The Latest on Latent Value

Backdrop

So, what has happened since our last update? As mentioned, inflation is easing faster than expected. I do not anticipate that it will fall in a straight line, but the trend is established. We have experienced positive news with some of our holdings, more on this later. There have also been some larger macro or industry announcements, which I believe should be beneficial.

The crux of the matter remains the disconnect between what the assets are worth, Net Asset Value (NAV) - there is an explanation in the previous piece - and what the market is currently willing to pay for them, the discount. I maintain my activist approach towards the management and the boards of the investment trusts in which we have holdings to encourage them to adopt policies to alleviate discounts.

In September, the UK Government’s auction of offshore wind licences flopped - it attracted zero bids. The auction failed because of a combination of the increased costs in building these assets and the government cap on the return electricity generators could make through the introduction of an Electricity Generator Levy (EGL) earlier this year. On the latter, one can sympathise with a government faced with rising electricity prices, but the law of unintended consequences can be harsh. Offshore wind farms and other sources of renewable energy are vital for the UK to meet its ambitious net zero targets. There is also pressure on fossil fuel producers to improve their green credentials. The listed renewables sector, as mentioned, is sitting on a discount which should prove attractive to a trade buyer. Established portfolios of operational assets trading at prices less than build costs should make economic sense for a buyer with deep pockets. In effect the government have now made new builds uneconomical. Therefore, investors who require assets will be attracted to a cheap off the shelf solution. Bids could unlock the latent value of our holdings in renewable energy.

Costs disclosure

The sector faces the issue of unfair cost disclosure. This has long been my view and, thankfully, it is shared by others with a much higher profile than myself. Sadly, as with many aspects of our industry, this topic becomes dry and technical very quickly. Summing it up in its loosest terms, the current cost disclosure regime makes Investment Trusts look much more expensive than they are, putting investors off. There is a growing lobby who are putting pressure on the regulator to address this, not least as the FCA is accused of not fulfilling their duty of care to facilitate market stability. Whilst the regulator is not likely to act quickly, I believe enough vocal and high-profile pressure will be placed on them to act in a fair way towards Investment Trusts.  We believe that this will be another factor in changing sentiment towards this investment class.

Merger & Acquisition (M&A) Activity

We have seen an increase in proposed M&A activity, although it is early days. Proposed mergers are emerging within the sector, with varying results. Where mergers are unsuccessful, boards are offering continuation votes to shareholders, which can lead to an ‘orderly wind up’ of the Trust. This will release value to shareholders and puts pressure on recalcitrant boards to move in the right direction.

Holdings

Home REIT has been a major disappointment. Trading has been suspended for most of this year as irregularities were discovered, leading (and it is a long story) to the manager and broker departing. A new manager was appointed, and they have a mountain to climb but are making progress. Our meeting with them has given us a level of confidence that has been lacking for some time. The board have also announced their staggered resignations, whilst embarking on a succession plan. I expect re-listing and trading to recommence in the first quarter of next year, but that could change. Reading between the lines, my personal opinion is that it would not be a surprise if some form of litigation were on the cards. 

Triplepoint Social Housing (SOHO) continues to deliver at portfolio level with attractive NAV returns. The board initiated a share buyback policy (the company buys its own shares) which allowed for large blocks of stock to be bought, decreasing the risk that these concentrated holdings might drive the price of the shares down in the future. A bid for SOHO’s nearest rival led to a modest boost to share price. SOHO themselves indicated that they would take action to try to address the issues with negative sentiment, announcing earlier this year their intention to sell assets to verify their valuations. This was well flagged to investors, but I was disappointed after reading the announcement that the assets sold were a very small part of the portfolio and the sale price was at a modest discount to the value of the holdings as reflected in the NAV. I am in regular contact with the manager and the board and have made my views clear. Neither the manager nor the board are moving fast enough to alleviate the situation. I am uncomfortable with their strategy, but the balance sheet now has a reasonable cash pile and I await their decision as to how this is deployed.

I wanted to demonstrate how proactively we have been addressing the issues with Investment Trusts, working to influence managers and boards to take actions that will help to change sentiment and unlock latent value. I have only used a small number of examples here, but rest assured my colleagues and I are in regular contact with the key people at many trusts. We are also acutely aware that several of our investments have calendar events related to discounts that require boards to act. In most cases, if the discount is wider than a set limit for a specific period, the board must conduct a continuation vote (asking the shareholders if they wish to continue to invest or move to an orderly winding up). In themselves, these events will generate a degree of discount narrowing. I should make it clear that wind up may be the best course of action in some cases, but not all. Many of our holdings have viable long-term futures, and I would be loath to lose out on future income streams for short term gain. In other words, when we are asked to vote on a wind up it will be done on a case-by-case basis.

