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
to NAV %
|Net Yield %||Performance|
1 year %
3 years %
5 years %
|Alliance Trust (LSE: ATST)||17||2.5||19||-3||37|
|Brunner (LSE: BUT)||14||3.1||28||-4||48|
|Dunedin Inc Gwth (LSE: DIG)||9||5.6||31||-19||32|
|Scottish American (LSE: SCAM)||11||5||31||-8||31|
|Scottish Mortgage (LSE: SMT)||11||2||53||10||82|
|Witan (LSE: WTAN)||10||2.3||31||5||51|
|FTSE All-Share|| || ||30||-4||37|
|FTSE 350 High Yield|| || ||19||-12||22|
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.
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Disclaimer: Tudor holds Scottish Mortgage. Witan, Dunedin Income and Growth and Alliance Trust.