10 outperforming and oversold investment trusts

In order to get around this issue, my Oversold and Outperforming investment trust stock screen focuses on two high-level factors that researchers have widely identified as pointers to outperformance: value and momentum. This is how the screen assesses each factor.

Value

The go-to valuation metric for investment trusts tends to be the discount or premium the shares trade at compared with reported net asset value (NAV) per share (the per share value of the company’s investment portfolio less debt). But there are many reasons why a screen will find it is not comparing like with like when looking at discounts and premiums. For example, higher-risk trusts, or those that have persistently underperformed, will tend to trade at wider discounts for good reasons. 

To get around this issue, this screen uses a standardised measure of where an individual trust’s discount or premium sits within its own historic range. This is known as a Z-score. The Z-score tells us how many 'standard deviations' a trust discount or premium is away from its average – in this screen’s case, the one-year average. The score gives a standard measure of value, with a score of -1 suggesting a trust is very cheap against its recent history and -2 suggesting it is incredibly cheap. That said, a weakness of using the Z-score is that when a trust has a very narrow discount range it’s likely to become less valuable. Most importantly for the purpose of this screen, though, is that it can be used to make like-with-like valuation comparisons between very disparate trusts. 

Momentum

Momentum is the well-documented tendency of strong share price rises to persist. This screen looks at three-month share price momentum. The focus is on share price rather than NAV because the latter does not factor in movements in the trust's discount or premium, which represents an important signal from the market. 

The screen chooses trusts based on a combined ranking for momentum and value. 

This is one of the few screens for which I’ve been able to source reliable data to back test; data with no 'survivorship' bias and no 'look-ahead' bias. The backtesting also helped me devise some 'portfolio' rules to stop the results veering towards a single niche theme, as can sometimes be the case. This year, for example, half the 10 stocks would have been focused on Japanese equities were it not for the portfolio rules. These rules explain why the ranking in the table does not run smoothly from 1 to 10. As ever, though, the results from this screen are considered as ideas for further research rather than an off-the-shelf portfolio. 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 and no more than two niche funds of the same type. 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.

Last year the screen had a lousy run, producing a sub 1 per cent total return compared with 10 per cent from a 50:50 split between the FTSE All-Share and S&P Global 1200. The index split I use to judge the screen against is an attempt to reflect the home bias of the investment trust universe as a whole. 

2018 PERFORMANCE

Source: Thomson Datastream

Both times this screen has reported really bad results, a trust investing in unlisted companies has provided a real hammer blow. This is what happened to the screen last year courtesy of Woodford Patient Capital. The issue of cross holdings with other Woodford funds as well as poor investment choices have been central in the share price calamity and my write-up from last year failed to highlight this now-very-evident risk, for which I wholeheartedly apologise. The cumulative total return from the screen since I began running it in October 2014 now stands at 67 per cent compared with 63 per cent from the index split. If I take the important step of factoring in 1.5 per cent for notional dealing costs the return drops to 55 per cent – feeble versus the index.

My write-up below focuses on some of the major themes in the screen, with further details of the two property plays included in the online version. Monthly updates of this screen feature in IC Alpha.

10 Outperforming and Oversold investment trusts

Source: Winterflood Securities

Japan

This year’s screen is big on Japan. The extent of the enthusiasm for Japanese equities is not fully reflected by the 10 trusts in the table above. This is because, as a 'niche' theme, only two Japanese trusts are allowed into the portfolio. Were the screen’s portfolio rules to be jettisoned – my original backtests of the screen suggest this would be dangerous – then half of the 10 trusts would be Japan focused.

In some ways, the recent strong performance of Japanese stocks – the Topix index has risen 9 per cent over the past month – can be linked to a recent rekindling of investors' enthusiasm for 'value' investing. Japan boasts lots of value opportunities, with many companies valued at a steep discount to book value. There are hopes that shareholder activism coupled with slow-but-sure reforms to corporate-governance codes have begun to make Japanese companies act to unlock value. A relatively stable political backdrop is also helping and investors seem to have become less concerned by the issue of deflation. 

