Katie Potts left her job as an electronics analyst at SG Warburg 25 years ago to start her own investment fund. She had become disillusioned because her views on companies had been subordinated to the bank’s corporate agenda; she decided she preferred to invest in good companies rather than make excuses for bad ones.
A successful strategy
She soon raised £65m for the new Herald Investment Trust (LSE: HRI), which would buy smaller quoted companies in the communications, multi-media and technology sectors in the UK and Europe, at a time when sentiment was very positive.
Rather than pay high prices, she parked much of the money in index-linked government bonds until valuations became more reasonable. This worked so well that Potts was able to raise another £30m in 1996, when the remit was globalised (though a strong focus on the UK, currently more than half the portfolio, was retained). That the value of the portfolio is now approaching £1bn, despite £122m having been spent on share buybacks, is testament to this strategy’s success.
Since launch, the share price has multiplied 14-fold, while UK small caps have multiplied nearly fivefold and the Russell 2000 Tech index nearly fourfold. Over five years, a 73% return far exceeds the UK small-caps index, but falls well behind the Russell index, dominated as it is by big US technology companies, which are outside Herald’s remit.
As well as being a good stockpicker, Potts has shown herself to be a shrewd market timer, not just in 1994 but again when she raised cash before the bubble burst in 2000 and in mid-2007. In 2002 and 2009 she borrowed to invest, enhancing subsequent returns.
Yet the discount to net asset value (the value of the underlying portfolio) at which the shares trade is currently 15%, and has been as high as 25%. The main reason for this is that the trust has limited appeal for professional investors. It has too much outside the technology sector and in the UK to be regarded as a tech trust; too much outside the UK and is too specialised to be regarded as a UK smaller-companies trust. These investors balk at the 280 holdings, the top ten of which, including advertising agency M&C Saatchi, make up just 18% of the fund.
Yet clearly, the strategy works. Potts likes to have a lot of small bets on the table as the best way of keeping informed about companies. She points out that big returns often come from small investments: her top-ten winners have generated £250m of profit since launch, and the top 20 £400m.
The secret of her success is that she runs the winners, while the losers are too small to dent the returns. This is shown by the portfolio at the end of 2018. The top-20 holdings have, on average, multiplied sixfold in value and been held for 11 years, while the next 20 have multiplied threefold and been held for eight years. The bottom 50, however, have lost two-thirds of their value since purchase. Potts’ reluctance to take profits means that Herald is dependent on takeovers to provide the cash for new ideas, but here, too, she is reluctant to sell out. Even though 11 of the top-20 holdings in 2007 have since been taken over and £550m raised from bids since then, Potts proudly points to deals she helped to frustrate and grumbles about the companies acquired too cheaply.
Room for small tech to grow
An investment trust is the ideal vehicle for such an illiquid long-term portfolio and Potts is positive about the outlook. Last year was dull, with a negative investment return of 5% and a peak-to-trough fall in the share price of more than 20%. Much of the drop has since been made back but, in time, there should be much more to go for. As big technology slows down, small technology companies should keep running.