Megabuyte, 2016. Original article.
The Megabuyte Interview: Katie Potts
There’s a certainty about Katie Potts. Hints to this fact start long before meeting her, as people’s complimentary statements are accompanied by subtly raised eyebrows. The impression continues upon arrival at Herald Investment Management’s classic office on Charterhouse Square, where I’m asked to please move to the opposite side of the table: “She likes to sit on this side.” Enter Potts – she doesn’t usually give interviews, she mentions more than once, as the press usually wants tips and you run the risk of distorting the market. I nod, noting it down: no tips.
As the founder and lead fund manager of Herald Investment Management, Potts has built a career on spotting opportunities at the small end of the market. Potts established what’s now one of the few remaining dedicated technology funds in 1993, and it becomes immediately clear that this macro view has resulted in a staggering level of industry knowledge. It’s slightly intimidating at first, but there’s no need for concern: Potts is outspoken, yes, but she’s also completely devoid of pretense or bluster. She’ll ask your opinion about what she’s said, and what’s more, she’ll ask you questions if she suspects there’s something you may know. Both rare traits indeed, yet arguably vital factors in the art of understanding the big picture.
Speaking of overviews, I ask Potts if she thinks the technology sector is underrated in the UK. “We don’t have the big winners they have in the States,” she says, in what I’m learning is her typically practical and well-informed manner. The big winners in the US has not only made the sector more popular there, she says, but it’s also ensured more profits that can be recycled into ever-bigger dreams. There are signs of that happening in the UK, says Potts, pointing to the money going into the London venture market. “But for the people chasing the next dot-com: I’m not sure it’s what I call tech.” There’s no shortage of entrepreneurism, Potts is quick to add: “But speaking in the purest engineering sense, my suspicion is, a lot is digital media rather than technology. That’s more an extension of advertising or the creative industries.” But, I venture, there are startups writing their own stacks? Potts nods: there are gray areas. “But a lot of it, I think, is front-end rather than back-end. A lot of the companies we were looking at who’ve have raised money – things like [food delivery app] Deliveroo – it’s not tech!“
There are certainly UK startups with viable business models, says Potts. But she’s concerned that the decline of the old engineering giants that people would aspire to work for – Marconi, GNK, Ferranti, STC, Rolls-Royce – means we’re no longer training young people for the next generation of (true) technology businesses. Entrepreneurism may be compensating for some of this, but back to whether the listed UK tech industry is underrated, Potts has another point to make:
“[There’s been] a dramatic reduction of weightings by professional long-term investors, pension funds and insurance companies. They were good quality shareholders, because they had a long-term view and were responsible owners of shares.” This stems from changes in regulation, tax and accounting rules: “There are no longer tax incentives to own UK equities, from a dividend point of view. … Insurance companies are almost out of equities, because they have to apply a bigger discount rate for regulatory purposes.” Some of these consequences are unintended, adds Potts, but it’s nevertheless led to more short-term investment attitudes: “One shareholder earning 10% is better quality than 10 shareholders earning 1%. When you earn 10%, you don’t have a short-term trading mentality. You care about the business.”
Value at the small end
The holdings of the Herald Investment Trust, which Potts launched in 1994, include plenty of the usual suspect from the listed technology sector in the UK and abroad, as well as a good number of lesser known companies. “There’s better value at the small end, because there are so few people who play in this,” says Potts. Each holding makes up a very small percentage of the fund as a whole – in part because the market has become less efficient: “There’s a worrying shortage of co-investors. … Because of the money leaving the market, there’s been undue pressure to deliver short-term performance, at the expense of making sure you’re investing properly for the firm to be competitive in the long-term.”
Herald held its 21st birthday party in February, and Potts invited the companies who’d made her more than £4 million – there were 66 names on the list. “We had quite a good turnout!” The average holding period of those companies was 13.9 years. In terms of what she looks for, Potts describes herself as value-oriented: “I want to work out how big the market is, how quickly the company might grow, and also grow into a low PE. … Some people would think what I do is rather risky – investing in early-stage lossmaking businesses. But to me, there’s huge risk in buying something like Facebook, because the valuation is already $250 billion. That has to be quite a lot of downside! Whereas at a small rate, you can buy 10% in a company for £1 million. You can lose £1 million, but you could make £10 million quite easily.”
