Premier Miton Global Renewables Trust — Potential for real return

Investment trusts, particularly those with long-dated revenue streams such as renewables, have been at the pointy end of the rising interest rate and asset valuation debate. The nominal yields of money market and fixed-income products have attracted investor attention away from investment trusts, where the return premium has not been seen as sufficient to offset the risk. While these products can minimise investor losses in nearer-term periods of market weakness and high inflation, it is a medium-term guarantee of negative real investment returns. In our view, investors will be drawn back to the relatively higher and, in many cases, inflation-linked returns found in many renewables trusts when returns improve and interest rates settle. PMGR has shifted its portfolio’s geographical weighting slightly to best combat the pressure of rising inflation and interest rates, with a 4.1pp increase in European investments and 3.2pp decrease in global investments.

PMGR reported good results on the back of high power prices in the six months to June 2023 and this, coupled with the continued growth of its assets, resulted in earnings per ordinary share increasing by 12.3% to 4.43p. The first two quarterly dividends (1.85p each) of FY23 were 5.7% higher than H122. Investor sentiment surrounding the renewable energy sector has weighed on valuations and widened discounts to NAV, negatively affecting PMGR’s holdings. We argue that the monetary flow towards fixed income will not be permanent and the combination of positive real yields and growth in underlying end-use in the renewables sector could present an attractive buying opportunity.

NOT INTENDED FOR PERSONS IN THE EEA

Investment trusts in the renewable energy space have been competing with fixed-income and money market products for investor attention recently. In a rising rate environment, the nominal yields of these competing products look attractive, and the rising rates have also put upward pressure on the discount rates used in fund asset valuations, putting some downward pressure on NAV calculations.

In our view, the flow of money into fixed-income and money markets products are transient rather than structural. The question investors are likely to ultimately face is whether they wish to secure a guaranteed loss in real terms or invest for higher than inflation yields and NAV growth at very moderate rates of risk. Five-year and 10-year UK gilt yields, as at 2 October 2023, are at 4.55% and 4.50%, respectively, and UK money market funds are typically returning 4.5–5.0% at present. Both of these are below UK inflation rates (UK inflation was at 6.7% at end-August 2023).

The yield on trusts in the renewable energy infrastructure sector is above inflation. The sector has an average yield of 7.39% as at 3 October 2023, with many individual trusts higher than this. In addition, many trusts offer elements of income and capital growth. The underlying revenue models of assets within trusts can have explicit inflation linkages for revenue, or methods by which inflation is passed through. Some have government price guarantees or historical subsidies for older assets, which are repriced annually in line with inflation. Most trusts also have organic growth pipelines and opportunities to improve asset performance that are typically not reflected in NAV calculations.

We would argue that it does not require the direction of interest rates or the yield curve to begin reversing for the preference for below-inflation nominal yields to run its course. The initial catalyst for the sectoral sell off was the spike in 10-year gilts in late September (see Exhibit 1, which shows base rates, 10-year gilts and PMGR’s stock price for reference). Fixed-income and money market products are attractive in periods of market uncertainty (and these products have seen very significant inflows), but the realisation of longer-term negative real returns is likely to weigh on sentiment. We would argue that just a period of stability is enough to be a catalyst for a reversal in both sentiment and fund flows over time. Naturally a falling rate environment would accelerate this switch back considerably but, importantly, we do not believe it is the trigger required.

For renewable energy as a sectoral bet, the debate about the policy environment potentially changing (particularly in the UK) is missing the point. Renewable energy growth is being driven in many parts by relative competitiveness, and the desire of major end-users to decarbonise and secure their energy supplies. The increased focus of many firms in the sector on recycling assets (ie selling developed assets and expanding their growth pipeline) reflects the significant underlying structural demand for renewable energy in its varied forms, as well as the infrastructure and end-use demand reduction required for decarbonisation.

It is a structural growth industry, and these pipelines of opportunity are generally not reflected in NAV calculations. We believe the current discounts to NAV for many renewable investment trusts are unjustified and see the sector as attractive. This view that the market is missing underlying growth and inflation linkages in assets is shared by PMGR (see below). There is also often conservative assumptions in many NAV calculations, as a long-term decline in power prices from current levels is generally assumed (some assume 40–50% below current levels by 2030).

