Spotting the true discount bargains

At a time when investing feels like navigating a minefield – with inflation, rising interest rates, an energy crisis and a recession just some of the risks out there – investment trusts have much to recommend them.

They are a straightforward way to diversify a portfolio by giving investors access to a number of areas and companies, including illiquid assets. They are led by experienced managers who follow market developments daily, in a world where momentous changes are happening at breakneck speed. They save investors the time and energy needed to make complicated decisions in sectors they are unfamiliar with. And they can use reserves to pay dividends even when their portfolio companies go through a rough patch, softening the blow for investors.

Times of crisis bring into sharp relief the features setting investment trusts apart from open-ended funds and individual stocks. And one of these is the gap between trusts' share price and their net asset value (NAV), also known as the premium or discount at which a trust is trading.

Since markets started tumbling in early 2022, 'discount' has been the operative word for discussing the investment trusts. On 31 December 2021, the sector (excluding venture capital trusts) was trading at an average premium of 0.2 per cent, according to data from the Association of Investment Companies. Nine months later, the same figure had turned into a -13.9 per cent discount.

No asset class has been entirely spared, and only a handful of trusts can currently boast a higher share price than their NAV. But when everything suddenly looks cheap, how do you distinguish the potential bargains from the traps?

Premiums and discounts

Generally speaking, a premium or discount gives investors an indication of how well liked a trust is. If you want to invest in a very popular trust, you expect to pay more than the value of its assets to own it, with the risk that the NAV performance might not live up to the hype, and ultimately investors will go elsewhere and share prices will start coming down.

Conversely, investing in a less popular trust may come cheap, but if the NAV performance stagnates and other investors do not start buying the shares, the initial discount might never close.

The key question then becomes: ‘why is a trust trading at a discount?’. What are the factors that have influenced the trust’s share price? Why is it so cheap? And how likely is it to recover?

There are a lot of things that can swing the outcome one way or the other. As Adrian Todd, senior research director at Investec, puts it, what a discount tells you about an investment trust in itself is “not very much”.

 “I think it can be really tempting for investors to see a discount to NAV, say -15 per cent, and think that that's really interesting," he says. "The challenge is that often there might be a real lack of catalyst for that to change.”

Discounts can be a symptom of what is happening at different levels. At the market level, if investors are feeling bearish, most investment vehicles will suffer, including investment trusts. At the sector level, there might be macro issues impacting one particular asset class or group of trusts more than others. Finally, at the trust level, the discount might have to do with the circumstances of a specific vehicle.

Making judgement calls on potential opportunities becomes even harder when discounts are so widespread, like now – investors have to think through a lot of noise to try and get to the bottom of what constitutes a potential opportunity.

Cheap sectors

A good place to get the lay of the land is by looking at how other trusts in the same space are doing.  

There are two main categories where discounts have widened “very dramatically” since the start of the year, says Mick Gilligan, head of managed portfolio services at Killik & Co: property and growth capital. 

As at 31 December 2021, the weighted average discount for the AIC UK commercial property trust sector was -4 per cent. Fast forward to September 2022, and the figure stood at -24.6 per cent. The gap for UK residential property trusts jumped from a 3.7 per cent premium to a -25.2 per cent discount. For European property, it has gone from a 0.8 per cent premium to a -36 per cent discount. You get the picture.

The blame in this case lies with rising interest rates, with investors worried about the impact they will have on property asset valuations and on the trusts’ debt costs.

The question of asset valuations is in fact relevant for all trusts investing in illiquid assets. Unlike with listed equities, there is a lag in the reporting of the net asset value for trusts, which can leave investors wondering about the true impact of macro changes on a portfolio for months on end. If investor sentiment turns negative, this can result in discounts widening more than warranted. 

The AIC growth capital sector went from a 0.8 per cent premium as at year-end 2021 to a -37.4 per cent discount in September 2022. Growth capital trusts invest in early-stage private companies that require a lot of capital, which can struggle in a bearish environment.

Traditional private equity vehicles are also seeing exceptionally wide discounts. According to Numis data, as at 3 November direct private equity trusts had an average discount of -20.3 per cent, while for funds of funds trusts this stood at -46.1 per cent.

Within a sector, one can also distinguish between longer-term trends that worry investors and news that results in discounts widening for a shorter period of time. This might be the case with the renewable energy sector, which saw quite a steep price decline between September and October due to a combination of rising gilt yields, worry over their impact on valuations, and the announcement of a revenue cap for renewable energy generators. 

The sector has since recouped some of its losses, and might recover more once the details of the revenue cap are agreed and its impact on trusts becomes clearer. This is a case where discounts might be interesting, given that some of these trusts were trading at a premium until not so long ago.

For example, Aquila European Renewables (AERI) recently reported a 5.7 per cent NAV increase for the third quarter of 2022, having lagged its peers in the first half of the year, with an increase in power prices and inflation offsetting the discount rate increase.