There are also reasons to be nervous about the region, though, which is reflected by the above-average discounts of trusts in the sector. The US-China trade war is weighing on sentiment given Japan’s standing as a major exporter. At a more localised level, the country’s tricky historical relationship with South Korea is once again fraught. Meanwhile, some of the value on offer in Japanese markets is simply a reflection of grim prospects for many companies, which seems particularly true of the country’s financial sector. 

Of the two trusts selected by the screen, CC Japan Income & Growth represents the more conventional play on the Japan theme. The Baillie Gifford fund is a bit more esoteric given its focus on smaller-and medium-sized growth companies. The trust’s top 10 includes a number of internet plays and its top holding, accounting for 6 per cent of the portfolio, is conglomerate Softbank, which is known for its investments in high-profile, lossmaking 'unicorns', such as WeWork and Uber. The trust cut fees at the start of the year.

US

This screen’s portfolio rules are less restrictive when it comes to US-focused trusts than Japan-focused ones. The US is classed as a mainstream theme by the screen. That said, there are only a handful of investment trusts that focus solely on the world’s largest stock market. Given the paucity of choice, it’s noteworthy that three such trusts ended up among the screen’s 10 picks. What’s more, two of these trusts have a specific focus on smaller companies. 

Wider-than-usual discounts on these trusts is, in part, a reflection of nervousness about the US economic outlook. Investors have been spooked by weak data, including a drop in the US manufacturing purchasing managers' index (PMI) to below 50 for the first time since 2009. Adding to the angst is the rumbling trade war with China. Investors concerns have been further fuelled by a U-turn in monetary policy, with the Federal Reserve already cutting rates twice in response to a fragile outlook. Another high-profile cause for concern has been an inversion of the US yield curve, which means it costs less to borrow in the short term than the long term. This is often taken to suggest the economic outlook is so bad interest rates will need to fall for some time as an antidote. That said, the signal from the yield curve is generally considered less reliable when yields are very low, as is the case now. A new worry over the past few weeks has come from the Fed’s intervention in the overnight money markets for banks following a sharp upward move in the so-called repo rate. And let’s not forget the possible impeachment of President Trump.

That said, economic news from the US has by no means been all bad, with some strong numbers from both the jobs and housing markets over recent months and positive noises about trade deals over recent weeks. The flip side to the negative economic prognosis suggested by lower interest rates is the stimulus they provide and the beneficial effect they have on the value of risky assets such as shares. What’s more, the upcoming presidential race in 2020 provides plenty of incentive for the incumbent to keep economic conditions strong. 

Despite recent angst, the three US trusts qualifying for this screen have put in solid performances over both one and three months. Part of this is down to a revival in enthusiasm for smaller companies, which have lagged growth-orientated large caps for some time. The strong showing by smaller companies has happened in tandem with the recent performance spurt by 'value'. The Jupiter US Smaller Companies trust highlighted by the screen picks up on both themes as it has a 'value' approach as well as focusing on small caps. The portfolio is also designed to try to preserve capital during downturns. The long-term track record is good and the trust’s performance seems to have improved since the manager tightened the investment process two years ago. The large-cap focused JPMorgan American also spruced up its investment approach in 2017, although the performance has not been that impressive since. Its current portfolio also has something of a 'value' feel, with a notable overweight position in financials.

Polar Capital Technology*

The Polar Capital Technology Trust (PCT)* can be seen as something of a play on the US market itself, given the country’s tech-rich markets are home to 70 per cent of the trust’s holdings. The trust – which principally busies itself with searches for next-generation tech winners – is somewhat cautiously positioned at the moment, with about 6 per cent of assets in cash as of the end of August. The company is also looking to profit from any improvement in the current US and China trade stand off. To do this it has increased holdings in Apple, Qualcomm and 5G-related plays.

Regulated residential housing

Two of the trusts highlighted by this screen focus on regulated residential housing. While the two trusts offer significantly different takes on the theme, both trade at wide discounts to NAV and offer high potential dividend yields as well as noteworthy risks. 

