Back small-cap innovators via Herald Investment Trust

If the UK market still looks cheap, it also remains a long way from offering stockpickers the excitement on offer in the US. World leading "new economy" names remain a rare sight in the domestic market, even if some believe the recent flotations of Deliveroo (ROO) and Darktrace (DARK) have set a new direction of travel. More old-fashioned sectors continue to dominate the market, from banks to miners.

Allocations in UK funds often tend to reflect this: of the best-performing UK portfolios from the last decade, names like BlackRock Throgmorton Trust (THRG) and ES River and Mercantile UK Equity Smaller Companies (GB00B1DSZS09) have big weightings to sectors viewed both as more cyclical and dated. Even Liontrust UK Smaller Companies (GB00B8HWPP49), a fund associated with the growth investment style, has some noteworthy allocations to more cyclical sectors.

Yet a middle way can be found. Although plenty of UK equity fund managers back innovative companies in disruptive sectors, it’s a specialist global fund that stands out for picking some of the best names the domestic market has to offer.

Herald Investment Trust (HRI) is not exclusively a tech fund, but its focus on communications, multi-media and technology shares points it in the direction of innovative names, while a small-cap bias offers potential for higher returns. While it has lagged established, US-heavy tech trusts like Allianz Technology Trust (ATT) and Polar Capital Technology Trust (PCT) over longer time frames, Herald has performed extremely strongly versus both open and closed-ended broad global equity funds, in the short and long term, while also outpacing UK funds over the long haul.

Importantly, Herald could fill a gap in investment portfolios which neither the big tech funds, or many global and regional equity funds, have managed to plug. Herald has often had a heavy weighting to UK stocks, with domestic shares recently making up nearly half of its assets, and some promising names appear among its top holdings. For example, identity data intelligence specialist GB (GBG), Next Fifteen Communications (NFC) and data analytics company YouGov (YOU).

Other holdings also set this trust apart. In the US, where investors are no stranger to disruption, the fund's focus on small-cap names such as software business Pegasystems (US:PEGA) can differentiate it from many other tech and US equity funds.

Herald Investment Trust has also enjoyed wins elsewhere. In Europe, Nordic Semiconductor (NOR:NOD) and BE Semiconductor (NETH:BESI) have benefited from recent chip shortages, with document automation software specialist Esker (FR:ALESK) also performing strongly this year. Holdings in Asia include Taiwan listed Momo.com (TW:8454) and Australian fund administrator Mainstream (AUS:MAI).

The trust's portfolio has performed admirably well, even amid the style rotations of 2021. In the trust’s half-year report to 30 June, its board noted that net assets grew by 14 per cent during the first half of 2021 following on from a 37 per cent return in 2020 as the portfolio benefited from a rush to digital businesses amid the pandemic. Yet talk of a value resurgence has seen the trust’s shares move to a more attractive buying point this year, with the share price discount to net asset value (NAV) widening. Having traded at a 6.4 per cent discount on 29 December 2020, Herald was on a much wider discount of 12.2 per cent on 16 July 2021, according to broker Winterflood.

Changing with the times

Herald has a long heritage, having been managed by Katie Potts since its launch in the 1990s. Its investment team is not afraid to adapt to market conditions, and the trust’s global remit allows it to do this accordingly. This is reflected in a recent decision to diversify away from the UK, driven by concerns highlighted in the trust's latest results about “gradually declining liquidity over several years,” and the potential for greatly increased regulation of its holdings due to consultations on audit and corporate governance. This desire to diversify has already fed into the portfolio, with an increased weighting to Asia in the first half of 2021 reflecting a “measured desire to reduce the UK weighting and add a greater number of Asian companies as they move further up the value chain.” The UK made up 48.8 per cent of Herald Investment Trust's assets at the end of June, followed by a 23 per cent allocation to North America, 11.5 per cent in Japan and Asia Pacific, and 10.3 per cent in Europe, Middle East and Africa (Emea).

Herald diversification comes in other forms, too. The trust's biggest five positions at the end of June – GB, Next Fifteen Communications, Pegasystems, Future (FUTR) and Diploma (DPLM) – represented just 9.6 per cent of its assets, and its 10 largest holdings accounted for less than a fifth of its assets. The trust had a hefty 352 holdings at the time making it look thinly spread, though this partly reflects the heightened risk of running a small-cap mandate. But if Herald Investment Trust looks much more diluted than many other small-cap funds, its returns speak for themselves. This level of diversification is also partly offset by the large gains made by certain winners: during the first half of 2021 podcast specialist and recent takeover target Audioboom (BOOM) delivered a gain of nearly 250 per cent. And Momo.com made the trust nearly 200 per cent over the same period.

That's not to say that such gains can be taken for granted. As with any portfolio firmly on one side of the value/growth debate, you may ask what the near future might hold for Herald, and whether growth stocks look precarious at a time of uncertainty over future growth and inflation.

Herald's investment team has acknowledged such concerns in its half-year results, warning that while sectors outside its remit may prove more vulnerable to higher interest rates, “capital expenditure is weak when the cost of money goes up, and historically the technology sector has been driven by capital expenditure.” But they add that tech spend is increasingly becoming a non-discretionary operating cost, with monthly or annual charges for servers, storage, applications and subscriptions. And “new technologies continue to open up, and cyber threats continue to evolve.”

While the short-term path for tech funds could be rocky, portfolios like these tap into longer-term, structural trends which could prove lucrative. Herald is also tapping into interesting niches in tech and other disruptive sectors, rather than simply piling into big tech stocks such as the FAANGs – Facebook (US:FB), Amazon.com (US:AMZN), Apple (US:AAPL), Netflix (US:NFLX) and Alphabet (US:GOOGL).

Herald Investment Trust is a valuable play on future trends and a way to fill strategic gaps in your portfolio. Buy. DB