Premier Miton Diversified funds
Neil Birrell, Premier Miton’s Chief Investment Officer and lead manager of the Diversified fund range has a look at an asset class that has struggled this year in the face of rising interest rates and suggests it could now provide a great opportunity.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
In favour; alternative investments
Many things to many people
Alternatives are thought of in many different ways by different investors. Frankly, it does not matter if you think they are a good asset class, a bad asset class or one that doesn’t really exist. It’s all about what they provide for you in your portfolio construction.
For the Diversified fund range, it’s simple. We are looking for attractive long-term investments that are lowly correlated to bonds and / or equities. However, that correlation can pick up at certain times and has done recently, as you will read below.
We are largely ambivalent with regards to asset class, as long as we can understand it (for us that means excluding gold and crypto-currency) and as you will see below, they are varied. You may have seen a video we produced recently in which Robin Willis, an alternatives specialist, talks on the subject. Robin manages the part of the alternatives portfolio in the Diversified funds that uses investment companies. Below he sets out the opportunity we currently see in this asset class.
The what and the why
We believe an allocation to alternative asset classes provides important diversification benefits to a balanced multi-asset portfolio. We seek to gain exposure to sectors that have a low sensitivity to moves in equity and bond markets and the broader economic environment. Often access to alternative asset investments is achieved via investment companies which, due to their permanent capital characteristics, we consider the most appropriate method to add exposure to, sometimes, less liquid assets.
This part of the portfolio held up well during the bond and equity sell off in the first half of 2022. However, despite resilient underlying performance, disappointingly share prices have dramatically de-rated since then as gilt yields have sharply risen. Investors’ demand for alternative income has dissipated in favour of the more traditional option of bonds, which are not exposed to equity volatility and discount risk. They also seem to have suffered from some indiscriminate selling of “UK plc” as investment companies invested in alternative assets and property REITs make up a large proportion of the FTSE 250 Index.
There has been a high correlation between share prices and gilt yields over the last year as we’ve witnessed a de-rating of share prices from premiums to underlying asset valuation to significant discounts to valuation.
We consider this sell off to be overdone as some investors seem to be treating these companies as “bond proxies” while giving little attention to the total return nature of these asset classes and offsetting factors such as inflation linkage.
As the risk-free rate has moved higher it is reasonable to assume the discount rates used in the companies’ discounted cash flow valuation process should also rise, leading to lower valuations. The share prices are now implying a significant increase in discount rates being used in future valuations. But this gives little regard for the growth dynamics of the revenue streams of these available from the underlying assets, of which there are some examples below. Any rise in discount rates would at least partly be offset by factors such as higher realised inflation than had been previously assumed.
Most of these companies’ revenues have significant inflation linkage. Meanwhile many of these companies have already been significantly raising their discount rates since the mini budget in September 2022. Continuing transaction activity in private markets at levels that support current company valuations also provides comfort.
We believe we’ll look back at his period as an attractive opportunity to add exposure to resilient alternative revenue streams, with attractive growth dynamics, at significant discounts to valuation.
We have built up a diversified portfolio of alternatives with what we believe are attractive growth drivers:
• Renewable Energy – essential assets valued conservatively in terms of assumed achievable power prices.
• Music Royalties – the growth of music streaming.
• Digital Infrastructure – the increased demand and scalability of the “plumbing of the internet.”
• Shipping – essential transport with attractive supply/demand dynamics.
• Battery Storage – ability to benefit from the growth of intermittent renewable power generation.
While some share prices have suffered due to some companies’ more idiosyncratic and self-inflicted issues, the broader UK alternatives investment company sector trades at roughly a 20% discount to NAV. Most of these companies would have had a premium rating a little more than a year ago.
We believe there are several potential catalysts which might lead to a positive re-rating of share prices. Perhaps any surprise to the downside in UK expected inflation numbers or a belief that interest rate expectations have peaked would be a stimulant.
But if not, company boards are under increasing pressure to act on behalf of shareholders. We are having an increasing number of conversations with company boards discussing potential remedial action for their share prices. Consolidation, M&A, asset disposals and returns of capital will become commonplace across the sector. Recently one of our music royalty companies received a cash offer reflecting a 67% premium to the previous day’s closing share price. There are several continuation votes on the horizon which will provide shareholders an opportunity to have their voices heard. And while we wait for the price recovery, we are happy to get paid with well-covered and resilient high dividend yields.
Out of favour; what we don’t understand
For multi-asset fund managers, the investment universe is too big to be able to fully understand. No one can be an expert in everything and I can’t imagine how big a team of fund managers and analysts would be required to cover all asset classes, in all regions, all the time, in the necessary detail.
Therefore, in the Diversified funds we stick to what we know. We have specialist investment teams for fixed income, global equities, UK equities, property company shares, alternatives and derivatives (for hedging and defensive strategies), with proven investment approaches, so that is what we stick to.
As Robin outlined above, we gain exposure to many different asset classes through investment companies, we may not be experts in the asset classes ourselves, but Robin is an experienced expert in selecting fund managers who themselves are experts and, importantly, he understands the investment company structure.
The recent correlation of some investment companies with bonds has, we believe, been erroneous, but understandable and presented an attractive opportunity after a period of poor performance that has impacted on the Diversified funds.