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Investment trust bargains and value traps

Many investment trusts look cheap, but make sure you buy bargains and avoid value traps
May 21, 2020

With the coronavirus crisis triggering violent moves in markets, investment trust shareholders have experienced gyrations of their own. The average investment trust discount to net asset value (NAV), excluding 3i (III), moved out to 22.1 per cent at the height of the market volatility in March. By contrast, earlier this year, the average discount had been as tight as 1.1 per cent.

Even though the worst moments of the market sell-off were several weeks ago, some investment trust share prices still look much cheaper than normal, and the average discount to NAV was 8.3 per cent on 18 May. But before you pile in, as with any investment made in the current, uncertain environment, it is very important to analyse the fundamental merits of the investment trust you are thinking of investing in, to try to determine whether it is a bargain or value trap. To help you do this, we have looked at how investment trust sectors are trading versus their 12-month averages, and whether these seem like opportunities or risks.

 

How sectors hold up

The chart below shows how the average trust's shares in each of the selected sectors, as categorised by analysts at Winterflood, traded versus the value of their underlying assets as of 18 May. As the chart shows, the selected sectors are still, in aggregate, cheaper than they have tended to be over the past 12 months.

 

Understandably, some areas look especially 'cheap'. But bargain hunters should exercise caution.

One sector that could reward patient investors may be private equity. As the chart shows, the average private equity trust was on a discount of more than 30 per cent. Analysts argue that some private equity trusts maintain fundamental appeal, although investors need to understand exactly why they look cheap.

Private equity trust shares traded at discounts to NAV even before the current crisis, in part because of liquidity issues and lingering reputational issues related to the financial crisis of 2007-09. More recently, the sector has suffered for different reasons. Myrto Charamis, director, investment companies research at Numis Securities, argues that share price weakness stemmed in part from a perception of private equity trusts as a source of “leveraged equity exposure”. Investors may also be attempting to anticipate falls in the value of private equity holdings, which are priced less frequently than listed stocks.

“We expect private equity [trust] NAVs will be affected in two waves, reflecting firstly equity market multiples used as comparables in the valuation and then, later in the year, the earnings of the underlying assets,” explained Ms Charamis.

The likelihood of falls in NAV and uncertainty over the extent of these means that a careful approach is warranted. Investors should be aware that such trusts have languished on large discounts before and could take some time to recover – if at all. But analysts at Numis argue that some trusts could prove more resilient than others and perform well because of the composition of their holdings. They also offer exposure to growth companies that are not available on public markets.

“We anticipate significant impact on NAVs [from write-downs], but we think there are mitigating factors that could limit it," adds Ms Charamis. "In particular, a focus on defensive sectors such as healthcare, technology and consumer staples, and resilient underlying assets."

Analysts at Numis highlight HgCapital Trust (HGT), which focuses on areas such as cloud computing and software as a service in the belief that the growth of these industries could accelerate in the wake of the lockdown. Although the trust’s sector focus seems narrow, it is geographically diversified, with investments across the UK, Scandinavia, North America and Europe. And its holdings also serve companies in a diverse range of sectors.

Recent investments include Argus Media, a provider of energy and commodity price reporting, cloud-based HR software firm P&I, medical imaging software company Intelerad and smartTrade Technologies.

Princess Private Equity (PEY), which focuses on private companies of various different sizes, experienced a fall in its NAV during the volatility earlier this year. It also cut its dividend, which was funded from capital, to maintain cash levels.

But analysts at Numis note that the trust has had a “thorough” revaluation of its holdings, suggesting that the extent of further write-downs should be limited. The trust also has exposure to sectors that should do well in the current environment, with around a third of its assets in information technology and healthcare at the end of March. This, and a high level of diversification across different geographies and sectors, could mean that the trust holds up better in uncertain times.