PMGR presents an attractive, multi-exposure opportunity in this environment. Its portfolio has been progressively repositioned for an inflationary environment, with shifts in 2021 and 2022 towards greater asset exposure in Europe and the UK compared to North America. One of the drivers of this was the higher degree of inflation linkage in European and UK compared to the US, where renewable power is usually sold on pre-determined fixed prices. The manager also expected EU and UK electricity prices to rise, which would benefit renewable generators. This was due to the structural shift in the gas market, replacing Russian gas with higher priced LNG, increased carbon prices, and the increasingly unreliable and ageing French nuclear power stations. These decisions largely proved correct with many of the UK and EU investments reporting very strong financial results, with increased dividends on the back of higher power prices and inflation-linked revenues.

James Smith, the fund manager of PMGR, recently wrote a report in which he questions whether investors are currently mistaking renewable energy investment companies for bond proxies as well as some of the sectors fundamental factors that will determine long-term value.

In the report, he argues that the disappointing performance among renewable energy investment companies is due to the overriding factor of the recent sharp increases in interest rates and bond yields. Smith highlights that he believes when yields rise, many investors look to sell stocks that they believe to be bond proxies, due to the fact these companies have a high level of visible and recurring revenues, with a high proportion of total investment return expected to come through dividends.

An example is the relationship between Greencoat UK Wind (PMGR’s largest holding within its portfolio) and gilts, comparing total returns over the short, medium and long term. In the short term, there has been a high correlation between Greencoat’s falling share price and the increasing yields on UK government debt over the first half of 2023. However, in the longer term, Greencoat’s total return has significantly outperformed the UK actuaries five- to 15-year gilt index.

The underlying argument is that, in the short term, the market is discounting the impact of higher interest rates, but it is forgetting to factor in the benefits of high inflation through inflation linkage within many portfolios. Greencoat incorporates third-party power price forecasts into its NAV calculation. These currently assume power prices will return towards £60/MWh by the end of the decade. However, it is worth noting that the first half of 2023 saw the UK wholesale baseload price average almost double this, at £116/MWh. Therefore, if we assume power prices will remain at current levels or higher, Greencoat’s NAV calculation can be seen as conservative.

PMGR invests across a broad range of renewable energy-focused market areas (see Exhibit 4). The majority of the portfolio is made up of the two largest sector areas, with the largest investment weighting, as at end September 2023, being yieldcos and funds at 40.7% of the portfolio. The second largest was renewable energy developers at 30.5%. Both sectors essentially own and operate renewable energy generation facilities. The significant difference between the two is that the developers take on significant project development risk, which includes several years of upfront work securing land for the project, environmental permitting, site design, grid connection application and design, planning approval, local consultation and any necessary studies that are required prior to development. In comparison yieldcos invest in or buy pre-existing assets with the aim of providing direct income to investors. Yieldcos and funds also are increasingly taking on construction risk as they try to improve returns on their assets. More entrepreneurial funds, like Octopus Renewables Infrastructure Trust (ORIT), do however take on construction risk outside of trying to improve returns by buying and developing projects which are in the ready-to-build stage.

Since our last note in March 2023, the geographic weighting of the portfolio has continued to see change, with a 1.4pp decrease in Chinese holdings. The most notable changes are the 4.1pp increase in European holdings and the 3.2pp decrease in global holdings. This highlights the fact the manager is increasingly preferring investments in Europe, as their revenues have better inflation linkage compared to the US and its peers.

Greencoat UK Wind (UKW) remained PMGR’s largest holding, representing a 7.2% weighting in the company’s portfolio. As mentioned in the manager’s view section, where we discussed Smith’s recent paper on the renewable energy investment trust market, Greencoat’s performance in the short term has seen its stock being traded off with the continued increase in interest rates. However, Smith states that he is not overly concerned with the company’s short-term performance, considering the recent market conditions, as he believes that UK renewable energy investment trusts are being mistreated within the market and are being traded as bond proxies (as outlined above).

Three European companies are represented in PMGR’s top 10 holdings: RWE and two funds, ORIT and Aquila European Renewables Income Fund (AERI). While listed in the UK, ORIT and AERI operate in Europe, and also add to the yieldcos and funds segment of PMGR.