On 8th September I awoke to the news that the Round Hill Music Royalty Trust was to be taken out at a 67% premium to the pre-announcement share price. I commented on this at the time, but it is worth repeating and expanding. As a brief reminder the portfolio owns songs by Bonnie Tyler, David Coverdale (Whitesnake) Louis Armstrong and Bruno Mars, to name but a few of the artists, and every time their song is played anywhere the trust gains a royalty fee. I have lifted the following from a note I wrote just after the announcement:

“Following this news, the investment management team quickly met to discuss our next steps and we agreed to vote in favour of the takeout. However, we decided it would be prudent to sell or at least try and sell the entire holding at small discount to the takeout price immediately. We sold our entire holding within hours, booking substantial profits for some clients and very attractive returns for other clients. On a total return basis since Initial Public Offering (IPO) clients are up c 28% and those that bought after the share price fell will be up substantially more and, in some cases, a lot more. I am comfortable in stating that no client should have lost money on this investment. It is a bittersweet moment in that the underlying portfolio performed in line and if not ahead of our expectations, sentiment was its downfall. I am happy to report on a successful exit for clients, but this was predicated on, in my view a manager acting in theirs and our best interests and a chair of the board who has been superb in his approach to shareholder interests (I have told him this).”

Performance Examples

By way of explanation the solid line(s) is the NAV and the squiggly line(s) the share price.

One can see the bounce in response to the announcements made by SOHO, although it has tailed off recently as the market digested the small scale of the event. Round Hill speaks for itself. In the case of John Laing Environmental Assets Group (‘JLEN’), this trust must have a continuation vote if the discount exceeds 10% on average for a year. At this pace, there will be a continuation vote next year. To put the discount into perspective, this is the widest it has been since IPO, but the Trust has 1.5 times dividend cover and yields more than 7%.

In some cases, boards have an action plan and, whilst it is welcome, one gets the impression they must go through the motions, meaning try everything, before the inevitable becomes unavoidable. One example of this is Triplepoint Energy Transition or TENT. They have a capital markets day later this month, but this appears to be a last throw of the dice moment given there is a board strategy day a few weeks later. To be clear, management, whilst slow to deploy assets, have created an attractive portfolio and delivered on NAV growth. In my view, however, the Trust is now too small to survive, and the market is signalling this with its pricing.  

My conversations with boards are generally positive and I emphasise the need for self-help, paying down debt, buying stock back and selling assets. The trust surviving, in most cases, is still our preferred outcome. With human nature involved, my experience with boards falls between severe frustration to outright admiration.  

Other options

Unsurprisingly, the recent period leads to some navel gazing and a re-assessment of other options that were available to us at the time. With our alternative exposure the attractiveness of the assets is the strong relation to inflation (notwithstanding the sentiment issue of NAV versus share price). For most of the time the relationship has been positive. When managing inflation targeting strategies, we must be mindful of liability matching. There are other asset classes that provide an index inflation return, which we chose not to purchase as we believe our alternative approach was the more prudent. I detest “whataboutery” and this analysis comes as close as I am comfortable with to the concept, but the chart below displays the traditional asset class (long duration corporate linkers) that we would/could have bought for the same exposure as alternatives.

Conclusion

I still fundamentally believe in these assets. Portfolios have mostly delivered what we expected. Sentiment has been the scourge. Trusts have begun to implement self-help but with differing levels of sincerity and, of course, success. There has one very notable success and other. Tail winds in the form of ill-considered government policy will aid some trusts and others are mandated to assess their continuation.  As a sector, yields are compelling and, as the interest cycle peaks and begins to wane because inflation is reined in, their strong cash flow indexed returns will, again, prove desirable. As interest rates peak in the UK and the market acknowledges, risk will re-price especially for long duration assets like alternative income, they will benefit when the market perceives rates cuts on the horizon.

There are catalysts in place to unlock value, but we must continue to employ patience. This can be frustrating as time frames are not fully determined. However, I am convinced that capitulating at this point will eventually lead to sellers’ remorse as returns are left on the table.

This article was prepared by James Calder, our Chief Investment Officer.. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us.