It was once rare for a trust to trade at a premium to net asset value – but not any more, so investors need to tread carefully, says Helen Pridham.
When you buy an investment trust, your main hope is that its share price will be higher by the time you want to sell. Whether this happens and by how much will largely depend on the skills of the investment manager in growing the portfolio, and the direction of the stock market or other asset classes in which it invests.
However, the outcome can also be influenced by movements in the trust’s share price relative to the value of its investments (its net asset value, or NAV) over the period, and whether it has moved from a discount to a premium, or vice versa. In recent years, investment trust performance generally has been boosted by narrowing investment trust discounts.
Ten – or even five – years ago, it was the norm for investment trusts to trade on significant share price discounts to net asset value. It was unusual for trusts’ share prices to rise close to or above their net asset value, let alone stay there for any length of time.
Discussions mainly revolved around what actions boards could take to control their discounts. Nowadays, however, many trusts are trading close to or above their net asset value. The average discount recently was under 3 per cent, while around a third of trusts were trading on premiums. This provides investors with a conundrum.
In the past a premium has been a danger sign for potential investors, because sooner or later it would disappear when investors took profits or a sector or investment manager fell from favour. It is not necessary to go very far back to see this happening.
When Neil Woodford launched Woodford Patient Capital (WPCT) in April 2015, it rapidly rose to a premium of around 14 per cent. But additional share issuance and disappointing performance sent its premium tumbling. Recently it was standing on a discount of over 12 per cent. That represents a 26 percentage point range in the value of the shares before accounting for the performance of the underlying assets.
However, recently there have been a number of individual trusts, such as Lindsell Train (LTI) and Syncona (SYNC), and some sectors, which have stood on persistently large premiums to net asset value. Demand for income has led to many high-yielding trusts in sectors such as debt, infrastructure and renewable energy trading at double digit premiums.
Even mainstream trusts such as City of London (CTY), Scottish Mortgage (SMT), Scottish American (SCAM) and RIT Capital Partners (RCP) have also been regularly trading on premiums this year, while others have been on historically low discounts.
How secure these price levels are remains to be seen, but investors would do well to be cautious. The dangers were illustrated when the premiums on infrastructure trusts fell back last year after the Labour Party spoke of its plans to renationalise various public utilities and crack down on PFI deals.
The table below shows how your returns can be affected by discount and premium movements. For example, if a trust’s share price falls from a 10 per cent premium to a 10 per cent discount, you would lose money even if its assets had grown by 20 per cent.
However, this has not deterred specialist investment trust stockbrokers such as Winterflood and Numis Securities including trusts trading on premiums on their recommended list. Charles Cade, head of investment company research at Numis Securities, explains: ‘We include trusts if they have unique mandates and investors are looking to the longer term. For example we like trusts in the infrastructure sectors even though they are on high single or double-digit premiums because they are usually long-term holds.’
Numis also believes that the portfolios of these trusts are conservatively valued. It lists International Public Partnerships (IPP) and HICL Infrastructure (HICL) among its recommendations. Another recommendation is Syncona, the life sciences trust, because of its unique portfolio and long-term investment nature.
But with equity investment trusts, Cade says it may be better to sell when premiums are high because historically they have proved unsustainable, and Numis has recently recommended selling trusts such as Lindsell Train, Independent and RIT Capital for this reason.
Winterflood Securities also includes trusts trading at premiums on its recommended list. Simon Elliott, head of investment trust research, says: ‘We always used to say that trusts on premiums were very expensive, but things are somewhat different now, which is partly to do with the asset mix and also due to the behaviour of investors.’
Although Elliott generally feels that premiums of 1 to 3 per cent are fine, he points out: ‘We do look at the downside risk to find out what explicit measures a trust has in place to limit the discount if the price falls.’ Among trusts recently on Winterflood’s recommended list trading on premiums were Monks (MNKS), Scottish Mortgage and TwentyFour Income (TFIF).
One of the reasons that trusts have moved onto narrower discounts and premiums is the increased demand from self-directed retail investors buying through platforms such as AJ Bell, Hargreaves Lansdown and interactive investor. Many of these investors do not study valuations.
Retail demand drives ratings higher
However, Mark Dampier, head of research at Hargreaves Lansdown, believes investors should be wary of premiums. ‘There is an argument that if you are investing over the long term it doesn’t matter whether you are investing at a premium because it will come out in the wash as the trust’s share price moves up,’ he says. ‘But I still don’t think it makes sense to pay more for an investment than it is worth. I think people with trusts on a premium at the moment should be selling up and recycling their money into less popular sectors such as UK equity income.’
Investors with regular savings schemes are vulnerable to buying shares at a premium without realising it. Elliott believes that investment trusts boards need to be more mindful of retail investors’ interests. ‘There is a greater risk that these investors may inadvertently buy trusts on large premiums unaware of the possible risk,’ he says. ‘There is an onus on boards to manage this situation.’
With discussion of an impending end to the global bull market in equities, which could cause a spike in investment trust selling, investors who are planning to withdraw their money soon may want to consider bringing forward their decision if their trust is on a tight discount or premium, to avoid losing out. However, long-term investors can afford to sit through any volatility.
Controlling the supply – buybacks and share issues
Although investment trusts start off with a fixed quota of shares, their boards can, subject to shareholder approval, decide to reduce or increase that number to regulate supply. They can buy their own shares back or issue more to help control discounts and premiums.
Until recently, most trusts were trading on relatively wide discounts due to the selling of their shares by institutional investors taking over control of their own investment portfolios. So the main emphasis has been on share buybacks. Since 1998, most trusts have sought authority from their shareholders to buy back shares up to the maximum annual limit of 14.99 per cent of their issued share capital when appropriate.
Other discount control mechanisms include tender offers, where the trust offers to buy a certain proportion of investors’ shares at a price closer to NAV, or an annual redemption facility. There are also more drastic alternatives where a trust is on a perpetually high discount, such as appointing a new manager, reconstruction or even liquidation. Some trusts have fixed lives or continuation vote policies written in at launch for this reason.
Shares which are bought back through regular buybacks will not necessarily be cancelled. The managers may hold them ‘in treasury’ in the hope they can be re-issued if and when investor demand revives.
If no shares are available in treasury and the shares are trading at a premium to net asset value, the board can decide to issue more shares. Most trusts have the authority to make secondary ‘tap issuances’ of shares of up to 9.99 per cent of their issued share capital but, with the approval of shareholders, they may be able to issue up to 20 per cent.
This type of ongoing issuance is normally undertaken by trusts whose managers can invest the proceeds in the market relatively easily. However, where there is a risk that the performance of the existing portfolio may be diluted by holding cash, the board may decide on a ‘C’ or conversion share issue. This money is managed in a separate portfolio in order to avoid any cash drag and the C shares are then converted into ordinary shares at a set date or when they are fully invested.