Sunday, November 27, 2022

Investment trusts can be bargains — but look past the discounts

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My father had a book on investing in shares written in the 1930s by an American ship’s purser who picked his investments — using stock price charts — while he sailed around the world. He would adjust his portfolio when he docked in New York. He attributed his superior performance less to his charts than to the fact that he could neither check share prices nor trade while at sea.

If he had disembarked recently he might have been shocked at how far equities and bonds have fallen globally this year. Markets face three serious challenges: inflation, rising interest rates to control that inflation, and the growing risk of recession that those higher interest rates induce. But these issues have created interesting opportunities for investment trust fans.

First, a quick primer on what makes investment trusts — a UK speciality — distinctive. Since the launch of the first in 1868, investment trusts have supported investors through many periods of inflation. The sector is now a very broad church, expanding from the original global equity funds into income funds, emerging market country funds, property funds and, recently, infrastructure and renewables funds.

Investment trusts can be rather more volatile than their unit trust equivalents, because many take on long-term debt and so may invest more than one pound for each pound of equity. This “leverage” amplifies the effects of rising markets — but also falling ones.

Unlike unit trusts (often known as “funds”), investment trusts are listed companies. The price of their shares can move to a discount if shareholders want to cash in and are willing to accept less than the value of the underlying assets — known as the net asset value (NAV) — to secure a sale.

This structure may seem strange initially, but it has its advantages. It allows managers to take a longer-term view and hold on to companies that may be unloved now but whose prospects are good even when markets get skittish.

By contrast, when investors sell units in a unit trust the managers must sell the shares of underlying holdings to meet redemptions, sometimes forcing them to sell good companies at precisely the wrong time.

Widening investment trust discounts have been a feature of falling markets — notably in the depths of 2008, which proved a fantastic time to buy. Discounts were greater then, but things looked even darker.

Discounts in global equity trusts have widened this year — from 5.8 per cent on average to 9.1 per cent, according to Winterflood research. Similarly, UK equity funds — from 10.7 per cent to 12.4 per cent.

An investment trust trading at a 12 per cent discount seems to allow you to buy £100 worth of shares for £88. Does this present an opportunity for longer-term investors to bag a bargain? Perhaps, but you cannot assume that all discounts will close when the market recovers. Some trusts trade at a discount most of the time for various reasons, so look at the long-term discount history before buying.

Do not ignore trusts on only small discounts. Some trusts manage discounts with a strong share buyback and issuance discipline to limit the future risk of you needing to liquidate shares just at the wrong time. Mid Wynd, the global equity trust that my team manages, does this — buying at a 2 per cent discount and issuing at a 2 per cent premium. This can benefit existing shareholders and be reassuring if you do not like the pricing volatility.

The key question when buying any trust is whether you want to own the shares held inside it. The health of these underlying companies can — in general — be checked by whether the trust continues to pay steady dividends during crises. Be careful.

Investment trusts can smooth dividend payouts by storing dividend income in times of plenty and distributing it in times of famine. You might want to check the “revenue per share” line in the report and accounts. If it is lower than the “dividend per share” number there is no need to panic: the trust has paid some of its dividend out of reserves rather than out of revenues. But you do not want to see that happening for too many years.

Given how far sterling has fallen and how much panic is in the air, the discounts on UK trusts may look particularly attractive to some. Recent events have not only taken the currency lower but have also taken 10-year gilt yields to around 3.5 per cent. It seems likely that the Bank of England will raise interest rates further, so perhaps it is best to wait for those adjustments to be made.

Higher gilt yields set the benchmark for the yield that investors ask on other assets, making some less desirable. UK property trusts have been among the worst-performing, falling on average by 39 per cent this year. When investing in these trusts, consider the effect of higher interest rates — most properties have mortgages of some variety. Consider, too, the likelihood of tenants leaving. City centre offices still seem risky, as do regional shopping malls.

Trusts specialising in logistics warehouses seem more likely to keep their tenants and may be able to raise rents in line with inflation. We hold shares in Segro, a real estate investment trust that owns the Slough estate — Europe’s biggest trading estate and home to companies like Mars and DHL.

Segro’s shares have halved this year. No doubt assets in this area will need to be written down to reflect higher interest rates, but if tenants continue to need their logistic warehouses then rents should flow in. I estimate these provide a 5 per cent net underlying cash flow yield in Segro.

Infrastructure funds had held up relatively well but have been hit by talk of windfall taxes on renewable energy installations currently selling electricity at £400/MWh rather than the £50/MWh they expected at the start of the year. In recent weeks the average renewable energy trust has seen its valuation fall from a 4 per cent premium to a 5 per cent discount.

So there are bargains to be found in the world of investment trusts. Prices may sink further before they bounce back, but if you buy and sail off for a while you are unlikely to notice. Just remember to focus on the quality of the underlying holdings and not simply the discount sale sticker.

Simon Edelsten is co-manager of the Mid Wynd International Investment Trust and the Artemis Global Select Fund

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