As well as his skill in finding the market’s best income stocks, Neil Woodford is also well-known for his bold bets on early-stage pharmaceutical and tech companies.
Unfortunately, not all of these investments have turned out as intended. In 2016 shares in Woodford-backed Circassia lost two-thirds of their value in a single day after the company announced that it was abandoning its allergy portfolio following a failed second trial of its dust mite allergy treatment. And this year, Woodford has had to defend his ownership of Allied Minds, which has seen its share price fall 66% over the past 12 months.
Mercia Technologies (LSE: MERC) is another of his struggling investments. Since listing at the end of 2014, the shares have lost nearly 40% as the company has been unable to convince investors that its portfolio is worth paying for.
A risky business
Like Allied Minds, Mercia incubates early-stage businesses. According to the firm’s half-year results published today, at the end of September, the fair value of its investment portfolio was £64.7m. This was up £12.7m thanks to £9.7m of new capital and £3m of “net upward value movements” (an increase in the value of its investments). Total net assets were £123.6m (up from £81m) with cash of approximately £55m.
As well as investing its own funds, Mercia also invests on behalf of third parties. This extra capital allows the group to scale up its investments as well as generate fees on the additional capital. Funds under management in the period to September were £337m, up from £220m in the first half of September.
To be able to retain third-party investors the company has to show that it can generate returns that can’t be found elsewhere. And it looks as if the business is proving its worth on this front. During the period to September, Mercia’s RisingStars Growth Fund I realised a £34.5m cash investment in Blue Prism Group plc, representing a 55 times return.
Unique approach
Mercia is unique in its approach to managing outside cash. By collecting fees on this money, the majority of the group’s operating costs are offset. In comparison, other similar companies only get paid when they realise value from an investment, which can take years. For the six months to September Mercia booked revenue of £4.8m (up 66% year-on-year) and a post-tax profit of £1.4m after accounting for operating costs.
Overall, it is a cash-rich venture capital business that’s generating revenue and has a record of producing enormous returns for investors. So why am I avoiding it?
Well, put simply I think Merica is too expensive. At the time of writing, the shares are trading at a discount to net asset value per share (41.1p at the end of September) of 12.4%, which is just not cheap enough.
Valuing early-stage tech businesses is notoriously tricky and there’s no guarantee that these investments will ever generate income. With this being the case, I believe that a wide margin of safety (deep discount to NAV) is required before investing in a company like Mercia. A discount of 30% or more to NAV would be more appropriate and protect investors from any failures in Mercia’s investment portfolio.
