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 30 June 2022
Market review
Global equity markets continued to decline in June, the MSCI All Country World returning -5.1%, while the S&P 500 and the DJ Euro Stoxx 600 returned -4.9% and -6.9% respectively (all returns in sterling terms). Negative returns were ameliorated by US dollar strength which gained 3.5% against sterling during the month. Weakness was driven by higher-than-expected inflation readings (CPI and University of Michigan Consumer Sentiment) and an increasingly hawkish response from the Federal Reserve, raising concerns about global growth/recession as consumers are squeezed by a combination of high inflation and rising interest rates. Unfortunately, much of the uncertainty has been driven by supply-side factors beyond the control of central banks, with Russia’s invasion of Ukraine and Covid-related lockdowns in China exacerbating supply-chain disruptions, food and energy shortages and stoking inflationary pressures.
May’s CPI raised doubts about the validity of the ‘peak inflation’ thesis, rising +1% m/m and +8.6% y/y, up from +8.3% y/y in April, and well ahead of forecasts at +0.7% m/m and +8.3% y/y. Price increases were broad-based, while food prices hit a 40-year high. This took its toll on consumer confidence, with the preliminary June University of Michigan Consumer Sentiment Index declining to 50.2 from 58.4 in May (well below forecasts of 58), with around 79% of consumers pessimistic about future business conditions, the highest since 2009. The combination of higher inflation and weaker confidence left inflation expectations for the year little changed, at 5.4%, although the five-year inflation outlook rose to 3.3% from 3% in the previous month (before falling back to 3.1% by the end of the month).
Sustained inflationary pressures brought expectations the Fed would raise the federal funds rate by 75 basis points (bps) rather than 50bps at the June Federal Open Market Committee (FOMC) meeting, and the committee duly obliged, delivering the largest hike since 1994, increasing the rate to 1.5-1.75%. The Fed’s median projection now suggests the benchmark rate will end the year at 3.4% – an upward revision of 150bps from the March estimate. The market has now, however, begun to discount economic softening leading to peak rates in the first half of 2023 and rate cuts in the second half. Peak interest rates could arrive sooner if the economy slows and inflationary pressures look contained, but for now that is not the case. Fed Chair Jerome Powell indicated the Committee is likely to hike rates by 50-75bps in July although he promised to be “flexible” in implementing policy as the Fed attempts to engineer a soft landing.
The US economy has not typically gone into recession without labour market weakness and thus far employment has remained strong. May employment data remained robust but tighter financial conditions may be starting to cool the economy. The ISM manufacturing PMI unexpectedly rose to 56.1 in May (above forecasts of 54.5), up from 55.4 in April (a 20-month low), driven by increases in new orders, production and inventories, but was well below highs. Price pressures remain elevated but eased for a second month, while employment contracted modestly. The headline Producer Price Index (PPI) increased +10.8% y/y, moderating from +11% y/y in April and +11.5% y/y in March. The Personal Consumption Expenditure Price Index (PCE) – the Fed’s preferred measure of inflation – increased +6.3% y/y in May (in line with forecasts), a deceleration from the record high +6.6% y/y in March.
Although the reopening of the Chinese economy and recent stimulus measures (including housing/auto sectors and direct consumer stimulus), should help alleviate global supply chain bottlenecks, it may also lead to higher energy prices, as we outlined last month. In addition, Russia could decide to further reduce the flow of gas to apply more acute economic and political pressure in Europe. This highlights the potential for higher energy prices and elevated volatility in the coming months – energy rationing over the summer months would undoubtedly hurt the European economy and particularly industrial sectors.
Technology review
The technology sector fell broadly in line with the US market in June as the Dow Jones World Technology Index declined -5.8%. There was again wide dispersion between technology subsectors as the Philadelphia Semiconductor Index (SOX) fell -17.4% while the NASDAQ Internet Index was down -9.4% and Bloomberg Americas Software Index slipped -5.5%.
