A lot of investors are unnerved by investment trust discounts and premiums. That’s unfortunate, because the concepts are quite simple, and they probably shouldn’t put you off buying these useful shares.
That said, not understanding the difference between discounts and premiums can cost you money.
In this short series of posts, I’ll explain how discounts and premiums work from first principles, and how you might profit from them.
If you haven’t already read my introduction to investment trusts, please do so to get a handle on the basics, then click back in your browser to continue.
What does your investment trust own?
So we all (now!) know that an investment trust is a company that purchases assets to hold or trade.
Such assets could include shares, property, bonds, or even exotic fare like farmland or art, depending on the trust’s mandate.
On buying shares in a particular investment trust, we become part owners in the trust and thus have exposure to those underlying assets.
For example, an equity income investment trust will own shares in large blue chip companies that pay good dividend yields. As an owner of shares in such a trust you’ll be paid a portion of the portfolio’s dividend income, minus costs and any income retained in the trust’s reserves. These trusts therefore appeal to investors who want a diversified income.
Alternatively, 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 believe (rightly or wrongly) that its manager is a good one. He may be buying the same sort of shares you could buy yourself, but you believe he is skillful at picking winners.
Net assets
Whatever the case, the trust will own a lot of stuff, which we term its assets.
It may also have debts (i.e. gearing), which would need to be repaid if the trust were to be wound up before its owners divvied up whatever was left.
Therefore:
Net assets = Assets minus liabilities
How to calculate the net asset value per share
While they amount to the same thing, it’s usually easier to work with an understanding of what portion of the trust’s net assets each of your shares is worth, rather to work off the trust’s total market value.
For illustration, imagine the world’s simplest investment trust, Monevator Investments PLC.
This trust owns shares in just two companies, Diageo and Glaxosmithkline. (It’s good to hedge your bets!)
Let’s say shares in Diageo are trading at £10 and Glaxosmithkline £12. The trust owns 100,000 shares in Diageo, and 50,000 shares in Glaxo.
The Diageo holding is worth £10 x 100,000 = £1 million
The Glaxo holding is worth £12 x 50,000 = £600,000
This trust has zero debts.
Therefore, for the net assets of Monevator Investments is £1.6 million.
Now, let’s say this trust has 1 million shares in issue.
Net assets per share = £1.6 million / 1 million = 160p per share.
So far so simple!
Investment trust share price versus NAV
A share is worth whatever someone will pay for it. There’s no right or wrong value for any particular share that you can work out with a formula.
This is why share prices are so volatile – the market is constantly trying to work out what’s the real value of each company.
With a vast drug maker like Glaxo, calculating its ‘right’ value can seem nigh on impossible. There are so many brands, new ventures, potential disasters and expired patients patents that can affect its profits from quarter-to-quarter, let alone alter the multiple that the market is prepared to pay for those profits.
However with an investment trust like Monevator Investments, it should be easy to work out its value. You just look at what assets it holds and its debts, calculate the NAV like we’ve done above, and hey presto – you’ve got its value.
And that’s true (ignoring for now more complicated trusts that invest in unquoted assets). In fact, you don’t even have to calculate the NAV. Data sources like Trustnet do it for you.
However, price is what you pay, value is what you get – and the two aren’t always in sync.
Discounts, premiums, and NAVs
In fact, it is often the case that the share price of a trust is less than its NAV per share.
For instance, Monevator Investments may be trading for £1.20 a share, despite its declared NAV per share being £1.60.
In this case, you’re getting £1.60 worth of underlying assets for just £1.20.
Bargain!
The discount is (£1.60-£1.20)/£1.60 = 25%
Less often you’ll find an investment trust with a share price greater than its NAV. (This is happening as I type with Anthony Bolton’s China Trust).
Let’s say Monevator Investments is trading at £1.80, but its net assets are still £1.60 per share.
The premium is (£1.80-£1.60)/£1.60 = 12.5%
In this case you’re paying 12.5% above what the shares would be worth if everything was sold off tomorrow.
Probably not so good!
Why do investment trusts trade at a premium or a discount to assets? Good question, and one I answer in part two.
Thanks for reading! Monevator is a simply spiffing blog about making, saving, and investing money. Please do check out some of the best articles or follow our posts via Facebook, Twitter, email or RSS.
{ 2 comments… read them below or add one }
Your IT articles are much appreciated. Investment trusts make the job of getting income from shareholdings easier than ETFs and some of them seem to smooth the variations, at the cost of perhaps lower growth. That’s a trade-off that is attractive to me as a potential retiree, and many thanks for reminding me of this useful asset class!
.-= ermine on: The Pinch – David Willetts says it’s the Baby Boomers Who are Wrecking the Economy =-.
I second ermine: great to see you focus on Investment Trusts rather than unit trusts as many financial sites often do. The best of them are cheap, offer the diversified benefits of ETFs, with the added bonus of being able to play the discount/premium game.
In my short investing period I’ve found ITs to be much more reliable sources of growth & income than individual shares. Look forward to more articles.