Investment trust investors have had a brutal 12 months. Last November, our 2022 investment trust special issue highlighted just how widespread share price discounts to net asset value (NAV) in the sector had become. Since then, things have mostly got worse.

Investment trust discounts are a reflection of a lack of demand for their assets, caused by a combination of factors. The macroeconomic environment is certainly unfavourable. Higher interest rates and recession fears have curbed demand for growth assets. And alternative investment trust valuations, for example in the infrastructure sector, are vulnerable to higher rates because the resultant increase in their discount rates reduces the value of their future cash flows. 

Investment trusts are also grappling with some more structural issues. A consolidating wealth management industry increasingly favours bigger, more liquid trusts, at the expense of the smaller players in the sector. 

Against this backdrop, some analysts are still enthusiastic about investment trusts’ prospects. James Yardley, senior research analyst at FundCalibre, calls this a “once-in-a-generation chance” to buy them – although he acknowledges that “you can’t rule out things getting worse before they get better”.

“The important thing to remember is that discounts aren’t something to be afraid of; it is the performance of a trust and the abilities of its manager that are likely to be the most significant contributors to success over time,” he says.

Others argue that it may be a while before the sector recovers, and investors should be selective in their search for bargains, as we have discussed in our recent feature (‘Fishing for trust bargains’, IC 6 October 2023). Overall, there are opportunities for the patient investor, but one needs to tread carefully and be prepared to wait for them to come to fruition.

 

Widening discounts

Excluding venture capital trusts (VCTs), the investment trust sector’s weighted average discount has actually stayed roughly stable in the past year. It has moved from -13.9 per cent at the end of September 2022 to -14.1 per cent one year later, according to Association of Investment Companies (AIC) data; the bulk of the discounts widening happened in the first nine months of 2022. But this year’s figure is slightly skewed by the partial recovery staged by the private equity sector over the period, particularly that seen at 3i Group (III).

With £18.6bn in assets, this mammoth trust accounts for more than 7 per cent of the whole investment trust universe. 3i was trading at a 22.3 per cent discount in September last year, and had moved to a 13.5 per cent premium one year later. This somewhat masked the fact that for the majority of sectors, discounts have in fact been widening. The chart below lists the sectors that have registered the biggest swings in discounts in the past year, whether on the upside or on the downside.

The chart is topped by alternative sectors that are deeply vulnerable to higher interest rates, which have unsurprisingly lost a lot of ground. Investors have been sceptical of the valuations of their underlying assets, although competition from fixed income, where yields are now more attractive, has also played a part.

For the infrastructure and renewable energy sectors, a rerating looks difficult without a change in the wider market environment, but many think they could prove attractive targets for merger and acquisition activity. Nick Greenwood, manager of MIGO Opportunities (MIGO), which invests in a portfolio of about 50 investment trusts, says that if we haven’t seen much of this yet, it’s likely to be because these kinds of transactions require due diligence and take time. He notes that while in principle “there is nothing wrong” with trusts in this sector, some are small in size and demand for them is low, meaning they may be snapped up by third parties – a case in point being Aquila European Renewables (AERI). 

For trusts where this proves the case, investors can collect an attractive yield as they wait and hope that the assets will eventually be sold near the NAV, delivering an uplift to the share price. However, since the underlying assets in these sectors are typically illiquid, transactions are far from straightforward. Greenwood says that most trusts have operational rather than construction assets, which in theory should put them in an easier position to sell. “But what you tend to find is that there’s always one or two assets that for whatever reason are difficult to sell, and take time,” he says. 

Hedge funds and flexible investment trusts also make an appearance in the chart of sectors whose discounts have widened the most, highlighting just how difficult the market has been to navigate and how jumpy trust investors are at bad news of any kind. Hedge fund BH Macro’s (BHMG) NAV total return was down 3.1 per cent in the year to 7 November, but its share price shed 22.3 per cent, partly due to concerns that wealth managers Rathbones and Investec may decide to reduce their combined holdings in the trust as they merge.

In the flexible investments space, Caledonia Investments’ (CLDN) NAV gained 4.2 per cent over the period while its share price was down 11 per cent, possibly due to investors being wary of private assets, which make up roughly a third of the portfolio. RIT Capital Partners (RCP) also contributed to the widening of the sector’s discount, as it faced scrutiny over the valuations of its private assets and its fees.

 

A private equity recovery?

As mentioned, private equity is one of the very few sectors whose average discount has narrowed over the past 12 months. 3i is a bit of an odd duck for both its size and concentrated exposure to Dutch discount retailer Action Group, which has been performing particularly strongly. But other private equity trusts also saw their circumstances improve, albeit not quite as significantly.

