10 outperforming and oversold investment trusts

The key valuation metric that is generally used when assessing investment trusts is the discount or premium a share price trades at compared with net asset value (NAV) per share. Many things can conspire to mean the typical discount or premium of any given trust varies significantly from others, such as: the asset class a trusts invests in; its manager’s track record; sentiment; its structure; and discount control policy. However, to get around this issue investors can use a standardised measure of where an individual trust’s discount lies in its own historic range (the Z-score), and this can be used to make comparisons between disparate trusts. Useful as the Z-score is, it is not enough for a screen on its own.

Momentum is a factor that extensive academic and industry research has shown can identify outperformance over the long term, although trading costs are likely to offset many of the benefits of this strategy, especially when applied to investment trusts that can be relatively illiquid and costly to trade.

Eureka!

Four years ago, I finally hit upon the admittedly simple idea of bringing these two factors together. I was also fortunate enough to source some reliable, high-quality historical data (actual data available compiled at the time on the actual trusts that existed at the time) from investment trust specialist Winterflood Securities. This allowed me to conduct a limited back test that suggested the method has some merit. Indeed, having recently updated my original back test to cover the 14 years to the end of 2017 it shows a cumulative total return for the period of 482 per cent after assuming a 1.5 per cent annual charge compared with 250 per cent from a 50:50 split between the MSCI World and FTSE All-Share indices.

Since I’ve been tracking my “outperforming and oversold investment trust” screen as I’ve called it, in the magazine, it has put in a decent performance and last year picked 10 trusts that generated a total return of 11.6 per cent compared with 7.7 per cent from a 50:50 split between the FTSE All-Share and S&P Global 1200.

2017 performance

Source: Thomson Datastream

Over the full four years I’ve run the screen it now boasts a cumulative total return of 71.2 per cent or 61.1 per cent after taking the important step of factoring in a 1.5 per cent annual charge. This compares with a 56.9 per cent total return from a 50:50 split between the FTSE All-Share and S&P Global 1200.

Versus what?

One issue I face with this screen is the question of what to benchmark it against. Investment trusts present investors with an opportunity to invest in many different geographies and asset classes but the universe of stocks this screen takes in bears very little resemblance to a global index.

While US stocks dominate most global indices (60 per cent of the S&P Global 1200, for example), they are widely under-represented among the investment trusts that qualify for this screen (it ignores hedge funds and pure debt funds). In fact, there are only five single-country US trusts to choose from, representing less than 2 per cent of the 275 trusts screened, although there are an additional three trusts focused on North America including Canada and some niche trusts, such as the small band of London-listed technology and healthcare trusts, that do offer significant exposure to companies across the pond.

Meanwhile, although there are a solid number of global trusts available, making up 17 per cent of the total, on average the US is under represented in these trusts' holdings with only about a quarter of their assets invested in North America and closer to a third in the UK (based on Winterflood data and equal weightings for all trusts).

London-listed investment trusts also have a major 'home bias' with UK funds accounting for over a fifth of the total compared with the 6 per cent weighting assigned to the UK by the S&P Global index – this still makes the UK the index’s third-best represented geography after Japan at 8 per cent.

The point of this long-winded observation is that while judging the performance of this screen against a combo of the FTSE All-Share and S&P Global 1200 runs the risk of looking disingenuous given the global nature of investment trusts, it’s probably a less terrible proxy than just looking at global indexes – not that anything is likely to make real sense for such an esoteric investment universe. The reason why diluting the S&P Global may appear disingenuous is that the runway performance of US markets and sterling’s weakness have served to turbo charge the index’s returns.  With 10-year US bond yields spiking over recent days, the fortunes of US equities could turn, although we’ve all heard that story before and investors have learned not to heed it which at some point will mean ignoring the inevitable.

How the screen works

The screen gives each trust a ranking based on a combination of value (Z-score) and three-month share price momentum. The top 10 trusts are then subject to rules (see below) that are designed to ensure the 10 picks are not excessively focused on a single theme. The restriction on niche themes means the top 10 do not reflect the fact that several Japanese and Vietnamese trusts ranked highly in the screen results. Other themes that are represented in the 10 picks are Europe, Private Equity and Healthcare. The rules are:

• Market capitalisation must be more than £100m.
• No tracker or hedge funds.
• No more than half the portfolio (five out of 10 shares) should be in funds with a niche theme. Trusts defined as niche are those focused on non-mainstream asset classes or sub-sectors such as private equity, debt, technology and biotechnology, and those focused on single countries (excluding the UK and US) or high-risk economic regions such as emerging markets. I also regard Asian smaller companies trusts as niche, but not Asian generalists.
• No more than half the portfolio (five out of 10 shares) should be mainstream funds of the same type. This rule does not apply to global funds, but it does to other mainstream themes such as trusts investing in the UK (large and small companies), Europe, the US or Asia.
• All trusts must trade at a discount to NAV.

