Will increased gearing supercharge returns at this out-of-favour trust?

Investors in the ACE 40-rated Impax Environmental Markets Ord (LSE:IEM) investment trust suffered a difficult 2023, with shares falling 3.7%.

The trust buys small and mid-cap companies from around the world that operate in “environmental markets” - firms which enable cleaner and more efficient delivery of our basic needs, and those that mitigate environmental risks.

• Learn with ii: How to become an ISA millionaire | ISA Investment Ideas | Top ISA Funds

But a turnaround could be due, argues ii’s fund analyst Alex Watts. He looks into why the trust has performed poorly, and what could be a catalyst for better returns. He also assesses a big announcement from the trust’s annual report: an increase in gearing to take advantage of cheap valuations.

Performance

Absolute performance was challenged by economic uncertainty and quantitative tightening, putting pressure on small/mid-cap, especially the higher multiple-growth businesses.

Performance on a relative basis was worsened due to avoiding “Magnificent Seven” companies, which largely don’t fit the stringent sustainable criteria of IEM’s portfolio.

While net asset value (NAV) rose 4.5% (-10.8% vs MSCI ACWI / -13.8% vs FTSE Environmental Technology), price returns to shareholders were negative as a discount of 8% materialised through the year.

The numbers in detail (for 2023 calendar year)

Net Asset Value (NAV) Return:+4.5%
Share Price Return:-3.7%
Benchmark Return (MSCI ACWI/FTSE ET): +15.3% / +18.3%
Discount: 7.9% (-7.9% vs last year)
Gearing: 6.2% (+4.1% vs last year)
Dividend: 4.6p (+15% vs last year)
Fee: New, cheaper tier added of 0.45% for assets over £1.4 billion

Outlook

While the managers’ focus is stockpicking, interest rate falls are expected to be supportive for small and mid-cap companies if economic data holds up. There’s also a trend in preferences towards sustainable products and services that over the long term ought to benefit the trust’s portfolio.

Portfolio

The 63-stock portfolio maintains a focus on Industrials and Technology sectors, with a heavy weighting to businesses providing solutions across resource efficiency and water, energy and waste infrastructure, and tech.

Recent additions have taken advantage where markets have derated, showing a preference towards quality cyclicals that now look undervalued. Furthermore, we see an increase in the Asian allocation, including the trust’s first position in the Chinese A-Share market via EV supplier, Shenzhen Inovance.

Gearing

The board in 2023 permitted an increase in gearing to take advantage of depressed valuations across the portfolio. In September, new financing arrangements were made, resulting in an increase in gearing from 2.1% of the portfolio’s net asset value at the end of 2022 to just over 6% at the end of 2023.

Discount

Throughout the second half of 2023, a wider discount weighed on returns for the trust. Shares finished 2023 at a discount of 7.9%, falling from trading at NAV at the end of 2022, with shares bought back during the period.

ii View:

One of the trust’s strengths is management’s deep and extensive experience across sustainable investment. They have a dedicated and thorough process of screening and selecting companies based on management’s strength, regulatory positioning and contribution to resolving environmental challenges, as well as assessing financial quality and valuation. The approach to sustainability is puritanical and unadulterated, investing only in companies that derive most of their revenue from themes that come from what the trust defines as “Environmental Markets”.

While the long-term tailwinds of societal and regulatory advances still stand for these companies, over the past two years the market has mostly overlooked these attributes and small and mid-cap-growth has derated quite indiscriminately since 2022, hurting IEM’s performance throughout 2022 and 2023.

Valuations across IEM’s portfolio have proved particularly sensitive to the economic cycle and haven’t recovered from the pain of 2022. But nonetheless, it’s positive to see that the operational strength within the portfolio has fed through to growth in earnings per share, implying today’s depressed valuations reflect a degree of overselling.

• Under-the-radar stock pickers to back this tax year
• ISA tips: how to invest £10,000, £50,000 and £100,000

The board and manager’s decision to introduce new fixed and floating gearing facilities is an interesting development, especially given the trust’s relatively minimal leverage of late. For the trust to now increase market exposure (at what is presumed to be around this cycle’s peak of developed-market lending rates) means having to pay a higher rate to finance this. For example, in 2023 the cost of financing for Impax Environmental Markets offset the marginal performance boost the leverage provided.

The increased gearing speaks to the manager’s faith that markets are excessively discounting the trust’s portfolio and that, when valuations revert, future returns will far surpass the hurdle of these financing costs. It seems that, if the Goldilocks scenario of an economic soft-landing and a falling away of base rates materialises, the trust’s portfolio of small and mid-cap growth companies may be well placed to rebound quickly. Therefore, this could well prove to have been great timing to increase leverage for the trust, but of course the leverage could exacerbate any negative returns if the performance of the portfolio were to deteriorate.

In all, recent performance for Impax Environmental Markets has disappointed versus the trust’s large-cap heavy comparator benchmarks (MSCI ACWI, FTSE Environment Technology), both of which benefited from differing exposures to the Magnificent Seven stocks in 2023. However, the base valuations of the portfolio and discount of the trust provide access to a now unloved area of the market that can still boast the enduring structural tailwinds of the world’s sustainable transition.

The 10% discount is a rarity for the trust, so it looks cheap compared with a five-year average of 1% premium. A sentiment change towards the smaller spectrum of the market, in tandem with trust’s generous buying back of shares, could see this improve. The introduction of another cheaper tier to the fee is a welcome addition.