Talking tech with the Techinvest fund manager

"It is important to stick to your criteria and ensure it ticks the boxes."

Chris Menon interviews Darren Freemantle, co-fund manager of the top performing Techinvest Technology Fund

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Talking tech with the Techinvest fund manager

Darren Freemantle’s £42m MFM Techinvest Technology Fund was 342.45p a share at the end of April, a share price gain of 284.9% since the start of 2009, and more than 122 percentage points ahead of its nearest rival in the Technology & Telecoms IMA classification table. Here he talks about investing in the tech space.

Chris Menon: How would you characterise the investment style of your fund?

Darren Freemantle: We are value-orientated growth investors. This means, firstly that we are seeking growth companies, or those with significant growth potential, within the technology space. So it may be those with significant capacity for earnings growth over a 3-5 year period. The value part is that those companies will have value characteristics associated with them as well. So you have strong balance sheets, with plenty of cash. So if they are loss-making it is not necessarily a problem because they have enough cash to take them through to profitability.

The other thing to point out with this style is that we are stock pickers, we are not themed investors. We are very much bottom up, stock pickers and are fairly agnostic as to the various sub-sectors within the tech space. If we are finding value in what some might consider a boring part of ‘old’ tech, then so be it.

Chris Menon: To what do you attribute the funds outperformance over the past 5 years against your peers and the benchmark?

Darren Freemantle: The reason for our outperformance is our focus on the smaller caps. If you look at our peer group within the IMA technology and telecoms sector, they tend to be specialising in the large and mega cap end. You tend to find when you look at their top ten holdings that they tend to be quite similar; you have the usual suspects in there, such as the Googles, eBay and Amazons of the world.

We are very much sniffing around in the smaller caps, those that are not very well followed by analysts. In fact, those that follow the tech space will sometimes find that they look at our list of holdings and have not heard of a number of names on the list.

You might say, what is a small cap? That could be anything from US$100m up to $1bn or more. Most of the fund is concentrated in stocks in that area.

I think that the US has a different definition of small cap than the UK. In the UK we might consider it be a anything with a market cap of less than £100m, whereas in the US you might consider that to be a microcap. I’ve heard the term nano cap used for companies with a market cap in the tens of millions of dollars.

We tend to go by the American definition of small cap, so it is sub $1-2bn. Over the three-quarters of the fund are in market caps of $100m to $1bn.

The thing to say about small caps is that those companies that are not well followed by analysts (they might only be followed by one or two analysts), those are the ones that are most likely to become undervalued and move up quite dramatically when investors start to take an interest in them.

The market for small caps tends to be less efficient than for larger caps.

Our unique proposition tends to be that as far as we are aware we don’t know of any other technology-focused fund on either side of the Atlantic (US, UK and Canada), aimed at retail, that actually specialises in small cap tech in the way that we do.

Chris Menon: Are you concerned that the US market is overvalued?

Darren Freemantle: We tend to be fairly relaxed about overall market valuation and what one call macro factors.

Are you talking about the technology sector in particular or just the US stock market in general?

Chris Menon: I was talking about the US market in general. But also there was talk about the US technology market being overvalued, then there was a small downward movement. I haven’t followed it that closely but probably the likes of Twitter and Facebook might still be considered to be overvalued?

Darren Freemantle: I think you’re making a good point there. There are probably two things to say there. One is that we’ve had a great run on the stock market since the beginning of 2009 and the aftermath of the banking crisis. By historic standards it is a long bull run to have got to this stage, so to have consolidation before the next leg up is perfectly healthy. It is to be expected, as well, after a long run that you are going to have some overvaluation around the edges.

If you are looking at the tech space in particular, I think it is fair to say that things are getting a bit overheated in some of the so-called ‘hot’ areas with some of the more hyped names. In the social media space, I think you mentioned Twitter as an example. In big data you may have heard of Splunk, while you could cite Facebook’s purchase of Whatsapp and the price it paid.

Having said that, we don’t think that longer term investors should be concerned for two reasons: one, if you look at the likes of Apple, its price earnings ratio is 12-15, it is growing at 15% per annum, $150bn in cash and you have Carl Icahn buying shares. He is a value investor: he wouldn’t be sniffing around the likes of Apple, and eBay as well, if he thought they were overvalued.

Also, if you look at a lot of the smaller caps as we do, a lot of them are profitable, highly cash generative, balance sheets very strong, stuffed with cash, and on very reasonable valuations.