10 outperforming and oversold investments trusts

Source: Winterflood Secturities

BlackRock Latin American*

It has been a turbulent time for BlackRock Latin American over the last year. The trust was a constituent of the 2017 portfolio and proved a drag on performance. It turned out to be a situation where a wider than usual discount proved to predict of trouble to come rather than being caused by the kind of excessive pessimism this screen aims to highlight. Are there grounds to hope for better this time around? Possibly, seeing as a number of reasons for uncertainty last year may be coming to a head. In Brazil, which accounts for 62 per cent of the portfolio, elections – soon to conclude through a second round of voting – should set the tone for markets. The trust has positioned itself for a government that will continue the reform agenda and victory looks likely for far-right former army captain Jair Bolsonaro, who, from a stock-market perspective, is regarded by analysts as the second-best choice from the first-round candidates. There have also been some sign of his rhetoric softening and his becoming more centralists, although this may be simple manoeuvring ahead of second-round voting. Recent elections in Mexico and progress with the renegotiation of the North American Free Trade Agreement (NAFTA) may help this market, too, which represents 29 per cent of the portfolio. Trade wars still cast a shadow over commodity prices which are important to Latin American economies, though. And the economic situation in Argentina looks dire, with fiscal cuts ahead and rates hitting a mind-boggling 60 per cent. Still the trust has reduced exposure to the country to just 1.7 per cent as of 31 August. Earlier this year the company also revealed a new dividend and discount policy aimed at bringing the share price closer to NAV. All in all, it’s not too wild to hope these markets may show better poise in the coming 12 months following the roller coaster of the last year.

Middlefield Canadian Income

The Canadian stock market is often regarded as a resources play, and as such the recent strong rise in the oil price is good news for Middlefield as well as the Canadian economy in general. However, while Middlefield was usefully overweight in energy as of the end of August, the portfolio offers far more breath than just resources. Indeed, recent outperformance of its benchmark – a composite of the high-yield US and Canadian indices – has been down to its bets on US technology and healthcare companies. The trust is able to invest up to two-fifths of the portfolio in the US. That said, the Canadian market currently offers better value and this is where over 80 per cent of Middlefield’s assets are currently found. Despite recent concerns about trade with the US, Canadian GDP growth has been strong, coming in at 2.9 per cent in the third quarter. Meanwhile, recent breakthroughs with NAFTA means the economy is better placed to benefit from substantial tax cuts by its neighbour. As the trust’s name implies, its shares offer attractive income boosted by the use of financial gearing.

Healthcare

Investing in healthcare companies is complicated and risky, meaning many private investors lack the expertise to confidently invest in the sector or the resources to build a suitably diverse portfolio to mitigate against the inevitable risk of value-destroying events, such as major drug-trial failures. This makes investment trusts a fantastic way for non-specialists to play this area and the exciting innovation currently under way. It is much less fun to be a high-profile fund manager investing in the sector when the inevitable failures of portfolio companies are painted as black marks against one’s abilities.

It’s hard not to feel some sympathy for Neil Woodford, whose choice of name for his Woodford Patient Capital Trust seems to have been roundly ignored by impatient hacks chasing a story of the fall of a great man. That said, through its patience and ability to accept the inevitable disappointments along the way, Patient Capital has been enjoying some noteworthy successes of late as well as the disappointments that have made for more-alluring headlines. Two events of particular note this year have been a massive loss from the failure of a clinical trial by Prothena in April and the massive gain from the listing of shares in Autolus on Nasdaq followed by a doubling in the price. While the one largely offset the other, there has been encouraging progress from many of the companies in the portfolio, 65 per cent of which were unlisted at the half-year stage. While the trust does not have an explicit healthcare mandate – it focuses on early-stage, innovative, British companies – 57 pent of the assets are invested in the healthcare sector. Forget the Woodford billing; Patient Capital is an interesting fund using the investment trust structure to lock in capital and allow it to pursue long-term aims.

