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Every week, Kyle Caldwell and guests take a look at how the biggest stories and emerging trends could affect your investments, with practical tips and ideas to help you navigate your way through. Join the conversation, tell us what you want us to talk about or send us a question to OTM@ii.co.uk. Visit www.ii.co.uk for more investment insight and ideas.
As investors, we love to grab a potential bargain, and those are seemingly rife in the investment trust space. There are many, many instances where the shares in the trust trade at well below the stated total value of the underlying portfolio. These so called discounts, in theory, offer you a cheap way into the fund. But there are some important things to understand. It's important to understand how to assess a discount, what might drive a discount, and also the potential pitfalls that come with this form of bargain hunting.
Dave Baxter:So welcome back to On The Money, the show where we look to unpick the issues affecting your savings and your investments. I'm Dave Baxter, the senior fund and content specialist here at II, and today I'm joined by Emma Bird, Head of Investment Trust Research at Winterflood. So Emma, thanks for coming in.
Emma Bird:Thank you for having me.
Dave Baxter:So let's kick off with the context. Investment trust trading on discounts is certainly not a new thing. It's, you know, I would argue, a structural feature of the sector. But those discounts have blown out since, what, late twenty twenty one, 2022? So we've moved on a lot since then.
Dave Baxter:We have seen a bit of a recovery for kind of share prices in the sector. This is a bit of a broad one, but where a kind of discount is standing now? What are the kind of levels versus recent years?
Emma Bird:Yes, sure. To put it in a historical context, for a number of years, from 2014 to 2021, the weighted average discount of the investment trust sector was pretty consistently narrower than 5%, other than a few relatively short periods of widening around Brexit and COVID. But generally, it had stayed pretty narrow in narrow single digits until the end of twenty twenty one, as you mentioned. So then the sector average discount widened significantly and quite sharply from just 2% at the end of twenty twenty one to a low point of 18% in October 2023. This was primarily driven by the changing inflationary and interest rate environment over that period, where sentiment towards rate sensitive asset classes really deteriorated and the investment trust sector has quite a lot of exposure to these types of assets, like growth stocks or alternative assets like infrastructure, property, private equity.
Emma Bird:So we saw a real sharp de rating of discounts. But as you say, they have narrowed somewhat since then. We've seen some derating to an average discount of around 11% at the moment. So definitely an improvement of where we were a few years ago, but still reasonably wide in a longer term historical context.
Dave Baxter:We'll get on to kind of how to assess the discounts, I suppose, in a minute, but it might be interesting to just add on to that point. Are the on a sector basis, where are the kind of discounts looking wider? Obviously, are some where they just still look enormous, or there may be reasons for that.
Emma Bird:Yes, so those would be the sectors that are highlighted, still the interest rate sensitive asset classes, particularly alternative assets like infrastructure, in particular renewable energy infrastructure, property and private equity. And there are, obviously, some valid reasons for this. Interest rates are still high. So the reason that the discounts widened in this higher interest rate environment was because investors were concerned that this new environment would negatively impact the underlying valuations of the funds, so it hit the NAVs, and because these types of funds only produce NAVs irregularly and on a delayed basis, the share price reacted before the NAV and somewhat more extremely, so that caused the discounts to widen. And there was potentially also, in certain cases, some scepticism about the accuracy of those NAVs as well and actually, at the valuations that are being published, could you really achieve that if you were to try and sell the assets?
Emma Bird:In terms of infrastructure, particularly renewable energy infrastructure and property, a lot of investors were also owning those investment trusts for income, for the yields that they were delivering. And once market interest rates, so gilt yields, started to rise, these dividend yields offered by the investment trusts looked comparatively less attractive. So the share prices fell in order to adjust that yield upwards on the trusts to maintain that differential above guilt yields, which are typically viewed as safer assets.
Dave Baxter:Yeah, yeah, risk free. Although maybe they've proved less than that in recent years. And as you mentioned, I suppose, of the direction of interest rates has had a a massive effect on things. But say you look at renewable energy infrastructure as one example, are there other big factors that investors should weigh up when they're trying to kind of assess whether there might be kind of recovery down the line? What are the big things to bear in mind?
Emma Bird:Yeah, so there's many things that you should look at, not just invest on the basis of discount at a point in time. So you need to fully understand the underlying strategy and the assets that it holds, particularly in these alternative asset classes like renewable energy infrastructure and the different factors that can impact the valuations as well as the income. So things like regulatory developments, how diversified is the portfolio, is it only exposed to maybe one type of renewable energy where a change in say wind speeds can impact their revenues or valuations. And a thing that's become, I think, more important across the entire investment trust sector in recent years is discount control mechanisms. Is the independent board doing things?
Emma Bird:Do they have policies in place to mitigate the downside discount risk from these current levels?
Dave Baxter:And are there, as you mentioned, know, very good point, a discount alone is not kind of reason to buy and there's so much more you need to consider. Are there kind of, I suppose, combinations of metrics and traits that would make trust look attractive? For example, maybe some things are on a discount, the actual share price has been doing well.
