How investors can take advantage of uncertain markets

The UK has a vibrant and growing early stage investment ecosystem, and recent market volatility offers an attractive entry point, write Ken Wotton and Bevan Duncan.

Early stage investments are typically associated with higher levels of risk, reinforced by the fact that 60% of UK start-ups fail within the first three years. Therefore, it is not surprising that people often turn instead to investments deemed “safer”, such as mega-cap stocks or government bonds, during periods of uncertainty.

However, the UK has a vibrant and growing early stage investment ecosystem and, despite the uncertain macroeconomic environment, we are not seeing a slowdown in opportunities to back ambitious management teams in high-growth businesses.

In fact, we believe that the recent market volatility provides an attractive entry point into small UK businesses. Although investing in smaller, high-growth companies comes with more unknown variables, through careful deployment of capital and portfolio construction, investors can mitigate some of the associated risks and reap the significant potential rewards of early stage investing.

An opportune entry point

Since the EU referendum, the UK equity market has suffered from investor exodus and, despite the post-election bounce, continues to trade at a large discount to other developed markets. Although the UK economy has held up, domestic smaller-cap stocks continue to be out of favour owing to the perception of greater risk.

In our view, the de-rating in valuations has largely been sentiment-led and UK economic growth has remained in positive territory, with consumer spending helped by real earnings growth. Company fundamentals also remain strong. We are finding that businesses with high-quality management, proven and profitable unit economics and scalable sales models continue to demonstrate strong growth momentum.

The Baronsmead VCTs’ top 10 AIM holdings saw average earnings growth of 12.2% over the most recent reporting period and have very low levels of debt. For long-term investment vehicles such as the Baronsmead VCTs, depressed valuations in the current environment present an attractive entry point for retail investors. The discount between small-cap share prices compared to mid-cap companies is at its widest for a decade – and the micro-cap to small-cap discount is at the widest point since 2011.

We have also seen a noticeable uptick in acquisitions over the past year, demonstrating that underlying company fundamentals and cash-to-cash returns are still performing well. This can be attributed in part to investors seeing good value in public markets, but also to the high level of private equity activity.

In 2019, the Baronsmead VCTs completed a number of unquoted and AIM portfolio company exits. On the unquoted side, four full exits, totalling £22.7million, alongside full and partial divestments totalling £21.3 million from the AIM portfolio.

Diversification is crucial

Nevertheless, the current environment warrants caution. By taking smaller initial stakes in a broad range of companies, we can manage downside risk while we assess the underlying scalability of the portfolio businesses. The best businesses are then provided with further capital and expertise to support accelerated growth.

Investing in a mix of differentiated asset classes also helps mitigate early stage company risk. For example, we invest in AIM stocks as well as unquoted businesses. AIM holdings are typically larger and more mature businesses, which provide diversification to the earlier stage unquoted portfolio.

Holding both quoted and unquoted assets can increase portfolio volatility compared to generalist VCTs. However, with fundamentally different risk profiles, the ensuing returns of quoted and unquoted portfolios have historically been complementary. In different years, the contributions from both have led to long-term consistency of returns.

Finally, looking across sectors to identify disruptive innovation can cut through specific market risks. Technology and automation are revolutionising industries, from gig economy sectors to traditional healthcare, as well as disrupting how people work and increasing labour productivity.

Fast-growing innovative companies, which provide these solutions, are less vulnerable to macroeconomic and political risks. Given that our investment strategy looks to deploy capital where economic growth is strongest, the Baronsmead VCT portfolios are well diversified across multiple sectors.

Disruptive tech drives growth

Over the past year, we have identified a number of high-quality businesses with strong fundamental characteristics operating in parts of the market benefiting from long-term, structural growth trends.

Diaceutics is a data analytics and implementation services business in the pharmaceutical sector, which listed on AIM in March 2019. By aggregating and cleansing data points from more than 2,500 clinical laboratories across 35 different countries, Diaceutics provides insights to companies launching precision medicine drugs.

In addition to financial support, our sector-specific insight and extensive pharma/tech network is enabling Diaceutics to acquire additional data sets and develop its software platform.

Another ambitious business that we committed further capital to recently was the unquoted global social commerce platform Moteefe. The company, which we first invested into in 2017, offers a print-on-demand solution for entrepreneurs, designers, marketers and influencers to customise and sell bespoke products through social media.

The technology-driven supply chain handles payment, order fulfilment, product delivery and customer service, as well as data analytics – allowing users to concentrate on the creative design process. This rapidly growing business saw 300% year-on-year growth in 2018 and our follow-on investment is helping the company expand into new international markets.

We also backed Rainbird, an unquoted software platform allowing businesses to encode sector-specific knowledge to make recommendations in a transparent and auditable way. Rainbird provides this “next generation of robotic process automation” to blue-chip enterprises, such as leading professional services companies – including two of the Big Four – and financial services firms.

We targeted the company as a continuation of our thematic investments in workplace automation, following our successful exit from Symphony Ventures in 2018.

Bevan Duncan and Ken Wotton are senior members of the VCT team at Gresham House Baronsmead.

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