Productivity, Sage, Sophos and Investment Trust Discounts

There was an interesting article last week in Investors Chronicle where Bearbull attempted to analyse the variations between company productivity. Productivity, or the lack of it in the UK, is one of the big issues weighing on the minds of politicians of late. Is the productivity of UK companies getting better or worse was one of the questions he attempted to answer.

For investors, productivity is surely one thing we should look at when deciding in which companies to invest. Those businesses that get the most out of the capital they employ (measured by Return on Capital, or ROCE), and also get the most out of their employees, are surely the ones most likely to be successful and generate the profits and dividends we like as investors.

But one needs to combine the two because obviously employees can be traded off against capital. By investing in more automation, employees can be reduced. But there is also the problem that businesses vary in nature. So natural resource companies such as oil producers can have large revenues and profits generated by relatively few staff, while retailers generate equivalent profits from much larger staff numbers.

Bearbull had a stab at producing a combined productivity index for a range of large cap companies, but as the results were still very wide ranging ended up focusing on whether their productivity was increasing or decreasing. Results were still varied.

There is a way to make use of such figures and that is to compare companies in the same business sector. For example software companies employ a lot of staff, but generally little capital apart from their past investment in developed software or in acquisitions. One way I used to look at companies in the software industry when I worked in it was to look at the revenue and profits per employee and I still find those useful measures. They can tell you a lot about the nature of the business.

It’s informative for example to compare two of the larger UK software businesses – Sage (SGE) and Sophos (SOPH). Sage has recently been the subject of a downgrade by analysts at Deutsche Bank and the shares have been heading south for some time as competition from new entrants into the accounting software space seems to be increasing. But at least they are making profits. Sophos is in the hot IT security sector but is still reporting operating losses.

But it’s interesting to look at their sales per employee – that was £124,320 in the case of Sage (13,795 employees) and £116,975 in the case of Sophos (3,187 employees) from the latest Annual Reports that are available. In other words, very similar. Operating profits per employee were £25,154 at Sage while Sophos reported a loss of £8,000 per employee.

The big difference was in average employee costs which were £57,194 at Sage and £95,387 at Sophos. The latter is a very high figure which helps to explain why they are losing money.

Sophos looks to be an example of where the directors and employees are taking most of the profits leaving very little for shareholders – indeed a negative return to them.

Investment Trust Discounts

I mentioned in a previous article the high share price discount to Net Asset

Value at RIT Capital Partners which encouraged me to sell the shares. The discount was actually a premium of 6.8% which I reported although I am advised it had actually been even higher in the recent past.

It is common knowledge with anyone who invests in investment trusts that discounts have narrowed in the last year with popular trusts now often on premiums. The dangers of buying trusts that trade at a high premium was recently evidenced by the fall in the share price of the Independent Investment Trust (IIT). As reported by Citywire recently, the share price unwound by 10.9% in one week after the premium shrank from a peak of 20% in June. It’s now only 6.2% but that’s still too high in my view.

The company performed exceptionally well in 2017 (NAV up 53%) but even so this is surely a case of investors expecting “past performance to be indicative of future performance” when every health warning on stock market investments tells you the contrary. The long-term performance record is good but there is a limit to the price one should pay for anything.

You can track the company’s performance, and the discount it trades at on the Association of Investment Companies (AICs) web site. There are many other relatively high performing investment trusts that still trade at a discount.

Why should investment trusts trade at a discount? Because just looking at the income they produce, if the management and administration charges reduce their income by 1%, when their yield was otherwise 5%, then the share price should be at a discount of 20% because otherwise people can buy the individual holdings of the company directly and increase their income in that proportion. That ignores the relative proportion of dividends paid out of income versus capital growth. Of late we have had lots of capital growth but that is not always the case. If the market starts to go down then share price premiums on investment trusts could well collapse.

A particular problem with investment trusts, and the reason why discounts, or premiums, can sometimes become extreme, is the relatively low volume of share trading even in large trusts, i.e. there is low liquidity. Buyers are often long-term holders with few active traders speculating in the shares. This problem tends to worsen in the summer months when many investors are on holiday so one needs to be wary of trading such shares in that period.

