Interactive Investor

Investment trust bargains: how to find them and where to look in 2023

19th January 2023 11:38

Kyle Caldwell from interactive investor

We explain the tricks of the trade to find potential discount opportunities, and name the three areas where analysts are finding plenty of value in 2023. 

There are various ways to weight the odds of investment success in your favour, including having a diversified portfolio, investing for the long term, and rebalancing a couple of times a year.

Another is to keep a close eye on valuations and seek out undervalued areas of the market. This approach is not for the faint-hearted, as it carries the risk of catching the proverbial falling knife. However, for those prepared to stomach the risk, buying on the cheap can potentially pay off over the long term.

Investment trusts, due to their structure, offer investors the opportunity to go shopping in the sales. And the good news for investors is that this month’s January sales have more discount opportunities than a year ago. Winterflood, the analyst, notes that at the start of 2022 the average investment trust discount stood at just 2.5% compared to 13.3% at the start of this year.

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're paying more than the assets are worth.

In this feature we highlight areas of the market and specific trusts that analysts and professional investors are finding value in on a discount basis.

But before we get to that, we run through some trust tactics to use when sizing up discounts.

Always good to pay less, but performance is the biggest driver of returns

The first thing to point out is that while investment trust discounts offer opportunities 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. To put it simply, if the trust doesn’t perform well it is likely to consistently have a high discount due to a lack of demand for its 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 can turn into a discount. When this happens, shareholder returns are negatively impacted. 

Investors who bought growth capital trusts on high premiums a year ago will have suffered. QuotedData, the analyst, points out that heading into 2021 Schiehallion (LSE:MNTN) and Seraphim Space Investment Trust (LSE:SSIT) had respective premiums of 59% and 20%. At the start of this year, both were trading on discounts of 20% and 57%. Rising interest rates were the trigger for the de-rating in both the discounts and share prices, due to both trusts investing in tomorrow’s potential growth stock winners.

Investment trust discounts: how to size up potential bargains

It is important to bear in mind that there will be a reason why a trust is trading on a discount. This could be related to poor investor sentiment towards the region it invests in, the way in which it invests in terms of investment style being out of favour, or lacklustre short- or long-term performance. Indeed, it could be all those reasons.

As with any investment trading on a cheap valuation it is important to not be seduced solely by discount. Instead, consider the prospects for the investment trust going forwards. If those prospects look bleak, then the discount could widen further, so now may not be a good time to buy.

It is a case of taking a view on whether the prospects for the trust will improve, which could then lower the discount.

Timescale is important. Those investing for the long term – five years or longer – will be buying today in the hope and expectation that the discount will, over time, reduce towards the value of the underlying investments held in the trust – the net asset value (NAV). For such investors it is less of a concern if the discount widens further in the short term, providing that it reduces over a longer time period. However, those with shorter timescales who are looking to make a quick buck from a wide discount narrowing will likely be more irritated if the trust gets even cheaper.

In short, discounts can work in investors’ favour, but it is important to think long term and to be patient. If you buy at the right time, resulting in a high discount falling to a low one, or even moving to a premium, the share price return will be boosted.

Other tricks of the trade

In some cases, large discounts can be a more permanent feature for trusts due to a lack of investor appetite for shares and a lack of share buybacks by the board.

Trusts with a low profile, or those that invest in a specialist area of the market, can also persistently trade at discounts to NAV. Such trusts tend to fly under the radar of many investors. With demand low, these trusts tend to persistently trade on a discount.

One way to gauge whether an investment trust board is willing to tackle its discount is share buybacks. By reducing the number of shares in circulation, there is less of an imbalance between supply and demand. In theory, this will reduce the trust’s discount, benefiting its shareholders as the share price will be given a boost as it narrows towards the value of the trust’s underlying investments.

Some trusts have discount control mechanisms. This is where boards promise to purchase their own shares if the discount exceeds a certain level, such as 10%, in normal market conditions. This can be beneficial for investors as, in theory, the discount will be contained.

Investment trust bargains at the start of 2023  

Following a tough year for most investment trusts in 2022, there’s still plenty of opportunities for investors. One area favoured by those looking for value opportunities is UK smaller companies. This part of the market houses companies that are more domestically focused, so it has been suffering from low investor sentiment towards the UK economy.

While there could be further short-term pain to come – with the UK expected to be in a shallow recession for two years – some fund managers argue that the sell-off in this part of the market has been overdone, with a lot of air kicked out of the tyres ahead of the recession.

Numis, the investment trust analyst, picked out three discount opportunities: Aberforth Smaller Companies (LSE:ASL), BlackRock Smaller Companies (LSE:BRSC) and Henderson Smaller Companies (LSE:HSL). As at 16 January, the respective discounts were 12.8%, 13%, and 11.8%.

