How investment trust double-digit discounts can reward bargain hunters

While there is always the risk of catching the proverbial falling knife, one of the structural quirks investment trusts have over funds is the potential to grab a bargain.

This is because investment trusts have two values: the amount the trust itself is worth (the net asset value or NAV), and its share price. When the share price is lower than the NAV per share, the trust trades at a “discount”. When the share price rises above NAV, it is trading at a “premium”, as you are paying more than the assets are worth.

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The ideal scenario is buying an investment trust on a discount and over time seeing that discount narrow or completely vanish, as this will give its share price a boost, even if there is no movement in the underlying NAV. However, the other side of the coin is that the discount could widen, so your shares lose more value than the underlying assets do.

New research from the Association of Investment Companies (AIC) shows that attempting to “buy low” tends to pay off. The research found that investing when the average investment trust discount is more than 10% may lead to significantly better returns over the subsequent five years.

The AIC’s analysis of investment trust returns since 2008 shows that when the average discount exceeded 10%, the average investment trust generated a return of 89.3% over the following five years.

However, when the average discount was less than 5%, the average return was 56.1% over the next five years.

The analysis was based on 128 five-year periods, each ending at a month-end, between June 2008 and January 2024.

Source: theaic.co.uk/Morningstar (ex VCTs). Past performance is not a guide to future performance.

Nick Britton, research director of the AIC, said: “While past returns don’t predict future performance, it makes sense that investing at wider discounts would lead to better returns. Not only are you buying assets on the cheap, but these periods of wider discounts often coincide with lower underlying valuations, giving the potential for a strong recovery when market conditions improve.”

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Where can investors find 10%-plus discounts today?

The discount of the average investment trust is currently 11%, having narrowed from 17% last October, the widest level since the global financial crisis.

When assessing the cheapness of an investment trust two things to consider are the current discount versus its history (such as the 12-month average), and how its discount compares with the wider sector.

In the global sector, Lindsell Train Ord (LSE:LTI) stands out. It is trading on a discount of -22.6% versus -8.7% for its 12-month average. The sector average discount is 10.0%.

For UK equity income, the following investment trusts look cheap on those two measures: BlackRock Income and Growth  (LSE:BRIG), Dunedin Income Growth (LSE:DIG), Lowland (LSE:LWI), Murray Income Trust (LSE:MUT), Schroder Income Growth (LSE:SCF) and Shires Income (LSE:SHRS).

The UK stock market remains unloved by investors, who are instead looking overseas for opportunities and to capitalise on the sizzling share prices of the Magnificent Seven US technology companies. While valuations for UK equities offer investors the opportunity to “buy low”, many investors are waiting on the sidelines for a catalyst that will revive the market’s fortunes.

Source: Winterflood to 8 March 2024.

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Specialist areas also offer some higher-than-usual discounts. However, care needs to taken as some trusts are arguably cheap for a very good reason and there’s the prospect of more pain to come rather than a recovery.

A specialist investment trust favoured by Peter Walls, fund manager of Unicorn Mastertrust, is RTW Biotech Opportunities (LSE:RTW). It is trading on a discount of -31.2% versus its 12-month average of -25.7%. The biotechnology and healthcare sector average discount is -14.6%.

Walls says: “There needs to be a story or a catalyst for a re-rating when an investment trust is trading on a large discount. Otherwise there’s the risk of a lobster-pot situation [with] it being very tricky to get out.” In the case of RTW Biotech Opportunities, the area of the market the trust invests in is enduring its worst-ever bear market, with rising interest rates one of the headwinds. Walls thinks we are at, or close to, the bottom of the biotech bear market, which has prompted him to take advantage of RTW Biotech Opportunities’ large discount. 

Other things to bear in mind with investment trust discounts

While investment trust discounts are an opportunity to buy a basket of investments for less than the sum of their parts, over the long term it is the performance of those underlying investments that has the biggest influence on the overall total shareholder returns. Put simply, if the trust doesn’t perform well, it is likely to consistently have a high discount due to a lack of demand for the shares.

Another important thing to bear in mind with investment trust discounts is that they typically have a greater tendency to converge to their mean discount rather than the value of their underlying investments.

Therefore, it is useful to consider the current discount versus history, and take a view over one, three and five years, for example. It is also worth comparing an investment trust discount with its wider sector.

Bear in mind that some trusts consistently sit in a tight discount range, meaning it is not a “true” bargain and the discount is merely “normal”.

Also be aware that when it comes to investment trust premiums, it is not usually worth paying over the odds. This is because high premiums do not tend to be sustainable over the long term. When conditions change, such as when investors become more cautious, premiums can fall and turn into a discount. When this happens, shareholder returns are negatively impacted.