The extraordinary investment trust bargains on offer

Last month was a reminder of the hidden risks that investors can sometimes encounter. The banking crisis plunged markets into chaos, and while some of the immediate anxiety has faded, the possibility of a recession still lurks on the horizon and the economic outlook remains downbeat. The temptation for investors to simply hunker down and sit in defensive assets – or go to cash – can be enormous.

And yet an easily forgetten lesson from history is that this kind of gloom can offer up great opportunities for the long-term investor. The improved entry points that have emerged over the past 18 months are arguably a testament to that – despite recovering from last year's lows, many once beloved shares in the UK and overseas are still trading well below near-term peaks. Higher interest rates do not automatically mean that shares' previous heights are irrecoverable. 

One area where bargains have become especially apparent is in the investment trust sector. Like equities more generally, trusts showed signs of a recovery at the turn of the year as sentiment lifted – only for the Silicon Valley Bank crisis to prompt a relapse. That has caused the discounts at which trust shares trade relative to the stated net asset value (NAV) of the underlying portfolio to balloon out once more, with Stifel analysts noting that the average discount moved from an already wide 13 per cent to 16 per cent over the first quarter of 2023.

This brings to mind a more uplifting parallel to the fraught times of the past: Stifel notes that this is the widest discount the sector has traded on for an extended period of time since the financial crisis, meaning a “wealth of cheap funds” on offer. Peel Hunt analysts recently offered a similar take, arguing: “While uncomfortable today, the opportunity cost of not getting involved at these levels is akin to the post-GFC period.” They add that there are “a number of situations where share prices are signalling distress but the underlying fundamentals do not (yet) reflect this”.

That said, the fundamentals are in many cases not quite so rosy as we might hope: in some cases there is good reason for pessimism. So assessing where the gloom is warranted, and where it might not be, is the task at hand.

What’s cheap, and why

A glance at the scale of discounts on which some trust sectors trade, relative to their 12-month averages, gives a helpful indication of where sentiment has really faltered. Using groupings from Winterflood Securities, one of the most evident laggards is the 'growth capital' sector, focused in many cases on mature private companies that may well float on public markets in the future. It offered an enormous average discount of 44.8 per cent as of 13 April, well above the already substantial 30.4 per cent average for the preceding 12-month period. The numbers are pretty stark within this category: Seraphim Space (SSIT), which commanded a chunky premium not long after listing in 2021, sat on a discount of nearly 65 per cent on 13 April this year, with the former Woodford Patient Capital fund Schroder UK Public Private (SUPP) on 54.4 per cent, troubled private growth play Chrysalis (CHRY) on 53.8 per cent, Baillie Gifford’s Schiehallion (MNTN) on 22 per cent (40.4 per cent for the C shares), and Schroder British Opportunities (SBO) on 33.5 per cent.

The absolute pummelling taken by this sector, as well as by erstwhile favourites such as Scottish Mortgage (SMT), Baillie Gifford stablemates such as Monks (MNKS), and the dedicated private equity trusts, points to two big challenges for investors. One is that a tightening of monetary policy means that many of the classic 'jam tomorrow' investments – including the tech stocks that flew so high in the last decade – are now exposed to higher discount rates that hurt asset valuations, as well as higher funding costs that could make life tougher for once-promising companies. That means investors are understandably wary about backing such trusts, and therefore demand a cheaper starting price as compensation.

The huge discounts on which many of these trusts trade also reflect a distrust of the valuations on unquoted assets. We have already seen significant writedowns in certain portfolios: one fundraising round last year put a huge dent in the valuation of Chrysalis holding Klarna, relegating it from the status of the trust’s biggest position and eating away at portfolio performance. Meanwhile, a rolling cycle of reassessments saw Scottish Mortgage conduct 351 revaluations on its private company holdings in the first half of 2022 alone, with the average change in valuation amounting to a 22.8 per cent writedown.

In other sectors, investors are still awaiting clarity. Private equity NAV updates, for one, are subject to a lag, and even when such assessments do arrive they can sometimes appear fanciful, given that transaction volumes will slow at times of economic uncertainty – and because trusts themselves, as the biggest single backers of their portfolio companies, can often prop up prices with just a small amount of additional capital. There can be similar issues when it comes to property trusts, where the infrequency with which a physical asset is bought and sold raises the question of whether true price discovery is taking place.

