How to spot cheap investment trusts

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The yields and discounts on investment trusts can look appealing but there’s lots to weigh up. Dave Baxter asks Winterflood’s Emma Bird what we should consider first.

0:51 - Where investment trust discounts are now

2:50 - Which sectors look cheap

4:59 - What to look at with a “cheap” trust

6:19 - What traits might make a trust look attractive

7:57 - One trust that stands out

10:25 - How to monitor an oversold trust

11:36 - Another “cheap” trust

13:04 - Other things to watch – and another trust

14:53 - What makes a dividend sustainable?

16:14 - The risks of buying discounted trusts

17:48 - Will the discount stay wider for longer?

20:26 - How to recognise a bad investment

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Dave Baxter, senior fund content specialist at interactive investor: As investors, we love to grab a potential bargain, and those are seemingly rife in the investment trust space. 

There are many, many instances where the shares in the trust trade at well below the stated total value of the underlying portfolio. These so-called discounts, in theory, offer you a cheap way into the fund. 

But there are some important things to understand. It’s important to understand how to assess a discount, what might drive a discount, and also the potential pitfalls that come with this form of bargain hunting.

So, welcome back to On The Money, the show where we look to unpick the issues affecting your savings and your investments. I’m Dave Baxter, the senior fund and content specialist here at ii, and today I’m joined by Emma Bird, head of investment trust research at Winterflood. Emma, thanks for coming in.

Emma Bird, head of investment trust research at Winterflood: Thank you for having me.

Dave Baxter: So, let’s kick off with the context. Investment trusts trading on discounts is certainly not a new thing. I would argue it’s a structural feature of the sector. But those discounts have blown out since, what, late 2021, 2022? So, we’ve moved on a lot since then.

We have seen a bit of a recovery for share prices in the sector. This is a bit of a broad one, but where are discounts standing now? What are the kind of levels versus recent years?

Emma Bird: Yes, sure. To put it in a historical context, for a number of years, from 2014 to 2021, the weighted average discount of the investment trust sector was pretty consistently narrower than 5%, other than a few relatively short periods of widening around Brexit and Covid.

But generally, it had stayed pretty narrow, in narrow single digits until the end of 2021, as you mentioned. So, then the sector average discount widened significantly and quite sharply from just 2% at the end of 2021 to a low point of 18% in October 2023. This was primarily driven by the changing inflationary and interest rate environment over that period, where sentiment towards rate-sensitive asset classes really deteriorated and the investment trust sector has quite a lot of exposure to these types of assets, like growth stocks or alternative assets such as infrastructure, property, and private equity.

So, we saw a real sharp derating of discounts. But as you say, they have narrowed somewhat since then. We’ve seen some derating to an average discount of around 11% at the moment. So, definitely an improvement of where we were a few years ago, but still reasonably wide in a longer-term historical context.

Dave Baxter: We’ll get on to how to assess the discounts in a minute, but it might be interesting to just add on to that point. On a sector basis, where are the discounts looking wider? Obviously, are some where they just still look enormous, although there may be reasons for that.

Emma Bird: Yes, so those would be the sectors that are highlighted, still the interest rate-sensitive asset classes, particularly alternative assets like infrastructure, in particular renewable energy infrastructure, property and private equity.

And there are, obviously, some valid reasons for this. Interest rates are still high. So, the reason that the discounts widened in this higher interest rate environment was because investors were concerned that this new environment would negatively impact the underlying valuations of the funds, so it hit the net asset values (NAVs), and because these types of funds only produce NAVs irregularly and on a delayed basis, the share price reacted before the NAV and somewhat more extremely, so that caused the discounts to widen.

There was potentially also, in certain cases, some scepticism about the accuracy of those NAVs as well and, actually, at the valuations that are being published, could you really achieve that if you were to try and sell the assets?

In terms of infrastructure, particularly renewable energy infrastructure and property, a lot of investors were also owning those investment trusts for income, for the yields that they were delivering. And once market interest rates, so gilt yields, started to rise, these dividend yields offered by the investment trusts looked comparatively less attractive. So, the share prices fell in order to adjust that yield upwards on the trusts to maintain that differential above gilt yields, which are typically viewed as safer assets.

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Dave Baxter: Yeah, yeah, risk free. Although maybe they’ve proved less than that in recent years. As you mentioned, the direction of interest rates has had a massive effect on things. But, say, you look at renewable energy infrastructure as one example, are there other big factors that investors should weigh up when they’re trying to assess whether there might be recovery down the line? What are the big things to bear in mind?

Emma Bird: Yeah, so there’s many things that you should look at, not just investing on the basis of the discount at a point in time.

You need to fully understand the underlying strategy and the assets that it holds, particularly in these alternative asset classes like renewable energy infrastructure and the different factors that can impact the valuations as well as the income. So, things like regulatory developments, how diversified is the portfolio, is it only exposed to maybe one type of renewable energy where a change in, say, wind speeds can impact their revenues or valuations.

A thing that’s become more important across the entire investment trust sector in recent years is discount control mechanisms. Is the independent board doing things? Do they have policies in place to mitigate the downside discount risk from these current levels?

