Investment trust discounts and premiums
My previous articles on investment trusts should give you primer on the basics if you need it.
Today I’ll focus on discounts and premiums.
Investment trusts on sale
For active investors – or even ‘passive’ investors in the old-fashioned sense of buying and tucking away funds for the long-term – now could be a propitious time to look into these investment vehicles.
Recent data from the Association of Investment Companies (AIC) has 37 out of the 38 investment trust sectors trading at a discount:
“Since the beginning of the year the discount of the average investment company has widened more than 10 percentage points – from 3.6% on 31 December 2021 to 14.3% on 18 November 2022.
With almost all investment company sectors on a discount, the Association has published a list of average discounts across all equity and alternative sectors.
Out of 38 sectors, only the Hedge Funds sector trades at a premium, of 3.8%. The sector is one of this year’s best-performing, with several of its constituents delivering for investors in turbulent times, the AIC said.
The most deeply discounted equity sector is North America, on a 26.5% discount, followed by India on a 14.9% discount and Global Emerging Markets on 12.4%.
Among equity sectors, AIC figures show the biggest discount changes in 2022 have been in the Biotechnology & Healthcare and Technology & Media sectors, where discounts have widened by 9.2 and 8.5 percentage points respectively.”
As a naughty active investor (in contrast to my passive investing co-blogger) I love rummaging around in the investment trust bargain basement.
And as a long-time plunger in such markets, now feels like as good a time as any to get more than you paid for when you buy an investment trust.
But what exactly is a discount, and why should you pay attention?
Let’s start at the beginning.
What does your investment trust own?
We all (now) know that an investment trust is a company that purchases assets to hold or trade.
Such assets could include equities, property, bonds, or even exotic fare like farmland or art. The specific assets held will depend on the trust’s stated investment objective. (Or mandate, in the jargon.)
When we buy shares in a particular investment trust, we become part-owners in the trust. Effectively we then have part-ownership of those underlying assets.
Our slice of the pie depends on the percentage of the trust’s total shares outstanding that we own.
Most of us will only ever own a few thousand shares in an investment trust. But it’s the same principle, whether you hold 0.001% or 10% of the trust’s shares.
For example, equity income investment trusts own shares in large blue chip companies that pay healthy dividend yields.
As a shareholder in such a trust, you’ll typically be paid your proportion of the dividend income generated by those blue chip equities – minus the trust’s fees, hidden costs, and any income it retains for future use.
Equity income trusts appeal to active investors who want a diversified income. But as a shareholder, you’ll also benefit (or suffer) from the rise and fall in the value of the shares your trust owns.
Similarly, you might buy an investment trust that owns property or miners or bonds – or pretty much anything else you can think of.
You might even buy an investment trust because you
hope think the manager is an especially skilled one.
They may be fishing from the same general pool of shares you could buy for yourself – or that you could invest in via a tracker fund – but you may believe the trust’s manager is more skillful at picking winners. And so you hope their trust will beat the market.
In any case, the trust will own a lot of stuff, which are called its assets.
The trust may also have debt (also known as gearing). These borrowings would need to be repaid out of assets if the trust were ever to be wound up, before its owners (the trust’s shareholders) could divide whatever was left.
Net asset value (NAV) = Total trust assets minus any debt
How to calculate the net asset value per share
While they amount to the same thing, it’s often easier to think about what portion of the trust’s net assets each individual share is theoretically entitled to, rather to work off the whole trust’s market value.
Let’s consider an example.
Imagine the world’s simplest investment trust, Monevator Investments PLC.
This recklessly mismanaged operation owns shares in just two companies, TI Corp and TA Inc. (Hey, it’s good to hedge your bets!)
Let’s say shares in TI Corp are trading at £10 and TA Inc is at £12, and that the trust owns 100,000 shares of TI Corp, and 50,000 shares of TA Inc.
The trust’s TI Corp holding is worth £10 x 100,000 = £1 million
Its TA Inc holding is worth £12 x 50,000 = £600,000
The Monevator trust has zero debts.
