- Discount widening badly affects investment trusts in market sell-offs
- Could a margin of safety now exist to buy into exciting fund portfolios?
There is plenty more turmoil to be expected in financial markets, and any investor tempted to snap up what look like bargains now ought to steel themselves for volatility.
Discount widening is highly disconcerting in bad times and is the reason the Investors’ Chronicle Alpha 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 trusts that hold quality companies in their portfolios?
One interesting observation 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 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, whereas the portfolio bottomed out in December 2008.
Of course, the past doesn’t predict the future, but some of the trusts flagged ('Investment trusts to avoid recession checkmate', IC Alpha 21 Oct 2022) are very cheap relative to their average share prices to NAV over the long run. That’s according to Z-Scores, which state how many standard deviations away a given measurement is from the mean value of observations.
Recently, several trusts are close to 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.
This begs the question: could history be repeating itself, and are the trust discounts bottoming before the markets? Our long-run system benchmark is based on a July-to-July rebalance and in 2021-22 it had a horrible year, losing 23.5 per cent. Since the summer, while negative, performance has largely been in step with that seen for the FTSE All-Share.
So there is a case to say the worst impacts of discount widening have already been suffered. If trust share prices are now moving in step with the market as a result, the Z-Scores could signal deep value.
Regime change and currency effects are changing parameters
There is plenty of scope for uncertainty. Recession risk is firmly on the horizon, but perhaps valuation risk is abating. Although the Bank of England raised interest rates by 75 basis points in November, it has signalled it will be less aggressive going forward (and less aggressive than the market has priced), so the discounted cash flow models that investors use to value shares should be subject to fewer swings.
That doesn’t mean shares won’t suffer. Earnings forecasts will come down for many companies, but for investment trusts already on a discount, there is a built-in margin of safety. In cases where those safety nets relate to some long-term growth trends that could make substantial gains in a recovery, this could be tempting.
There are other considerations, however. Some of the underperformance of the Alpha IT system versus the MSCI World index can be put down to currency factors. The strong dollar has inflated assets denominated in the currency, and shares in dollar-earning companies relative to investment trusts’ market capitalisation in sterling terms. Any reversal in dollar strength will make those discounts less extreme.
Arguments for buying now also must be set against the obvious risk that the investment trust shares themselves get dragged down by their sensitivity to UK market sentiment (ie, the shares’ own beta). Issues relating to trusts' own capital structures (for example, gearing) could also be negatively affected higher interest rates.
Still, as the experience of our 10-trust portfolio methodology in 2007-09 shows, there is precedent for trust share prices staying low but not falling any further before the recovery swings into effect.
We can’t expect a rebound from this spell of malaise to come from a catalyst as powerful as quantitative easing, as happened in 2009. But for investors who don’t like to try and time re-entry points, a heavily discounted investment trust sector certainly provides food for thought.