Emma Bird:Yes. So things to look at, yeah, as I said, not just a discount on its own, but one thing to look at, you can view the current discount in the context of history, so you can look at the current discount relative to its twelve month or five year average, or look at it if there's been similar market environments in the past, how has the discount reacted then, has it narrowed. So one metric that we can look at is what's called a Z score. So that shows how many standard deviations the current discount is away from the twelve month average. So a big negative number implies that the discount could be cheap relative to history, whereas a large positive number would imply that it's maybe expensive.
Emma Bird:Also looking at the discount relative to peers, so is the entire sector trading on a big discount because the asset class is out of favor potentially for good or valid reasons, or does this individual investment trust maybe offer a bit of an anomalous wide discount and an attractive entry point?
Dave Baxter:Yeah, yeah, interesting. And let's come on to some names then. So firstly, I will shower the viewers and listeners with some caveats, you know, this isn't any form of kind of advice, and I suppose we're just highlighting some names that, you know, display some of these traits. But that's kind of a beginning point for our own research rather than anything definitive. But, yeah, with that caveat or many caveats, what names have you kind of seen to be standing out in terms of being discounted but also potentially having some positive traits?
Emma Bird:Yes, so I looked at this by sorting the entire investment trust universe by Z score to give an idea of what things were looking cheap. And I think that does feed well into my point that I made earlier, because a lot of those did kind of flag out as ones that were cheap for a reason, so not ones that I would highlight, but one that did stand out was a trust called HG Capital Trust or HGT. That's a private equity fund that invests in private software businesses And the share price of that was hit particularly hard earlier this year around the general software sell off over concerns that AI would negatively impact these business models. So that investment trust is currently trading on a 32% discount as of May 27 versus a one year average of 15%. So it said score was minus 2.1 and the five year average is just 11%, so it's trading significantly wider than history.
Emma Bird:Obviously, there are some reasons for that, that we understand, so there are negative sentiment, but we think the portfolio is actually quite well placed. The companies that they invest in focus on really business critical software, like accountancy that we think are going to be some of the last to be disrupted by AI, so we think the current discount offers potentially a good entry point and if sentiment improves or the businesses can prove themselves to continue to be delivering and continue to be profitable, then we could see sentiment improve and see that discount now.
Dave Baxter:Well, I guess before we move on to other names, it'd be interesting, I was just thinking, would you say you were, yeah, you kind of went into HD Capital, as you mentioned it, that discount is very wide at the minute, but there's perhaps a lot of debate about whether it is an AI victim or still an AI beneficiary or something in between. Kind of going forward, how would you monitor whether that recovery is playing out? Like, what would you be looking for when it has its kind of trading updates and that kind of thing?
Emma Bird:Yes, I'd be looking at what HG Capital is saying about the underlying companies particularly, what are their revenues doing, how are they themselves utilising AI and how is that feeding into profitability and whether they're looking potentially at other investments. Do they view this as a wider opportunity? Are they using the negative sentiment to acquire new businesses at potentially discounted valuations to help with the future prospects?
Dave Baxter:Interesting. And what other names have been kind of standing out by
Emma Bird:these So another one that flagged as reasonably cheap on a Z score basis was the European Smaller Companies Trust, ESCT. So that invests in a diversified portfolio of quoted continental European small and mid cap stocks. That's currently trading on a 10% discount relative to a one year average of 8%, so it's a score of minus 1.4. So it doesn't sound quite as amazingly attractive as HTT, but what I think is interesting about this one is that it's recently implemented a new formal discount control policy where the board will use buybacks to aim to limit the discount to mid single digits, so obviously tighter than the current 10%. And we have seen the board being pretty active at buying back to help mitigate that discount volatility.
Emma Bird:It's also recently introduced an enhanced dividend policy, so aiming to pay out at least 5% of the previous year end NAV as a dividend to shareholders, so that offers an additional attraction to the fund. And we have also seen instances from other funds that have introduced this kind of policy and that's helped encourage more demand for the shares and helped the discount as well. I think there's some tailwinds for that discount to narrow Any that
Dave Baxter:other?
Emma Bird:So the other thing I'd highlight is, as well as just looking at discounts, another form of identifying value is by looking at the dividend yield. And so obviously, the lower the share price, the higher the yield for the same amount of dividend payout. So, just one more that I'd highlight, filtering the universe by yield. One that stood out was Foresight Environmental Infrastructure. So back in that renewable energy infrastructure space that we were talking about earlier.
Emma Bird:This fund invests in a very diversified portfolio of renewable energy infrastructure assets, private assets, so from solar farms to wind farms to energy storage and lots of others. That is currently offering a 10% dividend yield and it also recently announced an increase in its target dividend for the current financial year, so it has a prospective yield of even more at 10.2% and it's trading on a 25% discount to its latest NAV. So we think that that yield is attractive, particularly given that the dividend was fully covered by earnings in the last financial year and it's forecast to be comfortably covered in the next financial year as well and we don't see any of key risks to that cover. There's no kind of key financing risks or things like that And that we've seen in the again, the diversification helps with that revenue security and limits the volatility in the valuation as well.
