The value of renewable energy investment funds is underestimated

Oscar Wilde famously said that a cynic is “a man who knows the price of everything, but the value of nothing.”

Retail investors who continue to shun the renewable energy mutual fund sector may be susceptible to such cynicism because current share prices prevent them from seeing the intrinsic value in underlying portfolios of the sector.

We believe that investors logically ask themselves why a company’s share price is low, as this is often the only perspective from which to assess the market value of a company.

However, it is also true that volatile stock prices can often give a false impression of the true value of a company. In fact, investment strategies such as value investing are based on the understanding that the market often fails to realize true value.

However, the current low share prices do not reflect the growing evidence that renewable energy investment portfolios are undervalued. This means that the sector could be one of the most undervalued value areas on the UK stock market, as the investment case remains the same.

Proving the value

There are two ways to measure the value of these trusts. One is the share price, or how much someone is willing to pay for one share of the company.

The second way is to value the underlying portfolio of renewable assets, which is done by determining how much the market is likely to pay for each of the projects in aggregate, which is known as the net asset value (NAV).

For retail investors, renewable energy mutual funds provide one of the few entry points into private assets with strong, inflation-protected, contracted income.

If the total market capitalisation or total value of equity/shares of a mutual fund falls below the value of its underlying assets, the mutual fund is said to be selling its assets at a discount to its net asset value.

For some time now, most renewable energy investment funds have been trading at a discount to their net asset value, in some cases as much as 40 per cent.

By comparison, five years ago, renewable energy stocks were trading at an average premium of 8.9%, while the long-term average premium was 4.4%.

Today’s deep discounts have left many questioning the sector’s profitability, including whether trusts are accurately valuing the assets in their portfolios. But the evidence that these valuations are indeed accurate is growing.

Renewable energy infrastructure investment funds have completed around £500m of asset sales since the start of 2023, according to a new study by Barclays.

The prices of all of these transactions were at or above the valuations given in the net asset values of these trusts.

Why is this important?

This should provide investors with a sense of confidence in the real value of the assets they are buying that are currently trading at a discount, and also protect them from losses when investing in these funds.

Price vs. Value

One of the most common and unhelpful arguments when discussing the value of mutual funds is that they are expensive.

Investment funds are often wrongly perceived as expensive compared to open-ended funds. This is partly due to the Financial Conduct Authority’s cost disclosure regime for investment funds.

The system, which is a retained EU regulation, requires investment funds to report expenses in the same format as unlisted open-ended funds. This ignores the fact that the cost to an investor of investing in a fund is its share price.

This means that the current total costs of managing investment funds may artificially inflate the true cost of investing in these instruments.

In other words, lower share prices in the renewable energy fund sector are actually a signal that the costs to investors are low in terms of the internal rate of return.

Waiting for something

The picture for this sector remains unchanged despite the stock trading at a widening discount to its long-term average; today could be an attractive entry point.

We believe that the declines in renewable energy mutual fund stocks are unlikely to be sustained over the long term, and there are potentially a number of factors that could prompt this re-rating. There are three main reasons for this.

First, we believe the popularity of these assets is likely to continue globally as consumer demand continues to grow and governments continue to strengthen their commitment to the energy transition and achieving net zero emissions.

Second, as we approach a super election year and see continued growth in political stability, we can expect the risk premium associated with this sector to decline and investor confidence to rise.

Finally, renewable asset-focused investment trusts have traditionally been popular with UK retail investors as they provide individuals with the opportunity to invest in energy projects, democratising an area that would otherwise be the preserve of institutional investors.

Big investors rightly place a high value on the idea of diversification, especially in the face of market volatility. In fact, diversification is often described as the only free lunch in investing.