Navigating investment trust discounts and premiums

Discounts and premiums are often flagged up as a risk of investing in investment trusts, but they allow investors to buy in or sell at what seems like an opportune time. We highlight two Association of Investment Companies (AIC) investment trust sectors that look expensive, and two that look like good value, while identifying specific trusts to buy or sell.

EXPENSIVE

Property Direct - UK

UK commercial property had a strong 2014 and investment trusts in this area should continue to enjoy advances in their net asset value (NAV), according to Anthony Stern, analyst at Stifel. "However, with the funds trading at sizeable premiums to NAV, we believe much of the positive outlook is priced in," he adds. "Assuming we are approaching the top of the UK property cycle, we take a cautious stance on the sector. UK commercial property valuations rebounded by 93 per cent between the market trough in June 2009 and the end of February 2015."

Nearly all UK-focused direct property trusts are on high single-digit or double-digit premiums. "Demand for shares in many property investment companies and real estate investment trusts (Reits) has far outstripped supply," says James Carthew, research director at QuotedData. "New issues of stocks from some of these funds could put pressure on these ratings in the future."

Mr Stern says: "We worry that with asset valuations hitting new highs and capital growth about to slow, the sector could be exposed to de-rating."

He is particularly concerned about two trusts we count among our IC Top 100 Funds. F&C Commercial Property Trust (FCPT) is on a premium of 17.4 per cent, against a 12-month average of 12 per cent, and UK Commercial Property (UKCM) is on a premium of 11.1 per cent, against a 12 month average of 7.6 per cent.

F&C Commercial Property's dividend is only 75 per cent covered by the income going forward, so he does not see any room for growth in this. He says the trust has potential for strong rental growth in 2015, but much of its promising outlook is priced in.

Although UK Commercial Property should benefit as valuations rise in regions where UK institutions are now being more active, and it has a covered dividend and low leverage, Mr Stern rates the trust neutral. He cites a new manager, a less prime portfolio and the fact that it is trading close to its peak premium.

"We fear that the investors in these two key UK trusts may not get the full benefit of the underlying asset growth due to the risk of a premium contraction," he says. "Investors may want to take some profit or seek to re-enter at a more attractive valuation. There is downward pressure on the premiums as both funds have recently issued new stock. We realise many shareholders are holding the shares for the income, but fear that there is significant risk to their capital when buying at such a high premium."

However, professional investors and analysts don't suggest that you sell out of property wholesale.

Mr Stern admits that: "It is possible that we are a little early in this de-risking call," while Peter Walls, manager of fund of investment trusts Unicorn Mastertrust (GB0031218018), which we count as an IC Top 100 Fund, says: "I am not sure if I would sell out right now, I don't see the prospects for property changing anytime soon, although there is a risk to the ratings of the investment trusts."

He instead holds TR Property (TRY), also an IC Top 100 Fund. The portfolio is mostly invested in property shares, but also has a small allocation to direct UK property. It is trading at a small discount to NAV and has traded at around par for more than a year. This trust has made strong returns and offers a yield of 2.4 per cent.

Source: Winterflood as at 27 April 2015

Europe

Europe investment trusts are generally on tighter-than-average discounts, while a few are on premiums. Mr Gilligan highlights Henderson Eurotrust (HNE), which is trading at a premium to NAV of 2 per cent against its 12-month average, a discount of 0.4 per cent.

"Performance over the past year has been below average when compared with the sector peer group," says Mr Gilligan. "Returns in the fourth quarter of 2014 suffered notably from the writedown to zero of a holding in a Denmark-listed, ship fuel supplier, following an announcement regarding the discovery of fraud in its Singapore subsidiary, which represented over 1.1 per cent of NAV prior to the writedown. Despite this, the share price rating has moved from a discount touching around 5 per cent at times during the fourth quarter of 2014 to trade on one of the most expensive ratings within the listed European equity sector peer group. We believe this rating could come under pressure should performance continue to lag the peer group and therefore we prefer other strategies for exposure to Europe."

