Good quality investment trusts on wide discounts can help cushion portfolios from the turbulence of volatile markets. Value often acts as a buffer or shock-absorber. And once through the turbulence, such holdings can perform very well once sentiment starts catching up with the fundamentals.
Ecofin Water & Power Opportunities
I suggest Ecofin Water & Power Opportunities (ECWO) is one such example - space not allowing me in last month's column to explain its introduction into the Growth portfolio during September.
ECWO invests globally in utilities (around 40 per cent of assets), energy and alternative energy (35 per cent), infrastructure projects (15 per cent) and unquoted projects (5 per cent). The approximate geographical breakdown is North America 50 per cent, Continental Europe 25 per cent, UK 15 per cent and Emerging markets 10 per cent.
The split-capital structure of the trust is made up of Zero Dividend Preference Shares, Convertible Unsecured Loan Stock and Ordinary shares (ECWO). The Zeros and Loan stock 'mature' in 2016 and take precedence over the assets before ECWO. If one includes the bank debt, the gearing amounts to around 40 per cent. The structure and gearing has discouraged some investors, which is why ECWO trades on a discount of over 20 per cent and yields around 4.5 per cent.
And this presents an opportunity. My instinct is that the utility and energy sectors are undervalued, particularly in Europe. Now is a good time to be building exposure via what I consider to be an undervalued trust.
Over time, I see utility companies being allowed more pricing power given the enormous investment required over coming decades to upgrade the infrastructure. Indeed, it could be argued that the world is on the cusp of a boom in spending on gas and electricity infrastructure to address the gross underinvestment of recent decades as demand for power soars. All things being equal, this should result in healthy earnings growth for the sector.
Meanwhile, sentiment is also poor regarding the energy sector, in part because oil and gas prices have fallen. However, I cannot see prices retreating much further. It remains in too many countries' interests to ensure their oil and gas revenues continue to help pay for their increasing infrastructure and social policy costs and, in a few cases, rearmament programmes.
In this vein, the upcoming OPEC meeting later this month will be of particular interest. However, whatever the result, longer term few deny that there will be strong growth in demand for energy as populations grow and the 'great urbanisation' continues unabashed.
Approximately 80 per cent of ECWO's assets are invested in decent-yielding blue chips. The balance consists of 'special situations' which, historically, have proved profitable for management. Its 14 per cent exposure to the energy company Lonestar Resources is of particular note.
The company is focused on unconventional oil and gas production from its 30,000 acres in Texas. I say production because it is not an exploration company. In large part, the oil and liquid gas reserves are proven - these are genuine assets. The company is instead looking at ways of best crystallising value, and production is expected to rise significantly.
Other positives include the company being self-financing, the good reputation and expertise of the local management, the existence of mineral rights, and the positive relationship with local landowners who take a 20-25 per cent cut and whose co-operation is essential. Lonestar should do well even if the oil price remains at its present depressed level. Should prices rise, then it could do very well.
Speaking with the management, ECWO is intent on achieving a high and secure dividend yield. As time passes, the 80:20 split will gradually change in favour of generating more income. The continuation vote in 2016 will, to a certain extent, focus minds. Meanwhile, healthy revenue reserves of one and a half year's dividend, and a portfolio yield already in excess of the trust's yield, all suggest the necessary firepower exists. The recent handsome dividend increase is perhaps a sign of things to come.
Finally, the management is well respected. It is also very well invested in the trust, having recently further significantly increased its holdings. When seeking undervalued trusts, I always like to see management and investors' interests strongly aligned - it creates confidence that the crystallisation of that value is being sought.
All in all, ECWO is worth supporting in a diversified portfolio. There will be volatility because of the structure of the trust and the gearing, and because external factors such as the oil price will have a disproportionate effect on sentiment.
However, longer term, its exposure to undervalued sectors, a healthy and rising dividend stream, a strong and committed management, the conservative valuation attached to Lonestar Resources, and a healthy discount because of poor sentiment, all suggest patient investors will be amply rewarded.
October's portfolio changes
Within the Growth portfolio, I have top-sliced The Biotech Growth Trust (BIOG), Herald Investment Trust (HRI) and BlackRock Frontier Markets (BRFI), and sold entirely Scottish Oriental Smaller Companies Trust (SST) - all having had good runs and, in the majority of cases, discounts having narrowed somewhat.
Despite my long held optimism for the biotechnology sector, the decision to reduce BIOG was also in part because it is important to maintain portfolio balance. I feel comfortable with total sector exposure of around 10 per cent courtesy of both International Biotechnology Trust (IBT) and BIOG. The sector will remain volatile, and taking profits after strong runs are seldom the stepping stones to ruin.
With the monies raised, I have introduced two new holdings - Henderson Far East Income (HFEL) and Oryx International Growth Fund (OIG).
I consider HFEL to be a value situation, despite standing close to its NAV, because of its exposure to unfashionable sectors and its near 6 per cent yield. OIG represents value because of its track record, the outlook for smaller companies, and because it stands on a discount of around 25 per cent. I shall go into more detail in next month's column.
Finally, in the Income portfolio, I have added to the existing holding of IBT. Regular readers will know why I am positive about the sector. IBT was standing at over a 20 per cent discount when bought, which was an anomaly. The discount has come in somewhat since, but still represents good value given the outlook for the sector.
There is always the challenge when investing for income about getting the right balance between generating income in the short term and achieving capital growth over the longer. The portfolio yield of 4.3 per cent allows me to invest in growth sectors such as biotechnology and technology which typically yield next to nothing, but which offer the prospect of excellent capital growth. The search for income must never blind one to such opportunities.