Dave Baxter: As you mentioned, a very good point, a discount alone is not a reason to buy and there’s so much more you need to consider. Are there combinations of metrics and traits that would make a trust look attractive? For example, maybe some things are on a discount, but the actual share price has been doing well.

Emma Bird: Yes. So things to look at, as I said, not just a discount on its own, but you can view the current discount in the context of history, so you can look at the current discount relative to its 12-month or five-year average, or look at it if there’s been similar market environments in the past. How has the discount reacted then, has it narrowed?

One metric that we can look at is what’s called a Z score. That shows how many standard deviations the current discount is away from the 12-month average. So, a big negative number implies that the discount could be cheap relative to history, whereas a large positive number would imply that it’s maybe expensive.

Also looking at the discount relative to peers, is the entire sector trading on a big discount because the asset class is out of favour, potentially for good or valid reasons, or does this individual investment trust maybe offer a bit of an anomalous wide discount and an attractive entry point?

Dave Baxter: Yeah, yeah, interesting. Let’s come on to some names then. First, I will shower the viewers and listeners with some caveats. This isn’t any form of advice, and we’re just highlighting some names that display some of these traits. That’s a beginning point for own research rather than anything definitive. But, yeah, with that caveat, or many caveats, what names have you seen to be standing out in terms of being discounted, but also potentially having some positive traits?

Emma Bird: So, I looked at this by sorting the entire investment trust universe by Z score to give an idea of what things were looking cheap. I think that does feed well into my point that I made earlier, because a lot of those did flag out as ones that were cheap for a reason, so not ones that I would highlight, but one that did stand out was a trust called HgCapital Trust Ord (LSE:HGT) or HGT.

That’s a private equity fund that invests in private software businesses and the share price was hit particularly hard earlier this year around the general software sell-off over concerns that AI would negatively impact these business models. 

So, that investment trust is currently trading on a 32% discount as of May 27 versus a one-year average of 15%. So, its Z score was -2.1 and the five-year average is just 11%, so it’s trading significantly wider than history.

Obviously, there are some reasons for that, that we understand, so there’s negative sentiment, but we think the portfolio is actually quite well placed. The companies that they invest in focus on really business-critical software, like accountancy that we think are going to be some of the last to be disrupted by AI, so we think the current discount offers potentially a good entry point, and if sentiment improves or the businesses can prove themselves to continue to be delivering and profitable, then we could see sentiment improve and see that discount narrow.

Dave Baxter: Before we move on to other names, say you went into HgCapital, as you mentioned that discount is very wide at the minute, but there’s perhaps a lot of debate about whether it is an AI victim or still an AI beneficiary or something in between. 

Going forward, how would you monitor whether that recovery is playing out? What would you be looking for when it has its trading updates and that kind of thing?

Emma Bird: Yes, I’d be looking at what HgCapital is saying about the underlying companies, particularly what are their revenues doing? How are they themselves utilising AI, and how is that feeding into profitability? I’d also consider whether they are looking potentially at other investments. Do they view this as a wider opportunity? Are they using the negative sentiment to acquire new businesses at potentially discounted valuations to help with future prospects?

Dave Baxter: Interesting. What other names have been standing out?

Emma Bird: Another one that flagged as reasonably cheap on a Z score basis was the The European Smaller Companies Trust PLC (LSE:ESCT).It invests in a diversified portfolio of quoted continental European small and mid-cap stocks. That’s currently trading on a 10% discount relative to a one-year average of 8%, so it’s a score of -1.4. 

So, it doesn’t sound quite as amazingly attractive as HTT, but what is interesting about this one is that it’s recently implemented a new formal discount control policy where the board will use buybacks to aim to limit the discount to mid-single digits, so obviously tighter than the current 10%. 

We have seen the board being pretty active at buying back to help mitigate that discount volatility. It’s also recently introduced an enhanced dividend policy, so aiming to pay out at least 5% of the previous year-end NAV as a dividend to shareholders, so that offers an additional attraction to the fund.

We have also seen instances from other funds that have introduced this kind of policy and that’s helped encourage more demand for the shares and helped the discount as well. I think there’s some tailwinds for that discount to narrow.

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Dave Baxter: Anything else?

Emma Bird: The other thing I’d highlight is, as well as just looking at discounts, another form of identifying value is by looking at the dividend yield. Obviously, the lower the share price, the higher the yield for the same amount of dividend payout. 

So, just one more that I’d highlight, when filtering the universe by yield the one that stood out was Foresight Environmental Infra Ord (LSE:FGEN). So, back in that renewable energy infrastructure space that we were talking about earlier.

This fund invests in a very diversified portfolio of renewable energy infrastructure assets, private assets, so from solar farms and wind farms to energy storage and lots of others. That is currently offering a 10% dividend yield, and it also recently announced an increase in its target dividend for the current financial year, so it has a prospective yield of even more at 10.2% and it’s trading on a 25% discount to its latest NAV. 

