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Investment trusts at historically wide discounts

Some investment companies have sold off even more than their quality holdings, is this a buying opportunity?
September 16, 2022
  • Will investment trust share prices bottom before the rest of the market? 
  • Some trusts are extremely cheap relative to their historical level of premium or discount

Arguably there is plenty more turmoil to be expected in financial markets and any investor tempted to snap up what look like long-term bargains now ought to steel themselves for volatility. Owners of investment trusts have to be prepared for the double-whammy of the shares  in the fund’s portfolio selling off and the trust’s own share price falling more – widening the discount to net asset value (NAV). 

Discount-widening is highly disconcerting for holders of investment trust shares in the bad times and is the reason our investment trust selection criteria has underperformed both the FTSE All-Share and MSCI World indices in what has been a bad year for equities generally.  But is it possible these discounts now represent a margin of safety for investors looking to buy into quality companies held in trusts’ underlying portfolios?  

One hugely interesting point about our investment trust methodology track record (which goes back to July 2004) is that in the 2007-09 bear market, the maximum drawdown (peak-to-trough fall in value) of our 10-trust portfolio system occurred three months (December 2008) before the bottom was hit by its FTSE All-Share and MSCI World benchmarks. It was March 2009 before the nadir for both stock indices in that period.

Of course, the past doesn’t predict the future, but some of the trusts flagged are looking historically very cheap relative to their long-run premium/discount to NAV. The z-scores are showing several of our funds this month close to, or more than, two standard deviations below their average valuation relative to NAV.  That’s incredibly cheap, especially when some of their underlying holdings have already sold-off considerably. 

Given some of the shares held by high-ranking funds on our screen retain long-run quality characteristics and many more are plays on longer-term growth trends, investors can reasonably ask themselves whether this is a golden buying opportunity. 

Of course, there is plenty of scope for uncertainty. This week’s inflation print in the US came in higher than expected (at 8.3 per cent it was down but above forecasts) with sticky core inflation persistent at 6.3 per cent. The numbers saw markets quickly price in the possibility of more hawkish rate rises by the US Federal Reserve, with stocks selling off in anticipation of more expensive interest rates. 

The dynamic is that more expensive rates raise investors’ rate of return requirements from shares (so they maintain a risk premium over safer investments like government bond yields).  Given many big tech stock prices were bid up to incredibly high multiples of their earnings per share, even very profitable companies have seen their valuations fall. 

Inflation and the methods to deal with it will likely lead to recessions (and have seen countries like the US dip into technical recession – two successive quarters of GDP decline), which will be bad for company earnings. Downgrades to analysts’ expectations would see stocks get cheaper. 

But will investment trusts continue to sell-off? These juicy discounts offer a margin of safety in case the underlying assets fall further in value, possibly de-risking the entry point for investors looking to back long-term growth trends. 

That argument needs to be set against the obvious risk that the investment trust shares themselves get dragged down by markets or if they have issues in their own capital structures (for example high gearing) that get exacerbated by higher interest rates. Still, as the experience of our ten-trust portfolio methodology in 2007-09 shows, there is precedent for investment trust share prices staying low but not getting lower before the recovery swings into effect. 

Of course, we can’t expect a rebound from this spell of malaise to come from a catalyst as powerful as quantitative easing (QE), as happened in 2009. For investors who don’t like to try and time re-entry points, however, a heavily discounted investment trust sector certainly provides food for thought. 

This report gives the full list of investment companies that make up our ten-stock portfolio selected using the Alpha investment trust ranking methodology. We are featuring two trusts in the report and will cover more of the trusts in a second article next week. 

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