That all casts mystery over valuations, and raises the question of whether the discounts on offer are simply a more accurate way of pricing a trust than its NAV. Investors are thus left deciding what to believe. In other parts of the market, however, it is clear there are some trusts that are more mispriced than others.

Oversold inflation plays

Away from the sell-off in growth investments, Peel Hunt’s team has pointed to another trend of inflation-linked assets appearing to fall out of favour. Here we move firmly into some of the other popular alternative asset classes: Stifel data shows that the property UK healthcare trusts saw a discount widening of 10.6 percentage points over the first quarter, with UK commercial property funds and infrastructure funds suffering large-single-figure declines.

As Peel Hunt puts it, various “long-income, inflation-linked” options have sold off. LXi Reit (LXI), a real estate investment trust (Reit) with a yield of around 6.5 per cent, has been sitting on a discount of some 28 per cent. Supermarket Income Reit (SUPR) has seen its discount widen, while Residential Secure Income Reit (RESI) sat on a discount of nearly 40 per cent and a yield of 7.7 per cent.

There are, of course, questions about property as an asset class at a time of great economic uncertainty, with the risk that the shares continue to tread water at least for some time. That said, there is now plenty in the price. Idiosyncrasies also play a role here: LXi, for one, has had a tendency to 'prove' its NAV by disposing of assets frequently enough. But it has seen its remit change as it has grown over time, including absorbing Secure Income Reit last year and taking on more exposure to the likes of theme parks. That has caused some to take a wait-and-see approach with the trust for now.

Others may well continue to go cheap because of issues with refinancing in a time of rising interest rates. While many in the sector seem to have handled this well, Abrdn Property Income (API) ran into trouble in late 2022 by refinancing its debt at what one analyst referred to as “far inferior terms”, locking in a rate of 6.97 per cent versus the previous 2.77 per cent. With swap rates later coming down, the trust subsequently scrapped that agreement at a cost of £3.56mn and replaced it with an interest rate cap of 3.96 per cent.

But one once expensive sector now looks compelling. Having sold off on the back of gilt moves late last year, the infrastructure investment trusts no longer command the huge premiums that were for so long a feature of the sector. Much as they can prove correlated to bond moves and vulnerable to rising discount rates, such assets should still have less economic sensitivity than the likes of property, while also offering some inflation linkage. The big established names here have seen share prices fall to discounts, with HICL Infrastructure (HICL) on 5.5 per cent and International Public Partnerships (INPP) on 5.8 per cent.

The idea is that such funds will continue to generate strong levels of income and protect investors against inflation, even if the shares do remain volatile in difficult markets. However, when seeking bargains it can be important to look for a catalyst for change, where possible, rather than simply reaching for attractive price tags.

Idiosyncratic buys?

One example of this can arguably be found in a related sector. Sticking with physical assets, the digital infrastructure funds hold some appeal as trusts that should, in theory, enjoy a bounce back based on their fundamentals and a realisation that a mispricing is evident. One name we highlighted recently was Cordiant Digital Infrastructure (CORD), which still languishes on a discount of around 20 per cent. Like its rival Digital 9 Infrastructure (DGI9), the Cordiant fund launched to great acclaim in 2021 with its focus on fibre networks, telecoms towers and other assets vital to an increasingly digital world. The price, however, seems to have been held back by a hold-up in the trust’s acquisition of Polish company Emitel being approved, creating some cash drag and a delay on the point at which the trust would achieve its full potential in terms of income generation and total returns. The deal was approved at the end of last year, but the shares have yet to recover, suggesting investors aren't convinced yet. However, its completion did bring other welcome developments for the trust, such as the prospect of it hitting its 4p per year dividend target ahead of schedule.