However, I agree that around the edges some of those names, especially in the social media space, were getting a little bit overvalued. However, that isn’t an indictment of what’s happening with the tech sector in general.

Chris Menon: Are you finding much value out there at the moment?

Darren Freemantle: Yes. There are plenty of names out there among the smaller caps, that are looking extremely attractive still.

After the Dotcom bust of 2000 a lot of the tech space just got its head down and got on with the job. Now it is has found itself in a position where their balance sheets are in great shape, they have lots of cash and potential for strong growth, which still isn’t priced in.

Chris Menon: What criteria do you look for in a potential investment?

Darren Freemantle: Cash is very important. We like companies that have plenty of cash, that are likely to see themselves through to profitability.

Research & Development spend is extremely important with a tech company. If you have a tech company that isn’t spending a lot on R&D it is unlikely to maintain a leadership position. That would be another aspect to the criteria.

Chris Menon: Is it difficult to accurately measure R&D spend? I’ve read that because of the way that companies treat such expenditure it is difficult to make comparisons between companies in the same sector, never mind different sectors.

Darren Freemantle: I agree with you on that. It has probably got even worse in the UK in recent years because companies that have gone over to IFRS accounting are obliged to capitalise a proportion of their R&D expenditure. That makes things a little bit more difficult.

In the US, a company will provide accounts in US GAAP form, but it will also provide accounts in non-US GAAP form, where R&D isn’t capitalised.

It’s not to say that just because a company is spending money on R&D that it is necessarily going to be effective spend. Having said that, the reverse is almost certainly true: if it is not spending on R&D that is a red flag and a warning sign.

The other thing that is very important as well is the management team. If you have a management team that has done things in the past that have worked out well for shareholders.

Also, another area that we like is ‘recovery’ stocks as they can often make excellent prospects. You’ll often find that with a technology company early in its development it is perfectly normal for it to hit a glitch of some kind, especially if it is growing fast. And with those companies you might find that the shares ramped up early on as investors got into the story and then suddenly they all clambered to get out.

Chris Menon: Can you give me an example of a recent one?

Darren Freemantle: Probably a good example of that in recent years might be a company like Sandvine, in Canada. People got behind the story early on, got quite excited about it but it didn’t quite meet investors’ expectations. So investors sold out and the shares followed suit.

We kept a close eye on it and gradually increased our stake with the shares at very low levels because we felt that the company is in an excellent space. Now, with the shares rising the company is now the largest holding in the fund.

Chris Menon: What are the total costs to investors buying into your fund?

Darren Freemantle: It is a 5% up front charge in the prospectus, although we’re aware that not everybody pays that if they come in through certain platforms. There is also a 1.6% ongoing annual management charge.

Chris Menon: Among your top three holdings, can you explain what it is about them that you like?

Darren Freemantle: I’ve mentioned Sandvine. It is Canada-based company that is a play on the growth of broadband data traffic, especially mobile and video. The advent of the smartphones and the data that we’re all consuming either on the mobile or through our wifi at home means broadband data traffic is growing exponentially while the infrastructure is struggling to keep up with it.

The telecoms provider or ISP is going to have to get incredibly smart about how it delivers this data around the system. So it has got to look into the data, work out what it is, and try to route it accordingly. That is where Sandvine comes in. Its software is what is called ‘deep packet inspection’, it actually looks at the data to determine what it is and allows the telco to route it accordingly.

Now where this becomes a bit controversial is that we have a concept called ‘net neutrality’, that means all data should be treated equally. It was enshrined into the internet by its founding fathers. The idea is that you should treat every user, content and platform application equally, no matter what it is.

That is an argument that regulators in the US are having at the moment. Unfortunately, we can’t build the infrastructure fast enough to keep up with the exponential growth in traffic. So something has to give. I suspect that ‘net neutrality’ will have to come to an end at some stage but it will have to be highly regulated to prevent any potential profiteering by ISPs.

So this is a company with plenty of cash and it has a very strong product set. It has a CEO, Dave Caputo, with a good track record, so it’s one that we’re happy to have a 4.6% holding in at the end of April.

IndigoVision is a play on IP video security. This company was traditionally an “also ran” in the sector. It sold analogue cameras and encoders to help convert content for use in digital players. However, over the past year it has really beefed up its offering with a whole new range of IP digital cameras with associated software.

The coverage of public places by security cameras is incredibly important. However, you don’t just need the cameras, you need the associated systems so that you can track people, be able to rewind, pull things out and co-ordinate your surveillance.

