The key thing to watch with investment trusts is the relationship between their share prices and the assets they have invested in. While a particular trust might own £100m worth of assets, the stock market could well value the trust at £90m (a discount) or £110m (a premium) to those assets. Of course, a single trust's premium or discount may not tell us very much about the bigger picture. However, the overall data for the investment trust sector as a whole or for a specific area within it can be much more useful.
Trust valuation history
When investment trusts collectively are trading at a larger than usual discount to their underlying assets, it suggests that investors are shunning risk. Naturally, such occasions often turn out to be the best times in which to invest. Likewise, when trust discounts collectively tighten or even become premia, it is often because investors are very optimistic about the future, something that tends to happen at the late stages of booms. So, what are investment trust valuations telling us right now?
According to data from the AIC, the industry body that represents UK investment trusts, the sector was trading at a discount of 3.8 per cent to net assets as of the end of April. That is not far from its narrowest ever level of 3.2 per cent, which was reached in early 2006. The average discount since 1980, by contrast, has been 13.5 per cent.
A similar picture emerges from the sector's price/book ratio calculated by Thomson Datastream. This metric says that UK investment trusts are actually rated at a slight premium of around 1 per cent compared with the value of their net assets, and compared to a long-term discount of around 17 per cent.
Dear trusts, poor returns
If history is any guide, current investment trust valuations could be bad news for the outlook for UK stocks in general. Based on the Datastream series, the sector is more dearly rated today than it has been for around 90 per cent of the time since 1980. And on those rare occasions when valuations got as high or even higher than this, trouble followed for the FTSE All-Share index.
In September 1987, Datastream UK investment trusts' premium reached 7 per cent, just a few weeks before the legendary October meltdown. Even higher ratios around the time of the millennium were followed by the savage losses of 2002-03. Most recently, the peak valuations of early 2008 came ahead of the worst of the credit crunch bear market. Only in early 1994 was a stretched price/book ratio in this segment of the market not followed by disaster.
Over the past 35 years, this single metric has been a much better predictor of returns over a one-year horizon than any valuation indicator. A strategy of buying the market every time the discount was greater than 12 per cent and switching into interest-bearing cash above this level would have produced a compound annualised return of 19 per cent after reinvested dividends but before trading costs. By comparison, merely buying and holding the market would have made a mere 12.3 per cent.
Buy UK when trusts are cheap
What is more, such a strategy would have run far less risk, incurring 12.2 per cent annualised volatility versus 16.6 per cent for passively buy-and-hold. And while a passive approach would have suffered a 43 per cent peak-to-trough decline at one point, the discount-based approach's biggest loss was just 17 per cent.
Is the FTSE All-Share doomed to suffer losses over the next 12 months, based on investment trusts' current valuation? Although the odds based on this metric favour poor returns, there are other possibilities. One of them is that investment trusts get even dearer as the market pushes higher. But this would surely raise the risk of even more painful losses down the road. Another is that past relationships may have broken down.
Before the enactment of the Retail Distribution Review (RDR) early last year, independent financial advisers (IFAs) and wealth managers tended to put their clients into unit trusts rather than investment trusts because of the kickbacks they got from unit-trust providers. Now, though, this practice is no longer possible, so it could be that they are investing much more in investment trusts. And, if demand for investment trusts has risen a lot, that could be one reason for today's higher valuations.
While greater demand may be a factor, it is hard to quantify. Kieran Drake, investment trust analyst at Winterflood Securities, says that the most obvious reasons for the narrowing in discounts as calculated by his firm are the strong performance of equities more generally, as well as investors seeking out income-bearing assets. The valuation of UK equity income trusts would seem to bear this out, with their discount having vanished in both the Datastream and AIC series.
Faith in income trusts
The valuation of UK Equity Income trusts may have a message of its own about future trends within the UK market. Big discounts on these trusts have typically been followed by the FTSE 350 High Yield index beating the FTSE 350 Low Yield index over the next 12 months. Today's premium is therefore consistent with high-yield shares in general doing badly in relation to low-yield shares going forward.
Thin discounts, small-caps struggle
The same is true in UK Smaller Company investment trusts. Discounts have tightened substantially during the present bull market in equities. The last time that the Datastream sub-sector was so richly rated was in 1995. As the accompanying chart shows, this is not a good sign for future returns on the FTSE Small Companies index, in absolute terms or compared to the wider stock market.
What is especially interesting here is that the short-term outlook implied by the investment trust premium is at odds with the medium- to long-term outlook that I highlighted in this recent report. Based on a series of valuation measures, the UK stock market is likely to deliver modest positive total returns after inflation over the next five years or so. Of course, there is nothing to say that the FTSE All-Share won't suffer a poor 12 months starting now and then enjoy a good next four years.
Weakness on Wall Street – triggered by the end of quantitative easing – provides an obvious potential trigger for poor near-term returns in the UK. Smaller-cap and higher-yielding shares look particularly vulnerable, under the circumstances.