +37-40% y/y was well above consensus at +26% y/y, while net revenue retention (NRR) guidance of c130% (in line with the 131% during the quarter) should continue to alleviate investor concerns about post-pandemic deceleration.
Unfortunately, Docusign proved another earlier work-from-home winner that missed billings expectations for Q3 results/Q4 guidance, joining the likes of Zoom, Twilio and Peloton* with “more normalised buying patterns”, primarily in the US. There appears to have been a pull forward of demand that has created a tough comparison for the company over the next few quarters and it has so far failed to execute on demand stimulation efforts to offset this. That said, we continue to believe in the wider adoption of digital signatures and agreement process automation in a work-from-anywhere environment.
In the semiconductor sector, Marvell delivered strong results and guidance well above consensus expectations with strong y/y growth rates across all its end markets. This reflects its leadership position in strategic markets like 5G, cloud and automotive, several design wins ramping up and strong operational execution to unlock additional supply. Management continues to see strong momentum in 5G (with revenue expected to be up 30% q/q in the next quarter) driven by Nokia’s first-generation baseband ramp and the continued strength of global 5G deployments by Samsung.
Ambarella – a recent purchase – which provides AI vision processors for edge applications reported strong results and guidance, disclosing that its six-year automotive revenue funnel has tripled from $600m a year ago to $1.8bn today ($700m of which is already booked), including new wins at Uber and Rivian. As part of a broader turnaround strategy by new CEO Pat Gelsinger, Intel* announced plans to take its Mobileye unit public in mid-2022 at a >$50bn valuation, having acquired the company for $15.3bn in 2017, which should be supportive for Ambarella’s valuation as a computer vision competitor in the automotive sector.
Apple became the first ever public company to reach a $3trn market cap and now represents c7% of the S&P 500, surpassing IBM’s 1984 record of 6.4%. The stock benefited from a flight to safety during the month, as well as positive news flow. Near term, iPhone supply-chain checks and App Store third-party data points are both surprising to the upside, which bodes well for the December quarter despite headlines on build cuts.
Apple was also granted a stay in the Epic ruling that was supposed to be implemented during the month, meaning its in-house, in-app payment system will remain the only option for in-app payments on iOS for now, avoiding a small hit to services’ revenue (and taking away a positive for names such as Roblox). Finally, there is enthusiasm for AR/VR into a product launch in 2022 or 2023 as well as metaverse optionality.
In the internet subsector, the Financial Times reported that internet platforms including Facebook and Snap have been using a loophole in Apple’s ATT privacy policies to collect anonymized and aggregated user data for attribution, without uniquely identifying devices. It is a grey area sometimes called 'fingerprinting', the practice of which is a technical violation that Apple could stop. However, Apple are holding back on the most draconian enforcement, indicating that a quiet truce over iPhone privacy changes may have been reached.
Within e-commerce, Black Friday/Cyber Monday data points were relatively muted, but against a very difficult comparison (COVID-19/lockdown demand last year), and a backdrop of supply-chain issues and cost inflation which meant retailers experienced stronger demand early November as purchases were pulled forward. Amazon internal data was up >10%y/y, however the quarter may be impacted by an outage at AWS which knocked out major internet apps and services such as Twitter, Netflix and Disney+.
Outlook
Rapid vaccination/booster campaigns in developed countries appear for now to have broken the link between COVID-19 case numbers and hospitalizations and deaths. However, the Omicron variant has proved another sobering reminder of the inherent unpredictability of macroeconomic and market conditions, and a reminder of the need for a highly liquid and well-diversified portfolio.
The tensions between more macroeconomic growth, where we assume the fiscal impulse moderates and financial conditions tighten somewhat during the reopening, and perhaps easing inflationary fears – as supply further recovers, demand normalises – remains. A stronger economy will increase inflationary pressure and should, within reason, be positive for equities. Meanwhile a slower recovery will reduce the likelihood of materially higher bond yields and could support growth/risk assets.