Therefore, the net assets of Monevator Investments PLC is £1.6 million.
Now, let’s say this trust has one million shares in issue.
Net assets per share = £1.6 million / 1 million = 160p per share.
Each share is effectively a claim on 160p worth of assets owned by Monevator Investments.
So far so simple!
Investment trust share price versus NAV
Any share is worth whatever someone will pay for it. There’s no right or wrong value for any particular share that you can calculate with a formula – in the sense that whatever value you come up with, it’s irrelevant if nobody will pay that for it today.
This is why share prices are so volatile. The market is constantly trying to agree upon the correct value of every company.
Consider a giant drug maker like GlaxoSmithKline. Calculating its ‘correct’ valuation is likely impossible. There are many brands, new ventures, potential disasters and expired patients patents that can impact its profits from quarter-to-quarter.
Fluctuating sentiment also continually alters the multiple (the P/E ratio) that investors are prepared to pay for a claim on Glaxo’s profits.
Over the long-term our valuation estimate might prove to be approximately right. But in the short-term it’ll be precisely wrong – except by luck.
In contrast we can immediately see what a Glaxo share is worth right now by pulling up its share price on the Internet.
You might believe GlaxoSmithKline is worth £20 a share. But as I type this the market says it’s worth £14.55. That’s what someone will pay for its shares right now.
If you’re confident you’re right, you might buy Glaxo shares as they’re trading for less than your valuation and wait for the market to come around to your thinking. (That, in a nutshell, is stockpicking. But that’s for another day…)
Investment trust valuation is a little different
With an investment trust like Monevator Investments PLC, it’s usually very easy to work out its value. You simply look at its assets and debts, calculate the NAV like we did above, and hey presto – you’ve got its value.
This is true of any investment trust that holds a basket of liquid and quoted securities, where you can just call up the latest price of each investment. (I’m ignoring for now more complicated trusts that invest in unquoted or illiquid assets).
You don’t even have to calculate the NAV per share, unless you want to double-check something. Resources like the AIC’s website collates the stats for you. Trusts also regularly publish their NAVs via the London Stock Exchange’s RNS service.
Now before anyone objects, it’s true that the listed securities owned by the trust might be worth more or less than what the market is pricing them at today, and hence what’s reflected in the NAV.
That takes us back to the Glaxo discussion we just had.
But the point is a trust could in theory dump all its Glaxo shares at today’s market price.2 And that by doing so for all its holdings and then paying off the debt, it would (after costs) be left with that NAV in cash.
In other words, for mainstream investment trusts the NAV is not subjective or an opinion. It’s a fact.
Discounts, premiums, and NAVs
Despite this certainty, it’s often the case that the share price of an investment trust trades at less than its NAV per share.
And this may be an opportunity. Price is what you pay but value is what you get, to quote Warren Buffett.
For instance, Monevator Investments may trade for £1.20 a share, despite anyone with a calculator being able to see its NAV per share is £1.60.
So in this case, a buyer is getting £1.60 of underlying assets for just £1.20.
Bargain! The share is trading at a discount to NAV:
The discount is (£1.60-£1.20)/£1.60 = 25%
The general idea is that you get more for your money when you invest at a discount. Hopefully in time the discount will narrow, pulling the share price up towards the NAV and amplifying your returns.
Note there’s no guarantee this will happen though. (If there was, discounts probably wouldn’t exist.)
Sometimes trusts can languish on discounts indefinitely. Trusts may even be wound-up as a consequence. Doing so almost always closes the discount, but it typically comes after a period where whatever caused the discount (lousy returns, say) have already done a bit of damage.
Discounts can also be great for income investors who buy and hold, since the money you spend on your shares buys you more of the trust’s income generating assets.
For example, suppose a trust trading at £1 per share – the same as its NAV of 100p – owns a portfolio of blue chips that generates a 3% yield. If the share price falls to 90p to create a 10% discount to an unchanged NAV, then new buyers will enjoy a higher 3.33% yield from the trust. (That is, 100/90*3).
