UK investment trusts are trading at the widest discount seen since the 2007/8 financial crisis, according to recent research from Numis and Winterflood. Against a backdrop of weak investor sentiment, the sector weighted average discount widened from 2.3% at the start of 2022 to 16.4% by the end of March 2023.

For example, the Global sector is currently trading on a 9.27% discount to NAV versus a five-year 2.87% average, according to data from the AIC (Association of Investment Trusts). It is worth highlighting this investment trust sector because it houses some hugely popular trust names, such as Brunner Investment Trust (BUT), Scottish Mortgage Investment Trust (SMT), Monks Investment Trust (MNKS), Alliance Trust (ATST) and Lindsell Train Investment Trust (LTI).

For a brief recap, when we talk about a discount, we are describing the gap between the share price of an investment trusts versus its NAV, or net asset value. In other words, the value of the underlying assets in the trust’s portfolio.

‘Discounts are, at a fundamental level, a consequence of fewer buyers than sellers,’ says Alan Ray, an investment trust research analyst at Kepler Trust Intelligence. ‘If you think of share prices as a popularity contest, then a discount (or premium) is the “clearing price” at which buyers are willing to step in.’

There is an inevitability that discounts will widen during times of economic and market uncertainty as capital dries up, but such a steep level of discount should not last long. This suggests value can be found in this well-established and diverse part of the UK investment industry.

‘In our view, this has created some notable value opportunities, especially amongst sectors that have been hit particularly hard by the rising interest rate environment, including private equity, infrastructure and property, as well more growth-focused equity funds,’ says Emma Bird, head of investment trusts research at Winterflood.

Due diligence is, as always, vital, and investors should do their research before committing to an investment. To provide readers with a manageable starting list, Shares has scoured the data and produced five investment trusts that are trading below their five-year averages and where, we believe, this valuation gap could narrow over the months ahead.

WHAT TO CONSIDER WHEN THINKING ABOUT DISCOUNTS

When assessing whether a certain discount is likely to offer an attractive entry point, a key datapoint to look at is the investment trust’s current rating relative to its history. ‘A current discount considerably wider than the medium to long-term average could suggest that over time the shares will mean revert and experience a positive re-rating,’ says Bird of Winterflood.

But simply looking at a trust’s discount today compared to, say, its five-year average is, on its own, a vanilla analysis on par with judging a company share’s price to earnings versus its historical average. The world turns and things change, and the prospects for an investment trust can become brighter, or gloomier, as time passes.

Investors need to dig deeper. ‘Have there been fundamental changes to the trust’s management or investment approach that could impact future prospects that may mean that the discount remains at a wider level,’ says Bird of Winterflood.

She suggests that an easy next step would be to compare a trust’s prospects and discount with its peers. ‘If an investment trust is trading at a notably wider discount than its peers for no discernible reason, and if this has not consistently been the case historically, this can indicate an attractive entry point,’ the Winterflood investment head says.

A persistent discount could be a bigger problem, indicating a general lack of investor interest in the investment trust and its proposition. If a single discount sticks out in a peer group for years, it could be a sign of more structural lack of demand. ‘Is there something idiosyncratic about the investment mandate that puts investors off, or a structural reason? It is a good idea to look at report and accounts in instances like this,’ advises Kepler’s Ray.

ENTIRE SECTORS CAN SHINE, OR BE SHUNNED

An investment trust peer-wide discount might simply be saying that the sector is cyclically out of favour and, with time, might come back into favour, or it could equally be a signal that the stock market has a view that a particular asset class is about to fall in value.

‘The classic case study is the property peer group, where in 2022 discounts widened before property values fell,’ says Kepler’s Ray. The stock market correctly anticipated this because interest rates had risen, and this usually has a direct effect on property values.

‘Betting against this type of discount in the early stages could be risky, but sometimes moves like this can go too far and create opportunities if you are patient,’ says the Kepler analyst. ‘Equally, renewable energy trusts fell to discounts in 2022 as investors worried about potential windfall taxes that would, perhaps ironically, impact renewable energy generators.’

Premier Miton’s Nick Greenwood, who runs the MIGO Opportunities Trust (MIGO), says this can happen from a geographic point of view too. He says that investors have been turned off places like Vietnam, for example, because of China’s previous economic slowdown and ongoing political risk.

He says that the global economy is locked into China but security concerns in the West create a terrific opportunity for Vietnam. Greenwood believes it is an obvious place for US and European multinationals companies to do business and manufacture in the region while avoiding the political minefield of China itself.

Winterflood’s Bird also argues that it is wise to find out whether a trust has a discount control policy or if the board has previously tended to repurchase shares to limit the discount. ‘This can help limit downside discount risk, while maintaining exposure to any potential re-rating from a change in sentiment towards the fund.’

FINAL THOUGHTS ON DISCOUNTS

Asking why there is a lack of buyers of a particular trust or segment is a particularly good question if one hopes that a discount might narrow, says Ray of Kepler.

If the answer is, for example, that markets are very volatile and there is a lack of risk appetite, then one could conclude that the discount is not an indication that there is anything fundamentally wrong. But taking advantage of a discount in this type of scenario also requires some risk appetite.

Understanding why a particular discount exists helps an investor to form an opinion about whether they agree or disagree with the discount, and whether they think it is too wide. ‘It isn’t at all easy to know when other buyers will reappear to help narrow a discount, but having an opinion at least helps understand why other buyers might reappear,’ says Kepler’s Ray.

