Why the sun hasn’t shone for SQN

Installation of solar panels © iStock
A troubled solar-cell maker has cooled SQN’s shares

Back in March, I highlighted SQN Asset Finance Income Fund (LSE: SQN) as part of a number of specialist income ideas. This fund leases equipment and other physical assets to a portfolio of companies, using the steady cash flows from this to pay monthly dividends. Its borrowers are well diversified across different sectors, but some individual investments are still a significant percentage of the total fund’s value, meaning that a single defaulting borrower could have a noticeable impact on the fund’s net asset value (NAV).

In April we saw what could be the first significant example of this risk, as SQN announced a potential impairment on investment worth about 7% of the NAV in Suniva, a US solar cell manufacturer. SQN had a financing arrangement with Suniva, secured against manufacturing and production equipment. A decline in solar cell market prices, principally because of cheap Chinese imports, and a temporary increase in production costs, led the company to suspend production, and as a result Suniva was unable to make a scheduled payment due in March.

This is in effect a default, but all is not necessarily lost. SQN has reached an agreement with Suniva for the firm to enter into protective bankruptcy, which potentially provides the solar manufacturer specific relief over payments for a period. The manufacturer has also filed a trade case with US authorities asking for tariffs to be imposed on solar cell imports. All this will hopefully allow Suniva to return to profitability, in which case SQN hopes to make a full recovery of its principal plus all interest, as well as have a stake in the ongoing enterprise. Consequently SQN has not written down its investment, but does not expect to receive income from it in the near term.

The share price reacted dramatically to the news, dropping from 115p to a trough of 103p at the beginning of May. It has since recovered to 109p as an element of confidence has been restored. At the time of recommendation the premium to NAV stood at 14%, while at the current price the premium has contracted to around 10%. The good news is that SQN still looks capable of maintaining the current dividend distribution from the underlying portfolio, meaning the yield of 6.6% should help to anchor the share price.

• On a more positive note, River & Mercantile UK Micro Cap Trust (LSE: RMMC), which I recommended in April, has announced a compulsory partial redemption of shares (at 172.17p per share), which will take place in late June. I have seen some misplaced criticism of this move, on the basis that an investment trust shouldn’t have to sell shares because of supply and demand issues (unlike an open-end fund). However, this misunderstands the liquidity constraints of investing in microcaps and the potential long-term impact on performance if the trust size increases beyond a level the manager thinks is optimal. The only alternative is to let the number of stocks in the portfolio increase, which can be damaging if not properly managed.

Hence the redemption is a mark of success rather than failure. The trust’s NAV and share price have continued to rise rapidly since I first recommended it (the share price has gone from around 150p at the time to around 170p today), so this is something to be pleased about.

Activist watch

European activist investor Cevian Capital has spent $1bn buying up a 5.6% stake in Swedish telecoms equipment maker Ericsson, says Richard Milne in the Financial Times. Ericsson’s share price has dropped by around 40% in the last two years, amid falling spending by telecoms firms.

In the first quarter of 2017, the group lost $1.4bn. New chief executive Börje Ekholm plans to double profit margins by cutting costs and perhaps selling its loss-making media unit. But as Cevian managing partner Christer Gardell tells Reuters: “Plans are not enough to bring success. It is how the plans are implemented”. The activist intends to join Ericsson’s nomination committee, which proposes board directors to the annual meeting.

In the news this week…

• Fund managers are getting excited about the UK again, reports Chris Flood in the Financial Times. Investment managers who run global funds have increased their exposure to the UK over the past six months, “shrugging aside uncertainty over Britain’s future relationship with Europe and the looming general election”. In all, global managers are currently holding an average of 8.2% of their funds in the UK. That’s bigger allocation than the UK’s 5.8% weighting in the MSCI AC World global stock benchmark.

• Nearly 70% of investment trusts now have discount control mechanisms in place, says Jayna Rana in Investment Week. That’s up from just 40% five years ago (the figures do not include venture capital trusts). A key feature of investment trusts (which are companies that invest in other companies) is that the share price is independent of the value of the underlying portfolio (its net asset value, or NAV). Logically, the share price should reflect the NAV, but it can trade above it (at a premium), or more commonly below it (at a discount).

The discount control mechanism – which can take a number of forms – is meant to prevent this gap from growing too wide. They can be good news for existing shareholders, but bad news for bargain hunters – as Rana notes, the typical trust now trades on a “historically narrow” discount of 5%.