- Some inflation linkage goes unrecognised
- Growth-focused funds recover as rate cuts come into view
Latest inflation data from both sides of the Atlantic is an unwelcome reminder for investors that rapid rate cuts are not a foregone conclusion. The headline US inflation rate was 3.4 per cent in December, up from 3.1 per cent the month before. UK CPI inflation rose from 3.9 per cent to 4 per cent over the same period. These backwards steps have undone some of the progress made late last year by equities that investors see as particularly rate-sensitive, including some UK investment trusts.
The investment trust sector’s average discount was 13.2 per cent at the end of 2023. By mid-January that had moved above 15 per cent and, at the time of writing, was set to widen further as a result of Wednesday’s worse then expected UK inflation figure. While this is still an improvement on the 20 per cent average discount seen in the autumn, it does mean many trusts look cheap by historical standards. Nonetheless, interest rate cuts are still likely this year, and the task now facing investors is to identify the funds and sub-sectors poised to make a meaningful recovery in the not-too-distant future.
Outer space may not be the first place you’d go in search of hidden value, but with a discount of nearly 54 per cent as of mid-January Seraphim Space (SSIT) may be worth exploring. Given its tilt towards early-stage companies, the specialist space tech investor has fallen victim to the move away from growth-focused assets. However, some analysts argue that the fund’s portfolio is far from speculative, given that satellites are now crucial pieces of infrastructure.
“The space sector is bolstered significantly by geopolitical tension, in the sense that lots of governments want more monitoring capability for sanctions and in order to monitor climate change,” says Shavar Halberstadt, an analyst at Winterflood Securities. “There’s a lot of expenditure being made there and Seraphim’s portfolio companies are the beneficiaries.”
Infrastructure plays
Investors have also spent the past two years feeling bearish on more established infrastructure trusts, due to the fact that rising interest rates translate into higher discount rates. Higher rates today mean a greater cost of capital – and thereby returns in the future will need to be greater to compensate.
At the same time, power prices are likely to be higher in an inflationary environment – and so will revenue from energy assets. “Most of the market has been trading on the back of interest rate expectations as if they’re long term, fixed-rate bonds,” says Numis analyst Ewan Lovett-Turner. “I think that’s an overly simplistic view that forgets the fact that a lot of [infrastructure] cash flows have inflation linkage.”
Shares in International Public Partnerships (INPP), among London’s largest dedicated infrastructure funds, have proved highly volatile in the past 12 months. This is despite the fact that its largest holdings include critical assets such as gas distribution group Cadent and the Tideway wastewater project, as well as a handful of offshore transmission owners (OFTOs), which own the cables that connect offshore wind farms to the onshore electricity network. The latter make up about 20 per cent of the INPP portfolio and, helpfully, their revenue streams are separated from the performance of energy generators.
In other words, cables linked to wind farms generate the same level of income regardless of whether there’s a strong breeze and the turbines are turning, and are also relatively insulated from the cost pressures facing wind farm owners. There are relatively few opportunities for investors to gain exposure to the stable world of OFTOs, making INPP unique among listed infrastructure funds. Numis analysts also say that long-term earnings visibility suggests that the group can continue to deliver dividend growth of 2.5 per cent each year for at least 20 years, an attractive prospect for a fund trading at a discount of around 16 per cent.
Rival BBGI Global Infrastructure (BBGI) fared somewhat better in the past year – trading on an average discount to net asset value (NAV) of just 5 per cent or so, and continuing the historical trend whereby its share price premium exceeded those of other names in its sector. The fund’s higher valuation is likely to be a reflection of its entirely availability-based income streams, which generate revenue so long as its assets are available for use.
The portfolio consists of 56 “social infrastructure” holdings, including healthcare facilities, hospitals, schools and motorways. It’s also geographically diversified, with assets located exclusively in countries with AAA or AA credit ratings. BBGI’s seemingly reliable portfolio and comparatively shallow discount make it appear less of a recovery play and more of a hedge against further uncertainty in the coming months. There are, though, other risks facing INPP and BBGI over the medium term – read more here).
Private equity
Listed private equity (PE) funds are rarely thought of as defensive in the same way, because the companies in which they invest are less mature and therefore riskier ventures, with little guarantee of future profitability. Even so, many PE funds have seen discounts narrow somewhat over the past year, albeit the current average of around 19 per cent is still relatively steep.
It should also be noted that this figure would be far steeper were chronic outperformer 3i Group (III) – currently trading on a 24 per cent premium – not included in the cohort. But with a hefty discount comes a significant opportunity, provided you pick a winning fund.
Separating the leaders from the laggards can be especially difficult in a sector such as private equity, where transparency is sometimes in short supply. In these cases, Winterflood analyst Elliott Hardy suggests recent history can be a useful guide. “Within private equity, it’s important to look at their exits,” he says. “What track record have they produced over the last year with respect to realising their assets? If a manager is realising assets at a significant uplift, then it might give some signal as to the quality of those assets.”
Put simply, it’s important to ensure that a PE fund is selling its holdings for more than it purchased them for. HgCapital (HGT), an investor in software-as-a-service companies, has a particular knack for this – it achieved an average exit uplift of 31 per cent across £323mn of proceeds across the year to the end of September. Last month it sold its stake in insurance brokerage platform GGW to another private equity firm for £94mn, representing a 40 per cent uplift on its carrying value (purchase price minus depreciating factors).
Pantheon International (PIN), meanwhile, saw an average uplift on realisation of 27 per cent for the year to the end of May. This is not substantially lower than its 10-year average of 31 per cent. Although it has seen a share price uplift of more than 21 per cent in the past six months, it is still trading at a discount to NAV of 35 per cent, suggesting that there’s additional runway left. Pantheon’s board initiated a £200mn share buyback last year, indicating its commitment to returning capital to shareholders.
Ultimately, a more substantial rerating is somewhat dependent on falling interest rates. But investors don’t have to sit on their hands until central banks take action – there’s value waiting to be realised across the London market.
