Neil Woodford: "Unquoteds have huge potential"

This undervaluation is symptomatic of simple dynamics: the demand for capital in this sector is high, but its supply is very constrained. This reflects the fact that very few investors are willing to embrace the long-term ‘patient capital’ approach required in this sector to deliver successful outcomes.

Early-stage companies need nurturing to fulfil their long-term potential. This sits uncomfortably with many investors who take a short-term view and expect their investments to deliver returns within one or two years.

Early-stage business are also labour intensive from an analytical and an oversight point of view. They have the potential to deliver significant outsized returns over time, but they will often need periodic injections of capital before they become self-sustaining businesses. In this way, they should be viewed as partly-paid investments, where over time more capital is invested as the business begins to fulfil its potential and as pre-determined hurdles are overcome. Although these early-stage investments may be small in a portfolio context initially, we expect them to become bigger as they mature.

In many respects my team and I view all other stocks in the portfolio in the same way. We look at all companies through the same valuation lens, whether they are FTSE 100, midcap, Aim-listed or unquoted.

When undertaking investment due-diligence, we look at the business area the company operates in; its technology; its patent estate and market opportunity; its products and services; and its management team. Detailed analysis helps us to make a judgement about value based on a longer-term investment time horizon (typically, three- to five- years or sometimes longer).

There are nuances to this process. With early-stage companies, typically we are looking to invest before a company or product has made it to the market. In many circumstances, it will not have been approved by the relevant regulatory authority. The strength of a company’s intellectual property and research behind it is, therefore, crucial.

I have been investing in early-stage companies for more than a decade and along with my team I have been able to cultivate a network of trusted advisers who help reinforce our detailed due-diligence process. When this process is complete we then make a valuation judgement that reflect the risk, reward trade-off. It is no good having a solid business proposition, with leading technology, sound financials and strong management, which you then overpay for.

Valuation underpins all of our investment decisions. We are very conservative in terms of timelines and costs that might be attributed to a product. We also risk our capital at a high level, so we'll use a discount rate that can be fairly aggressive, perhaps 20 to 25 per cent, to ensure that the valuation reflects the inherent risks.

Our interest in this unloved sector of the market reflects our belief that it offers unrivalled investment opportunities. The risks are higher than in the more mainstream investment universe, but when adjusted for these additional risks, the rewards look extremely attractive.

University-inspired companies that have caught my eye

The CF Woodford Equity Income Fund (GB00BLRZQ513) is invested in 10 unquoted companies making up 5.4 per cent of the portfolio as at 31 October 2014, but it also holds several former unquoted companies, some of which such as Allied Minds (ALM) have only recently listed on the stock market. Many have close links to Britain’s universities.

The UK has some of the best universities in the world, developing some of the best intellectual property. Yet we have not had a good track record of converting these great ideas into long-term commercial success, mainly because, in my view, there is a distinct lack of appropriate capital. There is too much of a gap between academic research and the investment industry in the UK – by providing some of this much-needed patient capital we can help to bridge this gap.

NetScientific (NSCI)

The company commercialises research from top universities and teaching hospitals in Britain and the US, and is chaired by Sir Richard Sykes, former chairman of GlaxoSmithKline. The company lead products are a diagnostic for circulating cancer cells and a remote digital diagnostic for early-stage brain disease.

IP Group (IPO)

Founded in 2001, IP Group, partners with 15 British universities and has launched more than 70 spinout companies. The company's portfolio comprises holdings in over 70 companies including Revolymer, an innovative polymer technology company and Oxford Nanopore, two companies that are also in the CF Woodford Equity Income portfolio

Imperial Innovations (IVO)

Founded by Imperial College, London with technology commercialisation rights over intellectual property developed at the University. It focuses on healthcare but has other investments in other sectors. It also collaborates with Oxford and Cambridge Universities and University College London on a non-exclusive basis.

Allied Minds (ALM)

An innovation company that forms, funds, manages and builds start-ups based on early-stage technology originating from US universities and federally funded research institutions. It floated on the London Stock Exchange in June. The Woodford fund also holds the unquoted stock, Spin Transfer Technologies, which was spun out from the company.

• Neil Woodford is head of investment at Woodford Investment Management and manager of the CF Woodford Equity Income Fund, a member of the IC's Top 100 Funds.

Unquoteds in the CF Woodford Equity Income Fund

Total weighting 5.36% across 10 holdings (11 lines but two relate to Biofem) as at 31 October 2014.

The previously unquoted holdings in the CF Woodford Equity Income portfolio are:

Allied Minds 2.40%

RM2 0.52%

Circassia 0.38%

Xeros 0.15%

Source: Woodford Investment Management as at 31 October 2014