The out-of-favour investment trusts that are cheap for a reason

Investors on the lookout for investment trust bargains risk catching the proverbial falling knife. 

Substantial stock market corrections offer brave investors the chance to go bargain-hunting, but the big caveat and trade-off is the risk of catching the proverbial falling knife.

In the case of investment trusts, discounts to net asset value have widened across the board. During the worst of the sell-off, the average discount figure exceeded its widest point since the global financial crisis over a decade ago, reaching 18.4% on 23 March. That compares with an average discount of 17.6% on 31 December 2008.

By the end of March, the average discount had tightened to 11.8%, which goes to show how rapidly discounts can change and how investors need to be alert to potential opportunities.

There are various ways to detect whether a discount looks ‘cheap’. A useful starting point is to assess the discount relative to its historic average and then against the wider sector.

A more mathematical metric private investors can employ is the ‘z-score’ of a trust. This is another way to compare a trust's current discount or premium to its historic level. A positive z-score shows the current value is higher than the mean, while a negative value indicates the opposite. As a rule of thumb, a score of minus 2 or lower suggests the trust is looking cheap, while a positive score of 2 or more suggests it looks expensive.

While widely viewed as a useful metric, the z-score does have its flaws. James Carthew, head of investment company research at QuotedData, points out: “It is a good indication of a significant change in a discount or premium, but because it is an indication of change, a relatively small absolute change on an investment company that was trading close to asset value can show up as more significant than a big absolute change in a wide discount. So z-scores are not, on their own, an indication of an investment company looking cheap or expensive, but they are a good indicator of trusts that might be worth a closer look.”

As an example, data from stockbroker Winterflood at the end March, which highlights the top 25 cheap trusts based on the z-score metric, includes JPMorgan Elect Managed Growth. It makes the list despite its discount move not being dramatic, reaching a 7% discount compared to a 12-month average discount of 2.2%. 

Ultimately, further analysis needs to be carried out when it comes to z-scores and investors need to take a view on whether the trust’s discount is justified or cheap for a good reason.

Based on Winterflood’s z-score list, Carthew urges caution in a number of cases. First, he points out the highest z-score is Fair Oaks Income (discount of -52.2%), which had already announced it would suspend its dividends.

“Fair Oaks Income, alongside Blackstone/GSO Loan Income (-45.5%) and Tetragon (-69.4%),  which are also among the 25 trusts with the highest z-scores, all have exposure to portfolios of loans through structures called CLOs [collateralised loan obligations]. The rules that govern these structures prevent income from being distributed from them when too many of the loans in the portfolio are running into difficulties. Therefore, other trusts may follow Fair Oaks Income by cutting dividends. This is not a problem that is going to be easy to fix and so, for now, I would steer clear of these trusts.”

He adds other specialist trusts with wide discounts strike him as being too risky to be seen as bargains worth pursuing, including Tufton Oceanic Assets (-21.9%) and SME Credit Realisation (-50.4%).

In terms of potential opportunities, Carthew points out that Miton UK Micro Cap’s portfolio was already looking cheap before Covid-19 hit. It is now on a big discount as well, of -27.8%.

He adds: “There are some big unknowns about the long-term impact of the pandemic on the economy and many investors shy away from small companies in periods when the economy is struggling. I think this will recover in time, but it might be a long haul.”

Augmentum Fintech, which invests in fintech start-ups with a focus on businesses disrupting financial services, is also picked out by Carthew. He describes the discount of -43.4% at the end of March as “a bit extreme”.

Carthew says: “It reckons that it has a few companies in its portfolio that are actually benefiting from the current situation. These include Bullion Vault, a beneficiary of the rise in interest in gold, and interactive investor*, which has seen an increase in the number of trades going through its platform. Investors are understandably nervous about early stage companies in the current environment, but Augmentum’s discount does look a bit extreme.”

* Interactive investor is Money Observer’s parent company