Darkest before the dawn?

It has been a difficult period for investors in investment trusts over the last year and more – discounts have widened markedly, in some cases significantly so, as share prices have increasingly trailed net asset values (NAV). Investors have been selling and many holders are understandably nervous as to whether discounts will widen further. Yet, for various reasons, we may be approaching a point where discounts gradually turn a corner. The omens look promising. If true, there are some attractive opportunities at present for the patient investor.

Difficult times

To suggest recent times have been challenging is perhaps an understatement. Over 2022, the total return was 0.34% for the FTSE ALL-Share index, -7.83% for the MSCI World (£) index and -16.57% for the investment trust Closed-Ended Index. This year has not started well either. Returns for the first quarter to 31 March are 3.08%, 4.81% and -1.43% respectively. In other words, over 15 months, while the UK market is up 3.4% and overseas markets are down 3.4%, the investment trust index has fallen 17.8%.

To a certain extent, this becomes self-fulfilling. Sentiment has not been helped by the poor performance of some high-profile companies – particularly those pursuing a growth focus such as Scottish Mortgage Trust (SMT), which is a FTSE 100 company. Meanwhile, those focused on smaller companies have underperformed, rising interest and discount rates have undermined many alternative assets (especially those focused on income), while private equity investors have thrown in the towel.

The markets themselves will continue to be volatile as investors adjust to the new landscape of higher inflation and lower growth than consensus forecasts suggest, allied to the continuing shift in style towards ‘value’ investments. The transition to ‘sound’ money from ‘free’ money was never going to be smooth. This is an inflection point and market volatility in part acknowledges this adjustment. However, while such volatility may continue, investment trust discounts are currently too high.

There are nuances regarding this issue. An evolving shareholder base is one factor. The idea that investment trusts are the City’s best kept secret is perhaps no longer true. The growing presence of the retail investor at the expence of institutions is welcome, something many of us including the AIC (the sector’s respected trade body) have campaigned for. But some investors are tempted to sell when waters are choppy and buy when calm – current discounts may in part reflect this phenomenon, a factor to be considered going forward.

This and global events notwithstanding, experience suggests we are reaching a level where a lot of bad news is in the price. Whisper it quietly but, with some exceptions, in general NAV performance has been sound relative to indices – with many notable outperformers. Yet, courtesy of poor share price performance, the average discount has drifted out to 15.4% and this widening has often been indiscriminate. Therein lies the opportunity for long-term investors willing to ride out any further volatility.

Meanwhile, some perspective is important. An average discount of 15% is attractive and stands at the higher end of certainly its recent range. By way of context, discounts were a touch wider in the autumn, briefly reached 20% during March 2020 at a time of severe market stress, and yet were at minimal levels at the end of 2021. The current level leaves little to trust and is harsh given asset performance. Yet the sector has been here before and prevailed because of its inherent strengths.

We should remember that investment trusts possess an inherent advantage over the more commonly used funds known as unit trusts. The former is ‘closed-ended’ (like M&S and Shell, no new shares can be created by investors) and so the share price is traded and not the assets. The latter are ‘open-ended’ and so the assets are traded and not the share price. Investment trust discounts, reflecting the disconnect between price and NAV, can change depending on investor demand. Trusts can also borrow money to invest in their portfolios.

Such structural advantages allow managers in general to invest over the long term, not worried about the flow of redemptions forcing them to sell as with unit trusts, which is usually the sounder approach to the markets. Furthermore, this means investment trusts are better suited to certain illiquid investments like small companies, commercial property, infrastructure, private equity and renewable energy – assets which best flourish if given sufficient time. Meanwhile, the ability to ‘gear’ a portfolio helps in rising markets.

These structural advantages in large part account for investment trusts’ proud track record of outperformance not only of unit trusts – even when they share the same manager – but also of the various indices, over most time frames. Performance is also helped by the fact trusts tend to be cheaper than their counterparts and because scrutiny is much more robust – like all closed-ended companies, trusts benefit from an independent board of directors which scrutinize performance, remit, costs and can and do remove managers as necessary.

There are other advantages to investment trusts which may be of greater assistance than hitherto given the changing investment landscape. At a time when markets are volatile and investors increasingly seek income in part by way of value investing, a key advantage is their ability to pay dividends out of capital thereby offering higher payments than the underlying investment would normally furnish. They can also ‘store’ income by way of revenue reserves which can bolster payouts during turbulent times.

One could go on singing their virtues but calling the bottom is never easy – as the old market adage goes, it is unwise to catch a falling knife! However, unusually wide discounts, these companies’ inherent strengths which have stood the test of time and poor market sentiment in combination could provide an opportunity for investors to benefit from a triple tailwind – narrowing discounts, resumed outperformance and rising markets. With apologies to Meatloaf, but even two out of three aren’t bad!

Our portfolios continue to take advantage of attractive situations – companies which stand on attractive discounts relative to their provenance, performance and peers – private equity companies are good examples.

It is usually wise to invest when sentiment trails the fundamentals, particularly when the disconnect is pronounced. There is nothing to suggest it will be different this time. Indeed, quite the contrary.

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