Polar Capital Healthcare has a longer track record than Patient Capital but over the long term its record is notable for being poor compared with the peer group. The discount is correspondingly high compared with rivals. However, this focusing on long-term performance risks overlooking the fact the trust changed its mandate last year to switch from an income focus to a growth focus. Looked at over a year, its net asset value (NAV) total return of 15 per cent is usefully ahead of the 12 per cent average from the healthcare sub-sector. Meanwhile, over six months, only one of its five rivals bettered it. Performance will have been aided by 'gearing' through zero dividend preference shares.

Europe – Henderson European Focus

Henderson European Focus is the only European trust to appear in the screen results, but a number of its peers just missed making it into the portfolio. European funds have seen their discounts stretch out recently over fears about the state of the EU. While Brexit rumbles on – with the potential for pain on both sides – another potential rift has more recently been grabbing headlines with the new populist government in Italy pushing through a budget that suggests it may be as troublesome to the status quo as campaigning rhetoric suggested. Meanwhile, the rise of far-right populists across the region, and especially to the East, is a disquieting trend. President Trump has created some angst too by lashing out at EU trade policies. All that said, the EU economy on the whole looks fairly healthy, even if Italian finances and some banks’ exposure to Turkey are concerns. Monetary policy remains accommodative and equities look relatively good value compared with global hotspots – namely the US.

Henderson European Focus’s manager, John Bennett, is very experienced and respected. That said, his value-conscious investment style and focus on larger companies has been out of step with the market over recent years, which helps explain the emergence of a discount on a trust that has historically often traded at a premium to NAV.

Private equity

Private equity funds would have been far better represented in this screen’s results were it not for the rule that the portfolio should only contain five 'niche' funds. As it is, only one private equity fund made the cut: Standard Life Private Equity. There are potentially two factors weighing on sentiment towards private equity funds at the moment, despite strong recent NAV performance. Firstly, these types of fund tend to be very sensitive to any downturns and despite strong economic numbers this year there is also a lot of worry about the economic outlook due to trade wars and tightening monetary policy, especially in the US. The other cause for investor concern is that the private equity sector has been flooded with capital over recent years and there are grounds to argue deals are being done at stupid prices just to get money invested. Add in debt (often a key ingredient in private equity deals) and you have a potentially toxic mix. For its part Standard Life Private Equity offers a board play on the sector. The trust invests in private equity funds run by leading private equity firms, which are generally focused on large buyouts. Overall, its portfolio offers exposures to 350 private companies.

Crystal Amber*

The locked in capital that funds secure by adopting an investment trust structure means some very interesting esoteric opportunities exist in the sector. Crystal Amber is an example of this. While on the face of it, the trust is one of many UK small-cap funds, it actually offers something very particular. It runs a concentrated portfolio of position of about 20 companies and takes an activist approach designed to encourage its holding to unlock value. An example of the trust in action was its decision to take a holding in Woodford Patient Capital – another one of the trusts highlighted by this year’s screen – shortly after its lost nearly a tenth of its value after a major setback for its investment in Prothena (see above). Smaller-cap trusts are normally considered to be highly sensitive to wider market movements, so it is of some interest that Crystal Amber believes its approach can generate good returns come rain or shine.

Global generalists – Martin Currie Global Portfolio, Bankers, Caledonia

Three of the funds in the 10 stock portfolio are global generalists. This may be a reflection of nervousness about the global outlook given trade wars and rising US rate, which could have broad implications for valuations – the idea being the higher the risk-free return on offer from US government debt, the higher the return investors will demand from riskier assets, such as equities, which will require risker asset prices to fall.  

The highest ranking of the funds, Martin Currie Global Portfolio has a zero-discount policy so the small discount to NAV may not last for too long. Meanwhile, the trust’s manager of 18 years, Tom Walker, retired at the start of the month and has been succeeded by Zehrid Osmani, who has 20 years of experience. He briefly co-managed the fund with Mr Walker before taking the reins as part of the trust’s succession planning.

Caledonia’s value-discipline has been a drag for this trust and cash levels are high as it has struggled to find sufficiently cheap opportunities. As well as uninspiring recent performance, the trust’s wide discount to peers reflects the fact that about half the portfolio is unquoted and about half of its shares are controlled by the Cayzer family.

*The author owns shares in these trusts