 

Staying selective

Although seemingly cheap, UK commercial property trusts look particularly troubled because of the lockdown. Many trusts’ tenants have struggled to pay their rent, reducing the income and return available. As a result, 14 property trusts have cut, cancelled, suspended or altered plans for their dividend payments since the onset of the coronavirus crisis. They include UK Commercial Property Reit (UKCM), BMO Commercial Property Trust (BCPT) and Ediston Property Investment Company (EPIC).

But some trusts may fare better in future when lockdowns ease. Winterflood analysts say that while all these investment trusts have recently traded on double-digit discounts, “commercial property is a real asset, which will still have value once the pandemic is over, even if void levels rise”.

But do not underestimate the scope of changes in the sector: with the current crisis likely to accelerate moves away from office work and the demise of the high street, some property trusts may struggle to recover. And this could be widely reflected in the share prices of commercial property trusts – even ones that look better placed to navigate a post-coronavirus world.

One trust that isn't highly exposed to some of the most troubled commercial property sectors, such as high street retail, is Ediston Property Investment Company. This trust's share price performance has suffered, but it may be able to take advantage of longer-term trends because it focuses on areas such as retail warehouses, which could benefit in the wake of the lockdown.

In an update at the end of March its management team said: “It is our belief that our convenience-led retail warehouse assets, which constitute 61.6 per cent of the portfolio, will prove to be more resilient than other parts of the retail market. [When] lockdown restrictions are lifted, but social distancing continues, the attributes of out-of-town retail parks will appeal to customers. Their accessibility, ample car parking provision, space they provide for queuing and avoiding contact with other shoppers, plus the fact that they are open-air, makes them the logical choice to be reopened first.”

The trust has had mixed fortunes during the crisis. In May its board noted that it would collect around 74 per cent of the rent due to it over the second quarter. Just over half of its retail warehouse income comes from businesses such as food retailers that are considered to be providing essential services and allowed to keep trading.

However, around of a quarter of its assets were in offices at the end of March, and demand for these could decline in the wake of the coronavirus pandemic.

Trusts that invest in direct loans to companies have also moved out to significant discounts to NAV as businesses struggle to pay their debts. As with the property sector, the sheer economic pressures facing these trusts’ holdings means that caution is warranted. But some of those focused on a specialist niche may do better, such as BioPharma Credit (BPCR),  which invests in loans to life sciences companies secured against cash flows on approved life sciences products.

The trust traded at a 4.4 per cent discount to NAV on 18 May compared with a 1.3 per cent 12-month average. But its holdings have not been hit hard so far: at the end of March its managers argued that Covid-19 had “not had a material impact on the credit quality of the loans [it holds]”.

 

Equities

With various sectors looking troubled and volatility likely to re-emerge, equity trusts require just as much due diligence as those invested in illiquid assets. And although equity trusts that invest in unloved areas such as the UK or value stocks appear cheap, how they will perform going forward is uncertain.

Aberforth Smaller Companies Trust (ASL)​​​​​ had an extremely painful sell-off because of its focus on smaller companies, out of favour 'value' investment style and broader issues affecting the UK market such as dividend cuts. But the trust, whose managers look to identify underpriced stocks using detailed financial and industrial analysis, could in the longer term be a way to play improvements in the UK economy. The trust's biggest positions at the end of April included wealth manager Brewin Dolphin (BRW), specialist publisher Future (FUTR), brickmaker Forterra (FORT) and logistics firm Wincanton (WIN).

Another option is to buy into some of the more defensive trusts within sectors, including risky ones. Emerging markets equities are by no means defensive, but some emerging market trusts with a bias to high-quality market leaders look cheaper than they did before the recent market volatility. JPMorgan Emerging Markets Investment Trust (JMG), for example, has a bias to large companies with strong quality metrics, meaning that it had overweight positions in companies such as Alibaba (USA:BABA), Taiwan Semiconductor Manufacturing (2330:TAI) and Tencent (HK:700) at the end of April. The trust has a heavy tilt to sectors such as information technology, consumer staples and financials, and its holdings in the latter include one of India’s largest banks, HDFC (Ind:HDFCBANK).