A top tip in infrastructure trusts
Investment companies in the sector offer both protection from inflation and excellent value
Infrastructure investment trusts are trading at some of the widest discounts to net asset value (NAV) in the investment-trust industry, having traded at a premium for much of the past decade. The discounts reflect both investors’ increasing caution towards trusts and uncertainty over valuations. Trusts that own illiquid assets are harder to value than those with liquid investments, such as equities.
There are two ways these trusts can value assets. Valuers can look at recent comparable transactions or calculate asset values based on the investment’s long-term projected cash-flow generation. The subjective nature of both methods means that there is always some ambiguity around asset values of trusts with illiquid portfolios.
The latter method, based on long-term cash-flow generation, is also influenced heavily by interest rates. This method uses a discount rate to determine the ultimate terminal value. The discount rate is linked to interest rates. The higher the interest rate, the lower the terminal value, and vice versa. We’re seeing the impact this can have on valuations today. Wide discounts in the infrastructure investment-trust sector reflect investors’ caution around valuations in a higher interestrate environment. However, focusing on NAVs alone ignores one of the most attractive qualities of infrastructure investment trusts: cash flows.
Cash flows from infrastructure assets are usually tied to inflation, something HICL Infrastructure (LSE: HICL) illustrates. The company owns more than £3.1bn of assets with a market-leading inflation linkage of 0.8% across the portfolio. That means 80% of the cash flow from its assets is linked to inflation. The average life of the contracts in the portfolio is 33.1 years.
These long-term inflationlinked cash flows are attractive, but as analysts at Liberum, an investment bank, have pointed out, the “low-risk, long-dated cash flow increases duration risk and sensitivity to discount rates: a 1% increase [in interest rates] reduces NAV by 11%”. That explains why the trust trades at a 20% plus discount to NAV. Higher rates have introduced a level of uncertainty to the portfolio’s value. However, realworld examples have provided a clear example of why investors shouldn’t fixate on NAV values.
In the real world, demand for inflation-linked, long-duration assets such as toll roads and water companies, both of which HICL has exposure to, remains incredibly high. Over the past year, the company has been able to dispose of £500m worth of assets at or above NAV, illustrating that not only is NAV a subjective measure, but investors are also being too cautious by allowing the stock to trade at such a significant discount to the value of the company’s assets.
Sales at a premium
The company’s latest disposal was the US Northwest Parkway toll-road project in February, which brought in $232m, a 30% premium to book value at the end of September last year. Broker Numis has calculated that asset sales have added a total of 5.8% to the company book value, “which not only provides evidence of the current disconnect between public and private market valuations of core infrastructure portfolios”, but also partly offsets the effect of discount rates on NAV.
Part of the proceeds from the toll road will be used to fund a $50m share buyback. That shows “responsible capital allocation”, according to Numis, and may go some way to closing the discount. Alongside the buyback, HICL has a dividend target of 8.25p for its current fiscal year (to 31 March), producing a yield of 6.5% on the current share price. Analysts believe that the company’s NAV per share will climb from around 160p to over 170p by 2026. With the stock trading at a discount of 20% today, it seems to offer value with income from a hard asset with inflation protection.