So, we think that that yield is attractive, particularly given that the dividend was fully covered by earnings in the last financial year, and it’s forecast to be comfortably fully covered in the next financial year as well, and we don’t see any key risks to that cover. There’s no key financing risks or things like that that we’ve seen in the past, and the diversification helps with that revenue security and limits the volatility in the valuation as well.

Dave Baxter: You’ve already mentioned a very good one with the dividend cover, but are there other things you would look for when trying to gauge whether the dividend is sustainable? Because it’s interesting you picked a renewable energy name because we have seen a few of those cut their dividends in recent months.

Emma Bird: Yes. So, when looking at yields, it is key to determine whether you think that is sustainable. So, dividend cover is a key one. Is it fully covered by earnings?

If there potentially is going to be a shortfall, something else that investment trusts in particular can use is revenue reserves. So, are there sufficient revenue reserves to cover any shortfall in revenue that might occur as a short-term strategy? And are there any upcoming risks to the revenue? So, are there any upcoming refinancings that might lead to a large increase in debt costs that would impact revenue or other things like that.

Dave Baxter: Yep. I should add also that we’re discussing these measures for the DIY investor. A lot of those are available via sites like the Association of Investment Companies (AIC) and so on, so you can go and check revenue reserves or discounts versus peers and that kind of thing.

It’s interesting that you mentioned The European Smaller Companies Trust because some people may know that it was one of the original Saba targets, however long ago now, and it was just making me think that there are potential risks or at least inconveniences that we need to bear in mind when you have a big discount.

One being that an activist may come in, which you might regard as a positive, to be fair. But I was interested on your thoughts and on what potential forms of disruption or setbacks investors might have if they’re constantly going into these trusts on double-digit discounts.

Emma Bird: Yeah. Activist investors is a key one, particularly in recent years, we’ve seen a lot more of that in the investment trust sector. As you said, sometimes this can be a positive thing, it can help to encourage boards to narrow the discount or do other things to promote improved performance for shareholders.

Or sustained wide discounts can indicate that there is a structural lack of demand, so that could encourage boards to undertake a strategic review, which could lead to a change of manager, or potentially change of strategy, or managed wind-down, particularly for illiquid assets that can be a drawn-out process, where the ultimate value you get is uncertain.

So, yeah, there are risks in just investing in deeply discounted trusts.

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Dave Baxter: Are there any factors to bear in mind that might mean that discount stays wide for longer? One I can think of, for example, is you do have cases where investment managers, in particular, own a lot of the trust already, so maybe there’s actually less liquidity in the shares and it’s quite hard to shrink it.

Emma Bird: Yes, so there are definitely a few cases in this sector where there are large, either family shareholdings or manager shareholdings, which means that the amount of shares that are traded regularly is pretty small, so that really harms overall liquidity, as well as constraining the ability of the board to conduct buybacks. This is because buying back shares from the other shareholders would increase these large shareholdings even further, so that can constrain them there.

So, that can mean that the discount stays wide for those two reasons, as well as sometimes raising questions over corporate governance with one large shareholder who has control of the vote. 

An example I can think of is within the reasonably small biotechnology and healthcare sector. There’s one trust called Syncona Ord (LSE:SYNC) and that’s trading on a 45% discount at the moment. But there are maybe reasons why that’s actually not as good a value opportunity as something else in the sector, like Worldwide Healthcare Ord (LSE:WWH) Trust, which is only at a 7% discount.

But that potentially offers better value because the board there has a target to buy back shares at wider than 6% and try to maintain the discount there. So actually, there seems to be maybe more of a catalyst for that to re-rate rather than Syncona, which is on a 45% discount, but that has a very large shareholder, which has constrained liquidity. It’s also undergoing a bit of a strategy change, there’s some uncertainty over the future, it’s saying it’s considering selling some of its assets at a discount to carrying value, so, yeah.

Dave Baxter: Yeah, and it was going to be in wind-down and then it wasn’t in a wind-down? It’s a bit confusing.

Emma Bird: Yes, I think it entered wind-down and then it almost reversed it, but it is still going to return some capital. There’s definitely some questions about how much of the portfolio could be realised there.

Dave Baxter: And, finally, we’ve sort of touched on some of these issues, but a big discount or a very high yield could actually be a red flag. Are there ways of assessing that or confirming that? I mean, perhaps it’s a disastrous set of results or something like that?

Emma Bird: I think the key thing is to understand what’s going on under the bonnet. So, yes, not just taking a wide discount as a great bargain, but understanding whether there are reasons for it, rather than just looking at the numbers.

So, doing your research into what the fund does. Have there been any recent announcements to do with strategy, are there corporate governance concerns, are there activist investors or large shareholdings? I think it’s just doing as much research as you can.

Dave Baxter: Yeah, yeah. Well thanks for your time.

Emma Bird: Thank you very much.

Dave Baxter: And thank you for watching and for listening. Do let us know what you think. You can actually email us directly at: OTM@ii.co.uk.

Let us know your thoughts and some potential ideas for future episodes too. Hopefully, you enjoyed this one. Catch you next time.