Seeking investment trusts with the z-factor

However, before you simply scour the Morningstar or Financial Express tables for trusts with the highest discounts to net asset value (NAV), it is worth asking the extent to which this should govern investment selection. Clearly, the price paid for any investment is important, but should this be prioritised above all other considerations?

One Investors Chronicle reader highlighted the dilemma in a recent letter, as follows: "I have over the past couple of years been restructuring my portfolio, moving from unit trusts to investment trusts. In researching investment trusts, I look at premiums and discounts, plus z-scores, combining discounts with a z-score of -2.0 or greater.

"I have tended with cash in hand to wait for the required z-score. But how sound a position is this? My money is out of the market, maybe for months at a time, and I am an investor for the long term. Am I being too fussy? Using the wrong criteria?"

First, some background: investment trusts have a fixed pool of assets. They can trade on the stock market at a discount or premium to the value of their underlying assets. In theory, investors can buy trusts when they are trading on a discount to their NAV and, timed well, profit from both the narrowing of the discount and the rise in value of the underlying assets.

A good example might be Aberforth Smaller Companies Trust (ASL), which was trading on a discount of around 15 per cent in August 2012. Since then, investors have been able to benefit not only from the closing of the discount to around 6 per cent, but also an appreciation in the underlying assets. As such, the rise in its NAV was 89.7 per cent, but the rise in its share price was 107 per cent as of 20 August 2015.

Of course, the opposite may also apply. Investors can buy trusts on a premium, which usually happens when a sector is particularly popular. But they are then vulnerable to a fall in the underlying assets and a narrowing of the premium as the market falls out of love with the trust or its sector. As such, looking for those trusts that look inexpensive relative to their history also seems appropriate.

Using the z-score

The 'z-score' is a means of comparing a trust's current discount or premium with its historic level. Using this metric an investor can see whether the current discount level compares favourably with the trust's history. It can also help to even out differences between sectors. For example, smaller companies trusts will naturally trade at wider discounts to UK equity income trusts, but it doesn't necessarily mean they are a bargain. The discount may be wide and stay wide. The z-score can aid comparison.

The major platform providers and statistics providers such as the Association of Investment Companies (AIC), Hargreaves Lansdown, Citywire, Morningstar or Financial Express show discount/premium history for investment trusts. Morningstar also provides z-scores while the AIC gives bulletins on investment companies displaying attractive ones.

So far so good, but in looking at the reader's dilemma in more detail, some fund selectors take issue with his sole focus on investment trusts. In many ways, this has been proved the right approach in recent years, as in many cases investment trusts have outperformed their open-ended equivalents. However, there is no guarantee that this will endure indefinitely and across all sectors.

Stephen Peters, an analyst at Charles Stanley, says: "Moving from open-ended funds to investment trusts has probably been a good call for the reader as investment trust discounts have narrowed. The sector is now at one of the smallest average discounts for over 20 years - a point in 2006 and one in 2000 look to be the only other times it was less attractive.

"But to stay invested in the sector, you need to believe that it can outperform, irrespective of discount widening. That's possible, but hard."

Certainly, the investment trust structure provides managers with more flexibility, and the ability to borrow - known as gearing - may also contribute to returns, but this is not guaranteed.

And Mr Peters points out that investment trusts have some limitations: "If you are a growth investor it's harder to reinvest dividends in an investment trust than an open-ended fund."

He also says that investment trusts do not have a monopoly on good managers and funds, adding: "Only investing in investment trusts is extremely limiting."

How to select the best

With that caveat in mind, are the reader's criteria likely to lead him to the best investment trusts? Jackie Beard, head of investment trust research at Morningstar, believes analysis of premium and discounts can be useful, but not in isolation.

She says: "The discount is one factor for consideration but you need to consider relative discount not absolute discount. In other words, where is the discount now in relation to its historic average? So looking at the z-score too is helpful. But we would encourage the use of broader analysis as those data points can only tell you so much.

"It's important to understand the time horizon of the investor: it sounds like he's a long-term investor if he's switching his portfolio over, rather than a trader, so we would emphasise the need to invest in sound investment strategies, where there is conviction in the manager/team's ability to outperform over the long term. Thus, the discount is only part of the decision as not all investment trusts with an attractive current level of discount will be sound investments over the long term, and that discount could get wider. After all, it's there for a reason."

Mr Peters agrees that analysis of the discount/premium and z-score should therefore only form part of an investor's analysis some way down the line. He believes investors should start with a thorough analysis of where they want to invest: the UK, US, Europe, etc, and the style they want to use, for example, value, growth or income. At this point, investors should analyse whether there are active funds in their chosen area that can outperform passive equivalents. This may not be the case for markets such as the US, where active managers have struggled to deliver value over and above the index.

Only once this analysis has been done should investors look at the specifics of investment trusts. Even at this point, it should go beyond simply discounts and premiums. Kieran Drake, an analyst at Winterflood, says: "While this is certainly a useful tool for identifying potential value opportunities, there are other factors: is it is important to look at gearing, as well as liquidity - particularly for larger investors."

Mr Drake also points out that there can be structural reasons for the permanent shift in the z-score, which may mean that a trust never hits the reader's target. He adds:

"Discount control mechanisms are important and may be the reason for a higher z-score. A fund could be trading at a 10 per cent discount because the board has decided to keep it there. It may never get any wider. As such, a fund might meet an investor's investment criteria, but then never hit the z score target."

IC Top 100 Fund Finsbury Growth & Income Trust (FGT), managed by Nick Train, might be a good example of this. Over the past three years it has shown very little discount volatility, tending to trade from par to a 1 per cent premium. It would therefore not have stood out as a bargain to a price sensitive investor. Yet it is top quartile over three years, having delivered a return of 63 per cent as at 20 August 2015.

Equally, time spent waiting for the right z-score is a problem if it means that the investor is out of the market for some time. This may mean missing out on both capital gains and dividends. This may not have been such a concern when investors could earn a decent rate of interest on cash, but with savings rates lagging behind inflation, there is a significant opportunity cost to being out of the market.

Holding higher cash weightings can also mean investors are tempted to try to time entry and exit from the market. For example, even if the reader found an investment trust with the right z-score, would he want to invest if markets were at all-time highs?

A more disciplined approach to entry and exit is likely to be more fruitful over the longer term. As Ms Beard points out: "The benefits of pound cost averaging are well espoused and a good way to drip-feed cash into the market over a period of time."

Pound cost averaging forces investors to invest no matter what the market is doing, thereby avoiding the natural temptation to buy in when there is lots of optimism and prices are high, and to sell out when there is lots of gloom and prices are low.

Although an analysis of discounts and or z-scores can help identify bargains, it can also see investors miss out on some of the best and most consistent managers of investment trusts. While no one would suggest that this reader loses his nose for a bargain, he should consider widening his criteria to incorporate a few consistent long-term performers to ensure he remains invested.