Interactive Investor

Specialist investment trust tips for 2013: Part two

23rd January 2013 08:30

Fiona Hamilton from interactive investor

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Our annual examination of niche opportunities focuses on investments of a type not easily replicated outside of the closed-end investment companies sector.

Some are linked to equities so are likely to be at their best when stockmarkets are strong. Others invest in alternative sectors and should prove more resilient when stockmarkets are struggling. It is unlikely they will all perform well at the same time.

Read: Specialist investment trust tips for 2013, for our investment trust warrant and highly geared ordinary share picks.

Of last year's tips, Electra Private Equity Trust:fs, which invests directly in unquoted companies, achieved very attractive returns, thanks to a well-deserved narrowing of its discount. The private equity sector continues to look undervalued so we are extending our coverage to include a private equity fund of funds for the coming year.

We are also nominating a share in an established venture capital trust (VCT), as this is an overlooked sector that offers investors an attractive source of tax-free income.

Our zero-dividend preference share performed as hoped - F and C Private Equity:fs achieved a steady if unspectacular capital gain.

Zero-dividend preference shares: Utilico Investments

Zero-dividend preference shares (ZDPs) that are well covered by assets remain a good way of locking into relatively assured capital growth up to their wind-up date. As returns are all in the form of capital gain they are tax free if covered by an individual's annual gains tax allowance, or if the shares are held in an ISA or self-invested personal pension.

The zeros of F and C Private Equity:fs look very safe, however their net redemption yield to wind-up has fallen to 4%. Investors willing to shoulder a bit more risk for a higher return could consider the 2016 tranche of zeros issued by Utilico Investments:fs, which offer a net redemption yield of 5.1%.

Utilico Investments is a Bermuda-based investment company with a highly experienced management team that looks for undervalued assets. A third of the portfolio is in gold mining with 12% in renewables and 10% in electricity. Assets would need to fall by over 22% a year to threaten the full redemption at 160.52p in 2016.

Private equity: Electra Private Equity and Graphite Enterprise Trust

The discount on geared ordinary shares of Electra Private Equity Trust:fs has narrowed considerably, but it still looks unjustifiably wide given the trust's outstanding long-term record, its conservative valuation policy, and its exceptionally strong balance sheet. Over half the portfolio is in investments with a vintage of three years or more.

Oriel Securities reckons that the two largest companies in the portfolio have good realisation prospects. It has set a six-month price target of 1,970p and we are keeping the trust on our roster.

For our fund of private equity funds selection we are nominating Graphite Enterprise Trust:fs. It invests mainly in third-party managed private equity vehicles focused on Europe, but its long-standing management team invests in UK mid-market buyouts both directly and through its own limited partnerships. It claims this helps the team to make good choices of external managers.

Graphite has stakes in close to 40 private equity funds managed by 27 different managers, with underlying exposure to around 300 companies. Of those companies the 30 largest account for over 40% of the trust's assets and achieved 11% earnings growth in the year to the end of June, so these meaningful stakes are doing well.

Around half the trust's assets are in sterling-denominated companies and cash, with 35% denominated in euros and the rest in dollars. Euro weakness halved portfolio returns in the first half of 2012, but the flip side is that it is making some investee companies more competitive.

Graphite says it is capitalising on worries about Europe by topping up its exposure to funds on favourable terms and the trust is therefore more fully invested than it has been for years.

Graphite has performed far better than the FTSE All-Share over the past 10 years. Its net asset value per share has surpassed its pre-financial crisis peak, and we expect its discount to narrow.

Venture capital trusts: Northern 2 VCT

VCT shares purchased through the secondary market can be a good source of tax-free income and long-term capital growth. Investors do not enjoy the higher upfront tax relief on purchases of newly-issued VCT shares, but this is partly offset by the opportunity to buy into an established portfolio at a discount, and by the freedom to sell at any time without having to repay the initial tax relief.

More importantly, as with newly-issued VCT shares, any dividends are tax-free and those dividends can be above average as VCTs can distribute realised capital gains as well as income.

VCTs must invest most of their assets in a restricted range of securities that have been newly issued by very small unquoted or Alternative Investment Market-quoted UK companies. Individually such investments are high risk. But several VCT managers have succeeded in achieving quite impressive long-term returns, including Northern Venture Managers:fs, whose executives must personally invest alongside their VCTs in every new investee company.

NVM's three VCTs have similar portfolios and yields. All three try to keep their discounts below 15% through share buybacks and occasional tender offers.

Our choice is Northern 2 VCT:fs, which has paid out at least 5.5p a share in each of the past eight years, giving a tax-free yield of more than 8%. Its portfolio is relatively mature, and its five-year NAV total returns are among the best in the VCT sector, yet its shares are currently on a 19% discount.

Part three of our specialist trust tips features timber and infrastructure investments.