The best British tech stocks from a thriving sector

Move over, Silicon Valley. Over the past two decades the UK has become one of the main global hubs for tech start-ups. Matthew Partridge explains why, and highlights the most promising investments.

At the turn of the century, the UK technology sector was seen as a relative backwater, especially compared with the major tech centres in the United States. However, over the past two decades there have been “significant changes on both the development side and [to the] start-up landscape”, says Jeremy Leonard, co-founder and CEO of digital consultancy LEAD.

Thanks to some prominent success stories, one of the best university systems in the world and various tax breaks, there has never been a better time to set up a technology company in Britain.

What’s more, the recent fall in valuations may make technology stocks seem a risky proposition, but they still offer long-term value, while lower share prices and a weaker pound have also made many companies an attractive target for private-equity firms and large competitors.

Reaching the tipping point

Taavet Hinrikus, co-founder of Wise (previously known as TransferWise) and of investment platform Plural, has seen first-hand how the UK technology sector has boomed over the past 20 years. When he first moved to London in 2004 as Skype’s director of strategy to set up its office in Soho, “we were one of a handful of technology companies in the capital”.

But within less than a decade a cluster of technology companies started to emerge in the area. Many of these would later go on to be successful, either floating or being bought out for large sums of money, helping the sector reach a “tipping point”.

These early successes have had two main effects. Firstly, they proved to a younger generation of entrepreneurs that it was indeed possible to make a lot of money by starting your own firm rather than taking the safer option of working for an established one.

Secondly, many of the founders and senior staff who got rich from the buyouts and initial public offerings have set up new companies or become prominent tech investors. Hinrikus thinks that as a result, the UK sector has gone “from having the seeds of a tech ecosystem to being one of the biggest hubs in the world”.

Julian Rowe, a general partner at venture-capital firm Latitude, agrees. He thinks that while London hasn’t quite reached the point “where you have tech entrepreneurs investing in their fourth or fifth firms”, it is now common “to see people in the UK who are starting their second or third companies”.

This has also given people the confidence “not to sell their firm immediately after they get their first offer for $100m”. Instead, they are increasingly deciding to keep growing the company until it becomes a “unicorn” (a private company valued at $1bn or more).

The best and the brightest

The UK tech sector has also benefited from being able to “attract a lot of talent from abroad”, says Gary Dushnitsky, associate professor of strategy and entrepreneurship at London Business School. He thinks that immigration of skilled workers to the UK is particularly important for tech.

It has improved the calibre of programmers and software engineers and boosted the quality of tech firms’ management. Both factors are key building blocks of a sustainable technology sector.

Britain’s ability to attract the “best and the brightest” is such that London isn’t the only UK destination for tech workers and entrepreneurs anymore, notes Gerard Grech of Tech Nation, a national network for tech entrepreneurs in Britain.

While most European countries “have just one area where all their tech firms cluster, with even France limited to two”, there are as many as 20 mini-clusters in the UK. They include “Edinburgh, Manchester, Oxford and even Belfast”.

Grech is bullish about Britain’s ability to attract people with the appropriate levels of skills in future. He says the changes to Britain’s immigration policy post-Brexit are a net positive for the tech sector as they have led to “more visa routes for entrepreneurs and people with digital skills from outside the European Union”.

Money is flowing in

In addition to people and managers with ideas, tech firms also need large amounts of money. The good news is that investors have responded well to the various tax incentives and schemes that have been set up to encourage investment from individuals and venture-capital firms.

The three main schemes are the Seed Enterprise Investment Scheme, the Enterprise Investment Scheme and venture capital trusts. Grech also notes that a review of the rules governing listings should eventually make it much easier for entrepreneurs to float their firms on the London Stock Exchange.

Britain is in fact becoming such an attractive destination for venture capital that “whereas British tech entrepreneurs usually had to make a pilgrimage to Silicon Valley if they wanted to raise money”, the venture capitalists “are now having to come to them, because there are so many opportunities here”, says Latitude’s Rowe.

Several large venture-capital firms have recently opened up London offices. What’s more, while investment in tech by UK pension funds has been “criminally low”, even that “is starting to change”.The overall effect of this “huge push” to make it more attractive to invest in start-ups has led to several “record-breaking” years for tech investment, notes Lucy Coutts, investment director at JM Finn & Co.

This reached a peak last year, when £29.4bn was invested in UK start-ups, more than twice the total seen in 2020, and nearly 20 times 2013’s £1.5bn. Looking beyond start-ups, the government is aiming to persuade the private sector to double its spending on research and development (R&D) within the next few years.

