Buy into this top private-equity group

Many investors are put off private-equity group 3i (LSE: III), a FTSE 100 constituent, because of the persistently high premium to net asset value at which its shares trade. But given that the shares have more than quadrupled in the last five years, and paid generous dividends, shunning 3i has clearly been a mistake.

Following the recent full-year results, Christopher Brown, head of funds research at investment bank JPMorgan Cazenove, described a premium of 40% to the 31 March net asset value (NAV) of 604p as "looking stretched". Since then, following an update on retailer Action, 3i's largest investment, the share price has risen another 10% to 920p. Yet the shares are not as dear as they look.

First, Brown estimates the current NAV to be 625p per share, rising to 649p by the end of September and over 700p by next March. Second, fees from funds managed for investment clients generated 4.6p of earnings last year, implying a business value of perhaps 60p per share. Finally, the portfolio valuation looks conservative, as evidenced by 3i's historic record of selling assets for well above book value (the value of a company's assets minus its liabilities).

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3i's largest investment, accounting for nearly 30% of asset value, is Action, a European retailer best thought of as a reincarnated Woolworths. Action opened 197 new stores last year, taking the total to 890 across six countries. Like-for-like sales growth was 7%, and the amount of cash generated rose 37%. Brown forecasts 30% annual growth in cash flow over three years, based on like-for-like sales growth continuing at current levels and realistic growth in store numbers. That would add 45% to 3i's NAV. Consequently, the valuation of 16 times cash flow looks very undemanding.

But 3i is no one-trick pony. Excluding Action, the portfolio produced a 29% return last financial year, yet is valued at just 9.9 times cash flow a near 40% discount to the FTSE 250. 3i also has a 34% holding in 3i Infrastructure, a £2bn listed company investing in utilities, oil storage and the leasing of railway rolling stock, as well as PFI projects. This stake accounts for 11% of 3i's portfolio, but is lower risk and hence lower reward than the portfolio average, returning 16% last year.

Other notable investments include ferry operator Scandlines and travel agent Audley. The recent sale at a loss of lingerie business Agent Provocateur, bought by the previous management, followed by a e247m investment in a less glamorous German service provider to the automotive and components industry illustrates the tougher and more disciplined investment approach brought in by Simon Borrows, who was appointed chief executive five years ago.

The problems 3i encountered in the financial crisis are now a distant memory. The focus is on generating returns from growth, not leverage; net debt is negligible (though there is debt in the underlying investments). Earnings growth last year excluding Action was 13%. 3i is also committed to paying dividends, although a rising share price has put the yield at under 3%. Those who buy now run the risk of the premium to NAV narrowing, but 20% annual growth in NAV over the next two years should offset any derating, Brown points out. Any reasonable setback to the share price could provide an opportunity for a great long-term investment.

Activist watch

Activist shareholder Crystal Amber will urge Ocado to rebrand as a technology business and overhaul its investor relations team when they meet for the first time this month, says Ben Martin in The Daily Telegraph. The activist fund revealed a 0.5% stake in the food-delivery business a fortnight ago, and is expected to start a campaign to "shake up" Ocado, which has disappointed investors with its lack of process in how it licenses its technology overseas and the way it communicates with the City. The announcement last Friday of Amazon's $13.7bn takeover of American supermarket chain Whole Foods also sparked speculation that the online retail giant might soon bid for Ocado, sending its shares up 11%.

In the news this week

Index provider MSCI has decided to include China's A shares in its Emerging Markets (EM) index from June next year, says Natalie Kenway in Investment Week. MSCI had ruled against including China's mainland domestic shares in its index three times over the past three years, due to concerns about regulation and accessibility for global investors. The provider intends to add 222 China A large-cap stocks to the EM index, which will form approximately 0.73% of the index's weight. The move will oblige the $1.6trn of investment funds that track the index to buy into the Chinese mainland market.

The former manager of rock band Guns N' Roses hopes to raise up to £200m for an investment trust investing in the royalties of songs by artists such as Rihanna and Adele, says Yoosof Farah on Citywire.co.uk. Hipgnosis Songs, set up by Merck Mercuriadis, one-time manager of Iron Maiden, Elton John, Morrissey and Pet Shop Boys, pitched to investors last week and is planning an initial public offering at the end of this month. The fund will target a 6.5% dividend yield, and a 10% annual total return after fees over the medium term. It will charge an advisory fee of 1.5% of assets on the first £200m, scaling down to 1% over £300m, and a performance fee of 10% of any total net asset value return over a 10% hurdle. When fully invested, it will own a minimum of 300 songs.