- Trust discounts are a chance to buy in cheaply
- But they are also an obstacle to growth
Last week, we looked at an investment trust – Aberforth Split Level Income (ASIT) – whose management, low fees and record of unbroken dividend hikes have won it an enviable accolade: a share price in line with its net asset value (NAV). Such resilience is the exception in a sector whose average discount to NAV now sits at 14 per cent.
This struggle, as well as the efforts many trusts are making to correct those discounts, serves as a useful reminder of the odd market dynamic that can hurt such closed-end funds.
Logic suggests that, all else being equal, when £100-worth of assets cost £90, you should buy. This explains why trust buybacks are booming. But discounts are also an obstacle to growth because they hinder a trust’s ability to issue fresh equity at satisfactory prices.
This dynamic has been particularly pronounced for real estate investment trusts (Reits). For years, closed-end property funds were able to sell new shares in line with (and sometimes at a premium to) NAV, thereby providing a ready and cost-effective alternative to debt financing. This allowed asset portfolios to grow without diluting existing shareholders or overleveraging the balance sheet.
Today, not only is debt much pricier, but managers are unable or unwilling to tap equity markets, as doing so would force them to mark down NAV towards the discount level.
Market pessimism therefore becomes self-fulfilling. So long as investors doubt a fund can liquidate its assets at their audited value, or think asset values will decline, then a discount persists. But if a discount puts too high a price on capital issuance, then the underlying asset base also loses a critical leg-up. If those assets are liquid, things get trickier still.
One of the first people to recognise this defect was investing legend and philanthropist George Soros. In 1970, amid the growing popularity of Reits in the US, he wrote about what he saw as the sector’s inherent “boom/bust potential”.
Soros noted that the larger the premium to NAV, the easier it became for the trust to fulfil the expectation of higher earnings per share. All it had to do was issue new shares at the premium price, plough the capital back into high-yielding assets, and ride the wave higher.
Estimating a fair price for future earnings was therefore a fruitless endeavour, he argued, because the “price that investors are willing to pay for the shares is an important factor in determining the future course of earnings”. When growth slowed and investor disappointment set in, Soros predicted, a fading premium would only compound the slowdown in returns and earnings growth.
Though Soros’ observations focused on mortgage trusts, one can see the parallels in the low-interest rate world of the post-financial-crisis real estate boom. Where there is a growth market, the virtuous cycle of rising earnings, dividends, asset piles and premia to NAV can be very powerful.
Take shares in self-storage giant Big Yellow (BYG), which generated a monster 25 per cent average annual total return in the decade to December 2021. The final leg of that rally, which followed a £100mn share sale at a 45 per cent premium to NAV in June of that year, culminated in a 70 per cent premium to NAV. Today, the stock changes hands for £9.29, a 25 per cent discount to the latest audited NAV of £12.37.
When markets were bullish, investors benefited twice. First, from the shares’ premium, and second, via the advantages this premium gave to capital pricing and, therefore, operational growth.
Today, the opposite is true. This year, investment trusts’ primary and secondary equity issuance are both on track to fall to their lowest annual levels since at least 2009, according to data from Winterflood Securities (see below). For Reits’ trading conditions to really improve, not only do interest rates need to come down and rental income prospects improve, but share prices need to get back towards NAV.
