While discounts on an investment trust can often attract hedge funds and arbitrageurs looking to force a trust to wind up, they also provide an opportunity for investors to purchase assets on the cheap
Often, one person's problem is another person's opportunity. For example, Alex Ferguson's problem in plugging the gaps in his team's defence last season was an opportunity for other teams to score lots of goals against Manchester United.
And so it is that the perceived problem of discounts on investment trusts is actually often a tremendous opportunity. It goes without saying that, for investment trust managers fearful of losing mandates to run their funds, discounts are a major problem.
A large and persistent discount usually attracts hedge funds and arbitrageurs looking to force action that will lead the trust to wind up, or allows shareholders to realise their investment at close to net asset value. Discounts are to arbitrageurs like blood is to sharks. The international generalist sector is looking ripe for activity of this sort.
Rumours are circulating that aggressive investors are building stakes in a number of these trusts, such as Anglo & Overseas and Scottish Investment Trust. Nevertheless, while it is true to say discounts are a problem for trust managers, the position for investors in trusts is very different. Indeed, for investors, much of the negative comment about discounts is misplaced. So how then should discounts be viewed?
A discount on an investment trust is simply the difference between its share price and the value of the trust's assets per share (its NAV). So, the venerable Foreign & Colonial Investment Trust's share price stood at 181 pence at the close of business on 23 September 2004, while the NAV was 214 pence, making for a discount of 15%. It can be easily seen therefore, that the discounts to net asset value at which investment trust shares frequently trade, provide the investor with the chance to buy assets on the cheap.
Nevertheless, it is important investors approach the investment trust sector in the right way. There is little point in buying shares in an investment trust at a big discount if the discount never narrows.
Consequently you need to regard investment trusts either as very long-term investments, in which case the discount to net asset value is of limited relevance, or as tools to be used in the active management of a portfolio.
Many investment trusts make excellent long-term investments, due to their low costs and the various benefits of their closed ended structure. Moreover, investment trust directors are taking increasingly more proactive steps to improve shareholder value in a way that holders of open-ended funds, such as unit trusts, have no opportunity to benefit from.
By contrast, a shorter-term active approach to dealing in investment trust shares can prove very rewarding by exploiting the numerous inefficiencies that exist within the sector. However, this approach requires a proper understanding of why discounts occur and how to take positions to profit from volatility in the level of discounts.
The main reason why discounts occur is frequently said to be the structural imbalance between supply and demand for investment trust shares. In some areas this is true, especially among the large international generalist trusts where institutional investors, such as insurance companies, are placing consistent selling pressure on share prices that is insufficiently matched by buying interest from other sources.
Some institutions, such as life insurance companies, acquired investment trust shares in the 1970s, prior to having their own professional equity fund management departments. Over recent years, however, many of these institutions have been looking to reduce equity exposure, and their investment trust holdings have been obvious sale candidates.
Nevertheless, while important, the trend of institutional selling pressure is not the main reason for discounts, and certainly does not explain the tremendous volatility in the level of discounts.
This volatility is derived from the normal psychology that affects the valuation of any company's shares on the stock market. In other words, a small discount to net asset value, or a premium, is comparable to an ordinary firm's shares that trade at a high rating in the stock market (high PE ratio, and low dividend yield).
On the other hand, a large discount on an investment trust share is generally an indication that investors have little optimism about its future prospects, like a company with a low rating (low PE ratio, and high dividend yield).
Of course, all companies' share prices fluctuate in the short term, driven by the supply and demand for their shares, but ultimately the share price is a judgement of investors' expectations of the future performance of that company.
Part of that judgement will be an assessment of the quality of the company's management and part will be the attractions of its business. For an investment trust, therefore, the rating indicates the optimism investors have for the asset class in which the trust is invested, and the confidence in the trust's investment manager to do a good job in managing the portfolio.
The implication of this is that by looking at investment trust discounts you can tell a lot about consensus views in stock markets. In other words by comparing the discounts on different sectors of the investment trust market it is possible to determine in what areas investors have strongest opinions, and given the consensus view is frequently wrong, these comparisons can be used to guide asset allocation decisions.
This approach has been used to excellent effect by managers of funds of investment trusts, and is a reason why a number of these funds have achieved such strong returns for their investors.
For example, in the later stages of the technology boom in 2000, the technology specialist investment trusts saw their share prices move to large premiums to their net asset values, and several new ones were launched. At the same time, the shares of investment trusts managed with a value approach fell to substantial discounts.
Against this background it was a fairly easy decision for the managers of funds of investment trusts to rotate their portfolios out of technology shares and into the shares of value based funds with dramatically positive results when the mood in stock markets turned back in favour of value stocks in the summer of 2000. What then do current discounts on investment trusts tell us about the current climate in financial markets, and where are the best opportunities in the sector?
There is currently tremendous value, with many investment trusts trading at substantial discounts. One of the main messages from the high level of discounts is that investors are fairly cautious about the outlook for markets. Ironically this can be seen as an encouraging sign. As John Maynard Keynes said: "Successful investing is anticipating the anticipations of others."
In other words, it is not enough to have your portfolio positioned in a similar way to consensus, looking for the same things to happen. The successful investors are the ones who position their portfolios ahead of the crowd by making investments that benefit from the subsequent buying of others.
On this basis, the fact many investment trusts stand at large discounts despite recent buying interest from arbitrage investors is a sign investors may be too cautious about the outlook for global stock markets. This is illustrated by the wide discount on Edinburgh Worldwide of 17.1% (as at 24 September 2004).
Mark Urquhart, of Baillie Gifford, has being running Edinburgh Worldwide since November 2003 following the decision by Edinburgh Worldwide's directors to sack Edinburgh Fund Managers due to persistent poor performance. Urquhart's investment approach is to hold a portfolio of around 50 stocks chosen from the best ideas of Baillie Gifford's team of global fund managers and analysts.
This approach is likely to prove rewarding for shareholders, and Edinburgh Worldwide's performance has picked up strongly in recent months following a poor patch leading up to the end of June. If performance continues to improve the discount on Edinburgh Worldwide's shares should narrow significantly, while if good performance fails to be sustained then the discount should also narrow on the back of corporate activity.
Another area of opportunity is the emerging markets sector. While this is an area that has done well over recent times the discounts on the emerging market trusts remain at highly attractive levels. One example is Templeton Emerging Markets, managed by the famous Mark Mobius, a trust whose shares for many years traded at a premium to their net asset value.
A technical situation in the market concerning the final expiration of Templeton Emerging Market's warrants has caused the discount on the shares to widen sharply to over 17%.
With emerging markets likely to continue to perform well, Templeton Emerging Market's shares represent a great opportunity to buy a well managed fund, invested in an attractive area, and standing at a discount that should narrow sharply over the next year. It's opportunities like these you should look for the next time you hear about the problem of investment trust discounts.
• Discounts allow investors to buy cheap assets.
• Discounts on a trust are not worthwhile if the discount never narrows.
• Discounts often indicate current market sentiment which can be misleading.