Finding the next Facebook: how to find better returns beyond the stock market
The first annual report from Woodford Patient Capital, the investment trust launched by Neil Woodford, contained reminders that investors should strap in for the long haul.
The report laid out the trust’s major positions in “unquoted” companies, those yet to list on the stock exchange. There was plenty of good news – for example, the trust’s largest unquoted holding, the British biotech firm Immunocore, which makes up 5pc of the entire portfolio, saw its value jump by 16pc.
Investors will also note that Immunocore made a loss during the year. In fact, no profits were made at any of the leading unquoted holdings detailed in the trust’s report.
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This should come as no surprise, of course, but serves to remind the army of Woodford fans who joined in at the trust’s launch that their money is funding embryonic companies that may take a decade or more to fulfil their potential.
By investing in this way, they are hoping to buy a slice of growth that may no longer be available once these companies are mature enough to list on the stock market. Savvy investors increasingly view exposure to unquoted shares as an important ingredient in successful long-term investing. There are risks and technicalities that may rule it out for many, but the rewards could be great.
Here we look at the case for buying unquoted firms, and offer some routes for private investors.
Why buy unquoted?
Finding the next Facebook is the dream of all investors – the problem is that the next Facebook may not want to be found.
Listing on the stock market is the traditional route for companies to raise money and expand but there is increasing reason to think the giant, world-changing companies of tomorrow will not emerge this way. They may not need the large amounts of cash to build factories or hire great workforces that a flotation can provide.
Businesses that innovate in areas of IT, the internet or biotechnology are often able to make do with less, at least early on in their life.
This trend towards “capital-lite” growth was spotted by James Anderson, manager of the Scottish Mortgage investment trust.
Writing for Telegraph Money in November last year he said: “Building companies now requires far less capital than when Mark Zuckerberg [the Facebook founder] was a student. Some estimates suggest that building a software or internet company costs as little as a 10th as much as a decade ago.
“In turn this means that new enterprises have little need to become public companies with all the compromises, ceremonies and temptations to short-termism that this usually entails in the absence of a determined founder owner.”
Buy small firms – by buying big ones
Scottish Mortgage contains a number of unlisted companies, including Flipkart, an Indian e‑commerce company founded by two former Amazon executives, and Dropbox, an American “cloud” data storage firm.
Its top holding is Amazon, which is a listed company but has acquired dozens of nascent tech firms over the years – firms that may never now be listed in their own right. Buying Amazon shares, or those of other global tech giants such as Alphabet (owner of Google), Facebook and Alibaba, offers a route for ordinary investors to get exposure to these innovative start-ups.
Much has been made of Google’s activity in the area of robotics, including trials of driverless cars. Robotics is predicted to become a major trend in developed economies as productivity falls and populations age.
The so-called “Fang” companies – Facebook, Amazon, Netflix and Google – saw their shares grow by an average of 82pc in 2015 as investors banked on their stables of acquisitions producing the next generation of tech giants.
Investment trusts – a more direct route?
Woodford Patient Capital and Scottish Mortgage are both examples of investment trusts that blend quoted and unquoted holdings. Other trusts offer retail investors undiluted exposure to stakes in unquoted businesses.
They invest across a range of enterprises and look to hold their stakes until the company is bought or listed on the stock exchange. The companies include, but are not limited to, younger companies looking to grow without the need to satisfy the demands of public shareholders.
Ben Yearsley, co-founder of Wealth Club, an investment service for high net worth individuals, said: “There are all sorts of requirements that come with a public listing that are a headache for companies when they are looking to grow.
“Private funding can be more understanding to their needs and allow them to invest without the more instant demands of stock market investors.”
Mr Yearsley said he had recently invested in Pantheon International, an trust that invests in “private equity” funds that make investments in unquoted firms. Its shares are currently trading at a discount of around 30pc to the value of its assets. Such wide discounts are not unusual.
While privately owned companies are not inherently more likely to fail than listed ones, investors face “liquidity risk” – the chance that they cannot get their money out when they wish.
Ben Seager-Scott, director of investment strategy at Tilney Bestinvest, an advisory firm, said: “In pretty much all cases unquoted investments are considered very high risk, not least because there is essentially no day-to-day liquidity, so investors demand a significant premium in exchange.”
This makes any unquoted investment risky and investors need to expect to be invested for very long periods. The returns, however, can be worth the wait.
Mark Dampier, head of research at Hargreaves Lansdown, the fund shop, said: “Unquoted businesses are valued differently, perhaps only twice a year instead of daily. These valuations are usually pretty conservative, which means, when investments come to fruition, you can be pleasantly surprised.
“They appeal as an investment to buy and stick in the bottom drawer.”
Alan Brierley, director of the investment trust team at Canaccord Genuity, the stockbroker, recently rated the HarbourVest Global Private Equity trust as a “buy” that offers investors a high degree of diversification to reduce risk.
“It gives investors highly diversified and low-risk exposure to global private equity, with the portfolio comprising 750 funds and nearly 7,000 underlying companies,” he said.
Since launch, the HarbourVest trust has delivered an annualised total return of 11.2pc, based on its net asset value. Mr Brierley added that many of its holdings were reaching maturity, which “bodes well for ongoing realisations”.
The trust is currently trading at a discount of about 23pc.
VCTs – unquoted investing with a tax break
Venture capital trusts (VCT) are a type of investment trust with special tax status. VCTs are restricted to investing in small British companies with no more than 250 employees and £15m gross assets at the time of investment. A recent rule change means most companies held must be no more than seven years old.
If you invest at launch, 30pc income tax relief is available. Capital gains and dividends are also tax-free. Tilney Bestinvest suggested Octopus Apollo, Downing Two and Puma 12 as VCTs that focused on unquoted companies and were open for investment with tax relief.