Looking at Potts’ experience from 21 years at Herald, plus several years before – does she feel this has provided a unique perspective to make investment calls? “There was the ‘02 bust, and the ‘08 bust – and we’ve had eight years of recovery.” She thinks about it for a moment. “From my perspective, it’s not frightening now. Even having had such a strong run, it’s not as frightening as it was in 2000.” She remembers the first quarter in 2000, feeling like her skills were redundant as the valuations made no sense to her. “I’d been taking money out of the market in December ‘99 and stocks had gone up 100% after I’d sold. It was pretty frightening, because my valuation compass didn’t work! But a year later, my sales in December ‘99 looked quite sensible after all. I don’t remotely feel like that now. PE valuations are sensible. What worries me more is the structure of the market, and the lack of quality shareholders.”
This is a concern listed companies share, says Potts: “I think that’s one of the [reasons] the quoted market is dying: management don’t like short-term pressures. Nor do they like the bureaucracy of reports and accounts that you have to produce as part of the regulatory framework.” I mention how several CEOs of private equity-owned companies have echoed this in Megabuyte interviews: the freedom to make long-term choices in a growth stage is often a key reason for choosing to be unlisted. “How interesting,” says Potts, asking for more details, and for specific company names. Herald has raised two VC funds too, but Potts isn’t doing another one – it’s been challenging to raise follow-on money, leading to heavy dilution. But it’s been a good exercise, she says, something every fund manager could benefit from doing: “I think there’s too much top-down fund management now, and not a lot of bottom-up.”
Winners and losers
Potts started her career at GNK, which provided her scholarship to study Engineering Science at Oxford. She spent five years at Baring Investment Management before joining the UK electronics research team at SG Warburg in 1988, where she made a name for herself in the industry. She won’t say too much about that though, nor will she volunteer anything remotely personal. But her modest recollection of establishing Herald in 1993 speaks of conviction and determination:
“I’ve always been passionate that smaller companies could offer more growth than larger companies,” she says, referencing her pre-Herald days as a broker. “I became a fund manager, thinking I would offer a vehicle to my clients who found it difficult investing in smaller companies. I raised the money from my pension fund clients.” Herald was created as a vehicle to mitigate the liquidity risk of smaller companies: “But that’s the whole point of Herald: you’re supposed to take a higher risk. But none of the losses have been noticeable to shareholders, because we have a diversified portfolio. We’ve made 10 times our money in far more stocks have have gone bust!” She laughs, but in a moment she’ll back up this claim with a torrent of numbers.
It goes wrong sometimes of course – not very recently, mind. But Potts can easily name her biggest losses: that’s Plasmon, which did large disc drives – they went bust; Ingenta, which is still in business as Publishing Technology; and MAID, which became Dialog – that was a £4million loss: “Those are my three worst-performing investments, engraved on my heart!” She laughs. “I’ve had other companies go bust, but not on the scale of £4 million.” The circumstances have been different each time, says Potts, but the most important factor is management: “There are certain people I wouldn’t invest in again, if I haven’t had a very nice experience. That’s why it does help, having experience and a track record and getting to know people.”
Equally, Potts knows the names of her biggest wins, which she’s happy to report are on a much larger scale. “The biggest profit is about £34 million – that’s Imagination Technologies so it changes every day.” Other big wins include Diploma, Telecom Plus, Autonomy, Advent Software, SDL, Northgate Information Solution. “I’m very proud of the fact that we’ve compounded at 17.6% a year in the UK over 21 years. We haven’t done as well in overseas markets, but I think people would be surprised how well we’ve done in the UK. … It shows we got the timing right, of selling in the bubble and buying back in the bust.” So in total, Herald’s assets have appreciated by £600 million after expenses, interest and dividends paid – about £500 million of this has come from the UK portfolio. This is on £95 million in raised capital, less £45 million in share buybacks, confirms Potts.
The patience approach
The original concept for Herald has been well and truly proven then, I say, and she nods: “Yes. But I was thinking that if we fund enough small companies, we’ll eventually have some big companies. It’s a sadness that although we’ve been successful at making money, creating jobs and saving jobs, our real money is being made by selling out rather than trading up.” Having said that, Potts thinks tech is a fun sector to be in: “You’re providing to every market: insurance, retail, the government, the consumer. There’s always some innovation, always something coming along.”
It’s important not to get too carried away with fashions, says Potts, whose ultimate advice is to not be too greedy. “But equally, some of my best returns have been made when I put some money into a company that’s gone wrong, but the case is still fundamentally valid. You have a chance to average, and then you have a worthwhile stake as it comes right.” Good companies will often disappoint a little at first, as fundraising is all about telling your story in the most appealing manner: “You just have to be prepared for things to take longer. I’m sensitive to how we are different from a lot of investors: we will regularly make investments that we expect to be dead money for a couple of years. … It takes time for real businesses to come through.”