This specialist software fund is still cheap
HgCapital Trust’s portfolio looks expensive, but its strong record should reassure investors, says Max King.
Private equity trusts have produced some of the best returns in recent years, but investors remain sceptical. The average fall in shares in the first quarter was 9% and the average discount to net asset value (NAV) grew from 15% to 21%.
The £2bn HgCapital Trust (LSE: HGT) is top of the performance table with a five-year return of 233%. Growth in NAV has compounded at 20% for the last ten years, yet the shares trade on a 7.5% discount.
Hg was one of the few trusts to sail through the financial crisis unharmed. Its strong financial position then enabled it to buy businesses while competitors were forced sellers. It sold underperforming, peripheral investments to focus on its core speciality, software and services, investing mostly via the $30bn of funds run by Hg. Sales at its top-20 portfolio companies in the last five years have grown by 22% and cash flow by 28%.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
However, these businesses look richly valued on a multiple of 27.4 times cash flow, well above the 20.5 for the S&P 500 software & services sector. With many investors believing the technology sector is still highly priced, this valuation premium accounts for some of the scepticism. Investors worry that it’s too good to last.
A greater focus on profits
David Toms, Hg’s director of research, puts this into context. The value-to-sales of loss-making firms has halved in the last year, he says, but that of profitable firms is only down 4%. “Unprofitable companies were growing sales much faster, but growth for growth’s sake has been hit hard.” A year ago, unprofitable companies were valued at very similar levels to profitable ones, but now they have reverted to their historic valuation discount.
The software sector now trades on 18 times cash flow, compared with 14 for non-software, yet the valuation relative to free cash flow is similar at 28 and 27. This reflects the low capital requirements of software.
Twenty years ago, software companies were selling large packages, making sales lumpy and vulnerable to delays and postponements. Now, sales are by annual subscription, making them more predictable. Software sales growth in 2022 was 11%, compared with 6% for non-software. Hg focuses on businesses with “consistency and replicability of performance,” says Nic Humphries, Hg’s senior partner. He expects “software sales to continue to grow at 2.5 times the rate of GDP”.
Hg concentrates on mission-critical business-to-business software. It does not invest in start-ups: “we track businesses on average for five years before investing”. While it does not rule out unprofitable businesses, a clear path to significant margins is essential. Portfolio businesses are highly profitable, generating an average 35% margin of cash flow to sales.
High-quality management
The manager’s continued ability to find new investments at attractive prices was shown by two acquisitions in early April, costing Hg a combined £114m. This still leaves £318m of liquid resources available for future purchases, assuming no disposals. The fact that disposals in 2021 were at an average uplift of 40% to book value confirms that the portfolio valuation, far from being extravagant, is modest.
The management of the portfolio is labour intensive and the managers are well rewarded for success. As for all listed private equity trusts, the total expense ratio is high (1.4% in 2021). This makes most private wealth managers reluctant to invest in the sector and so it trades at generous discounts to net asset values that are both conservative and out of date. Therein lies the opportunity for private investors concerned only with performance.
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
-
Christmas at Chatsworth: review of The Cavendish Hotel at Baslow
MoneyWeek Travel Matthew Partridge gets into the festive spirit at The Cavendish Hotel at Baslow and the Christmas market at Chatsworth
By Dr Matthew Partridge Published
-
Tycoon Truong My Lan on death row over world’s biggest bank fraud
Property tycoon Truong My Lan has been found guilty of a corruption scandal that dwarfs Malaysia’s 1MDB fraud and Sam Bankman-Fried’s crypto scam
By Jane Lewis Published
-
Halifax: House price slump continues as prices slide for the sixth consecutive month
UK house prices fell again in September as buyers returned, but the slowdown was not as fast as anticipated, latest Halifax data shows. Where are house prices falling the most?
By Kalpana Fitzpatrick Published
-
Rents hit a record high - but is the opportunity for buy-to-let investors still strong?
UK rent prices have hit a record high with the average hitting over £1,200 a month says Rightmove. Are there still opportunities in buy-to-let?
By Marc Shoffman Published
-
Pension savers turn to gold investments
Investors are racing to buy gold to protect their pensions from a stock market correction and high inflation, experts say
By Ruth Emery Published
-
Where to find the best returns from student accommodation
Student accommodation can be a lucrative investment if you know where to look.
By Marc Shoffman Published
-
Best investing apps
Looking for an easy-to-use app to help you start investing, keep track of your portfolio or make trades on the go? We round up the best investing apps
By Ruth Emery Last updated
-
The world’s best bargain stocks
Searching for bargain stocks with Alec Cutler of the Orbis Global Balanced Fund, who tells Andrew Van Sickle which sectors are being overlooked.
By Andrew Van Sickle Published
-
Revealed: the cheapest cities to own a home in Britain
New research reveals the cheapest cities to own a home, taking account of mortgage payments, utility bills and council tax
By Ruth Emery Published
-
UK recession: How to protect your portfolio
As the UK recession is confirmed, we look at ways to protect your wealth.
By Henry Sandercock Last updated