Starting with the screen’s domestic play, the Civitas Social Housing Reit invests in supported social housing. This is specially adapted accommodation for people that need significant care and support, such as those with mental, physical and learning disabilities or autism. This kind of accommodation is 100 per cent funded by central government, which removes risks associated with weak local authority finances. Civitas buys already completed properties, so it also avoids development risk. Most of its lease agreements run to 25 years and are inflation (consumer prices index) linked. What’s more, agreements are usually in place for rents to be paid while properties are empty, which is common due to the lengthy process of preparing care plans for new tenants.

All this may sound like it make a pretty water-tight investment case, but there are caveats that explain the shares’ wide discount to NAV. While central government may be the ultimate source of rent, the money comes through a circuitous route before ending up in Civitas’s pocket. Local authorities receive earmarked funds from central government. The local authority then agrees a contract with a care provider for appropriate accommodation and care services. In turn, the care provider goes to a housing association or 'registered provider' to source the property and connected services. It is the housing association or registered provider that eventually enters into the lease with Civitas. 

The rub is that the housing associations and registered providers that work in this niche and pay Civitas look a bit flaky based on recent reports from their regulator, the Regulator of Social Housing (RSH). The RSH began to kick the sector’s tyres when one of Civitas’s big lessees, First Priority, ran into financial trouble in early 2018. Civitas’s  properties were quickly taken over by another provider, and the financial impact was limited. But the regulator has since raised concern about the governance and financial viability of many registered providers and housing associations, which included clients of Civitas making up 40 to 50 per cent of the rent roll, based on estimates by research house Edison. 

Concerns about the complicated contract relationships go beyond the implications for rental payments should a registered provider or housing association go under. There are mismatches with contract timings. Civitas’s 25-year leases compare with 10 year average contract lengths between its lessees and care providers. What’s more, central government can cut off the funding of rent if Civitas’s lessees fail to ensure certain standards are met in regard to: ensuring tenants have sufficiently high needs; rents are appropriate; and that service levels and property adaptations meet standards.

So, Civitas is not the cast-iron, government-backed, inflation-linked income story it may first appear. That said, there is a huge shortage of the type of property Civitas is providing and the trust is taking a proactive role in attempting to develop standards among its clients. These are reasons to feel more comfortable with the bumper yield. Investors would, however, have more reason to feel comfortable were the dividend actually covered by earnings – last year’s 5p payout was only backed by 3.6p of adjusted earnings per share. It is hoped that full cover can be achieved by deploying a new loan facility to buy properties and take the loan-to-value towards a 30 per cent target.

The other regulated residential-housing play alighted on by the screen is focused on Berlin apartments. The German residential market has strict rules on rent increases. Phoenix Spree Deutsche (PSDL) has, until earlier this year, been making significant returns on its investments in Berlin’s undersupplied market by refurbishing properties, which acts as a trigger to allow it to then push through noteworthy rent rises. It has also seen major valuation uplifts by converting blocks to condominiums and selling units. 

The shares tanked earlier this year on news of proposals, presented to the Berlin Senate on 30 August 2019, aimed at preventing private residential rents being set at free market levels. The new regulations are expected to face significant legal challenges but, if they are enforced, it will prove a major blow to Pheonix’s business model and is likely to cause a noteworthy drop in NAV.  

While this is a source of huge uncertainty, over half of the buildings owned by the Pheonix are already split into condominiums that could be sold. In the first half condominium sales prices per square metre were 16.7 per cent above book value. What’s more, the company reckons that the “evidence from other cities where similar rent controls have been introduced suggests condominium prices likely to benefit in the medium term”.

Going global

Two reputable global generalists with solid income credentials have made the list: Witan and F&C Investment Trust. In both cases, discounts have widened as the trusts have underperformed their indices over the past years. The discounts are hardly mind blowing, but could proved relatively attractive entry points for these two portfolio mainstays, which tend to do a pretty good job of at least matching their benchmarks over time while giving broad global exposure.

*The author holds shares in this trust