Universities are rising to the challenge

Britain’s universities are also helping to drive UK tech forward. Our universities are punching above their weight. Indeed, according to the Times Higher Education World Rankings, four British institutions – Oxford (in top spot), Cambridge, Imperial College and UCL – are in the global top 20, with a further seven (LSE, King’s College London, Manchester, Edinburgh, Glasgow and Warwick) in the top 100.

However, despite universities’ reputation for producing world-class research, the tech sector has traditionally been regarded as “quite weak at making the transition from laboratory to market”, says Coutts.

But in recent years there has been an effort to change this, with the Higher Education Innovation Fund sponsoring more collaboration and sharing of knowledge between universities and firms.

As a result, universities are starting to commercialise more research. While much of this still comes from Oxford, Cambridge, Imperial College and UCL, which account for 40% of university-related ventures, “other institutions, such as Birmingham, are also starting to produce their own”, she adds.

Barriers remain. One of these is that universities are too “transactional” – they still seem a lot more interested in “maximising the slice of the pie” they secure from their intellectual property (IP) rather than growing the IP, says Rowe.

Rowe thinks that universities need to make it more attractive for staff to commercialise their research by reducing the percentage of any firms that universities take. Otherwise staff will not devote much effort to starting new companies, or they will move to countries that offer a better deal.

Nonetheless, while UK institutions “need to develop better processes and structures to translate ideas into companies”, Britain still “has the elements to make this area a huge success”, says Louis Coke, senior investment manager at Charles Stanley. These include “great academic facilities, talented students from the UK and overseas”, as well as the “capital markets and the investor base” to ensure they stay in the country. He notes that between 1998 and 2018, almost 1,000 companies (across all sectors) were created from university research.

A resilient industry

The British technology sector is also resilient enough to shake off the recent bursting of the tech-share bubble, says Malcolm Ferguson, partner at Octopus Ventures. While the dramatic share-price falls may now “make it a bit harder for firms to raise capital”, such downturns “are a normal part of the cycle”.

He notes that many of the most well-known tech companies began during some of the worst downturns, “with PayPal and LinkedIn being formed from the wreckage of the dotcom bust, while Uber started during the global financial crisis”.

In any case, with people “still looking for growth”, really good technology companies remain highly valued, says Brendan Gulston, co-manager of the Gresham House UK Multi Cap Income Fund. There is also a “strong appetite for takeovers” in the industry, especially since recent falls mean that the UK stockmarket “is now relatively cheap”. With the largest tech companies now starting to accumulate cash and private-equity firms presiding over plenty of capital to deploy, there have been several prominent acquisitions over the past year.

Gulston experienced this directly in May 2022 when HG Capital bought Ideagen, a software company that Gulston’s fund had invested in at an early stage, for more than £1bn. It paid a high multiple of 34 times earnings before interest, tax, depreciation and amortisation (Ebitda).

Gulston also notes that US private-equity group GTCR is considering a bid for digital-identity specialist GB Group, while other funds are reported to be mulling over their own offers. Demand for UK tech firms hasn’t diminished.

Rich pickings for investors

Of course, takeovers from bigger companies can be a double-edged sword for shareholders, as they “mean that companies end up being acquired before they reach their potential”, say Victoria Stevens and Alex Wedge of Liontrust.

This in turn means that it may take some time before the “dearth” of large-cap UK tech shares is rectified. Still, takeovers can allow investors to turn a quick profit. More broadly, the fall in prices means that there are now “plenty of rich pickings” for ordinary investors. They have a wide range of cheap UK tech shares to choose from in the “vibrant small-cap sector”.

Stevens and Wedge also believe technology companies will benefit from the fact that the acceleration to digitisation that occurred during the pandemic will endure.

In certain sectors, many companies “experienced five years of changes in five months” as firms who “had previously been trying to get customers to pay attention to them were suddenly inundated with demand for their products”.

The fact that the UK tech sector “is much stronger in producing world-beating software than it is in producing hardware” should mean that it continues to do particularly well. Octopus’s Ferguson thinks that at present the UK is particularly strong in five main areas: financial technology (fintech), deeptech (engineering technology), health-related technology, consumer technology and business-to-business software.

In particular, investors should keep an eye out for technologies that will reduce the huge pressures on the NHS, especially addressing the shortage of health practitioners. He is particularly interested in digital therapeutics, the use of software in treatments and the application of artificial intelligence to diagnoses.

Charles Stanley’s Coke thinks the fact that the UK has a “large and well-established financial services industry”, which is struggling to make its services affordable for the average consumer, will ensure that demand for fintech remains high.

While technology firms around the world are trying to provide products, UK firms “tend to understand our regulatory system better than overseas firms”. The added bonus of developing fintech products is that good products “generate reliable cash flows from what may well end up being quite a ‘sticky’ client base of financial services businesses and end users”.

