In my last article (‘Investment trusts 101: the key differences between trusts and Oeics’, IC, 14 March 2023) we looked at the basic mechanics of investment trusts (ITs): what they are, how they work and how they differ from open-ended investment companies (Oeics) or funds. But the key for investors is how they can assess whether or not a particular trust is good value.
Base value
ITs and Oeics have the same valuation base: the current or ‘marked to market’ value of the assets owned, usually shares in other quoted companies but often in ITs, other or ‘alternative’ asset classes. Most ITs publish a net asset value (NAV) figure every day. However, this should only ever be viewed as a management estimate, unless the trust only invests in quoted, liquid shares and has no gearing. While this NAV describes a baseline for the share price, it is rare for an IT to trade at its NAV.
Geared investments
A key difference between Oeics and ITs is that ITs can borrow money or issue debt instruments to extend their investments. This can be a positive or a negative depending on: the interest rates on the debt, the net gains from the assets acquired (the gap between returns and the cost of debt), changes in the value of the assets funded and the gearing level itself. Essentially, geared investments amplify the change in value of an investment, both up or down, and the payment of interest lowers total returns.
So what, in practice, is a geared investment? The best example is pretty close to home for many people – a mortgage. In the table below, we show how changes in the value of a house and your gearing level impacts on the value of your ‘investment’ in it. Here, your ‘investment’ is the ‘deposit’ or ‘equity’ and the gearing is the mortgage. The higher the gearing, the greater the movement in your original ‘investment’ when the asset value (here the house price) moves, either up or down. When looking at ITs, it is very similar with the ‘investment’ being the trust’s own equity resources and gearing the external debt.
When looking at a mortgage as an illustration, the gearing level would be the same as the loan-to-value (LTV) ratio.
| Impact of gearing on investment returns | ||||||
|---|---|---|---|---|---|---|
--- Positive returns --- | --- Negative returns --- | |||||
Price change → | 10% | 20% | 30% | -5% | -10% | -15% |
Gearing % ↓ | ||||||
25% | 13% | 27% | 40% | -7% | -13% | -20% |
50% | 20% | 40% | 60% | -10% | -20% | -30% |
75% | 40% | 80% | 120% | -20% | -40% | -60% |
90% | 100% | 200% | 300% | -50% | -100% | -150% |
| Source: Investors’ Chronicle | ||||||
Geared investments make bigger returns in a positive climate as the debt is a fixed sum, but in a negative climate gearing feels more painful, especially if debt is high and equity low. For example, with 90 per cent gearing, it only takes a 10 per cent decline to wipe you out. Normally trusts would not have such high levels of gearing as a personal mortgage and more typically would be limited (internally) to around 20-40 per cent.
Always chase a discount?
IT pricing is complex, but does a discount mean that the shares are cheap? Not automatically. The stock market is always looking forwards rather than at the current (even historic) NAV when assessing IT shares so a discount can mean that the market expects the reported NAV to fall in the future rather than seeing value. If the discount is fairly long-standing this is more likely to be the case. Where there has been a sharp fall in the price without specific news, that is more likely to have been driven by selling, and in this case the discount could have run too high through over-selling. There is more likely to be value in this instance, but again it is not assured.
Research is always needed into the valuation of the underlying assets to see why the discount is present and whether it is excessive. That exercise is fairly straightforward for quoted investments by examining, say, absolute and relative PE ratios of the shares held. However, it is much more difficult for alternative investments such as infrastructure or private equity funds where valuations are both opaque and highly subjective. There may be a permanent discount just because of a lack of visibility.
So, a discount should pique your interest and prompt further investigation rather than being an action trigger as you may be perceiving value that does not exist.
Is value hard to spot?
It can be and generally will be harder to spot in an IT than in a single stock or Oeic. If investing in an IT with a large skew towards alternative assets, the task becomes that harder still. Unlike an Oeic, where a quick glance at the portfolio bias or the top 10 holdings gives a good understanding of the investment proposition, with an investment trust you will need to delve into the report and accounts, especially the notes where the finer, and often key, details are recorded. That can be a tall order and almost certainly needs a more in-depth understanding of financial markets, different financial instruments and accounting methodologies. However, it can be well worth the effort and ITs can, and regularly do, become mispriced.
So, enough about the theory – what about the practice and identifying investment opportunities? In the next two articles we will look at a selection of ITs, first the more vanilla funds (bias towards listed equities) and finally those with more of an exotic twist, towards alternative investments.