June saw several companies host analyst days which provided a good reminder of the highly attractive long-term prospects and expanding addressable markets for many technology leaders. At its analyst day, Advanced Micro Devices (AMD) provided updated long-term targets for a 20% revenue growth CAGR and gross margins above 57% addressing a $30bn TAM by 2025. This positive update was driven by confidence in continued data centre strength, the Xilinx acquisition integration, and the company’s product roadmap. Snowflake’s investor day showcased its expanding platform capabilities that have the potential to drive additional workloads to their platform. New product announcements included Unistore (transactional database) and Python for Snowpark (machine learning) which further reinforce the company’s transition from cloud-native data warehouse to complete cloud data platform.
As is typical for June, there were relatively few earnings announcements ahead of the Q2 earnings season which starts in mid/late July, with preannouncement season in the two weeks prior to this. Unsurprisingly given current macroeconomic uncertainty and poor investor and consumer sentiment, companies gave conservative guidance, albeit accompanied by relatively solid results and an upbeat tone around the longer-term opportunities.
The most notable slowdown in demand has been in the consumer internet/online retail space where there were sizeable profit warnings from European apparel e-commerce companies Boohoo*, Asos* and Zalando* all reducing guidance. This was due to weaker than expected Q2 trading since their updates in early May, a trend also seen at other retailers such as Nike and Bed, Bath & Beyond. This follows earlier warnings from Snap, Walmart, and Target who experienced a sudden slowing of demand during recent months as consumer budgets have been squeezed and the spending mix has tilted from goods towards services, including travel and entertainment.
The significant deterioration in consumer sentiment indicators seen in Europe has quickly translated into weaker consumer spending within online apparel, but it was notable that Zalando’s share price quickly recovered early losses despite halving its profit outlook, which suggests investors may have already priced in material profit downgrades. Zalando has begun to undertake efficiency measures, including a reduction in marketing investments and the introduction of minimum order values in 15 additional markets.
In semiconductors, Micron Technology announced in-line quarterly earnings, but accompanied by a notable guide down for the next quarter and a downbeat assessment of PC and smartphone markets (which saw weakness towards the end of the quarter). Customers are adjusting inventories and Micron expect these adjustments to continue into 2H22. Despite PC/smartphone weakness, the company expects continued strength within cloud/data centre, networking and automotive/industrial. Based on the demand environment, Micron is immediately taking action to cut its bit supply growth trajectory and reduce the level of bit supply growth in FY23 as well as protecting profitability by managing its capacity utilisation of older nodes. Encouragingly, Micron shares fell by less than estimate revisions, suggesting a weaker outlook had largely been anticipated.
In software, Adobe Systems reported quarterly results in line with expectations as revenues increased +15% in constant currency. Its key metric, net new Digital Media ARR, came in above consensus at $464m but Q3 net new Digital Media ARR guidance came in well below expectations due to more acute seasonality and macro headwinds. Despite the lowering of Q3 guidance, management maintained their FY22 Digital Media ARR guidance. However, this may prove optimistic given the worsening economic backdrop and we would have preferred to see more cautious guidance.
Smartsheet delivered in-line results but with billings +36% y/y, a smaller magnitude of upside than previously and a sequential deceleration. Full-year revenue guidance was only modestly raised and did not reflect the flow-through from the current quarter’s outperformance. Encouragingly, management commented that the updated guidance was mindful of the current economic environment and incorporated an element of macro-related prudence by factoring in longer sales cycles. The company is not, however, seeing any macro impacts yet and underlying trends remain robust with record new customer bookings and the strongest new logo adds since the IPO.
Oracle* also delivered a strong quarter as revenues, margins and EPS all came in ahead of consensus, although upside was driven by strength in perpetual licence revenues (+25% y/y) and total database revenues up by double digits. Cloud growth was less impressive at +22% and only in line with expectations as the sequential deceleration saw growth below the targeted mid-20s level.
Software M&A activity continued as Zendesk was finally (after rumours, denials and a failed earlier sale process) acquired by a private equity investor group led by Permira and Hellman & Friedman for $10.2bn in an all-cash transaction. The 34% premium to the previous day’s close resulted in a valuation multiple of c5x 2023 EV/Sales. This was a disappointing outcome for investors considering that as recently as February 2022 Zendesk had rejected an offer valuing the company at $127-$132 per share, but against a much more challenging backdrop and lower peer group valuations.