The manager added to both the RWE and Octopus positions since February 2023 due to share price weakness, as he believes both funds have solid portfolios and their share prices are likely to rebound. As of 3 October 2023 PMGR’s top 10 holdings represent 53.9% (see Exhibit 4) of the entire portfolio (up from 52.2% as at end-February 2023), with seven of these holdings being yieldcos and funds. Two new additions to the top 10 were Foresight Solar Fund (with a 4% weighting in the portfolio), which pioneered solar investing as a UK-listed investment trust with assets across the UK, Spain and Australia, and SSE (4.1%), a multinational energy company headquartered in Scotland.

Stock performance for many underlying holdings has also been affected by generally poor sentiment towards renewables developers in the past two months. This has been driven in part by newsflow stemming from some specific high-profile profit warnings and revisions by major renewables developers Ørsted and NextEra Energy Partners (neither owned by PMGR). The issues driving these announcements have been quite stock and investment specific and not shared by investments held by PMGR.

In terms of the portfolio’s sector exposure (Exhibit 5), in the six-month period since end-February 2023, the largest adjustments are decreases of 1.1pp in biomass generation and production and 1.7pp in energy storage, as well as increases of 1.3pp in renewable financing and energy efficiency and 2.0pp in yieldcos and funds.

As shown in Exhibit 6, for the 12 months to end-September 2021, PMGR strongly outperformed its benchmark. However, this was not the case for the 12-month period ending in September 2023, when both PMGR’s total share price return and total NAV return fell further behind the MSCI AC World Index and the CBOE UK All Companies Index. Compared to the note we released in March, however, PMGR’s performance is significantly more closely correlated and in line with its benchmark, the S&P Global Clean Energy Index, as can be seen in Exhibits 6 and 7, suggesting its performance is more reflective of the general market conditions (which were mentioned at the beginning of the report).

While the fund does not construct its portfolio with reference to any index, in 2021 it adopted a new performance benchmark, the S&P Global Clean Energy Index. Over the 12 months to end-September 2023, PMGR has performed in line with the index, which can be seen in Exhibit 7, which is a true a reflection of the general renewable energy market conditions seen over the last year. For the six-month period to 30 June 2023, PMGR had an asset total return of negative 6.2% (negative 7.3% for the year ended 31 December 2022), which slightly outperformed the S&P Global Clean Energy Index in the same period with a value of negative 11.5% (6.6% for the year ended 31 December 2022).

Note that the index returns for periods of more than one year in Exhibits 6, 7, 8 and 9 also include the trust’s benchmark prior to FY21, which was a broad global infrastructure index. The index, like PMGR’s portfolio, consists of listed companies involved in the generation and supply of renewable energy, although in terms of constituents the two are very different, with the index having higher exposure to the United States and to companies at the technology/components end of the renewables value chain.

In Exhibit 10 we present PMGR alongside a group of peers who have been selected from several AIC sectors, all of which to some extent are connected to renewable energy, utilities and/or infrastructure.

Although PMGR is the smallest fund in the peer group in regard to market capitalisation, if it was measured by total shares including the zero dividend preference shares (ZDPs), it would be similar in size to Jupiter Green. As at our last note in March 2023, PMGR ranked third by NAV total return performance over three years (out of 16 funds). However, in the seven months since, it has fallen to 16th. This reflects difficult market conditions over recent months. Ongoing charges at 1.68% (1.7% in FY22) are above average; however, PMGR has maintained a strong dividend yield of 6.2%, positioning it ninth within the peer group. PMGR ranks 16th (of 16 peers) by NAV total return performance over the past year.

PMGR has the second lowest discount to NAV within the peer group at 9.2% as at end-September (14.3% as at 10 October 2023), which is significantly below the peer group average of 20.8%. Since our last note in March 2023, nearly the entire peer group has widened or increased its discount to NAV, except for PMGR, which has closed its discount from 17.7%. This demonstrates the resilience PMGR’s discount to NAV has shown in the six-month period since March 2023 (as can be seen in Exhibit 11) in comparison to the rest of the sector. This somewhat reflects the investment structure of PMGR, with its NAV being largely comprised of listed market valuations rather than private valuations.

