Ok, it sounds like the kind of question you might find lurking inside a Christmas cracker, but an ECWO ordinary share has a published net asset value of 174p (as at 31 December 2010) but can be bought at a bargain price of 130p (as at 31 December 2010), representing a 25% discount. Sounds too good to be true.
In a sense this is not unusual as investment trusts (closed-end funds) often trade at a discount to net assets, which is probably due to another layer of management charges and listing costs over and above the costs embedded in the underlying investments. Or maybe the market is discounting managers' abilities to generate above-average performance over the long-term. As an investment vehicle, I like investment trusts as the charges are usually lower, you can buy them at a discount and the performance is usually superior to comparable unit trusts.
The two main reasons that attracted me to ECWO in the first-place are (i) thematic, as I wanted exposure to the water and energy sectors as I believe that demand for these will remain strong as the world's population continues to grow and (ii) potential value, given that ECWO trades at a discount to net assets and those underlying assets may themselves be lowly-valued - ie the potential of buying cheap assets...at a discount!
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| Source: London Stock Exchange |
For the record, my average cost per share is 144p and, after dividends equating to 6p per share, my break-even cost is 138p per share.
Background
ECWO was launched as a geared equity vehicle in February 2002 with the intention of delivering a high, secure dividend through investing in utility companies, as well as preserving capital.
As at March 2010, ECWO held investments valued at £553m. In a snapshot:
- 75% were in the US, UK or Europe, with the remaining 25% in other industrialised economies and emerging markets (China, HK and Brazil = 15%);
- 53% were in Electricity, 11% Gas and 6% Water; 30% in multi-utility and utility-related;
- 85% were in listed companies and 15% in unquoted equities and corporate bonds.
The Company is essentially a holding company for the investments its holds. The whole business of making and monitoring investments is conducted by the Investment Manager, Ecofin Ltd, under a management agreement. Ecofin Ltd is paid 1.5% of 'chargeable assets' and is entitled to a kicker should chargeable assets increase by 10% over the previous period (Ecofin gets 15% of any excess over the 10% hurdle), which seems generous to me as there does not appear to be a cumulative component - ie from my interpretation, should assets fall by 25% one year, and then rise 20% in the second year, they Manager would get a 1.5% kicker in year 2 even though net assets would be 5% cumulatively lower after two years. Let me know if I have got the wrong end of the stick.
The Company has had a horribly messy capital structure with all sorts of Capital Shares, Income Shares, Ordinary Shares, Deferred Shares, Subscription Shares, Zero Dividend Preference Shares (ZDPs) and Convertible Loan Stock (CULS) in existence within the past five years. In fact, the two pages in the Annual Report covering the capital structure are enough to send an insomniac to sleep. Thankfully, the Company publishes the net asset value of diluted ordinary shares on a weekly basis, so that acts as a focal point to me.
But for all that, ECWO appears to have delivered. According to the Investment Manager (p6 of 2010 Annual Report), the annualised return (IRR) on net assets since 2002 is 16% and the IRR on the ordinary shares since they came into existence in June 2005 is just under 15%.
The risks that the Company faces include: the utility sector is capital intensive (which can gobble up cash flow), is subject to regulatory intervention (think OFWAT, OFGEM etc) and government spending; the renewables sub-sector is in its infancy and there will be casualties along the way (eg portfolio company, Hansen, has been struggling recently); the Company has relatively high levels of gearing (see below); the Company invests in other Ecofin funds (objectivity?); forex and hedging exposure, and the annual charges (TER of 2.5% in 2010 Annual Report) are slightly on the high side and will act as a drag on future performance.
The Rules
Because ECWO is a closed-end fund, the normal Rules do not apply. I will use them as a starting point, but will tinker as required. The starting point for the analysis is the 12 months to 31 March 2010 (FY10) and any reference to ECWO or the Company is in relation to the ordinary shares unless otherwise stated.
1 - Assets - the net assets of the Company totalled £449m, which is split between ordinary shares £387m and zero dividend preference shares (ZDPs) £62m (see below). The net asset value of the ordinary shares (on a fully diluted basis) is 174p. It is worth noting that 85% of the assets are listed investments, and are thus valued on a market valuation basis.
2 - Market value of the ordinary shares is £275m, so that ticks the box.
3 - Cash Flow - as the Company is essentially managing a big pot of money, out of which it needs to pay dividends and service debt, an analysis of cash flow is not especially relevant. If the Company needs to raise liquidity, it will sell some of its investments, most of which are shares in large, listed utility companies.
4 - Debt - Debt totalled £177m, being £35m of Prime brokerage borrowings (essentially an overdraft), £62m of Zero Dividend Preference Shares (ZDPs) and £80m of CULS (Convertible Loan Stock). The ZDPs have a gross redemption yield of 7% pa and will be redeemed in July 2016 (dividends are rolled-up rather than paid) and the CULS pay interest at 6% pa and will be redeemed in July 2016. That's the beauty of leverage...to borrow at 6-7% pa, invest and generate overall returns of 15% pa after costs and tax.
From a gearing perspective, this equates to gearing of 45% at March 2010 (after cash is deducted), which in English, means that for every £1 of ordinary shareholder equity there is 45p of borrowing. The Company has the ability to increase this up to 60% as a maximum. Note that, for this purpose, whilst preference shares are equity instruments, they are treated as debt.
The Directors believe that this level of gearing is sustainable because "utility companies in which the Company invests provide essential services, have substantial real assets and typically pay dividends".
5 - PER - closed-end investment companies tend not to be valued or measured on a PER basis, but more on a net asset basis. As stated, the current discount to net assets on the ordinary shares is 25%.