Outlook
Market sentiment remains extremely negative, with the lowest AAII (American Association of Individual Investor) bullish sentiment recorded since 1992 with just 15% of investors bullish. The consumer faces meaningful pressure from soaring inflation (CPI 8.6%), while high gas prices (>$5/gallon), oil prices (Brent >$100) and mortgage rates (6%) are all contributing to the tightening of financial conditions, on top of the Fed’s biggest rate hike since 1994 (75bps).
Market breadth remains weak with just 19% NYSE stocks closing above their 200-day moving average at the half-year point and the average stock’s correlation to the S&P 500 at the high end of recent ranges. Investors are concerned company earnings estimates need to be cut across the board. Within the technology space, almost half of NASDAQ composite stocks are down >50% from their 52-week highs, so hopefully negative revisions are to some degree already reflected in this weakness.
There are some encouraging signs, however. While growth stocks were weak for much of the second quarter, they performed better on a relative basis to value stocks towards the end of this period as bond yields rolled over (the US Treasury 10-year yield moved back down through 3%). Fed futures curves suggest US interest rates might peak as soon as 1Q23 and the demand destruction brought by an economic slowdown ease inflationary pressures. Meanwhile, the spread between the 10-year bond yields and 10-year inflation-adjusted bond yields (TIPS) – which reflects inflation expectations – also look to have peaked and the Bloomberg Commodity Index has rolled over in recent weeks, which hopefully suggests we are past the peak of inflation concerns.
In a slower economic environment, we are hopeful growth companies will regain at least some of their scarcity premium, assuming they are still able to deliver reasonable growth. If valuation multiples begin to stabilise, we are also hopeful the underlying growth of companies’ revenue and cash flows should begin to drive stock returns. We believe many names in our portfolio fall into this category given the digital transformation imperative and the need for companies to adopt more technology not less to address cost, labour and efficiency issues and to continue to compete effectively. Even in the more cyclical areas such as semiconductors, very significant P/E compression should now at least partially reflect the likely negative revisions. As such, we will be watching stock price action in the coming months, particularly how stocks perform in response to negative revisions (better action is a precursor to stabilisation and part of a normal market-bottoming process).
We remain cautious on the outlook for consumer spending, so remain biased to adding to our enterprise exposure. CIO spending surveys indicate solid IT budget growth this year and next. JP Morgan’s 142 CIOs covering $114bn spend expect +5.3% 2022 IT budget growth and +5.7% in 2023 versus -4.8% expected during the pandemic. The massive rearchitecting of enterprise workloads to the cloud continues to offer a long runway for growth, with cloud accounting for just 22% of budgets today, expected to rise to 42% in five years. Morgan Stanley’s CIO survey found similarly steady budget growth with cloud, security, digital transformation and AI remaining in the top five priorities. Obviously, this depends on the economic backdrop, but we expect many of these projects to prove relatively resilient in a mild economic downturn, absent a longer lasting, deeper recession which would have widespread impacts well beyond the technology sector.
We are naturally cognisant that CIO surveys may be a more coincident than forward-looking measure of IT spending. If the macroeconomic environment continues to deteriorate then even strategic vendors will feel some softness. Near term, there are clear risks from a further escalation of the war in Ukraine, possibly via potential economic contagion from Germany/Europe’s heavy reliance on Russian gas. Even if there is a meaningful downturn, however, recent quantitative research from Bernstein shows the technology sector has historically performed in line with the overall market if its relative starting valuation is not elevated versus history. Today, the technology sector trades at 1.14x the market versus its 1.2x long-term average since 1977 and is supported by a stronger aggregate balance sheet.
We continue to hold a relatively high cash level and a small position in deep out of the money NDX put options to soften the portfolio beta, given the more challenging macro backdrop. However, we remain constructive on the opportunities available in technology following this material valuation reset and, at the margin, have begun to rotate back towards our favoured growth stocks and themes at the expense of more cyclical names. We will be paying very close attention during the forthcoming Q2 earnings season and will be looking to take advantage of any overreaction to more conservative outlooks (expectation resets would be healthy, in our view). We will also be travelling extensively in Q3, meeting many companies and looking for opportunities to add to those where there is a dislocation between strong long-term positioning/opportunities, near-term fundamentals and deflated stock prices.
*Not held in Fund
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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