The best British tech stocks and funds to buy now

One technology investment trust that Lucy Coutts of JM Finn & Co recommends is the Herald Investment Trust (LSE: HRI). Run by veteran tech investor Katie Potts, it focuses on smaller quoted companies in the areas of telecommunications, multimedia and technology. Nearly half the holdings are based in the UK, compared with just 24% in North America. The largest holdings include Next Fifteen Communications and GB Group. While the fund has had a “torrid time” of late, Coutts thinks that it offers “great value” given its large discount to net asset value (NAV) and long record of beating both the FTSE and the Nasdaq indices.

Another trust Coutts likes is Chrysalis Investments (LSE: CHRY), which invests in a large number of private companies in the UK and Europe. These include several well-known British tech names such Starling Bank, The Hut Group, Klarna and Wise (formerly TransferWise). This fund is not for the faint of heart, especially since its share price has fallen by 75% this year in the wake of the collapse in tech valuations. But Coutts thinks that the trust’s discount to NAV of 33% gives investors a lot of upside, especially if the sector rebounds.

If you want to invest in university spinouts, then Louis Coke of Charles Stanley suggests IP Group (LSE: IPO), which specialises in taking ideas developed at institutions and turning them into “great businesses”. About two-thirds of the portfolio is invested in life sciences, with the rest in the wider tech sector. At present it has relationships with 17 universities, including Bath, Manchester and UCL, as well as stakes in the venture-capital arms of both Oxford and Cambridge. Coke thinks that IP Group’s “connections, record and capital” enable it to add real value, giving it a competitive advantage over other companies in this area.

One of IP Group’s big holdings is Oxford Nanopore Technologies (LSE: ONT), which accounts for roughly a fifth of the portfolio. Nanopores are minuscule holes; they are embedded in high-tech electronic products to analyse molecules. The group says it has developed “a new generation of sensing technology”. The firm is not making any money, so it is only for investors who are willing to tolerate high levels of risk. However, Julian Rowe of Latitude argues that Oxford Nanopore’s subsector is relatively niche, but growing extremely quickly, making the stock a good long-term investment.

A less risky stock is Big Technologies (Aim: BIG), which specialises in personal monitoring devices used in healthcare and for tagging young offenders. Liontrust’s Victoria Stevens and Matt Tonge, who have been cornerstone investors in the company, praise its “great intellectual property” and “long, predictable contract structures”. They are also very positive about CEO Sara Murray, one of the founders of Confused.com. They see her as “a classic owner-manager”. While the shares are pricey on a 2023 price/earnings (p/e) ratio of 36, this is more than justified by the fact that sales nearly doubled between 2019 and 2021 and continue to grow strongly.

Stevens and Tonge also like Tribal Group (Aim: TRB). Tribal provides educational software to help universities monitor students’ progress. They think that Tribal’s move “towards a subscription-based software-as-a-service model” and upgrades to its technology will help it maintain a large market share in the UK as well as move into the lucrative Australian market. Tribal is on a 2023 p/e of 17.

Recommended

State pension errors – why tens of thousands of mothers could be missing out on millions in state pension payments
State pensions

State pension errors – why tens of thousands of mothers could be missing out on millions in state pension payments

LCP launches Mothers Missing Millions campaign amid DWP state pension errors.
3 Dec 2022
The top funds to invest in now
Funds

The top funds to invest in now

As market volatility continues, here are the top funds, stocks and investment trusts investors are putting their money into, according to one investme…
2 Dec 2022
The best places to live in the UK – and how much they will cost you
House prices

The best places to live in the UK – and how much they will cost you

Thinking of moving? Here are the best places to live in the UK and how much they will cost if you are buying.
2 Dec 2022
The pros and cons of smart meters – should you switch?
Personal finance

The pros and cons of smart meters – should you switch?

A smart meter can help you keep tabs on your energy usage, but is it better than a regular meter? We take a look at smart meters vs regular meters.
2 Dec 2022

Most Popular

Is it cheaper to leave the heating on low all day?
Personal finance

Is it cheaper to leave the heating on low all day?

The weather is getting colder and energy bills are rising, but is it really cheaper to leave the heating on low all day or should you only turn it on …
1 Dec 2022
Fan heater vs oil heater – which is cheaper?
Personal finance

Fan heater vs oil heater – which is cheaper?

Sales of portable heaters have soared, as households look to cut their energy costs. But which is better: a fan heater or an oil heater? We put them t…
21 Nov 2022
UK house prices fall at their fastest pace since 2020
House prices

UK house prices fall at their fastest pace since 2020

UK house prices fell 1.4% in November, their biggest fall since June 2020.
1 Dec 2022