‘However, investors should note that discount volatility is an inherent feature of the investment trust structure and there is no certainty of a re-rating in the near-term, particularly against a backdrop of macroeconomic uncertainty and negative investor sentiment,’ says Winterflood’s Bird.

FIVE INVESTMENT TRUSTS TO BUY

AQUILA EUROPEAN RENEWABLES – (AERI) 83p

Aquila European Renewables (AERI) invests in renewable generation assets in continental Europe and Ireland, including wind, solar and hydropower projects.

WHY THE DISCOUNT WILL NARROW

Last year was transformational with 80% growth
in operating capacity, adding €30 million to revenues, greater balance between technologies, record NAV total returns and 5% dividend growth. It targets assets where the energy source is most abundant, such as wind farms in the Nordics and Iberian solar developments. Projects are located across six countries and six power markets. By technology, solar represents 51% of the portfolio, 44% in onshore wind and around 5% in hydro electric power.

Numis analysts note a step change in disclosure around future earnings capacity and average dividend cover of 1.6-times over the next five years (1.8 in 2023). Run by a conservative German management team, it has committed €20 million to share buybacks to support the share price, which is trading at a record 15.5% discount. Five-year average discount data is not available, but it stands at -0.05% over three years. Investors can benefit from a 5.9% income yield in the meantime.

CT UK CAPITAL & INCOME – (CTUK) 304p

The former BMO Capital and Income trust, CT UK Capital & Income (CTUK) is one of the AIC’s Dividend Heroes, having increased its dividend every year since its launch in 1992 and maintaining a strong build-up of revenue reserves to support this going forward.

WHY THE DISCOUNT WILL NARROW

Manager Julian Cane looks for companies with an element of quality to their earnings’ growth, allowing for a sustainable dividend, and where companies can demonstrate strong defensive moats and pricing power. He is not an income-chaser and is happy to trade off yield for future growth prospects, something that has become more apparent in the portfolio in recent years as high yielders face increasing pay-out sustainability risk.

The market conditions since early 2021 have      not been conducive for this strategy, with large-caps and value stocks outperforming, but we believe that such short-term drawbacks are an inevitable part of investing and now could be an interesting opportunity to consider a more growth-biased fund whose characteristics would be complementary to the typical income strategy. Currently, the trust yields 4.1%.

MERCANTILE INVESTMENT TRUST – (NRC) 198.4p

Pricing power and long-term competitive strength have always been a focus for Mercantile’s investment team when selecting companies to back. The managers believe that these are the businesses that are best placed to navigate the current environment and become the market leaders of tomorrow.

WHY THE DISCOUNT WILL NARROW

With Mercantile de-rating to trade on a mid-teens discount, we think the shares are worth a look for those wanting exposure to the UK mid & small cap space. The managers have been cautious on sectors exposed to higher interest rates such as real estate, and this appears to have paid off well over the past six months, with the NAV up 13% versus a FTSE 250 return of 5.5% (to 23 March 2023).

The managers Guy Anderson and Anthony Lynch are very experienced in difficult markets, with a combined 35 years investing in mid and small cap companies. If UK interest rates are now at, or near the peak, as most seem to think, small and mid-caps should begin to attract investors again as the market starts to price in future rate declines and attention turns to growth once more.

RIT CAPITAL PARTNERS  – (RCP) £19.41

Often referred to as a capital preservation fund, RIT invests across a wide universe and has a similarly asset diverse and international portfolio. It also puts part of its funds in the hands of outside fund managers deemed exceptional, hopefully gaining the benefits of skills and experience not available inhouse.

WHY THE DISCOUNT WILL NARROW

After 10 years or more of consistent NAV increases it is understandable that 2022 unnerved many long-standing investors. RIT’s ethos is to fall by less than the market during a downturn, limiting your losses and protecting your hard-earned capital, but there is no guarantee it will always make you money.

But we believe can deliver medium-term capital growth through the purchase of risk assets, including equities and private companies, when exceptionally bad years are evened out over,
say, a three-year period. RIT offers a highly differentiated multi-asset offering, which will complement many portfolios.

SCOTTISH MORTGAGE – (SMT) 665.4p

Unashamedly focused on growth, Scottish Mortgage has suffered from the effects of rising interest rates on company valuations and the global economy more than most. It runs a highly differentiated and long-term approach and the manager and board have repeatedly highlighted during the good times that it was likely to suffer periods of weak performance, that investors need to be prepared to weather.

WHY THE DISCOUNT WILL NARROW

Managers Tom Slater and Lawrence Burns remain focused on the long-term and are sticking to the trust’s key interests, such as digitisation of society, the intersection of biology and technology, and energy transition. It is hard to argue that these will not be hot areas of investment in future, and will produce corporate giants that are barely known today.

Given the poor NAV and share price performance over the past 18-months or so, we believe it is encouraging that the managers have been facing some heavy scrutiny from the board, surely a key part of its role.

We would not expect any knee-jerk reactions but in the context of reported criticisms by the now departed director Amar Bhide over the proportion of the portfolio in unquoted companies and the management of the trust, reassurance is required. Confirmation that key reviews and controls have been followed by the board would certainly help sentiment and address accusations that ‘procedural violations’ had been ‘brushed aside’.

DISCLAIMER: The author of this article (Steven Frazer) has a personal investment in Scottish Mortgage

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