Numis said: “We think that the sector is well placed for a recovery and would highlight the strength of the balance sheets of many of the underlying companies compared to previous cycles, while attractive valuations create an opportune breeding ground for M&A.”

Analyst Winterflood favours Mercantile (LSE:MRC), which invests in both mid-cap and small-cap shares. It is trading on a discount of 12.4%.

It said: “Despite Mercantile’s quality growth bias being out of favour in 2022, we believe that the fund is poised to be resilient in the short term and has the firepower to deploy into attractive opportunities.”

Peter Hewitt manager of the CT Global Managed Portfolio Growth (LSE:CMPG), also picked out Mercantile and Henderson Smaller Companies. In a video interview with interactive investor last month, he said as the stock market is forward-looking it has already judged that inflation will cool in 2023. If and when this happens investors will react favourably, snapping up cheap mid-cap and small-cap shares.

Property is another area the pros suggest offers opportunities. High interest rates have negatively impacted property valuations and put pressure on balance sheets due to increases in financing costs. However, James Carthew, head of investment company research at QuotedData, sees value in trusts specialising in logistics.

Carthew says: “The case for these companies is still strong – the shift to e-commerce, and the need to invest in supply chains and bring more manufacturing back to the UK is keeping up pressure on the demand side, while planning constraints help squeeze supply. We think that rents will continue to rise in this sector.

“However, valuation yields are rising (putting downward pressure on valuations) and may rise further. A higher cost of debt is having an impact on values (although the cost of most debt in the sector has been fixed) and on construction activity too.”

Carthew favours Tritax Big Box REIT (LSE:BBOX) and Urban Logistics REIT (LSE:SHED), which have respective discounts of 34.5% and 22.1%. He notes that Tritax Big Box REIT was on a premium of 13.6% in early April 2022, which is another example of how high premiums do not prove to be sustainable.

Carthew is also drawn to abrdn European Logistics Income (LSE:ASLI) and Tritax EuroBox Euro (LSE:BOXE), trading on discounts of 31.2% and 43.9%. He notes that the duo “operate in markets where e-commerce is playing catch-up with places like the UK.”

Winterflood favours Schroder Real Estate Investment Trust (LSE:SREI), on a discount of 37.2%. The analyst notes that it has a “good long-term performance record”, and “in contrast to a number of its peers, it has gradually rebuilt its dividend following a suspension and cut in response to the outbreak of Covid-19 in early 2020”. It adds that the latest quarterly dividend gives a prospective yield of over 7%, which is fully covered by earnings.

Numis also sees discount value in Schroder Real Estate, as well as LXI REIT (LSE:LXI)The analyst also named TR Property (LSE:TRY), which invests in property shares, as offering the potential to benefit from a “double discount”, given many of its underlying listed property holdings trade on wide discounts to their NAVs. The discount is currently 8%, which Numis argues is “an undemanding entry point...providing investors [with] a one-stop shop for exposure to listed property stocks and a manager with a strong track record”. TR Property is also one of Winterflood’s investment trust ideas for 2023.

Private equity is another sector where there’s strong consensus among the experts that bargain opportunities are available. Over the past year, discounts have widened across the sector due to concerns among investors that falls in listed markets are putting downward pressure on valuations for unlisted companies. The predicament that investors face is that NAVs are reported quarterly by private equity trusts, resulting in a timing lag on when the valuations are reported. Therefore, those NAVs potentially do not reflect the reality of what those assets could be sold for today. At the moment, the latest valuations are for the end of September.

However, analysts argue that too much bad news has been priced in, and that the value of investments held in private equity trusts is holding up better than some investors fear.   

Carthew notes that while valuations may be cut “the degree of this is unlikely to be anything like as great as share prices suggest”. He added: “These trusts will be re-rated in time. What is hard to predict is the catalyst for this.” He picked out abrdn Private Equity Opportunities (LSE:APEO), which is on a discount of 41.2%.

Winterflood has tipped HgCapital Trust(LSE:HGT), with a 15.5% discount. It said: “In September 2022, the fund reported £480 million of realisations over the year to date with an average exit uplift to December 2021 valuations of 29%. Therefore, it would seem that the type of businesses held in the portfolio exhibit some degree of resilience in that regard.

“It is this resilience that leads us to recommend HgCapital Trust for 2023. Faced with the prospect of geopolitical instability, economic uncertainty and market volatility, we believe that the ‘boring’ companies in the Hg portfolio have defensive characteristics.”

Numis also favours HgCapital Trust, and highlighted Oakley Capital Investments (LSE:OCI). It says both discounts, currently 15.5% and 34.2%, “more than factor in potential asset value declines”.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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