11 investment trust discount opportunities

A Kepler analyst offers a three-month market review and examines the state of the trust universe.

When we last updated our portfolio of discounted opportunities, markets were basking after a vaccine-pumped rally which proved good for NAVs and saw discounts narrow. The last three months (since 7 January 2021) have been rockier.

While the news about the timetable for re-openings has been good in the UK and in the US, and the results from the Israeli experiment have been close to ideal, Europe and the emerging markets have had setbacks. There has been some volatility in the hottest sectors in the rally and, indeed, in the growth sectors which have dominated the post-crisis period. For example, Scottish Mortgage (LSE:SMT)’s share price was up 16% for 2021 at one point, fell 28% and is now back where it started the year.

Overall, however, it has been a good three months for investors in investment trusts. A weighted average of the whole investment trust sector has generated share price returns ahead of global and UK stock indices, in part because their discounts have narrowed on the whole. Below, we discuss the state of the investment trust universe before turning to the 11 trusts we have previously highlighted as having wide discounts that we would expect to close over time, whilst also retaining, in our opinion, good NAV potential.

Three-month market review

It is exactly three months at the time of writing since our last review of our discounted opportunity portfolio. In the quarter to 7 April 2021, markets have ground higher, although the UK has lagged relative to global markets after doing exceptionally well in the final quarter of 2020. The investment trust universe as a whole, on a weighted average basis, has performed in line with the MSCI ACWI (using an iShares ETF as a proxy) on a NAV basis, with the average share price outperforming as on average discounts have narrowed.

Investment trust sector performance

Source: Morningstar. Past performance is not a reliable guide to future returns

In fact, the Morningstar investment trust universe is now trading on a weighted average premium of 6.5% (as of 07/04/2021), up from a discount of just under 2% as of our last review. This is a remarkable turnaround from the discount of over 20% that was seen just over a year ago in the aftermath of the coronavirus crash.

Discount

Source: Morningstar. Past performance is not a reliable guide to future returns

As the table below, ordered by the narrowing of the discount over this period, indicates, some ‘value’ sectors and some seen as victims of the pandemic have continued to close their discounts.

We would typically classify Global High Income, Commodities & Natural Resources and UK Equity & Bond in the first category, and the UK Commercial Property sector in the second. The first category saw some excellent NAV total returns as the reflation trade continued (see table below).

However, it hasn’t simply been a case of a rotation into value: the ‘Covid winner’ sectors of Property – UK Logistics, and Growth Capital have continued to see their discounts narrow, even if NAV returns were relatively muted. Among the few sectors to see a widening discount are some high-growth markets which have taken a breather – China, Japan – and the infrastructure funds. Returns in China have actually been good over our period, although this is misleading: the sector peaked in February after a sharp rally and both NAVs and share prices have fallen significantly since then.

Sector discount moves

Source: Morningstar, as at 07/01/2021 – 07/04/2021. Past performance is not a reliable guide to future returns

This coincided with a rise and decline in the fortunes of growth versus value (with SMT emblematic, as noted earlier). Since positive vaccine results were announced in September and October 2020, value has outperformed growth. However, with the exception of some very frothy areas, growth indices and trusts have not performed badly but, rather, failed to keep up. As a result, unfortunately the high-quality growth trusts have not yet fallen out of favour enough to qualify for our portfolio.

Source: Morningstar. Past performance is not a reliable guide to future returns

The widest discounts on individual trusts continue to be seen in specialist areas which are most obviously threatened by the consequences of the pandemic, or trusts in wind up or otherwise troubled. The aircraft leasing funds, which have seen their business models called into question by the pandemic, have the widest discounts – over 90% in one case.

After various funds in wind-up, and Tetragon Financial Group (LSE:TFG) (which we removed from our list in the last review), Riverstone Energy (LSE:RSE) (a portfolio member) has one of the widest discounts, as does BMO Commercial Property Trust (LSE:BCPT)– although the latter has seen a significant narrowing of the discount from 40% to 34% over this period. We discussed the prospects for BCPT in a recent property sector review.

Performance of discounted opportunities portfolio

Turning to the portfolio of discount opportunities, particularly strong performance was seen from the UK trusts once more. Our relatively recent addition Downing Strategic Micro-Cap (LSE:DSM)has seen good NAV returns over the period (see the table below) compounded by a discount coming in from 21.1% to 11.2%. River and Mercantile UK Micro Cap (LSE:RMMC) saw its discount narrow by almost as much, and now sits at just 7.1% below NAV. When we added RMMC to our portfolio back in February 2019 it was trading on a 13.5% discount. Henderson Opportunities (LSE:HOT) has also seen its discount narrow and it is now almost in single figures – in from over 15% when we added it in 2019. Both have seen very strong NAV returns to back up a narrowing discount as sentiment towards the UK has improved, which could mean it is natural to wonder if the move has run its course. In our view, there is still more to come in terms of catch up in the UK. Sentiment should, in our opinion, continue to improve during the summer as the economy actually opens up and vaccines are shown to work in an open society, as they have in Israel. We believe the UK economy opening up ahead of continental Europe and while the emerging markets are still struggling with the pandemic should give its market impetus.

