Ian Cowie: cheap for a good reason or badly mispriced bargains?

Our columnist runs the rule over an out-of-favour area, where a seasoned investment trust professional buyer argues the gloom is overdone. 

Rising interest rates, falling house prices and fears of an imminent economic recession have plunged investment trusts focused on British shares into the bargain basement. Average discounts to net asset values (NAVs) have doubled during the last year to levels last seen in 2009.

That prompts this question: are these investment trusts cheap for a good reason or badly mispriced bargains for the brave?

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Seasoned stock-picker Peter Hewitt, who has managed CT Global Managed Portfolio Growth (LSE:CMPG) since 2008, argues that the gloom is overdone and events might surprise on the upside. He explained: “Discounts are at levels not seen since the global financial crisis of 2008 and 2009. Over the past year, the average sector discount has widened from 8% to 16%.”

Turning to individual investment trusts, the top performer in the Association of Investment Companies (AIC) ‘UK All Companies’ sector over the last five years is Schroder UK Mid Cap (LSE:SCP), with a total return of 19% and a current yield of 3.4%. Despite top 10 underlying assets including the cult teenage boys’ toys company Games Workshop (LSE:GAW), the global car dealer Inchcape (LSE:INCH), and the home furnishings retailer Dunelm (LSE:DNLM), this investment trust continues to trade at a 13% discount to its NAV with total assets of £242 million.

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Fidelity Special Values (LSE:FSV) ranks second over the same period, with a total return of 13% and a dividend yield of 2.8%. It is priced at an 8% discount to NAV with total assets of just over £1 billion. Perhaps surprisingly, the largest single holding here is the Swiss pharmaceutical giant Roche (SIX:RO), followed by the British manager of ‘zombie’ insurance funds, Phoenix Group Holdings (LSE:PHNX) and the banks NatWest (LSE:NWG) and Barclays (LSE:BARC).

Ranked third over the last five years, Mercantile (LSE:MRC), demonstrates just how difficult this period has been for British investment trusts with a total return of 8%, albeit somewhat sweetened with a dividend yield of 3.6%. This £2.2 billion giant, with a history that dates back to 1884, includes Dunelm and Inchcape among its top 10 underlying assets which also feature the speciality retailer Watches of Switzerland Group (LSE:WOSG). Meanwhile, MRC remains priced 15% below its NAV.

One explanation for these funds - and most others in the AIC’s ‘UK All Companies’ sector - trading below NAV is disappointing recent returns. Over the last year, Mercantile, which is top of its sector over this period, delivered total returns just under 3.2%; Fidelity Special Values, which ranks second, achieved less than 1.2%; while Schroder UK Mid Cap, which is third, underwhelmed with less than 0.4%. You would need a very special kind of eyesight to spot the Brexit dividends here.

Worse still, looking to the future, an estimated 2.4 million fixed-rate mortgages are due to expire before the end of next year, when higher costs will reduce homebuyers’ ability to spend elsewhere because their old rates were fixed before the Bank of England began raising its base rate from 0.25% in late 2021.

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According to think-tank Resolution Foundation, a total of 4.4 million fixed-rate mortgages will expire before December 2025, hiking these homebuyers’ annual costs by an average of £2,900. Former Bank of England economist David Blanchflower recalled painful memories of market reactions to last year’s budget when he said: “The moron premium is back.”

No wonder many potential homebuyers and stock market investors have decided to delay purchases and wait for lower prices in future. Nationwide, Britain’s biggest building society, reported on Monday that house prices are now falling at their fastest annual rate since 2009.

However, to return to where we began, Hewitt remains upbeat. He said: “The UK stock market has underperformed and while this may continue in the near term, valuations of UK equities are discounting the most pessimistic outcomes and are substantially below long-term averages.

“There is no doubt that patience is required and there is a significant opportunity for positive returns from UK equities.”

Against all that, it is only fair to add that such a long-term view has yet to be rewarded in the short term, with CMPG suffering a 6.6% loss over the last year. It delivered total returns of just 6.1% over the last five years and pays no dividends.

Anyone seeking to emulate Hewitt’s brave optimism should be willing and able to have their patience tested.

Ian Cowie is a freelance contributor and not a direct employee of interactive investor.