Investment Trust Bargains

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By

Tudor Davies

Published in Investing Strategy on 5 January 2010

Discounts have widened despite last year's stock market rally.

Investment trusts are usually significant beneficiaries in bull markets. The twin effects of narrowing discounts to net asset value and the use of gearing (borrowing) often amplifies index gains. 

Something odd has happened in the last year; investment trusts have under performed. Since July, discounts have actually widened, from 7.5% to 10% according to recent research from Winsresearch. I reckon this has thrown up some bargains, but first let's take a look at why discounts and gearing matter for investment trusts.

Supply, demand and use of debt 

OEICs and unit trusts are priced daily at their net asset value (NAV). Just like an individual portfolio of shares, values of holdings are summed to give an overall value. 

Investment trusts are quoted on the stock market like any other share and their price fluctuates with buyer demand. When demand is high prices rise to, or above, NAV (as is the case with property investment trusts right now). When demand is low, they can slump to prices below NAV (as is the case with private equity trusts right now).

In addition to the market affecting performance, investment trusts can borrow to invest. Say a trust has a portfolio valued at £100 million. It may borrow another £50 million to invest in more shares. The total value available for investment is £150 million. If prices rise by 10% the fund will be worth £165 million. £50 million is debt so £115 is attributable to shareholders. A 10% gain has become a 15% gain. Of course gearing also magnifies investment losses in exactly the same way.

Now some investors trade in and out of trusts according to their discounts, buying when discounts are large and selling when the discounts narrow or the shares go to a premium. People who are not investors, but herd followers, buy investment trusts when they are on a premium to NAV, almost guaranteeing they will lose money.

I don't tend to trade investment trusts. I like to buy when prices are at a decent discount to NAV and the reason is perfectly simple, almost too simple. I like dividends. 

When an investment trust is sitting on a discount to NAV of, say, 5% I get 5% more dividends than if I bought the underlying shares directly. Now, if you're a long-term buyer and holder of equities why would you bother going direct? Presumably because you reckon you're better than the managers of such trusts. But remember if you're getting a 5% discount you've got be 4% better (after annual charges of about 1%).

I suppose the other reason is that you could create a portfolio with a much higher starting yield. And here I would have to agree, and my recommendation would be to go to trustnet, identify the top ten holdings with a suitable yield and buy them.

Cheap looking investment trusts 

Investment Trust
(or benchmark)		Discount
to NAV %		Net Yield %Performance
1 year %		Performance
3 years %		Performance
5 years %
Alliance Trust (LSE: ATST)172.519-337
Brunner (LSE: BUT)143.128-448
Dunedin Inc Gwth (LSE: DIG)95.631-1932
Scottish American (LSE: SCAM)11531-831
Scottish Mortgage (LSE: SMT)112531082
Witan (LSE: WTAN)102.331551
FTSE All-Share  30-437
FTSE 350 High Yield  19-1222

All the highlighted investment trusts have increased their dividends annually for at least 20 years, apart from Dunedin which has a 10 year record of annual increases. They are able to do this because, unlike unit trusts, which have to distribute all their income, investment trusts can retain an element of income for distribution during tough times. 

Yes, I know the average buy direct investor could do the same thing, but how many of us yearn for the virtues of deferred gratification?

Another sector I think worthy of consideration is private equity (although not for income seekers). This was given a right bashing last year as doubts about covenants, banking facilities and liquidity all dominated the investment agenda. At one stage discounts to NAV were approaching 60%, although they have since narrowed to nearer 30%. I will be taking a closer look at private equity in the near future.

More from Tudor Davies:

Disclaimer: Tudor holds Scottish Mortgage. Witan, Dunedin Income and Growth and Alliance Trust.

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Comments

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BarrenFluffit 05 Jan 2010 , 3:09pm

Where there's borrowing NAV is a moveable feast depending on the valuation method; IT's often use both in their accounts.

Alliance is not a pure stock market investment; there is a pensions business and investment in property. Hence the bigger discount.

Why no FTSE yields in the table?

xdante 05 Jan 2010 , 7:32pm

I think your maths is wrong regarding the effect of annual charges - in fact they cost you more than you imply, and in your example of a 5% discount with a 1% annual charge I think you would be better off buying direct (unless you expect an annual return from the trust in excess of 20%).

The annual charge is levied on the total assets under management. Let's assume you buy £100 of assets at a 5% discount to NAV, so you spend £95. Assume a 5% dividend yield, 5% capital growth, and a 1% management charge. So in the first year you earn £5 in dividends, £5 in capital gain, and pay a £1 management charge. Your return is £9 on an outlay of £95, or 9.5%.

Now compare that to buying the £100 of assets directly. You earn £5 in dividends, £5 in capital gain, and pay no management charge. Your return is £10 on an outlay of £100, or 10%.

So in fact, if the annual charge is A%, and the discount to NAV is D%, and your expected annual return (including dividends and capital growth but before deducting A) is R%, your total return is R*(1+D)-A. Buying direct your return is simply R. Rearranging the equation, to get an equivalent return from an investment trust as buying direct, you require a discount of A/R.

That's not to say I disagree with your sentiment. Taking Alliance Trust as an example, their annual return over 5 years is 7.5%. Their Total Expense Ratio for the last year is just 0.7%. A/R is 9.3%, so their current discount of 17% is adequate.

curedum 06 Jan 2010 , 3:50pm

xdante's maths are correct, though we must remember the extra costs of buying an equivalent collection of shares directly compared to a single deal with an investment trust.

westwinds3 07 Jan 2010 , 12:12am

I was trying to do these sums about a week ago and came up with these figures for true total expense ratio, allowing for the discount:
Value and Income IT 0.80%
Blackrock Smaller companies 0.49%
Alliance Trust 0.33%
Temple Bar IT 0.18%
City of London IT 0.16%
Merchants Trust -0.11%
i.e. Merchant's Trust offer a 6% yield and have a negative TER. They are actually paying you to look after your money. They have some fairly expensive debt, and when this is allowed for, I would expect the TER to be similar to Temple Bar or City of London.
By any standards, good conservative investment trusts have active management and lower true charges than even a Vanguard tracker.

firtles 07 Jan 2010 , 10:04am

Dunedin's dividends for 2008 and 2009 are the same (at least according to TD Waterhouse's dividend history) - 3.75p and 6.5p each year,so the 10 year increase record is wrong. British Assets Trust might be worth a look too. Last year's divi up to 6.11p from 5.84p with a discount of about 10.5% at 114p

divitiae 07 Jan 2010 , 1:18pm

The cost of going direct is massive, 10 shares at £1.50 to buy and then £11.95 to sell is over £100 and that dosen't include reinvesting 10 sets of dividends.
I am 50% in a trust and 25% in ETFs.

alarmbells 08 Jan 2010 , 2:04pm

Latest accounts from Dunedin (year to 31 jan 2009). 2009 divi 10.25p 2008 divi 10p. 2.5% increase. A small increase is on the cards for the year ending 31 jan 2010. http://www.dunedinincomegrowth.co.uk/

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