Take a gamble investing in a fresh company

We examine the attractions of unquoted companies and explain why some fund managers are so keen to see them included in their holdings when they used to be viewed as an inaccessible “niche” sector.

Why the increased interest in unquoted stocks?

The dramatic drop in the amount of capital required by many of today’s up-and-coming companies means they often don’t need to come to the stock market to obtain financing for expansion. James Anderson, the co-manager of Scottish Mortgage, says they are not building factories or power stations but are instead doing most of their business on the internet and can finance growth through their own cashflow.

At the same time, unquoted companies are no longer a collection of minnows — they can grow to become large companies very fast through their use of internet-based disruptive technology. Airbnb is now the world’s largest hotel company although it owns no hotels, while Uber is the world’s biggest taxi company, but owns no cars.

Understandably, a number of sharp-eyed fund managers want a piece of these fast-growing companies and the only way to do this is to buy them while they are unquoted. The board of Scottish Mortgage says: “The increase in the number of unlisted investments in the portfolio in recent years has been in direct response to a shift in the balance within the capital markets between the providers and consumers of capital, rather than a change in the managers’ philosophy and approach.”

The pros and cons of unquoted stocks

Buying into a company before it has publicly listed is traditionally regarded as a risk. However, the rewards can be great, because it is often in these early stages that companies grow the fastest. In the case of Alibaba, the giant Chinese online retailer, Scottish Mortgage was able to acquire a stake while the company was still private and is now sitting on a handsome profit.

While some commentators are concerned that too much money is going into “risky” unquoted companies and that Scottish Mortgage’s permitted holding of these stocks is worryingly high, Mr Anderson argues that this is to misunderstand what risk is and to turn your back on valuable opportunities.

“People say this represents a dangerous bubble. I say it is nothing of the sort and we should be putting more money into unquoted companies because this is where wealth is created,” Mr Anderson says. “The fact is that most companies fail, but this is not an argument for avoiding investment in them at an early stage. This is the way to discover the next Facebook or Amazon before it becomes a household name.”

He says that another reason for investing in privately owned companies is that many entrepreneurs feel they would be hemmed in by the restraints of operating as a public company more exposed to the short-term pressures exerted by the public.

“Many tech companies want to stay private because by doing so they can invest their money creatively for the future, whereas if they were public they would have analysts asking ‘where is the cash’ and complaining if they didn’t meet the quarterly earnings forecasts.”

Neil Woodford, who runs the CF Woodford Equity Income fund and Woodford Patient Capital investment trust, is another manager who believes in the merits of investing in unquoted companies. He says: “The more that we have done in this space, the more we have become convinced that this is an incredible area for investment. The early-stage asset class is neglected and fundamentally undervalued.”

Mr Woodford is one of the few UK fund managers prepared to put money into start-up companies at the earliest stages of their existence. He has a focus on healthcare and this is one area, he argues, where there is a shortage of capital because investors are not prepared to think sufficiently longterm to tolerate the time lag between seedcorn investment and a profit.

One difficulty that fund managers face in investing in unquoted tech companies is that they often find themselves competing with tech giants, such as Google and Facebook, who are also looking for dynamic young businesses, know the industry inside out and have large war-chests of cash. Facebook, for example, has used its knowledge of the market to buy four of the six largest social-media platforms in the world.

How to invest successfully

Mr Woodford aims to mitigate risk by keeping holdings in unquoted companies small in relation to the size of the overall portfolio. He also checks whether the companies are meeting their own targets. If they are, he is prepared to invest more money; if not, he will stop or withdraw funding.

Mr Anderson does a lot of research into companies based on the west coast of the US or the east coast of China because that, he says, is where the largest number of dynamic young companies are to be found. His team has built up considerable experience in this field, along with an enviable list of contacts. He says: “We are one of the first doors at which people knock when they are seeking funding. We aim to become a trusted partner of these companies — someone who is going to remain alongside them over the years.”

The elite unquoted businesses

Airbnb

The accommodation marketplace brings together guests and hosts from all over the world and charges each side a percentage of the gross booking value. James Anderson of Scottish Mortgage says: “In 2014, there were over one million listings on the site and the number of nights booked doubled year-on-year.”

Immunocore

A biotechnology company that is developing drugs to redirect the immune system to kill cancer cells. Neil Woodford, the fund manager, says: “The company has the potential to become a prominent force in this fast-evolving new field of medicine.”

Spotify

The music-streaming service has a library of more than 20 million songs. Mr Anderson says: “Its potential scale and growth rate has been transformed by consumption shifting to mobile devices. Spotify wants to be a digital-content distributor with the potential to reshape the music industry.”

Oxford Nanopore

A business developing next-generation technology for molecular diagnostics, with DNA sequencing being the first application. Mr Woodford says: “We have invested to support further product development and innovation.”

HelloFresh

This internet company provides meal ingredients and instructions directly to the customer’s door. Mr Anderson says: “We think this could be a very large and global market opportunity.”

Purplebricks

An online estate agent that prides itself on doing most of its business outside office hours. Mr Woodford says: “We identified this as a highly disruptive business, led by a successful and ambitious management team, and we put in two injections of capital.”