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Seeking discount value

John Baron highlights the importance of monitoring discounts and premiums to portfolio performance.
January 10, 2013

Regular portfolio maintenance is essential for profitable investing. Last month's column looked at the importance of rebalancing as part of this process. A further part, peculiar to investment trust portfolios, is the regular monitoring of value through the discounts and premiums of both existing and potential holdings. This also provides another opportunity to revisit strategy.

Discounts and premiums

Both these live portfolios had a good 2012. The Growth portfolio was up 20.07 per cent and the Income 17.72 per cent. This compares with their respective Apcims Growth and Income benchmarks of 9.99 per cent and 7.79 per cent - all figures being total return. The need for regular portfolio maintenance is given added urgency if performance has deviated from benchmarks by some measure.

For an investor should never be complacent about the market. It can often surprise, so approach with humility. Wiser investors than I can profit from short-term movements. As regular readers know, my philosophy is to by and large stick with the market in the belief that if one remains loyal, it will reward over the longer term.

The extent to which returns are impacted if just a few of the best days are missed is illustrative. Investors who put £1,000 into the FTSE All-Share in October 2000 would have seen it grow to £1,330 by October 2010 - not a good decade by historical standards! But if the 10 best trading days had been missed, then the return would have halved to just £720!

However, there is one downside with staying invested: the longer in the market, the greater the chance of suffering a market crash. Memories are still fresh of the FTSE 100 losing a third of its value in 2008. But a couple of portfolio strategies, pursued together, can help to lessen the impact of market setbacks, while also enhancing returns over the longer term.

The first is rebalancing or diversification. The second is to seek value: to 'prune' investment trust portfolios by constantly asking whether existing holdings look expensive relative to potential alternatives, and thereby conversely questioning whether potential holdings look cheap by comparison.

Changes to the discounts and premiums of trusts present both opportunities and risks to the investor. Trusts standing on a premium to net asset value (NAV) can be riding for a fall. Cheaper trusts standing on wide discounts can do disproportionately well should sentiment turn and the discount narrow.

But seeking value is not just about a simple comparison of discounts. A host of factors need to be considered. Investors must first ensure they are comparing apples with apples - trusts within the same sector and/or geographic region. Furthermore, seeking value is about comparing discounts and premiums relative to performance - sometimes, premiums are justified if performance is consistently ahead of the peer group. Other factors that affect discounts - such as a change in managers or strategy, or level of gearing - also need to be considered.

However, it remains a fact that anomalies can and do exist. Some trusts do represent better value than others over the longer term, and switches are worthwhile. But it should always be remembered that such considerations should help to time long-term changes in portfolios, and not short-term trading opportunities which typically raises cost and hits performance.

 

 

Portfolio changes

Accordingly, during December, in both portfolios I have reduced or sold entirely three trusts which have been held for a long time, performed well, and now stand at premiums. These are Jupiter European Opportunities (JEO), Perpetual Income and Growth (PLI), and Scottish Oriental Smaller Companies (SST). Apart from JEO in the Income portfolio, they remain core holdings in both portfolios.

I also sold Dunedin Smaller Companies (DNDL) in the Income portfolio after a 32 per cent price gain over five months, which reflected excellent NAV performance and the disappearance of the discount. I also top-sliced North Atlantic Smaller Companies (NAS) in the Growth portfolio after a 20 per cent price gain over a 10-week period helped by a closing of the discount.

Purchases common to both portfolios have been European Assets (EAT), Schroder UK Mid Cap (SCP) and TR Property (TRY). All three trusts have good track records under their current managers, stand at decent discounts and thereby represent good value.

EAT focuses on mid to small companies on the continent, with the average capitalisation of holdings being around E1bn. Sam Cosh, its manager at F&C, has recently taken over the running since when performance has improved significantly. Speaking with him, his philosophy is to buy good quality companies at the right price, perhaps depressed by short-term difficulties, and to hold for the longer term.

 

 

A unique feature of EAT is that it pays out a

6 per cent dividend, expressed in euros, based on the trust's NAV at the beginning of the year. The announcement last week confirmed a 44p dividend for 2013 which, when one factors in a 9 per cent discount when bought, suggested a 6.4 per cent yield at purchase. Sentiment regarding Europe is negative and asset allocations are low. While sceptical about eurozone prospects, I still believe a lot of bad news is baked into the prices of many excellent companies. Therein lies our opportunity.

A similar approach to stock selection - quality growth at the right price - is adopted by Rosemary Banyard at SCP, who has been running the trust since 2003. I continue to believe smaller companies (including mid caps) offer good opportunities. It has a good track record, partly reflected in the 2.5 per cent dividend having increased by 50 per cent since 2007, with revenue reserves exceeding 18 months. SCP was bought on a 19 per cent discount.

Meanwhile, TRY is run by Marcus Phayre-Mudge at Thames River and has just completed a merger with its sibling Sigma trust. It invests in the shares of property companies but has a 10 per cent weighting in physical property. Post merger it will be weighted approximately two-thirds large-cap stocks and one-third small cap, with over 60 per cent exposure to the continent. Again, I consider market sentiment is overly depressed - rents are rising with earnings, while the marginal cost of debt is falling. If inflation does pick up, then real assets with rising income should benefit. A good track record, a 15 per cent discount and well covered dividend of 4 per cent warranted its inclusion.

Meanwhile, I have introduced Invesco Leveraged High Yield (ILH) to the Income portfolio when at a 10 per cent discount. Investing mostly in high-yielding bonds, it yields 8 per cent and has performed well over the last few years - helped by high gearing – as investors have sought yield. Being now a little more cautious, it has reduced its gearing over the past year but still believes value can be found, particularly in the financial sector. Again, it has healthy revenue reserves of around two years.

Finally, my one 'luxury' is the introduction into the Growth portfolio of Aberdeen Asian Smaller Companies (AAS) despite its premium, because of its unsurpassed track record and my continued enthusiasm for the Far East, and Baillie Gifford Japan (BGFD) on an 8 per cent discount - for reasons I'll explain in next month's column.

View John Baron's updated Investment Trust Portfolio.