There are various ways to improve the odds of investment success, including having a diversified portfolio, investing over the long term, and rebalancing a couple of times a year.
Another one 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. At the end of 2023, the average investment trust discount stood at 9%.
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.
In this article, we highlight areas of the market and specific trusts that analysts and professional investors are finding value in on a discount basis.
But first, we run through some considerations when sizing up discounts.
Always good to pay less, but performance is the biggest driver of returns
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.
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Investment trust discounts: how to size up potential bargains
It is important to remember 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, or the trust’s 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 the 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 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 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 from 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’s 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. A recent feature named the investment trust boards that had been the most proactive in making share buybacks in 2023.
Also be mindful of the fact that 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 2024
Over the past couple of months investment trust discounts have narrowed from record high levels. The average discount started 2023 at 11.7% and hit a post-2008 trough of 16.9% at the end of October before recovering to 9.0% on 31 December. The discount decline was due to a strong end to the year for various trusts – particularly those investing in alternative assets. The rally was fuelled by expectations that interest rate cuts will take place in 2024.
However, there’s still plenty of opportunities for investment trust fans, with analysts highlighting two areas in particular: UK smaller companies and alternative assets.
Both have been out of favour in the rising interest rate environment. As UK smaller companies are more volatile than larger companies, this area of the market suffers when investors become more cautious and reduce risk, which has played out as interest rates have risen.
Moreover, as this part of the market houses companies that are more domestically focused, it has been suffering from poor investor sentiment towards the UK economy.
While there could be further short-term pain to come – with the delayed recession possibly materialising in 2024 – 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.
But a big catalyst for reviving the fortunes of this part of the market could be the peaking of the interest rate cycle. The consensus is that the next move for UK interest rates is down, due to inflation cooling. Prices rose by 3.9% in the 12-month period to November, down from 4.6% in October, and 10.1% in January 2023.
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Winterflood, the investment trust analyst, points out that further declines in inflation and interest rate cuts are catalysts that could lead to a re-rating for UK smaller company-focused investment trusts.
According to Winterflood, the fixed amount of shares issued under the investment trust structure, means that smaller company trusts are not exposed to the potential liquidity risk faced by funds, where managers can, at times, be forced to reduce or sell holdings to meet investor redemptions.
It adds: “If one or more catalysts emerge, increased recognition by investors that UK small-cap investment trusts are structurally most suitable to effectively navigate the liquidity issues, should provide the potential for a re-rating of the funds themselves, alongside increases in underlying valuations.”
Its two favoured plays for the sector are JPMorgan UK Smaller Companies (LSE:JMI) and Odyssean Investment Trust (LSE:OIT), although the latter is currently (as at 9 January the time of writing and sourced from Winterflood) trading on a small premium of 2.6%, so does not present a discount opportunity.
JPMorgan UK Smaller Companies will pique the interest more from a discount perspective. Its discount is -10.3%, slightly lower than its 12-month discount average of -12.4%.
Georgina Brittain, manager of JPMorgan UK Smaller Companies, explained in a recent interview with interactive investor that her approach is to find attractively valued, high-quality companies that have positive momentum.
James Carthew, head of investment companies at QuotedData, says fund managers of UK equity funds are in agreement that UK equities look cheap relative to peers, particularly US stocks.
Within that, he notes that smaller companies look cheaper than large ones and appear cheap relative to history.
He adds: “There is a good argument that the outcome of the next general election is a foregone conclusion and therefore already priced into the market. UK growth seems anaemic, but a severe recession seems unlikely. Inflation is still above target, but further interest rate rises are unlikely, and a rate cut or two is likely in 2024. In general then, the UK market may pick up in 2024.”
Jonathan Davis, editor of the annual Investment Trusts Handbook, picks out Henderson Smaller Companies (LSE:HSL) and Aberforth Smaller Companies (LSE:ASL) as potential opportunities. The respective discounts are -10.2% and -11.6%, slightly narrower than their 12-month averages of -12.4% and -12.8%.
Henderson Smaller Companies is one of interactive investor’s Super 60 investment ideas and managed by experienced stock picker Neil Hermon. The investment approach is focused on identifying quality growth companies and holding them over the long term.
Aberforth Smaller Companies adopts a value approach. This trust has also been tipped by Kepler Trust Intelligence. Investment trust analyst Thomas McMahon said the trust “stands out given the value opportunity” due to how cheap the companies held in the trust have become.
Speaking on our On The Money podcast last month, Davis pointed out that now is a great time to take advantage of investment trust discount opportunities.
“It has been a very bad time to be an investment trust investor in relative terms as the last two years have seen this dramatic de-rating. But it is [now] a very good time to become an investment trust investor because of these discounts, which are offering very attractive opportunities.”
Charlotte Cuthbertson, a fund manager at Asset Value Investors and co-manager of MIGO Opportunities Trust (LSE:MIGO), picks out River and Mercantile UK Micro Cap (LSE:RMMC), offering a -18.7% discount versus an average of -17.1% over the past year.
“This is what we call a Russian doll discount, as there’s a discount on a discount on a discount. The first layer is that the UK market is lowly rated versus both its own history and international peers. The second part is that micro-cap stocks have even lower valuation ratings that smaller companies. And the third element is that the trust is trading on a discount itself.”
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As well as picking out UK smaller companies trusts as one area that “looks attractive as they are on very decent discounts”, Davis is also attracted to renewable infrastructure trusts. He highlighted Greencoat UK Wind (LSE:UKW) as a potential opportunity, trading on a discount of -11.3% versus -11% for its 12-month average.
Carthew agrees that this sector stands out for bargain opportunities having been out of favour as interest rates rose. He says investors “could almost throw a dart at the sector and come up with a bargain”.
In particular, alternative asset trusts that pay an income have been out in the cold. This is due to the higher level of income investors can obtain through lower-risk assets, with cash and government bonds with short lifespans offering yields of around 5%. Such a backdrop reduces the appeal of trying to obtain bigger returns for a higher amount of risk.
However, now that the interest rate cycle has potentially peaked, alternative asset trusts could see their fortunes change for the better as bond yields fall in value as and when rates are cut.
Carthew adds: “High yields, growing dividends that are often well-covered by cash earnings, and predictable revenues with inflation linkages all add up to an attractive cocktail. Solid, well-established funds on attractive yields/discounts include NextEnergy Solar (LSE:NESF), Foresight Solar (LSE:FSFL), Bluefield Solar Income Fund (LSE:BSIF), and JLEN Environmental Assets Group LSE:JLEN), offering discounts of -16.9%, -15.3%, -12.8% and -15.7%.
“Of the battery funds, we really like Gore Street Energy Storage, on a discount of -21.7% – although its share price is now well off the bottom.”
Cuthbertson favours Ecofin Global Utilities & Infrastructure (LSE:EGL) and Atrato Onsite Energy (LSE:ROOF), offering discounts of -12.5% and -22.1% respectively. Both are higher than the 12-month average discount figures of -6.3% and -18.3%.
She adds: “The rise in interest rates and bond yields undermined the income that alternative asset trusts were offering. This area suddenly became friendless, which drove discounts wider and wider.
“While we are not returning to the days of historically low rates, the prospect of interest rate cuts in 2024 will take some of the pressure off alternative assets as this will cause bond yields to fall.”
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