A total dividend of 3.7p (two quarterly dividends of 1.85p each, which is 0.10p up from the quarterly FY22 dividend payment) has been paid so far in FY23. These dividends represent an increase of 5.7% compared to the dividends paid in respect to the first half of 2022. It is, however, worth noting that the previous dividend of 10.2p was rebased downwards, from FY21 onwards, due to a change in capital structure, which resulted in a repayment of a portion of the funds ZPD shares at the end of 2020.

Premier Miton Global Renewables Trust has been part of the Premier (now Premier Miton) stable for almost 20 years, ever since the 2003 rollover of the Legg Mason International Utilities Trust. Initially known as Premier Utilities Trust, it changed its name to Premier Energy & Water Trust (PEWT) in 2008 and subsequently to Premier Global Infrastructure Trust (PGIT) in late 2017. PGIT’s mandate built on that of PEWT, investing in equity and equity-related securities of companies operating in the energy and water sectors generally, as well as other generic infrastructure investments. In October 2020, reflecting a gradual shift in focus towards the renewable energy segment of the infrastructure universe, PGIT’s shareholders voted in favour of proposals to change its name to Premier Miton Global Renewables Trust (PMGR) and its investment remit to a more targeted investment proposition dedicated to renewable energy and sustainable infrastructure investments. The trust has been managed since 2012 by James Smith.

PMGR sits in the AIC’s Infrastructure Securities sector, a peer group for funds that invest in infrastructure shares. There is currently no sector for funds investing in renewable energy shares, underlining the differentiation of the trust’s approach. While it is hard to find an equity benchmark to reflect PMGR’s diversified global approach, since FY21 the trust has measured its performance against the S&P Global Clean Energy Index (previously it used a broad global index of infrastructure shares).

The trust’s official investment objective is to achieve a high income and to realise long-term growth in the capital value of its portfolio. PMGR pays dividends quarterly. The trust is geared via ZDPs (see below).

PMGR’s policy is not to employ any gearing through long-term bank borrowing. However, the company employs gearing through the issue of ZDP shares by PMGR Securities 2025. The group is not subject to a maximum level of such gearing but the number of ZDP shares that may be issued is limited by the applicable cover test in respect to those ZDP shares (the ratio of the NAV of the group plus the accrued capital entitlement to the ZDP where capital entitlement must not be less than 3.5 times).

PMGR’s use of ZDPs as gearing (see our initiation note for more details) has the advantage of eliminating annual interest coupons, with the redemption value of the ZDPs instead hopefully being covered by the trust’s higher investment returns (as a result of the gearing effect) over the life of the ZDP issue, although it also carries the potential risk of being highly geared in a falling market. The 2025 ZDP issue was smaller than previous issues, with £14.2m shares issued at 100p – equivalent to c 50% gearing – on 30 November 2020. The 2025 ZDPs have a redemption price of 127.61p, equivalent to a gross redemption yield of 5.0% at issue.

This gearing is calculated as the ZDP share liability over the equity attributable to ordinary shareholders. The nature of the ZDP shares means that the gearing is, for the time being, ‘semi-permanent’. PMGR’s board will review the company’s capital structure on the maturity of the ZDP shares in 2025.

Gearing based on ordinary shares at end-August 2023 was 39.55% (56.5% for the six months to June 2023 and 48.4% as at 31 December 2022), and as at 30 June 2023 the ZDP share cover (non-cum) was 2.32x (2.51x as at 31 December 2022). The NAV total return for the ZDP shares was negative 10.4% in the six-month period end 30 June 2023.

PMGR is an investment trust with two classes of share: ordinary shares and ZDPs, which it has used throughout its existence to provide gearing. PMGR has an indefinite life, subject to a five-yearly continuation vote, the next of which is due in 2025. At the March 2020 vote, more than 99% of votes cast were in favour of continuation.

As shown in Exhibit 13 below (major shareholders), PMGR’s ordinary shares have a high level of retail ownership on platforms such as Hargreaves Lansdown, Interactive Investor, AJ Bell and Halifax Share Dealing (which together account for around half of the share base). The average daily trading volume on the London Stock Exchange over the past 12 months (Exhibit 14) was c 24.4k ordinary shares, or c 0.1% of the share base.

Given PMGR’s geared capital structure, movements in gross assets are amplified in the net assets. PMGR’s ZDPs are also a sterling liability, therefore the manager may use currency hedging to offset any sterling underweight in the portfolio and is currently substantially hedged on the portfolio’s euro exposure.