When investment trust discounts actually spell ‘cheap’

Joe Bauernfreund, who manages the AVI Global Trust Ord (LSE:AGT) portfolio, looks at how to avoid value traps in the investment trust sector. He also tells us why AVI is backing a controversial strategy at the Chrysalis Investments Limited Ord (LSE:CHRY) trust.

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Dave Baxter, senior fund content specialist at interactive investor: Hello, and welcome back to our Insider Interview series. I’m Dave Baxter and joining me today is Joe Bauernfreund, investment manager on the AVI Global Investment Trust. Joe, many thanks for joining me.

Joe Bauernfreund, manager of the AVI Global Investment Trust: Thank you for having me.

Dave Baxter: Let’s start with what the fund actually does. You have a bit of a value focus, a bit of an activist tendency, but take me through the four main areas in which you invest.

Joe Bauernfreund: Yes, so the four areas that we invest in, broadly speaking, are family controlled holding companies. They currently make up somewhere between 30% and 40% of the portfolio.

We invest in other closed-end funds, and that makes up just under 30%.

We’ve got a lot of investments in Japan, and they make up a little bit over 20% right now, and recently we’ve been adding to Korea, which has been a very exciting opportunity for us. We currently have over 15% invested in Korea.

Dave Baxter: You mentioned those family controlled companies. That’s not really an area that many funds focus on. So, what’s the appeal there? How do they differ from other companies?

Joe Bauernfreund: There are a number of features that really appeal to us. First, many of these family controlled holding companies own very high-quality businesses and they invest with a very long-term perspective or horizon. That accords and aligns with our own investment objectives.

Second, they trade very often at wide discounts to their net asset value (NAV). They are inefficiently valued by the market and that’s also appealing to us. We think the market often gets the valuation wrong on these kind of companies because they are quite complex. Oftentimes, the assets that they own are unlisted and so the valuation is less certain. There’s less research, and sometimes there can be less liquidity, and all those features give rise to an inefficiency which we seek to exploit.

Dave Baxter: You recently built this allocation in South Korea, which has clearly been a market doing extremely well. What’s led you there, and what’s the case for focusing on that market still?

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Joe Bauernfreund: Korea has been a cheap market for many years. It’s been very unloved by both domestic investors and foreign investors.

A new president came into power last year on a platform to boost the value of the stock market. Back then, the Kospi was trading at around 2,500, and he proposed that he’d get the value up to 5,000 within a few years. It actually just breached 5,000 last night. Oh, well, intraday.

The reason why he’s so fixated on the stock market is really to do with trying to encourage domestic investors, particularly young investors, to generate wealth for themselves via the stock market, and to remove some of the impediments to investing in the stock market.

Broadly speaking, there were a lot of chaebols [conglomerates]. Very wealthy families that control huge companies on the stock market. They are seen to be running those companies in the interests of the families and not in the interest of minority shareholders. So, as part of the proposals of the president to boost the performance of the stock exchange, he’s introduced a series of measures, a carrot and stick approach.

They’ve borrowed some aspects from the corporate governance reform experience in Japan over the last decade. It’s fair to say that they’ve probably analysed and studied what went on in Japan over the past 10 years and seen the positive results of that.

Examples include proposals to force companies to cancel treasury shares, and to limit the voting of shareholders to 3% regardless of how much they own when it comes to voting for independent directors or independent auditors. Some of the carrots that have been spoken about include some tax advantages to encourage companies to pay higher dividends, which is good for the families but also good for minority shareholders.

Finally, you mentioned that obviously the market has gone up a lot, and how it stacks up today. The really interesting thing about many companies in Korea is the fantastic earnings growth that we are seeing coming through.

There are some large companies. We own Samsung C&T, which is a holding company that owns Samsung Electronics Co Ltd DR (LSE:SMSN) and Samsung Biologics. So, it’s benefited from the very strong performance of Samsung Electronics. But Samsung Electrons continues to have very high prospective earnings growth.

There are other similar family controlled holding companies that give us exposure to other industries that have fantastic growth prospects. One example is HD Hyundai, which is exposed to shipbuilding. They are the leading manufacturer of environmentally friendly LNG carriers, and they are also going to win, we think, a number of US naval shipbuilding contracts, which should provide a strong order backlog and visible earnings growth.

Dave Baxter: It doesn’t sound like you’re tapping into that AI excitement, which has partly been associated with the big rise of Samsung Electronics, but also SK Hynix, which is a stock we all know.

Joe Bauernfreund: We have some exposure via Samsung Electronics. We don’t own SK Hynix currently. But the other attraction of all these companies is they trade on very, very wide discounts. The discounts there are 50%, 60%, or 70% in some cases.

The government’s measures are really designed to encourage ownership of the stock market, but also to encourage companies to do something about their valuations and about shareholder returns.

So, we’ve already seen discounts start to narrow, but when you can find fantastic businesses that are growing rapidly, that aren’t valued excessively, and that are trading at 50% discounts, and you know that the government and the shareholders are going to be doing things in order to narrow that discount, that’s quite an exciting prospect for us.

Dave Baxter: A part of the trust that many of our viewers will be interested in is investment trusts. Discounts there are extremely widespread, but things can go wrong. So, how do you gauge when a investment trust discount is actually an opportunity?