Infrastructure plays of different stripes are also worth a mention. Peel Hunt points to Gore Street Energy Storage (GSF), which recently traded on a discount of around 9 per cent versus a 12-month average of 4.2 per cent. “Understandably, there is a lot of excitement about the structural need for battery storage and the important role it plays in the energy transition,” the team notes. “However, the GSF discount may be a reflection of how far out some of [the trust's] construction projects are, particularly when compared to the other two peers in the sector. SDCL Energy Efficiency Income (SEIT) also falls into this camp.” On the latter portfolio the team notes that the energy efficiency subsector has broadly seen discounts widen, but argues that SEIT offers greater scale and liquidity than its peers.

All investments come with risk, but some analysts think current prices offer the potential for certain high-risk options to confound the doubters, even in the current environment. Mick Gilligan, of Killik & Co, describes it as “understandable” that high-growth investments trade on big discounts, given that early-stage companies often need additional investment in tough times.

The biotech sector is one such example. However, he notes: "The pharmaceutical sector is about to enter a period where patents on a lot of blockbuster drugs are about to expire. Drug pipelines need to be replenished and I think now is an attractive time to buy into this space.” He points to International Biotechnology (IBT) which recently traded on a discount of around 7.5 per cent, with a 4.3 per cent dividend paid from capital. “This is accretive to NAV and helpful compensation for income seekers while they await a re-rating,” he says. A similar offering, Syncona (SYNC), is on a chunky 25 per cent discount. The trust, which holds a good number of early-stage life science businesses, has successfully exited many companies that it started from scratch.

In biotech there are also different levels of risk on offer. BioPharma Credit (BCPR) recently traded on a 6 per cent discount to NAV. That’s roughly in line with its one-year average but the trust, which invests in the debt of life sciences companies, has continued to hold up well from an operational perspective. And its annual financial report, published in March, noted that the percentage of floating rate loans within the portfolio had increased from 46 to 81 per cent over a year, giving some protection at a time of rising rates. The trust’s shares continue to offer a chunky dividend yield of around 7 per cent.

Equity options

Some of the bargains on offer allow investors to capitalise on the very structure of investment trusts. Several prominent fund managers run both trusts and open-ended fund equivalents – and with the former trading on discounts, that represents a cheaper way to access these managers. There are plenty of examples here, from the big equity trusts run by Baillie Gifford to Nick Train’s Finsbury Growth & Income (FGT) and UK value fund Fidelity Special Values (FSV). However, investors should be aware that taking this route may also mean embracing some of the racier characteristics that trusts can have, be it unquoted holdings, a greater focus on other less liquid investments such as small caps, gearing, share price volatility and the chance of greater portfolio concentration.

That brings us back to the question of whether Scottish Mortgage, on a discount of 16-20 per cent in recent weeks, looks to be a bargain. Peel Hunt’s analysts see it as one of a series of long-term outperformers given a valuation that viewed from a certain perspective seems “extraordinary”. But it remains hard to gauge how bad sentiment on the trust will get. "Given the cloud of negative sentiment hanging over SMT it is not clear where the discount will settle," they say. "However, if we apply the average private equity trust discount of around 40 per cent to the unlisted holdings and a 15 per cent discount to the listed equity assets [the average for trusts in the technology sector], then a blended discount of around 22 per cent is fair value."

Notwithstanding its success in recent years, Scottish Mortgage should arguably be viewed as a holding that accounts for a smaller part of your portfolio, and one that may have a long road to recovery. The trust is also facing up to some very idiosyncratic problems – such as bumping up against its 30 per cent limit on unquoted investments (something that could prevent it from participating in cash calls from its portfolio companies) or the trust's recent boardroom spat. Investors may well prefer more conventional plays on structural growth stories, such as the traditional technology trusts which also sit on big discounts. They should at least treat what is now a contrarian investment with the caution such a status deserves.

But whatever the merits of individual bargains, at the current moment the wisest course may in fact be to simply steer clear of the most expensive trusts – or at least think carefully if such a price tag is warranted. Peel Hunt recently pointed to multiple names trading on higher ratings than their peers – from BlackRock World Mining (BRWM) to Fidelity Asian Values (FAS) and Abrdn Equity Income (AEI). These are exceptions, however: uncertain as times are, it is at least easier than normal to avoid paying over the odds.