Less often you’ll find a trust priced greater than its NAV. This is more common in bull markets, or for a popular new launch.
For instance let’s say Monevator Investments is trading at £1.80. Net assets are still £1.60 per share.
Then the premium is (£1.80-£1.60)/£1.60 = 12.5%
Now you’re paying 12.5% above what the shares would be worth if everything was sold tomorrow.
Probably not such a good deal!
Also, what I said above about discounts boosting your income is countered with premiums. They reduce the yield from the trust’s underlying investments.
Paying premiums can be costly
For one very illuminating example, when I wrote the first version of this article in 2014 Fundsmith’s then-new emerging market trust traded at a premium to NAV. This was despite its initial assets being merely cash.
You were paying, say, £1.05 to buy £1.
People wanted to own the shares as a bet that fund manager Terry Smith’s stock picking prowess would extend to emerging markets. However that didn’t really pan out, the shares slipped to a discount, and in 2022 the trust was wound up.
So beware hype and premiums kids!
For another example, popular fund manager Nick Train’s Lindsell Train investment trust was trading at a premium of nearly 100% a few years ago.
In that instance investors were betting that the NAV was misstated. This line of thinking was possible because Lindsell Train’s largest asset is a holding in Train’s own investment company, also called Lindsell Train.
With unlisted investments like that, the pricing certainty I talked about doesn’t hold. (This is most commonly seen with private and venture capital trusts.) Hence you can’t be sure of the NAV.
To his credit, Train repeatedly warned investors they were probably paying too much for the trust’s shares. And for the record the share price has halved since those days. Indeed last month you could even buy the shares at a discount.
Sometimes a small premium is the price of entry to a very popular trust, particularly one that has some kind of discount control mechanism allied to its strong appeal.
For instance, Capital Gearing Trust is usually priced just over NAV.
More egregiously, infrastructure trusts have tended to trade at double-digit premiums, although this year these have finally collapsed as bond yields have risen, reducing their relative attractiveness.
Personally I’d never pay more than a couple of percent as a premium. And then only very rarely.
A few final tips on discounts and premiums
Here’s a few things you may be wondering about – or that maybe you should be wondering about if you’re not:
- Fund factsheets and data suppliers usually give the discount or premium as a percentage figure.
- Typically a negative number – for example -5% or (5%) – indicates the level of discount to NAV.
- In contrast a positive percentage indicates a premium to NAV.
- As mentioned, investment trusts must release regular RNS press releases to the stock market. You can find these on various websites. I always check these for the latest NAV per share, and I do the discount/premium calculations for myself. Sometimes the online data sources and factsheets are out of date.
- Another reason to check is that different data suppliers often treat debt and accrued income differently in their calculations. (For example, one may count debt on the balance sheet at its face value, while another calculates its impact on NAV based on what it would cost to pay off the debt today).
- Why do investment trusts trade at discounts? And why on Earth would anyone pay more for a trust than its assets are worth? Great questions, that I’ve previously attempted to answer.
The whole discounts and premiums malarkey was often pinned by old-school Independent Financial Advisers as the reason they put their customers’ money into unit trusts rather than investment trusts.
Clients were too easily confused, they said. (“Honest guv, nothing to do with the commission that unit trusts kicked back, but investment trusts could not…“)
Yet confusion, panic, and mispricing can be your friend if you’re involved in the quixotic (and generally ill-advised) game of active investing.
To that end, I think investment trusts and their mercurial discounts offer a dedicated active investor an interesting halfway house between open-ended funds and ETFs and the outright stockpicking of single company shares.
And after a long sell-off in shares that have hit investment trusts pretty hard, discounts abound.
If you’re an active investor for your sins, happy hunting!
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- Investment trusts are companies that invest in other companies, so in effect they are actively managed funds. Passive index fund investors prefer the warm comfort of low fees and getting the market return to the potential (but in practice rare) upside from active management. They’d therefore choose trackers and ETFs over investment trusts. [↩]
- In practice this might move the share price if it owned a lot relative to the company’s outstanding share count. Again: details! [↩]