“We believe the reason the fund has been a laggard in the sector is due to higher levels of cash drag and a higher relative proportion of construction assets. Both these factors are now coming to an end,” Stifel analysts wrote in a recent note confirming their ‘positive’ rating for the fund. “The de-rating appears to be overdone and the fund is now the ‘cheapest’ in the sector.”

Board quality and buybacks

Once the bigger market and sector picture is clear, next comes the real challenge of telling one trust from another.

At this level, Dan​ Cartridge, assistant fund manager at Hawksmoor Fund Managers, stresses the importance of the role played by an investment trust’s board. “Particularly across the listed equity investment trust space, some discounts persist for a long time, because there's no real desire from boards, or actually even investors in some cases, to actually narrow that discount,” he says.

It is worth trying to find out how aligned the board is with shareholders. A board of salaried people who do not own shares of the trust will be less incentivised to ensure the best outcome for shareholders than a board whose compensation is equally split between shares and cash.

Some trusts have good discount control mechanisms in place. Cartridge cites Diverse Income Trust (DIVI), which offers an annual redemption facility that allows investors to redeem all their shares at NAV minus costs.

A key tool that boards use to narrow discounts is share buybacks. Investors can check whether a trust’s board has carried them out in the past to gauge its willingness to stand by the vehicle.

After discounts widened during the Covid pandemic, there were boards that did not buy back shares and let their trusts languish on discount for months – that would be a potential red flag, says Cartridge. For example, Real Estate Credit Investments (RECI)'s shares fell to a significant discount at the time and it did not initiate buybacks, despite expressing confidence in the portfolio's NAV – the discount did not close until mid 2021.

A recent Numis note cites Personal Assets Trust (PNL) and Troy Income & Growth (TIGT) as two trusts that have long had success in controlling their discounts through buybacks. Another virtuous trust on this front is Capital Gearing Trust (CGT), which since 2015 has adopted a ‘zero’ discount control mechanism that sees it issue shares on a small premium and buy them back on a small discount, in order to ensure that its share price trades as close as possible to its NAV.

Numis analysts have argued for alternative trusts to increase their buyback activity, partly on the grounds that “a record of seeking to limit discount volatility, through measures including buybacks, is likely to be recognised in the long term as part of investors’ assessment of capital discipline and governance”.

There have been some encouraging signs on this front, for example from private equity trusts, which are not traditionally big on buybacks. Pantheon International (PIN) increased the pace of its buyback programme from August. One private equity trust that has proven its keenness to back its NAV through buybacks is Oakley Capital (OCI), which is currently trading on a circa 40 per cent discount yet has bought back £71.7mn worth of shares in the five years to 16 September 2022 – more than all the other private equity trusts combined.

Style, size and structure

Investec’s Adrian Todd lists some other general factors that it might be useful to take into account when thinking about discounts. 

One that is especially relevant this year is the general sentiment towards a trust’s management style. For growth-orientated equity funds in the past 10 years, “the manager’s capability may not actually be that special, but the performance could have still been fantastic, because the macro backdrop was really supportive of that style of investing”, he explains. This year, those trusts would have seen not only painful NAV decreases but also significant share price declines relative to those falls.

Scottish Mortgage Investment Trust (SMT) is the highest profile example of a trust falling from favour this year. It has seen its share price move from a 2.7 per cent premium in December 2021 to a -10.8 per cent discount as of 3 November. But holders would still contend its managers are among the most experienced tech investors out there.

Finally, other aspects worth considering include a trust’s size, with smaller trusts likely to pay the price in terms of growth even if their assets are performing well, and how well it uses its close-ended structure. 

“If you've got a fund that is investing in liquid listed equities in a long-only format, with no gearing, it's probably hard to make the case for why you should own it in investment trust form, versus the various open-ended options you could use,” Todd says.

Investment trust sectors with the biggest discount/premium movements this year

No data available for the private equity sector. Source: AIC.

Find below all the features in our special issue celebrating the investment trust. 

Spotting the true discount bargains - Val Cipriani highlights investment trusts trading at a discount

Where the money has been flowing in a year of turmoil - Dave Baxter looks at how investment trusts have fared in raising funds this year

IC Income Portfolios - one year on - Dave Baxter reveals how our experts' pick of income trusts has performed and what changes are being made

Around the world in eight investment trusts - Alex Newman runs our global investment trust stock screen to produce the best investment ideas for regional diversification

Gearing up and down - Val Cipriani reports on the big gearing movements in the investment trust world over the past year

The professional picks 2022 - Our panel of experts pick their preferred investment trusts for the year ahead

Investment trusts hold up as refinancing risk looms - The sector has largely timed refinancing right

Capital preservation with a personal touch - Personal Assets Trust provides an asset allocation case study for a tough bear market

How cheap is Scottish Mortgage? - Looking beyond the growth trust's price tag

Investment trusts' unlisted headache - Exposures to private companies have brought their share of problems

When discounts signal a new buying opportunity - Our investment trusts system bottomed early in 2009, will history repeat?

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