With the average investment trust at its widest discount since the global financial crisis, investment trust analyst Thomas McMahon reveals the trusts that have caught his eye. He also names his favourite income generators for the year ahead.
Lee Wild, head of equity strategy, interactive investor: Hello. With me today I have Thomas McMahon, investment trust research manager at Kepler Trust Intelligence. Hi Thomas.
Thomas McMahon, investment trust research manager at Kepler Trust Intelligence: Hi Lee.
Lee Wild: After a terrible 2022, the past 12 months have been fantastic for most equity markets, especially if you've been invested in US tech. So it seems like we're over the hump. What have been your highlights of 2023?
Thomas McMahon: I think it's been a difficult year for the investment trust sector. We've seen discounts widen across the board, particularly in alternative assets but also in equity markets. I think you're right that things have improved as the year has gone on, but there's still a lot of wariness out there and valuations are still very cheap.
I would say the things that have stood out as having been highlights, of having done well, obviously, there is the US tech rally. That's been very narrowly focused. And if you look at the US market, excluding those large tech stocks, it's gone pretty much sideways. Particularly interesting areas have been India, which has had another really good year as it has about three years in a row now of some really quite outstanding returns. It's been expensive all the way through, just as the US has, but it's delivered another good year and it still looks set up to do really well. There are a number of trusts that have made good money out of that.
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Japan, I would say, also stands out. The returns have been good, not outstanding, but I think it stands out because you've seen the development of a number of themes that make it look like it's going to do really well for some time to come. So, you've got some very serious corporate governance reforms, which really started around 10 years ago amid a lot of scepticism. But it's really starting to see overseas investors piling into the market and [we’re] seeing real fundamental reform in how Japanese companies do business. You’ve seen record dividends, record buybacks, the outlook looks equally good. So, I would say India and Japan stand out as being good news stories.
Lee Wild: Were there any investment trusts that really stood out from the crowd in 2023? Did you learn any lessons?
Thomas McMahon: Sticking with the India and Japan theme in India, Ashoka India Equity Investment (LSE:AIE) has delivered another outstanding year, generated a lot of alpha, and has actually been issuing equity regularly, which, given that most investment trusts have been buying back shares, if not carrying out more drastic activity, really stands out.
Within Japan, it's been a similar story for AVI Japan Opportunity (LSE:AJOT), which has been issuing shares through the year as very focused on the corporate governance angle. Probably a key lesson would be that markets and economies are two very different things and just because the economic news is very negative doesn't mean that equity markets are going to do poorly. And there are always opportunities out there, even if the overall picture seems gloomy.
Lee Wild: Looking ahead to next year, there are so many potential outcomes for 2024. What is your outlook for the next 12 months?
Thomas McMahon: We could all make predictions and could be proven completely wrong in a few weeks’ time. Personally, I think the environment we're facing is that we're going to have a relatively mild recession. It looks to me like we're going to see interest rates stay relatively high for relatively long. So, that creates a picture of reasonable economic growth, or at least not a dramatic decline and high interest rates. So, I think possibly that's a pretty good outlook for the NAVs of investment trusts, particularly in UK, Europe, US small-cap where valuations are low and potentially emerging markets too.
Whether we see discounts come in, they've widened out to record levels over the course of 2023. We've seen a little bit of a jump towards the end of the year. But over the course of the year, it's a story of dramatic widening. I'm not convinced that's going to change, at least not immediately, because I think that while you have high nominal returns on cash accounts, even if these returns are very meagre, it's going to be quite tempting for investors to stay with cash, particularly if there's a lot of debate about whether the economy is going to continue to do poorly. So, I suspect the NAVs story is quite good and maybe the discount story would be for later in the year.
Lee Wild: Income remains a popular theme and investors can still earn more from investments than they can from cash in many circumstances. So, for those of us who want to invest for income over the next 12 months, which investment trusts do you think we should be looking at?
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Thomas McMahon: The first thing to say is that if you'd invested in cash when accounts were yielding 4% or so a year ago, you would have done worse than if you'd invested in equities. If you think back to the end of 2022/beginning of 2023, there was a lot of risk aversion in markets. People were very worried about the impact of high inflation. We're expecting a recession any moment. People would have been very tempted to hide out in cash, but you would have done better in equities. So, I think it's important to remember. The outlook for cash is slightly better over the next year. If you take the Bank of England forecasts on interest rates at face value, they don't expect them to decline until the second half of the year. And if you look at market expectation for Consumer Prices Index (CPI), you're maybe looking at a 1% or 2% real return on cash.
I think you can do a lot better than that in equities because if you consider a yield of 4% or so on an investment trust, that's maybe a little bit less than you can get on a cash account. But valuations are so low, I'd expect you to get really good, at least some, price appreciation, which will do better than cash. So, I think people should be thinking about putting their toe back into the water.
There are numerous options. One that’s tried and tested is City of London (LSE:CTY), the largest trust in the sector. Very liquid, has a high yield of 5% or so, has absolutely bullet-proof revenue reserves. And it's been pretty dependable year on year.
But if you wanted something a bit more exciting, there are a number of trusts that invest in the small and mid-cap space where there's really low valuations, so potential for good capital appreciation along with income, perhaps a lower starting yield CT UK Capital and Income Ord (LSE:CTUK) would be an example of quality-growth focused for an income fund. Small and mid-cap focused won't yield as much as City of London but has more growth potential. So, those would be two to look at. But there are many more.
Lee Wild: The average investment trust is at its widest since the global financial crisis. Are there any heavily discounted sectors or individual trusts that catch your eye? And are investment trust boards doing enough in terms of share buybacks to shrink those discounts?
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Thomas McMahon: I think in the last six months, boards have become extremely active in trying to tackle persistent discounts. We've seen a really sharp uptick in corporate activity. So, that could be buybacks, as you mentioned, or it could be more substantial tender offers for 15%, 25% of the shares, or even mergers. We see a number of mergers and there are a few situations where it looks like we might see more.
I think both you and I think it's most likely that we're going to get away with a relatively mild recession, [in which case] a lot of the concern about the valuations of private equity portfolios are going to prove to be mistaken. So that's one reason why discounts of 20%, 30%-plus are appealing. But then there's also some technical factors to do with cost disclosures and regulations. And in the Autumn Statement, the chancellor stated that he was directing the FCA to look at how legislation could be rewritten without going to the boring technicalities.
The upshot is that any change in how fees have to be presented and reported could be really good for investment in some of the ostensibly more expensive sectors like private equity. So, I think that's a really interesting area.
But I think in general I would say that pretty much everything is cheap right now. So, rather than trying to pick the biggest discount and the biggest winner in that sense, this is probably a good time to just be looking at accumulating relative more boring areas. So, if you want to be invested in the UK, actually UK small-caps for the long term, this is a good time to buy. If you want to be invested in technology, you can get a discount and you know you can invest via a discounted foreign investment trust structure. So, I think that's probably how I would be looking about it, it's probably quite a good time to be accumulating across a variety of sectors.
Lee Wild: Thomas McMahon, investment trust research manager, Kepler Trust Intelligence, thanks very much for joining me today.
Thomas McMahon: It's a pleasure.
Lee Wild: And thank you for watching. And make sure you subscribe to the interactive investor YouTube channel.
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