This has partly to do with the apparent resilience of their underlying portfolios, and perhaps also with just how wide the discounts were to begin with. Jason Hollands, managing director of Bestinvest, also argues that private equity trusts are being conservative in their valuations in the current environment, something that, if true, investors can take comfort in. Numis analysts also deem private equity investment trusts “a very attractive investment opportunity”, noting that the discounts are wider than in the secondary market where private equity assets are traded. Average discounts stand around 30 per cent for direct private equity trusts and 44 per cent for funds of funds; meanwhile, the analysts estimate that buyout funds are trading at a circa 10 per cent discount on secondary markets.

“Despite a difficult macro backdrop, earnings and revenue growth are generally remaining resilient in underlying portfolios,” they say, citing solid performance from Oakley Capital (OCI), for example. Princess Private Equity (PEY) and HgCapital Trust (HGT) have also been doing well in the year to 7 November, with total NAV returns of 9.4 per cent and 7 per cent, respectively.

So has Abrdn Private Equity Opportunities (APEO), whose discount has remained pretty much unchanged over the period. Abrdn has recently sold its European private equity business to Patria Investments, an alternatives asset manager based in Latin America, and while APEO’s management team is expected to remain in place, Numis notes that “it will be interesting to see if this triggers any wider review by the board”.

 

Some cheap trusts

One way to gauge how cheap trusts are trading is to look at the Z-score: a measure that calculates how far a trust’s premium or discount to net asset value (NAV) is from the one-year average. A Z-score can be considered to be fairly cheap when it gets below -1 and extremely cheap at or below -2.

Top 20 Z-scores* as of 6 November
Trust	Discount	Z-score
Troy Income & Growth	-5.3	-4.4
Henderson High Income	-7.5	-3.7
Henderson Far East Income	-5.0	-3.1
Foresight Sustainable Forestry	-35.9	-2.7
Lindsell Train IT	-11.3	-2.6
Harmony Energy Income	-36.3	-2.6
Ceiba Investments	-61.1	-2.6
JPM Global Core Real Assets	-32.8	-2.5
Weiss Korea Opportunity	-6.6	-2.5
Polar Capital Global Healthcare	-9.4	-2.5
Ecofin Global Utilities & Infrastructure	-17.6	-2.4
Brunner	-13.3	-2.4
Mobius Investment Trust	-8.9	-2.3
JLEN Environmental Assets	-28.0	-2.3
New Star IT	-37.1	-2.3
Middlefield Canadian Income Trust	-18.8	-2.3
Augmentum Fintech	-50.5	-2.2
Fair Oaks Income – US$	-8.4	-2.2
Scottish American	-3.5	-2.2
*Trusts with more than £100mn in assets. Source: Winterflood.

In our regular “around the world” feature, we look for trusts with attractive Z-scores that also have good short-term share price performance. As this implies, Z-scores on their own should be considered a source of ideas rather than inherently attractive, considering that investment trusts often become particularly cheap for good reasons.

That is arguably the case for the trust with the lowest Z-score (of -4.4) as of 6 November. Troy Income & Growth (TIGT) has had to suspend its discount control mechanism because it was running out of cash to fund the buybacks, and is now looking for a merger. The mechanism is a distinguishing feature of the trust, so this is a bit of a blow. Among others that rank well on Z-scores alone, Henderson Diversified Income (HDIV) is preparing to merge into Henderson High Income (HHI), which appears to be providing some aid to the share price of the former but penalising that of the latter. Meanwhile Henderson Far East Income (HFEL) is having a pretty bad year performance-wise.

But the process still throws up a few interesting names. Brunner (BUT) is a global equity investment trust that has been increasing its dividends every year for half a century, and its NAV performance on a one and three year basis looks very respectable. Unlike most of its peers, the trust isn’t doing buybacks. Its current Z-score is -2.4. Scottish American (SAIN) is another dividend hero, one of the few trusts in the Baillie Gifford stable whose share price held up comparatively well until recently. The trust, whose Z-score is -2.2, has a lower yield than its peers in the equity income sector because it chiefly targets dividend growth. But its long-term track record looks solid. 

Two others with Z-scores of around 2.5 are also notable. Polar Capital Global Healthcare (PCGH) has a fixed life. It is due to run until 2025, at which point investors have a decent chance of getting the investment back at NAV levels, creating an opportunity for the discount to narrow as the date approaches. Finally, JLEN Environmental Assets (JLEN) is a way to gain exposure to a diversified range of renewable energy assets; the trust has a solid track record and has pledged to increase its dividend by 6 per cent in the current year (ending March 2024), although like the rest of the sector it has to contend with leverage and higher discount rates.