Faith Glasgow takes a deep dive into explaining how investment trusts seek to reduce discounts through share buybacks, examining whether this tactic works.
Share buybacks are used by investment trust boards to reduce the number of shares in circulation, as a mechanism for controlling the trust's share price discount to net asset value (NAV). In theory, buying back shares should help to adjust the disparity between supply and demand, thereby pushing the share price up, improving investor sentiment and reducing the discount.
But how far does that work in practice? The experience of some investment trusts during the market turmoil of 2022 might suggest it’s not terribly successful.
Buybacks on the rise, but not a panacea for containing discounts
A recent report by broker Numis notes that buybacks were last year up by 39% compared with 2021, as the average investment trust discount widened from around 2% at the start of the year to around 16% by mid-October. By that time, more than 60% of trusts were trading on a discount of more than 10% – double the percentage at the end of 2021.
Buyback activity was dominated by large equity funds – particularly growth-oriented global trusts, which had a horrible time as inflation and interest rates rose and investor sentiment turned against them.
“Growth-focused investment companies including Scottish Mortgage (LSE:SMT) and Monks (LSE:MNKS) were among the largest re-purchasers,” the report says. Scottish Mortgage bought back £231 million of shares, while Monks repurchased £199 million.
Nonetheless, both Baillie Gifford-managed trusts have seen their discounts remain persistently wide, reflecting the extent to which the growth style has fallen out of favour. Scottish Mortgage shares are down more than 50% since their peak in November 2021, and the discount is 21.6%; while Monks’ share price remains almost a third down since the end of 2021. It trades on a -13% discount.
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Numis reports that a number of other large equity trusts with ‘fixed’ discount control mechanisms also instigated substantial buybacks last year, including Witan (LSE:WTAN), Alliance Trust (LSE:ATST), F&C (LSE:FCIT), Smithson (LSE:SSON) and Finsbury Growth & Income (LSE:FGT).
Additionally, buybacks increased among trusts investing in less liquid assets, including private equity and property, despite the balance sheet and cash flow constraints.
Numis sees them as a “useful tool” in this context. “We believe boards should set realistic expectations, particularly that buybacks are unlikely to ‘march-in’ a discount, but can help limit discount volatility, improve liquidity and spreads, as well as giving confidence in the NAV and demonstrating a focus on shareholder returns,” the broker comments.
Yet share buybacks attract plenty of critical comment. The question is whether they actually deliver for investors in practice, and how well-founded the various criticisms levelled against them are.
Do buybacks add value?
In general, investment trust analysts seem to regard buybacks as a positive for private investors. Pascal Dowling, a partner at broker Kepler Partners, observes that the fact that directors have the ability to repurchase shares and move discounts should be a reassurance to shareholders that they have some control over a trust’s fortunes.
“The job of the board of directors is to represents shareholders’ interests, and buybacks are a useful tool in their arsenal, allowing them to provide an exit for shareholders who want to sell their holdings and to protect those who want to remain invested from excessive discount volatility. They are of definite value to investors if used wisely,” he argues.
Moreover, as James Carthew, head of investment companies at QuotedData, points out, if a board commits to buying back shares, “it can be a good indication that it feels the shares are too cheap and it is determined to do something about that, which is also an indicator that it believes in the accuracy of the NAV – both of which should be good for sentiment”.
However, Dowling points out that buybacks won’t prevent discounts widening if there is just no demand for the shares, as was the case for growth trusts last year. They can’t fix wholesale negative sector sentiment.
One interpretation of a board’s involvement in the fortunes of a trust through its use of buybacks is that they indicate a lack of faith in the capacity of the manager to do a decent job of choosing robust investments that will grow to reduce the discount organically.
Dowling rejects that argument, pointing out that share prices can be influenced by numerous external factors that don’t necessarily have anything to do with the fund manager’s investment decisions. At a macro level that could be, for instance, war or a pandemic; at a micro level it might be a forced sale of shares driving the share price down when the underlying assets are doing well.
“Where there is an external reason for downward pressure on the trust’s share price, buybacks allow the board to buy the shares back from investors who want an exit and hold them on treasury, from where they can be reissued to new investors when the demand is there for them,” he comments.
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Against that, boards often argue that there is a choice between buying back shares at a discount and using that capital for new investments, says Carthew. If a board decides to use the money for buyback in certain situations, rather than giving the manager the opportunity to invest, that could be read as concern about their stock-picking ability.
He gives an example: “There will definitely be times when preserving capital to make new investments will result in a better outcome for investors – at times of market panic, for example.
“A decision to opt for share buybacks instead at that point might reflect a lack of attractive investment opportunities, and at the margin, that could be construed as a lack of faith in the manager to identify those opportunities. But the remedy for that is to sack the manager, not to shrink the fund by buying back shares.”
Timing the market?
There’s also an argument that boards are looking to try and time the markets when they buy shares back, aiming to pick them up when markets are down and re-sell them when sentiment is strengthening and prices are rising.
Certainly, some boards set formal or informal discount ‘trigger levels’, so they will consider initiating a buyback when the trust’s discount widens to, say, -10%. So timing the market, or timing generally, is to some extent intrinsic to the whole process, given that the purpose of share buybacks is to help counter negative sentiment.
But as Dowling explains, while boards do need to be very aware of market sentiment as a context against which to consider buybacks, they are not setting out to “buy cheap and sell dear”.
“During very severe corrections, such as the great financial crisis or the pandemic, it doesn’t actually matter what level the market or NAV are in absolute terms when shares are bought back,” he says. “It is the share price relative to the NAV - the discount – that makes the difference. So in that sense the board is ‘timing the market’ but in terms of sentiment by acting when sentiment is against the trust or asset class.”
Share buybacks may be able to influence discounts, but in the process they increase costs for investors. That’s because when the number of shares in issue is reduced, the fixed costs of running the trust have to be spread across a smaller number of shares – although Dowling says this is likely to be pretty minimal unless the board engages in a lot of buyback activity over time.
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For trusts that use gearing (borrow to invest), reducing the size of the share base also means borrowing per share is increased. Additionally, there are transaction costs, although these can be offset against the ‘gains’ involved in repurchasing the shares at a discount.
“One might argue there is also the opportunity cost of buying shares back when the cash could have been deployed into other investments that could have delivered compounded returns in the future,” Dowling adds.
Dial down discount volatility
Do share buybacks actually work as a means of controlling discounts? While Carthew makes the point that because investment trusts operate with a fixed pool of capital - and indeed typically tend to over the long term outperform equivalent open-ended funds because of it – it is not necessarily realistic to expect discounts to be eliminated.
Some investment trusts, including Capital Gearing (LSE:CGT), have zero discount control mechanisms, meaning the share price and the NAV is as close as they can be all the time.
Carthew notes: “Only investment trusts with highly liquid portfolios can contemplate zero discount control mechanisms. However, I think boards should aim to moderate discount volatility using them.”
But Andrew McHattie, author of Investment Trusts – A Complete Guide, says it is not clear whether they do actually achieve much over a prolonged period.
“Academic studies seem to suggest mixed results...that share buybacks may work as a signalling mechanism to the market that the trust considers its rating to be unacceptable, but often their impact is short term and the market reverts to its prior position as sentiment and the assessment of future returns regain prime importance.”
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