Toward year end and into early 2022, high-growth software companies came under intense pressure with valuations compressing by more than 25% as a rapid rebound in the 10-year US Treasury yield back towards 2021 highs (c1.70%) and a ‘bear steepening’ in the yield curve raised concerns about the susceptibility of high multiple stocks to tighter financial conditions.
While valuations for growth companies are normalising and the fundamental outlook for our sector remains encouraging, one large uncertainty remains – the impact of Omicron on countries such as China who continue to pursue a zero COVID-19 strategy. It feels like there is a limit to how long these countries can hold back the tidal wave of Omicron. Either way, continued headwinds to economic growth will remain either in the form of waves of tight restrictions or the impact of the virus itself. This also has potential to create further supply-chain disruption and market volatility if the situation becomes more acute.
Encouragingly, Goldman Sachs’ Effective Lockdown Index (ELI) has indicated that new COVID-19 variants have seen policy responses and impacted mobility, but by less each time and the impact on GDP growth has become less pronounced. The fiscal impulse is waning in the US but remains supportive in Europe and potentially in China.
Labour market tightness has been widely reported given the ‘Great Resignation’ currently underway, and 4.5 million Americans quit their jobs in November, the highest in the two decades of tracking. Job openings remain near record levels. Attracting and retaining skilled staff has come up at many of our recent company meetings. Competition for talent has long been a feature of the technology landscape and runs all the way up to the largest companies. We expect many of our holdings to continue to be able to compete effectively in a tight labour market, and the wider shortages and wage inflation to act as a meaningful driver for the adoption of automation and artificial intelligence (AI) in every industry.
We remain constructive on the fundamental outlook for the technology sector and continue to expect the portfolio to deliver strong growth as the necessity of digital transformation continues to drive IT spending, cloud adoption and the increasing integration of AI into the world. Morgan Stanley’s 3Q21 CIO survey indicated that 45% of CIOs expect IT spend to increase as a percentage of revenues in their organisations over the next three years (versus 5% who are expecting a decline). A December 2021 survey by McKinsey found 56% of respondents reported AI adoption in at least one corporate function and 27% reported at least 5% of EBIT attributable to AI. We also continue to believe the pandemic spurred even laggards to adopt the cloud and digitally transform in order to support vast numbers of remote workers and customers alike.
Structural drivers for the sector remain strong: annual software spending has expanded to 3% of US GDP from 2.25% in 2018; our conversations with many company management teams indicate a strong demand environment; and R&D as a percentage of US capex has reached 20% from a low to mid-teens level over the past 20 years, while software capex has reached a new high of 16.9% of total US capex from 10-11% pre-GFC and just c7% in the early 1990s.
It is also worth noting from a long-term structural perspective that many of the most acute pressures in the economy and society today can be best alleviated, if not totally solved, by the application of more technology rather than less: labour shortages call for a higher degree of automation, online skills training, the ability to work from anywhere and deeper online labour markets; climate change requires creative and ambitious technological solutions, products and services delivered with greater energy efficiency and ever more data to understand the world we wish to preserve; an aging population requires remote health provision, personalised medicine and greater connectivity.
All these things will benefit from ongoing advances within the technological stack, but most significantly from the adoption and proliferation of AI. The pandemic has demonstrated the extraordinary power of innovative technology at scale, with everything from mRNA-based vaccines invented and deployed within a year to a cloud infrastructure and technology-supported economy that did not break down.
The Fed’s recent more hawkish pivot has driven a sharp growth to value rotation that has little to do with technology fundamentals. We do not believe valuation excesses have fully unwound, but we are starting to see more attractive opportunities. According to Goldman Sachs, at the time of writing value has outperformed growth by 24% in five days, coinciding with a 31bp increase in real yields, which is a good reminder of the extent of the rotation.
Our team of 10 will be (virtually) meeting a large number of companies and listening to a huge number of earnings calls in the coming weeks. If, as we expect, the tone of these interactions remains positive and this correction in high-quality growth equities continues, we would expect to move back to a more growth-centric and fully invested position, particularly as we progress through earnings season and see how stocks react to management guidance.
*not held
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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