Discounts and performance of shortlist

Source: Morningstar, as at 07/01/2021 – 07/04/2021 Past performance is not a reliable guide to future returns

It is interesting to see Schroder Japan Growth (LSE:SJG)’s discount narrow, too. This is, we would note, the most value-exposed trust in what is typically a growth-dominated sector. Both the Japan and Japanese Smaller Companies sectors have seen their discounts widen over the period, but SJG has bucked the trend. If the global economic picture remains more conducive to value as the developed world comes out of the pandemic, then we think this trend could continue.

The discounts of the private equity trusts are a little more complicated to interpret. Following our last update (data to 07/01/2021), Oakley Capital Investments (LSE:OCI) (OCI) reported a NAV backdated to 31/12/2020 which was up 13% from its NAV last June. This means the real discount was wider than reported at the time of our update, as we highlighted was likely to be the case. Similarly, the current discount of 25% is based off that 31/12/2020 NAV, and so with markets having risen since then it is likely an underestimate. NB Private Equity Partners (LSE:NBPE) publishes its NAV monthly, so there is a less pronounced effect by comparison.

Of those that have seen their discounts widen, Aberdeen Smaller Companies Income (LSE:ASCI) has actually performed well on an NAV basis but the share price has lagged. This may be because investors have been more interested in either high growth or deep value trusts, as this has generally been a period of significant risk appetite. ASCI’s quality growth strategy may have been too conservative for many investors. Its current discount of almost 18% looks very good value, we think, relative to the general picture for UK-focused trusts. Menhaden (LSE:MHN)’s NAV total returns have also been good, with the share price not following, while Riverstone Energy (LSE:RSE) has not reported a NAV.

Portfolio changes and outlook

As a reminder, we have published a target discount level for each of the trusts in this list, whether it be an absolute level or relative to a peer group. Our target for RMMC was the average of the UK Smaller Companies sector. Since it was included in our initial list of ‘discounted opps’ (in February 2019) the discount has roughly halved, coming in from 13.5% to the current 7.1% (it has been as low as 5.5% in the last three months). With the simple average of the sector now at 8.6% (according to JPM Cazenove), RMMC has met our target. It has been a fantastic ride for shareholders since February 2019. The managers have delivered a NAV total return of 54.3% while the shares have risen 65.3% thanks to the narrowing discount. This trounces the returns of the sector, which has generated 35.6% on a weighted average basis and the Numis Smaller Companies ex IT Index, which is up just 29%.

Performance since selection

Source: Morningstar. Past performance is not a reliable guide to future returns

It will be sad to say goodbye to the trust. As a reminder, this list is intended to represent what we see as interesting discount opportunities, where a trust with good NAV prospects has fallen deeply out of favour and where we see the scope for the discount to narrow over time. When we selected RMMC we felt the market was over-reacting to the departure of the previous manager given the new manager had worked closely with him. Furthermore, the opportunity in the micro caps seemed strong and the company structure good. We think RMMC could continue to do well, but it is hard to frame it as a great discount opportunity now! We are being cold and sticking to our price target. HOT and DSM are both on wider discounts and offer a similar exposure to the UK, which we believe will continue to see improving sentiment this year. In the case of HOT, our price target is par, based on the highly geared, cyclically-exposed trust’s performance in past cycles, while DSM still has some way to go to catch up with the sector average. Aside from these UK-focussed trusts, all the others remain some way from our price targets, as the below table indicates.

Old portfolio and price targets

Source: Morningstar, Kepler

That deletion takes our list down to 10. After the rally in discounts that we have seen before and since last year’s pandemic crash, and with the universe on a premium of 6.5%, the cupboard is relatively bare in terms of new ideas. We do think the discount on BCPT is too wide, but with so much uncertainty in the property market regarding the long-term future of retail and the fact all the generalist trusts are trading on wide discounts, we find it hard to get conviction on how, when and to where the discount closes. European trusts also look interesting at this point in time in our opinion, with most of them trading on low double-digit discounts and the pace of vaccination starting to pick up in France and Germany. However, we note that, while there may be a relief rally in the short term, these sectors have tended to trade on quite wide discounts in recent years, so the upside to the discount – the point of this shortlist – may be relatively muted.

The one addition we are making is CC Japan Income & Growth (LSE:CCJI). We selected SJG on the basis that its style was deeply out of favour and when the stylistic preference for growth versus value reversed it could do very well on both a NAV and share price basis. We still believe this to be true, but currently CCJI offers an even better opportunity. It is trading on a 12.9% discount, and has outperformed SJG in the reflationary rally. It also has c. 20% of gearing, which should see the NAV respond well as and when risk appetite returns in Japan. Meanwhile it offers a 3.3% yield from a market which generally offers little. Finally, the corporate governance reform which we have discussed many times is highly supportive for a dividend strategy such as this. CCJI traded on a premium prior to the coronavirus pandemic.

New portfolio and price targets

Source: Morningstar, Kepler