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The Mysteries of Shrinking Discounts

uk smaller companies

Annabel Brodie-Smith, Communications Director at the Association of Investment Companies, Explains Why Tightening Discounts Aren’t Such A Bad Thing

It’s been an interesting start to the year for the investment company sector, with the average discount hitting a historic low of 3.4% in January.  A strong period of performance, the insatiable desire for income and the impact of RDR investment companies have all contributed to recent demand for investment companies.

But this milestone moment is especially interesting, given that discounts have been a perennial topic – accounting for a significant proportion of the sector’s media coverage.  Of course, many enthusiastic investment company supporters have always been happy to buy shares at a discount (i.e. when the share’s price is less than the value of the underlying assets) – receiving income on all the assets, and with the potential for discounts to narrow in the future. Advisers, meanwhile, have historically tended to be more ambivalent about discounts, although this has become less the case recently as familiarity with the sector has improved.

But where do historic discount lows leave us now?  Firstly, it’s worth bearing in mind that 50% of the sector is still trading on a discount wider than the overall industry average – and, whilst no investment should ever be made on the basis of discounts alone, there are always investment opportunities to be found.

Yield Unto Me

Secondly, though, it’s worth remembering that, with rates of return on savings accounts also at record lows, investors are hungry for yield and the demand for income has played a strong role in the narrowing of investment company discounts overall.  The investment company industry’s strong dividend track record, and the breadth of choice when it comes to yield, is something that investors have become increasingly prepared to pay for. For example, the Global Equity Income sector, with an average yield of 4.1%, is currently on a premium of 2.6%, meaning investors are prepared to buy shares priced above the net asset value.

In addition, investment companies in sectors which have not traditionally offered attractive yields have now changed their approach. BlackRock World Mining is an interesting case of a company that’s taken an innovative view to dividends.  Since the company increased its yield to 4.1%, the company’s shares have rerated, with the discount at 19 February 2014 at just 1.3% (having been at an average discount of 9.5% over the last 12 months). 

This has been despite a turbulent time for commodities and natural resources. The Global Emerging Markets sector is currently on an average discount of 9% – almost twice the overall industry average – due to the volatility and sell off in Emerging Markets over the last year or so.  Yet JPMorgan Global Emerging Markets Income, with its significant 4.8% yield, is currently on a small premium of 1.4%.

Long Term Success

As well as demand for income, the strong overall performance record of investment companies has stimulated demand, with the average investment company to the end of January 2014 up by 7% over one year, 20% over three years, 104% over five years and 165% over ten years.

Investment company boards have also played a role in the narrowing and the increased stability of investment company discounts. Since 1999, investment company boards have been able to ‘buy back’ their shares to help keep a floor to the discount – thus becoming the buyer of last resort.  Since then, boards have also been able to hold shares bought back in treasury, for potential reissue at a later date, to help control supply and demand further still.  Clearly, though, with demand for some investment companies and sectors so strong, many investment companies are currently in the enviable position of regularly issuing new shares instead to help keep up with demand.

So are we in a ‘brave new world’ for investment company discounts? Or could these record lows be used as a converse market indicator?

Interestingly, analysts at JPMorgan Cazenove note that, since 2001, there has been a close correlation between changes in the absolute level of the FTSE All Share and the investment company sector discount. Rising markets, they add, are almost always accompanied by narrowing discounts. However, JPMorgan Cazenove also explains that it does not always follow that a period of narrowing discounts is followed by a market fall. This was not the case, for example, in 94-97, when discounts widened as markets rose.

Growing Advisor Awareness

It also seems likely that RDR has made a contribution to the increased demand for the investment company sector. Matrix Solutions’ Financial Clarity survey, on behalf of the AIC, showed a 66% increase in adviser and wealth manager investment company platform purchases in the first nine months of 2013 post RDR in comparison to the same period in 2012.  For our own part, we trained over 1,400 advisers in 2013, a considerable rise in comparison to just over 800 in 2012, and we have a comprehensive training programme underway in 2014.

Critical Moment for Emerging Markets

Of course, the outlook for investment companies will be strongly influenced by market performance, and the AIC’s recent investor confidence research underlines the impact that the short-term direction of markets can have on private investors’ confidence.

Whilst confidence overall has changed little over the last 12 months, the same cannot be said for confidence in Emerging Markets, which has gone from being the most favoured, to one of the least favoured sectors in the space of 12 months, with the Asia Pacific sector suffering a similar fate.  In contrast, developed markets are back in vogue after a strong year of performance. Ironically, many professional, contrarian investors are now looking at increasing their exposure to the Emerging Markets sector, and there has been much comment in the media about discount opportunities in the emerging markets sector, underlining the difference in perception amongst different types of investors. 

Private Equity Sector

There’s no telling where markets might head, but the Private Equity investment company sector illustrates very clearly how contrarian investors can be rewarded, as well as the need to take a long-term view and avoid ‘panic selling’.

It’s fair to say that the Private Equity sector had a terrible credit crunch, with uncertainty over the sector and the valuations of their assets, contributing to a dramatic widening of discounts.  So it’s perhaps not surprising that at 31 January 2009, the average discount for the Private Equity sector had widened out to 48%.  Yet since then, the average Private Equity investment company is up 128% to 31 January 2014, compared to 105% for the average investment company, and the average Private Equity investment company discount is now 15% at 31 January 2014.

What Can we Learn From Discounts?

Discounts are a very useful measure of market sentiment, and given the narrow discounts that are especially pronounced in the income-focused sectors, they are a clear illustration of which issues are preoccupying investors at the moment.  But, as we’ve seen, investment company boards have tools at their disposal to help keep a floor to discounts (and premiums, for that matter).

Income has become a precious commodity, and is well worth paying for in many investors’ eyes.  But it seems like wider-than-average discounts could offer opportunities for contrarian investors. 

Of course discounts are just one issue, and most importantly advisers need to look at the all other criteria when considering an investment company – after all it’s the manager, investment strategy and portfolio that you should be buying into.

 

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