Unfortunately, the Boston bombings showed us all the importance of video security in public places. On the back of that a lot of US cities intend to spend heavily on video security. The upcoming World Cup is another example. Travelling fans will be monitored over IP networks for their safety and security. The video security sector is likely to see a dramatic increase in investment over coming years.

IndigoVision is a very small company, with a £35m market cap. It is not well followed and there is only one London analyst following it. We think it has been overlooked by the market and looks good value relative to its peers at the moment.

Red Knee Solutions is another Canadian company, Toronto-based, that provides software for converged billing for telecoms. So, if you are roaming from one territory to another and using different telecoms providers and using voice, data, SMS and apps, this is a company that helps telcos put billing together in real time for them. So, you can go to a website and see what your billing is up to the minute. They operate in 90 countries at this stage. What was transformational for them back in 2012 was that they made an enormous acquisition, of the Nokia Siemens Networks’ converged billing network. It bought in about 1200 staff, many times the size of Red Knee.

Investors often say that is a red flag as there you have potential banana skins all over the place with such an acquisition. However, it was in 2012 that they did it and it has been extremely successful, which is proof of the extremely strong management team that Red Knee have.

The most recent results show a very strong backlog for the company. Some investors maybe were a little disappointed by the last set of results as recurring revenue was slightly down but that was really due to a change in the revenue mix, which will probably improve again in the next quarter.

Again, it’s another company that isn’t well followed at all. It is one that should show significant growth over the next few years.

Chris Menon: How many holdings do you have and what’s your average holding period?

Darren Freemantle: I think it is 73 at the moment but it is typically between 70 and 90. As to our average holding period, I haven’t actually worked it out but, when we acquire a stock we always take a 3-5 year view. We very, very rarely invest on a shorter term basis. We have a long-term time horizon when we invest in a stock and we encourage investors in our fund to have the same.

Chris Menon: When researching funds what screening tools do you use to sort out the wheat from the chaff? (For example, is there a fundamental database you could recommend?)

Darren Freemantle: It’s our own model, we look at forward earnings, the company versus its sector. We look at price to sales ratios as well, we look at the potential for margin improvement, we look at the R&D as I’ve mentioned. The strength of the balance sheet, how much cash is there to help it keep going if it is loss making, is very important as well.

Then I suppose you have the more abstract factors such as the strength of the management team, and maybe looking at the prospects for the industry and the wider economy. That helps you build in a confidence factor for that particular stock that you can throw into the model and see what comes out.

For a fundamental database we look at Bloomberg. There’s a wealth of information available going back many years, from financial data and metrics, company news flow and chart technicals. Transcripts of earnings conference calls between management and analysts are also available and can provide some important insights, especially regarding North American companies.

We also find that, especially for UK companies, a meeting with management can be an important way to get a deeper understanding of a story.

For the UK stocks as well we look at Company REFS. That is a very good resource for giving one a snapshot of a company and where it is. That can often be a very useful first pass, to have a look at the Company REFS sheet to see if you want to have a further poke around at it.

Chris Menon: What warning signs put you off investing in a company?

Darren Freemantle: The thing not to do, particularly in the tech space, is to fall in love with a particular story or technology. You must recognise that there is incredible execution risk with tech and it is fast moving sector and you should be willing to change your mind as a result of the story changing.

It is important to stick to your criteria and ensure it ticks the boxes.

Chris Menon: For those trying to educate themselves in terms of investing could you recommend an accessible book?

Darren Freemantle: Well actually, I mentioned Company REFS didn’t I. Well, one book that springs to mind is ‘The Zulu Principle’. That was written by Jim Slater who actually devised Company REFS…That really focuses on the ‘Growth at a reasonable price’ (GARP) philosophy. It serves as an excellent primer for investors that are interested in smallcap investing because it really highlights how investors can profit from following a small company that is a very much niche player in its space.

You often find the smaller companies can be a lot simpler to understand and the benefit of it is that, and he touches on it in his book, you are following a company that not many others are following so the chances of you spotting something that others haven’t found are much higher than if you were following the likes of BP or Vodafone.

Another one that springs to mind for technology investors is ‘Super Stocks’ by Kenneth Fisher. He wrote that back in the early 80s. That is more tech-focused but again is good for the smallcaps. He touches on the importance of margin growth, price to sales ratios and the importance of R&D spend to investment analysis as well. There is plenty in his book on recovery plays where he talks about where tech stocks hit a glitch in their development and how that can be a great time to pick up a smallcap stock.

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