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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
One of the main attractions for putting money into investment trusts is the ability to potentially buy assets for less than they are worth. Hypothetically, you could potentially pay 90p for something that is worth £1. Bargain!
Unlike traditional funds like unit trusts, the price of an investment trust is dictated by market demand. That means the price can vary dramatically from the net asset value, also known as NAV.
Mercantile Investment Trust is a good example as it trades on a 12.6% discount to net asset value, according to AIC data. That means you effectively pay 87.4p for £1 worth of assets.
It is one of the UK's oldest investment trusts and has stakes in well-known companies such as housebuilder Bellway, fast food seller Domino's Pizza and second hand car advertiser Auto Trader.
Investment trusts have ways in which they can close the valuation gap, such as buying back their own shares. By doing so the trust is effectively creating demand for its own shares and pushing up the price.
Premium to NAV
It is also possible for investment trusts to trade above the value of their underlying assets. For example, popular fund Lindsell Train traded on a 40% premium to its net asset value at the start of June 2016, according to the AIC. In that situation, you would be paying £1.40 for £1 worth of assets. Not a bargain.
Some investors may argue that Lindsell Train has a fantastic track record, so it is worth paying a premium for top quality fund management. After all, it has delivered 24.5% annualised total return over the past five years, claims Morningstar. That's more than twice the 9.89% total return from its FTSE World Total Return benchmark.
Another issue is that approximately one third of Lindsell Train's net asset value is a stake in its management company. This is a private business and therefore potentially illiquid shareholding, thus difficult to value accurately.
Importance of valuation technique
Comparing NAV to share price is the traditional way of valuing a business that generates revenue from its assets, rather than from selling a particular product or service. Investment trusts fall into the former category due to the equities, bonds or property assets they typically own.
Understanding the relationship between the NAV and share price is particularly important because these vehicles can borrow money. If a trust is wound up then any debt would have to be repaid from the cash generated from asset sales before being handed back to shareholders.
This is why paying a premium for a trust could leave investors out of pocket if things go wrong, while they could be in profit if an investment trust trading at a discount to NAV starts selling its assets.
Where to find the information
An investment trust's NAV is easy to find as many publish the figure through the London Stock Exchange's regulatory news service (RNS), some even post the total daily. You should also be able to find the number on trade body the Association of Investment Companies' (AIC) website: www.theaic.co.uk.
It is not a simple case of avoid those on a premium and only buy those on a discount. A good, well-run investment can be worth backing even if the shares trade above NAV. On the flip side, many trusts trading below NAV are 'cheap' for a reason.
A trust carrying too much debt could see interest payments rise or management unable to service the debt when hitting a bad patch.
Investment trusts can trade at a big discount if investors have no faith about the ability to sell underlying assets. The same applies if investors don't believe the fund manager has the right skills to grow the trust.
A sector might be out of fashion and investors believe the fund manager may lose interest or not be able to generate value from the trust, hence a big discount.
The other reason why trusts trade at a discount is the market doesn't believe the NAV is credible. This, in particular, can apply to stakes in private companies where valuations are often based on previous fundraisings.
This article is provided by Shares Magazine. Shares publishes information and ideas which are of interest to investors. It does not provide advice in relation to investments or any other financial matters and does not guarantee the accuracy or completeness of the information in this article.
Investors acting on the information in this article do so at their own risk and AJ Bell Media Limited and its staff do not accept liability for losses suffered by investors as a result of their investment decisions. Shares is published by AJ Bell Media Limited part of AJ Bell.
