For many investors, the appeal of investment trusts lies in the ability to pick them up at a discount to the value of the underlying assets. In theory an investor can buy £1 worth of shares for 90p and wait until the market recognises the anomaly, with the lucky buyer benefiting from a rise in the assets and a narrowing of the discount.
Start at the bottom
This phenomenon has been seen clearly across a number of sectors in recent years. For example, at the bottom of the market following the financial crisis (in March 2009), the average discount in the Smaller Companies sector moved out as far as 16%, with the average across the investment trust sector at 8.7%.
Those able to spot the opportunity saw significant gains. In the Smaller Companies sector (which was hit particularly hard during the crisis), most trusts saw a significant rise in assets from depressed levels in 2009, but the narrowing of the discount provided a second boost for investors. For example, the net asset value of the Henderson Smaller Companies (HSL) investment trust rose 169.9% over the five years to 24 August, but its share price rose 201.4%. The net asset value of the Chelverton Growth (CGW) trust rose an impressive 99.9% over the same period, but its share price rose 134.8%.
These types of gains can seem seductive and, as such, it is tempting to be on the look-out for apparent opportunities. The problem is that the greatest opportunities tend to come when it is extremely uncomfortable to invest.
The biggest influence on the level of discounts and premiums is markets and – until recently – markets were at all time highs and therefore opportunities were limited. As we write (Sept 2015), the average discount across the investment trust sector is 5.5%, but some sectors would still seem to offer value.
There are flaws in simply buying those companies on the highest discounts to net asset value, particularly in this environment. Firstly, discounts tend to be relatively stable from cycle to cycle. While the UK Smaller Companies sector might still look attractive at 10.4%, when investors realise that it was 12% at the height of the last bull market in 2007 (stats from February 2007), it doesn’t look so appealing.
Discounts reflect sentiment towards a sector and that sentiment may be poor for a reason. To avoid some of the problems inherent at looking at the absolute level of discounts, it can be worth looking at the ‘z-score’ for individual trusts. This is a means of comparing a trust’s current discount or premium to its historic level. This measure can help investors compare across sectors. z-score are available on the AJ Bell Youinvest website. In general, a trust trading at a z-score of -2 or lower would be considered ‘cheap’, while one trading at 2 or higher would be considered ‘expensive’.
Are there other reasons why a trust’s discount might change? And could this provide opportunities? There will always be idiosyncratic reasons for shifts in individual trusts. For example, the Majedie Investments (MAJE) trust saw a significant narrowing of its discount in late 2013 after it announced a change in its management structure. Murray International (MYI) has seen its shares move from a premium to discount as manager Bruce Stout has seen his investment style move out of favour.
Another reason for structural – as opposed to cyclical – shifts in the discount might be changes in discount policy. For example, a trust board might commit to maintaining a certain discount level by instituting a buyback programme or having continuation votes. Trusts with poor liquidity will tend to trade further from their net asset value (either above or below, depending on their popularity) and so any measures to improve liquidity may see a shift in their discount or premium.