Dave Baxter:Are there I mean, you've already mentioned a very good one with the dividend cover, but are there other things you would look for when trying to gauge whether the dividend is sustainable? Because you you know, it's interesting you picked a renewable energy name because we have seen a few of those kind of cut their dividends in recent months.
Emma Bird:Yes. So when looking at yields, is key to determine whether you think that is sustainable. So, yes, dividend cover is a key one. Is it fully covered by earnings? If there potentially is going to be a shortfall, something else that investment trusts in particular can use is revenue reserves.
Emma Bird:So, are there sufficient revenue reserves to cover any shortfall in revenue that might occur as a short term strategy? And are there any upcoming risks to the revenue? So are there any upcoming refinancings that might lead to a large increase debt costs that would impact revenue or other things like that.
Dave Baxter:Yep. And I should add also that, you know, we're discussing these measures for the DIY investor. A lot of those are actually available via sites like the AIC and so on, so you can go and check revenue reserves or discounts versus peers and that kind of thing. I did want to return to it's interesting you mentioned European smaller companies because some people know may know that because it was one of the original sabotargets however long ago now, and it was just making me think that there are, I suppose, potential risks or at least inconveniences we need to bear in mind when you have a big discount. One being that an activist may come in Yeah.
Dave Baxter:Which you might regard as a positive, to be fair. But I was interested on your thoughts and, yeah, on what potential forms of disruption or setbacks investors might have if they're constantly going into these trusts on, you know, double digit discounts.
Emma Bird:Yeah. So I think activist investors is a key one, particularly in recent years, we've seen a lot more of that in the investment trust sector. As you said, sometimes this can be a positive thing, it can help to encourage boards to narrow the discount or do other things to promote improved performance for shareholders. Or sustained wide discounts can indicate that there is a structural lack of demand, so that could encourage boards to undertake a strategic review, which could lead to a change of manager, or potentially change of strategy, or managed wind down, particularly for illiquid assets, that can be a long drawn out process, where the ultimate value you get is uncertain. So, yeah, there are risks in just investing in deeply discounted trusts.
Dave Baxter:And are there any factors to bear in mind that might mean that discount stays wide for for longer? Like, one I can think of, for example, is you do have cases where investment managers, in particular, own a lot of the trust already, so maybe there's actually less liquidity in the shares and it's kind of quite hard to shrink it.
Emma Bird:Yes, so there are definitely a few cases in this sector where there are large, either family shareholdings or manager shareholdings, which means that actually the amount of shares that are traded regularly is pretty small, so that really harms overall liquidity, as well as constraining the ability of the board to conduct buybacks because buying back shares from the other shareholders would increase these large shareholdings even further, so that can constrain them there. So that can mean that the discount stays wide for those two reasons, as well as sometimes raising questions over corporate governance with one large shareholder that has control of the vote. So an example I can think of is within the actually reasonably small biotechnology and healthcare sector. There's one trust called Syncona and that's trading on a 45% discount at the moment. But there are maybe reasons why that's actually not as good a value opportunity as something else in the sector, like Worldwide Healthcare Trust, which is only at a 7% discount.
Emma Bird:But that potentially offers a better value because the board there has a target to buy back shares at wider than 6% and try to maintain the discount there. Actually, there seems to be maybe more of a catalyst for that to re rate to rather than Cyncona, which, yeah, on a 45% discount, but that has a very large shareholder, which has constrained liquidity. And it's also undergoing a bit of a strategy change, there's some uncertainty over the future, it's saying it's considering selling some of its assets at discount to carrying value, so, yeah.
Dave Baxter:Yeah, and wasn't it it was going to be in a wind down and then it wasn't in a wind down? It's a bit confused.
Emma Bird:Yes, yeah, I think it entered wind down and then it, yeah, almost reversed it, but it is still going to return some capital. Yes, there's definitely some questions about, yeah, how much of the portfolio could be realised then.
Dave Baxter:And I guess, finally, we've sort of touched on some of these issues, but I suppose a big discount or a very high yield could actually be a kind of red flag. Are there ways of kind of assessing that or confirming that? I mean, it's just kind of a disastrous set of results or something like that, but
Emma Bird:I think the key thing is to understand what's going on under the bonnet.
Dave Baxter:So,
Emma Bird:yes, not just taking a wide discount as great bargain, actually understanding are there reasons for it, rather than just looking at the numbers. So, yes, doing your research into what the fund does, any recent announcements to do with strategy, are there corporate governance concerns, are there activist investors or large shareholdings. And yeah, think it's just doing as much research as you can.
Dave Baxter:Yeah, yeah. Well thanks for your time.
Emma Bird:Thank you very much.
Dave Baxter:And thank you for watching and for listening. Do let us know what you think. You can actually email us directly on otm@ir.co.uk. Let us know your thoughts and some potential ideas for future episodes too. Hopefully, you enjoyed this one and catch you next time.
Dave Baxter:Hi.