Discounts – Feeling the Squeeze

by | Sep 25, 2014

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Narrowing Investment Trust Discounts Are Starting to Pinch, says Brian Tora


 

Anyone who knows me will appreciate that I have a soft spot for the investment trust sector. Not only have I served on the board of an investment trust – I once ran a discretionary portfolio management service invested exclusively in investment trust shares and have also worked with the sector’s trade body, now called the Association of Investment Companies, on a number of projects.

I also own shares in a number of investment trusts, so to find myself preaching a little caution on the sector feels somewhat strange to say the least. My concern, though, is the narrowing of the discounts over recent years which has contributed to some excellent share price performance. While the industry as a whole undoubtedly views this as a positive development – it makes new issuance easier, for a start – it suggests a rethink in how you assess which to own.

 

A Matter of Fashion?

Even during the unsettled period ushered in when the summer was at its height, discounts have held within a tight range. In their monthly report on the investment trust sector published in August, Winterflood Securities estimated that the average discount is a little under 6%, excluding private equity, hedge funds and direct property. While this is a little wider than the lowest point (a little over 4% according to Winterflood), it is still a far cry from the double-digit discounts that were the norm until comparatively recently.

The reasons for discounts coming down are difficult to determine accurately. The more level playing field created by the introduction of RDR may have played a part, but it is unlikely to be the sole – or even the major – influencing factor. The greater availability of savings schemes and a more proactive approach to discount management, through share buy-backs and the use of treasury facilities, will have played their part.

Interestingly, though, investment fashion may also be contributing to investor activity and thus driving smaller discounts in some sectors. The demand for trusts offering higher yields has risen significantly, with non equity assets, such as infrastructure and debt, accounting for an increasing proportion of this universe. Indeed, often these trusts stand at a premium to net assets. Even equity funds with higher yields now enjoy a smaller discount – less than half that of lower yielding trusts.

 

Not Much of A Cushion

The problem with shrinking discounts is twofold, as I see it. First, a cushion that might protect the share price at times of difficult market conditions is effectively removed. In the wake of the financial crisis of six or so years ago, discounts ballooned. With the benefit of hindsight, this provided a massive opportunity, but it didn’t feel like it at the time. Should any of the geo-political issues bubbling away around the world lead to markets retrenching, we should expect discounts to widen.

Second, small discounts remove part of the attraction of owning an investment trust’s shares in the first place. Obviously, one of the big arguments often used is that buying a basket of investments worth £100 for £90, or even less, made good sense, but that case gets more difficult to make when the purchase price is nearer to par. There are other perfectly valid arguments for owning investment trust shares, but to lose one advantage is a pity.

 

A Barometer of Taste

Make no mistake, I am not advocating eschewing investment trusts when it comes to portfolio construction. Rather I am advising careful research and just a little caution when this throws up a particularly narrow discount or even a premium. And perhaps some patience in the future. After all, discounts can be viewed as a barometer on investor sentiment, so when the outlook appears bleak, it is natural for discounts to rise. That is just when good opportunities arise.

 

Brian Tora is an associate with investment managers, JM Finn & Co

 

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