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Over the past 40 years I have been an investment trust analyst, stockbroker and fund manager, helping manage RIT Capital, the Electric & General Trust and, until recently, the Mid Wynd Trust. Rarely have I seen the sector on such high discounts.
An investment trust, like a unit trust, is a vehicle that invests in a portfolio of assets — the older trusts invest in shares in quoted companies. Unlike a unit trust, an investment trust has a company structure and is quoted on the London Stock Exchange.
Add up the value of all the assets held and you get what is called the portfolio’s net asset value (NAV). You would imagine that the company holding these assets would be valued as the sum of its parts — no more and no less than the NAV. But this is often not the case. Sometimes, as now, trusts can find themselves trading at a discount. Why?
A number of factors may be at play. It may reflect poor performance — the result of inept management. It may be market sentiment, which is leaving shares in certain sectors beaten up. A discount can also reflect fund structure. Some of the widest discounts today are in trusts with large shareholders — perhaps from the institution managing the assets. This limits the power of ordinary shareholders to change a manager, close a fund or — as happened with Hipgnosis last month — overthrow a board.
Another factor might be transparency. Where a trust has a large allocation to private equity, investors may have doubts about the true value of unlisted holdings. Unlisted shares are often valued on the basis of the last private transaction — if that deal took place in happier markets, investors add a further discount for what they think the shares might be sold at today. This should not necessarily deter you from buying these trusts. Many trusts with private equity exposure, such as Caledonian, Oryx and 3i have excellent long-term performance records.
Managing the discounts
If the discount on an investment trust becomes very large, there is a case for the trust to dispose of some assets or use some of its income to buy in its own shares, gradually raising the net assets per share for the remaining investors. Recent examples include Pantheon in private equity and Greencoat UK, a renewable infrastructure trust which initiated a £100mn share buyback last month to help tackle a 20 per cent discount.
Some boards have a permanent discount policy. At Mid Wynd the board instructed us to buy in shares if they hit a 2 per cent discount. For most of our tenure the trust actually traded at around a 2 per cent premium, and we issued shares regularly to stop that premium growing excessively. This meant the trust got bigger — which benefited investors, as the running costs per share fell.
There are pros and cons in trying to manage the discount. A discount management policy such as Mid Wynd’s is arguably good for holders — it protects them from the extra volatility that trusts can bring. Potential buyers might argue that rival trusts on much deeper discounts look more attractive, but you should beware of buying on discount alone. You may come to appreciate this discount management policy later when it is time for you to draw on the assets. You don’t want the bad luck of suffering falling share prices and a widening discount at that point.
Share buybacks are easier with some trusts than others, depending on the nature of the underlying assets and how liquid they are. As with any company, there can be a compelling case for management to buy back shares if it does so at a level that enhances value for all remaining shareholders. It sets a high hurdle for the returns on any other investment of funds.
But buying back shares can also lead to smaller trusts shrinking below a sustainable size, which raises costs per share and may ultimately mean a merger or winding up is required.
Should I buy a discounted trust?
Large discounts can be a warning flag to potential investors, but can also represent a great opportunity. As indicated earlier, discounts rise and fall with sentiment among retail investors. In my experience, these flows have a history of being good counter-indicators of market prospects. When markets are overheated there tend to be inflows into “hot” funds, which can trade at large premiums — as many infrastructure trusts did a few years ago.
When the mood turns those unlucky shareholders see both the underlying asset valuations fall and the trust premium rating becoming a discount rating. And this combination can be magnified in trusts that borrow money. The trust sector frequently has very disgruntled short-term investors and very happy long-term investors.
On this basis, I see the current wide discounts in the trust sector as more of an opportunity than a threat. So how do you choose an investment?
My selection always starts with the underlying assets: British and Japanese smaller companies currently seem very good value. Take the FTSE 250, for example. It is down nearly 12 per cent this year, and companies here trade on significantly lower price/earnings multiples than their counterparts in the US and elsewhere. Investment trusts in this space are on a discount of 10-20 per cent. That is a double discount, therefore.
After identifying the best sectors, I would select the manager with strong records. Be careful when looking at tables that you are comparing like with like — a smaller cap manager’s performance will look very different from a large cap manager’s at the moment. Trusts can vary widely within each sector. Look closely at the trust’s objectives, which should be very clear. My preferred one is “to increase wealth ahead of inflation over the long term — five years or more”.
Understand that for a trust to create more value than an index tracker fund its make-up needs to differ from the index, so in terms of performance it will sometimes be ahead and sometimes behind the index after costs. Take the long view when judging performance.
I also usually look at where the trust is managed. Unfortunately, a number of the trusts with mediocre performance bear the brand names of very large investment houses. This tends to mean that neither the board nor the fund manager have much “skin in the game”. The investment policies may be set centrally rather than tailored to a specific trust, and management may take a limp approach to discount management. There are exceptions — but not many.
Lowland for UK exposure and Nippon Active Value for Japan seem to fit most of the above criteria.
History suggests discounts on well-managed trusts tend towards their long-term averages and so should shrink. That means if sentiment and business conditions improve, trusts should offer investors an extra kick of returns. And even if a sector remains gloomy for a sustained period, closing discounts on well-managed trusts should offer some compensation.
The author is a former fund manager
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