In the past 18 months, the discount has ranged from 8.8% (June 09) to 25.9% (Dec 09). The level of discount appears to have increased in line with the economic turmoil as the average discount was 2.6% before mid-2008 and it has been 17.7% since mid-2008 (Source: p2, 2010 AR).
A fundamental part of my analysis on this blog is to identify investments that are under-valued, particularly with reference to long-term earnings and current valuations. Whilst the same methodology does not apply for close-end investment trusts, it is possible to reference the current price against the historic level of discount. ECWO's discount is currently at the high end, implying a low relative valuation.
Another point to mention is that because of the existence of the ZDPs, the Company's ordinary shares are ineligible for inclusion in the FTSE indices. With a fair wind, ECWO might have just about crept into the FTSE 250 based on market value, but it isn't allowed, so this probably helps to keep it under the radar of a lot of investors. That said, there is a big institutional holding with Invesco holding 28.7% of the ordinary shares at March 2010, and the eight institutions that disclosed holdings above 3%, held 63% of the ordinary shares cumulatively.
6 - Yield - the DPS for FY10 was 5.5p, however the Chairman commented that they expect to pay semi-annual dividends of 3p per ordinary share going forwards, which equates to 6p per share and a yield of 4.6% based on the current share price of 130p.
The Revenue return per ordinary share for the past two years has been 5.9p and 6.9p respectively, which gives comfort that a dividend of 5-6p is covered. Furthermore, one of the advantages of the closed-end funds is that they can build up reserves to cover future dividend payments. ECWO has a Revenue Reserve of £15m versus an annual ordinary dividend bill of £10-11m, implying that they have 1.5 times the dividend in the 'reserve bank'. This will help to provide continuity and stability to future dividend payments at the current level.
7 - ROE - the return to shareholders is comprised of a Revenue component (dividends and interest received by the Company) and a Capital component (change in market value of investments, most of which is unrealised). It is difficult to use this as a reference point for ROE as the Capital component is essentially derived from a valuation taken at a particular point in time and does not represent 'earned' income. Consequently, I shall take the directors' statement that they generate post-tax returns of 15-16% pa as my proxy for ROE.
8 - Directors - the five directors hold 320k ordinary shares, £250k CULS and £80k of ZDPs, representing a total investment of c£750k, or £150k each. This is not a huge amount, but the dynamics are slightly different insofar as they are acting more as custodians of the Company, whereas the Investment Manager (Ecofin Limited) does the day-to-day management of the investments. Two of the directors are shareholders in Ecofin (or various holding companies or pension plans) which have an estimated £10m of vested interested in ECWO. Plus the generous performance fee arrangements, of course. All very messy, but enough to probably conclude that the directors interests are aligned with the ordinary shareholders.
9/10 - Buy or Bye? - see above and below re discount.
Update
The interim results for the 6 months to September 2010 were announced at the end of November. Whilst net asset value had fallen in light of the continuing tough economic climate, volatile markets etc, there was good news in the form of a higher interim dividend (3.25p), with the intention that this will be maintained for future payments and will be increased "when conditions permit". Better still, the Chairman commented that there may be scope to increase the yield by focusing more on higher-yielding investments.
As with the Annual Report, there was plenty of reference to the utilities sector being priced at historically low valuations, with high yields, and the last sector to enjoy recovery.
Conclusion
I'll let the Chairman have the penultimate word as he has articulated perfectly my rationale for investing in ECWO (Source: interim report):
"In the public equity markets, however, the sector remains under-owned by investors although valuations are attractive and the dividend yields available in the sector are among the highest available in the equity market. Historically, the utilities sector has been a sector that recovers late in the cycle following a recession and this looks to be the case in the current recovery as the sector has underperformed the broader market in 2010. For the patient investor, however, the sector offers income, low downside risk and the prospects of growth and a re-rating as the global economic recovery gains strength."
On top of that, I think that the shares are a little unloved because of the capital structure as well as not being in the FTSE 250, which keeps them under the radar.
For me the shares are a BUY at 130p. It's difficult to come up with a fair price as there is a bit of a moving target with the discount to net assets and the potential of a general revaluation of the global utilities sector. I'll start to get interested when the discount narrows to, say, 5%, which gets us to a target price of 165p- 170p. However, I am content to sit there for the long-term provided that the directors and managers can continue to generate long-terms IRRs of 15-16%, as this is consistent with my investment hurdle.
I will update once the results for the year to March 2011 are published.
Happy New Year!
I will update once the results for the year to March 2011 are published.
Happy New Year!
Thanks very much for your study. In answer to your question about the fees, I found the following on their website:
ReplyDelete"The performance fee is subject to a high water mark based on the Company’s previous performance, adjusted where appropriate for capital inflows and outflows during the financial year."
That's the good news.
I don't like the fact that they take a percentage of chargeable (and not net) assets. Chargeable assets include the zdp and culs. This ups their standard management fee by more than £2m pa (1.5% of zdp accrued entitlement + culs nominal value) while increasing risks for the ordinary shareholders. They thus have every incentive to stick to their maximum gearing level. I agree with you that it's a cheap way to buy attractive assets but I'll be filtering out their questionable balance sheet strategy by mixing a holding of ords with a good chunk of cash.
Hi SP
ReplyDeleteThanks for that. I agree with you on not liking fees on chargeable assets.
I guess that a (relatively) high level of gearing will stifle future share price growth, but from a long-term holding perspective, provided they can continue to deliver a 15%+ return after costs have been factored in, I'll be happy as it should wash through to the ordinary shareholders in one way or another.