But Mr Walls says: "I am not sure that European equities are moving into bubble territory. Price-earnings ratios are higher than in the US, but Europe is in a different part of the cycle. The discount tightening on the trusts reflects the improving economy in Europe so it is maybe one to stay with for now."

If you want to be invested in Europe, one alternative could be a smaller-companies trust such as European Assets (EAT). The valuation gap between smaller and larger European companies has contracted significantly meaning smaller companies look relatively cheap. European Assets trades at around par, as has been the case for about two years, and its rating is much less than some trusts offering a similar yield to its 5.2 per cent.

Source: Winterflood as at 27 April 2015

GOOD VALUE

UK Equity Income

UK Equity Income investment trusts traded at a premium for much of the last year. However, recently the premium has moved to a discount and, if you are initiating a portfolio, this could be a good time to get into this area, according to Mr Gilligan.

"What is perhaps more surprising is that the discount has been driven by the price failing to keep up with the strong NAV returns of the funds over the past few months," say analysts at Investec Securities. "The buyers strike might have two causes: the first being concerns over the impact of the UK election on stocks and the second investors' appetite for yield finally starting to wane.

"The election worries should have little impact on the large blue-chip stocks due to their diversified overseas earnings offsetting potential sterling weakness, and with inflation in the UK and Europe at record lows, significant rate rises still seem some way off. While the former concern is probably the most likely culprit for the weakness, the causes are less important than the opportunity that they have presented, as now some of the best-performing funds have moved to very attractive discounts."

These include IC Top 100 Fund Lowland Investment Company (LWI) which is on a discount of 8.3 per cent, in contrast to its 12-month average of 0.5 per cent. This has underperformed its peer group average and the FTSE All-Share over one year, but its long-term performance remains strong, and it offers a yield of nearly 3 per cent.

Henderson Opportunities Trust (HOT), which is run by the same manager, James Henderson, is also trading at a much wider discount than its one-year average.

Edinburgh Investment Trust (EDIN) is on a discount of 4 per cent, compared with its 12-month average of 3.1 per cent. "It is large, liquid, and is run by Invesco's Mark Barnett," comment analysts at Investec. "The performance has been excellent post Neil Woodford leaving the helm in January 2014, and the portfolio is exposed to tobacco, pharmaceuticals and telecoms sectors, so there is a degree of defensiveness to it."

The trust has a market cap of £1.3bn.

Source: Winterflood as at 27 April 2015

UK Smaller Companies

A number of trusts in the UK Smaller Companies sector have seen their discounts widening over the past few months. Reasons could include the forthcoming election and the prospects of the country leaving the European Union, according to Nick Greenwood, manager of fund of investment trusts Miton Worldwide Growth (MWGT).

"I would hold off buying until after the election, but I am relaxed on the outlook for UK companies and they might even benefit from a weaker pound," he says.

Investment trusts that have experienced discount widening include three of the most liquid and best long-term performing funds: BlackRock Throgmorton Trust (THRG), and IC Top 100 Funds BlackRock Smaller Companies Trust (BRSC) Standard Life UK Smaller Companies (SLS).

"This allows investors to get a broad exposure to the sector by potentially allocating to all three of these funds, allowing diversification and aiding liquidity," say analysts at Investec.

BlackRock Throgmorton is on one of the widest discounts in the sector, at 17.9 per cent compared with its 12-month average of 14.1 per cent and narrow point of 8.2 per cent.

"This is despite good NAV performance," they continue. "The price has, however, lagged behind and aided the discount widening. NAV return is also strong over the longer term, with 10-year annualised returns of 9.9 per cent compared with 6.1 per cent for the index. Five-year numbers look equally strong, at 19.6 per cent compared with 14.4 per cent for the index."

Other trusts that have experienced discount widening include Aberforth Smaller Companies (ASL) on 13.4 per cent, compared with a 12-month average of 7.9 per cent.

"Aberforth tends to benefit from mergers and acquisitions (M&A), so should do well," says Mr Walls. "It is quite good value."

UK companies are attracting strong interest from overseas buyers, with M&A deal values reaching $39.7bn for the first quarter - the highest figure since 2008, according to analysis from Deloitte.

Source: Winterflood as at 27 April 2015