Joe Bauernfreund: That’s a good question. There’s certainly more to it than just simply looking at discounts and saying something is cheap. If you read all the books about investing, we hear about efficient stock markets, and a big feature of what we do is built around the idea that stock markets aren’t always efficient.

In particular, where you’ve got areas of the stock market that are neglected or overlooked by investors, that creates an inefficiency. So, first, if something’s on a discount and if stock markets are efficient, then that discount is there for a good reason. It’s probably a value trap and perhaps that’s a warning to stay away. So, we try and think what’s the market missing and is there an inefficiency there?

For example, in the investment trust space, when you have private equity trusts trading on very wide discounts, there’s obviously a number of factors behind that, but one could be that investors are uncertain as to what the true NAV is.

Yes, the company reports a NAV, but particularly at times of change, perhaps there’s question marks about those discounts. And, if we’re able to build a case around the NAV being more robust perhaps than other investors might imagine it to be, then that’s an inefficiency that we can exploit and take advantage of the discount.

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Dave Baxter: How would you judge that in the private equity space? Are you digging into the underlying holdings and looking at some form of earnings growth, or where do you start?

Joe Bauernfreund: It very much depends on the structure of the trust. Within the private equity space, you have, broadly speaking, two types of investment trusts. You have fund of funds that are very largely diversified, hundreds of different funds, thousands of different underlying companies, and you can’t realistically carry out a valuation exercise.

But there are indications that you can look for the support or challenge the reported NAVs. The biggest example of that comes from the secondaries market, and you can see transactions that occur often for those very same underlying funds. Recently it’s been the case that secondary transactions have been effected at around 5% to 10% discounts perhaps.

So, that lends some support to the official NAVs. If you then find those trusts trading at 30% discounts or, as they were a year or so ago, probably closer to 40%, then there’s an argument that that’s particularly cheap and attractive.

Dave Baxter: For context, secondaries are where private equity have existing assets and then people can buy into them later on?

Joe Bauernfreund: That’s right. Then there are some private equity funds where they have more direct exposure to direct investments, specific companies. Oakley Capital Investments Ord (LSE:OCI) would be an example of that. There, you can build an argument or an investment case around the valuations of specific companies, and we look at both opportunities.

Dave Baxter: You’ve already mentioned Oakley Capital, but I wanted to touch on a couple of other prominent investment trusts in the fund. They’re very different beasts. We’ve got Chrysalis and we’ve got Cordiant Digital Infrastructure Ord (LSE:CORD). What are your general rationales for each?

Joe Bauernfreund: Well, we bought both Chrysalis and Cordiant in early 2024. If you recall, that was shortly after interest rates started going up, growth markets sold off, and there was uncertainty about the valuations of their underlying assets.

In the case of Chrysalis, there’s a lot of exposure to high-growth companies. Klarna Group (NYSE:KLAR) is a big investment, and Starling Bank is another. NAVs fell, discounts widened, investors hated it, and that was interesting to us.

In the case of Cordiant, there was a close peer purportedly or supposedly in a similar digital infrastructure industry, which suffered very sharp declines in valuation that tarnished Cordiant’s case, even though they were very, very different assets. That allowed us to buy in on a very wide discount at a time when other investors were shunning it.

But going back to Chrysalis, it was our argument at the time that shareholders were, or the market was, overly penalising the shares. There were signs that valuations were bottoming out and that the exit market, in terms of corporate activity or potential IPOs, was warming up. The prospect of Chrysalis being able to monetise some of those assets at valuations that were possibly above where they were being carried at that time, seemed realistic to us.

So, we accumulated a large stake. We became the largest shareholder, with roughly 18% of the shares. As you say, it’s been our largest investment for a while now. What we’ve seen is that they have been able to monetise some assets. Klarna, I guess, is a case in point. There’s talk about potential corporate activity at Starling Bank.

At the same time, the board have committed to returning capital, as and when capital is received from disposals, which we think is very much the right thing to do.

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Dave Baxter: Interestingly, Chrysalis has decided that it’s going to make no new investments for a while. It’s going to focus on maximising value from its existing investments and returning capital to shareholders. How do you deal with that criticism from some investors that it’s a missed opportunity, that the trust [and] its holdings have further to run, and that we should really stick to our guns?

Joe Bauernfreund: Well, very simply the shares are trading at a 30% discount more or less today. What that means is if they were to receive cash of £1 when they sell an asset and they were to reinvest it, the market would immediately value that at 70 pence. So, immediately suffering a discount, which is not good for shareholders.

Second, if they were to take that £1 and buy those shares on a 30% discount, that would generate an immediate uplift to NAV by having bought shares at a 30% discount.

So, I think from both sides of the argument, there’s a very compelling case to be made to return that capital to shareholders rather than make new investments.

Dave Baxter: What’s been your latest investment trust buy? And in terms of sectors, where are you eyeing up there?

Joe Bauernfreund: Within the investment trust space, we haven’t made any new investments in the last year. We’ve added to several of our existing investments. It was probably 2024 when we invested in Cordiant and Chrysalis, and it was the last time that we made big investments in the investment trust space.

Dave Baxter: Joe, many thanks for your time.

Joe Bauernfreund: Thank you.

Dave Baxter: And thank you for watching. Do let us know what you think about this in the comments. If you are a fan of this series, do hit the like button and the subscribe button. Thanks and take care.