I hold none of the companies mentioned above, for the avoidance of doubt.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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RIT Capital Partners, Foresight 4 VCT and Sepsis

RIT Capital Partners (RCP) is an investment trust that recently issued its interim report. As one of my longer standing holdings, first purchased in 2003 although I have reduced my holding of late, I read the report with interest. RCP has been a long-standing favourite of private investors having traditionally taken a somewhat defensive investment approach. But the portfolio is now most peculiar. It contains 8.8% of “quoted equities” but many of them are held as “swaps”, 27.7% in “long-only funds”, 19.7% in hedge funds and 0.6% in derivatives. There is 9.1% in direct private investments, 13.2% in private investment funds, 23.1% in “absolute return and credit funds”, 3.0% in “real assets” (which includes gold, silver, corn and soyabean futures) and 2.0% in Government bonds (with more swaps in there also). This is certainly an unusual portfolio to say the least.

Personally when I invest in a fund or an investment trust, I prefer them to invest directly – not pass the buck to some other fund manager. This trust has effectively become a “fund of funds” of late with a large proportion of its investments placed into other funds. Otherwise it appears to be hedging against armageddon.

The Chairman of the company is long-standing Lord Rothschild who is aged 82. When I have attended the AGM of this company I have never been very impressed by the way he handled the meeting or the responses to questions.

The total return net asset value performance in the half year was 3.2%, but 6.2% on share price. The current share price discount to NAV is actually at a premium of 6.8% according to the AIC and the dividend yield is 1.6%. Over ten years the total return (NAV) has been 103% when sector performance was 135%. So it’s not exactly been a great performer. I sold the remainder of my holding after reading the interim report.

Foresight 4 VCT

Another investment trust but of a very different nature is Foresight 4 VCT (FTF) which is of course a venture capital trust. It recently issued its Annual Report for the AGM due on the 11th October. I may attend it although my holding is very small.

The Annual Report does make interesting reading although it fails to mention a past complaint by some shareholders about the over-statement of reserves in the years 2013-2015 which resulted in an illegal dividend allegedly being paid. The auditor, KPMG, who still audits this company make no comment on this and neither do the directors in the Annual Report. But the Audit Committee report does mention that the company has received a letter from the FRC questioning the accounting policy for performance related incentive fees. The company has responded. Both issues are likely to be the subject of questions at the AGM no doubt.

This company has two very large holdings in its portfolio – Datapath and Ixaris. I have been very dubious about the valuations put on the latter company by this and other VCTs as I know quite a lot about the business. I used to be a director and still have a direct holding. This is particularly so after the disclosure by the Ixaris Chairman of the latest business challenges at the recent Oxford Technology VCT meeting.

I will be voting against the reappointment of KPMG as auditors at this company, against the sole director who is standing for re-election (is it not recommended that all directors of fully listed companies stand for re-election?), and against approval of the Report & Accounts.

But FTF did raise some more money this year and is investing in what appear to be interesting companies. One of their new investments has been in Mologic which is a medical diagnostic company. What sparked by particular interest was their product for rapid diagnosis of sepsis which I only narrowly survived a few years ago. Up to 50% of people who develop sepsis die from multiple organ failure, even though it can be treated with antibiotics. It is often misdiagnosed or treatment commenced too late, so a rapid diagnostic tool will be of great use.

Dr Hadiza Bawa-Garba was convicted of gross negligence manslaughter over the death of six-year-old Jack Adcock from sepsis but subsequently challenged being struck of the medical register. She won the latter legal case this week after a big campaign by doctors and a major crowdfunding exercise. Bearing in mind the other contributory factors, and the difficulty in spotting sepsis I consider the original conviction a gross miscarriage of justice. You can feel just slightly under the weather and next minute you are unconscious and in the intensive care unit as I know very well. Jack Adcock had other medical conditions that will not have helped.

There are 44,000 deaths from sepsis every year in the UK, and children are particularly at risk. It appears that cases of sepsis are rapidly rising although that might be due to better diagnosis. Even surviving it can mean life changing injuries. See https://sepsistrust.org/ for more information or if you wish to support a charity that is raising awareness of this deadly disease.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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