See part one of this in-depth look at investment trust NAVs, discounts, and premiums if you don’t already know what those terms mean. Now for part two!
The stock market isn’t totally efficient in my view, but it seldom hands out free lunches.
You might then wonder why an investment trust would ever trade for less than its assets are worth (a discount) – let alone why some people would be dumb enough to pay more (a premium).
In fact, there can be good reasons for both situations, and discounts in particular are pretty common.
In late summer 2008, for instance, I posted about income investment trusts trading on 10% discounts in the deep bear market.
Discount aisle
Reasons for a trust trading on a discount may include:
- Investors are scared, and so having been dumping their shares in investment trusts, which are less liquid than their underlying holdings. This can mean the trust’s share price falls faster than its NAV, increasing the discount.
- Investors are skeptical that the trust’s NAV is worth what it claims.
- A lack of faith – investors may believe bad management is going to reduce the investment trust’s NAV instead of growing it. This is often seen with trusts with a poor track record.
- Disinterest. Perhaps the most common reason for a discount is simply the whims of fashion. Discounts often close and widen from month to month with little apparent rhyme or reason.
Theoretically a genuinely large discount should be arbitraged away by the market before long; in reality sometimes discounts can persist for years.
Alliance Trust, for instance, is one huge old trust that has traded on a discount of nearly 20% for an age. Arbitragers have looked at releasing the value (by buying the entire trust and then selling all its holdings for a 20% gain, minus costs) but so far nobody has pounced.
Premium aisle
As you’d expect, reasons for the rarer situation of a trust trading on a premium are the inverse:
- Investors are bullish, and have bid up the price of relatively illiquid trusts in their mania.
- Suspected undervaluation in reported NAVs. This happens a lot with illiquid or unquoted investments like property and private equity, where investors may judge the NAV of a trust has probably risen beyond its officially reported value.
- Strong faith in management. See Anthony Bolton’s China trust. Investors believe Bolton’s record suggests he can grow the NAV sufficiently fast to make up the premium and more, so are happy to pay it.
- Fashionable. If an investment trust has been in the news or is one of the only ones operating in a hot sector, it’s often bid up in price.
As a rule of thumb, it’s best to avoid buying investment trusts trading on a premium, as you may lose money if it closes. However this can keep you out of excellent trusts like RIT Capital Partners for years.
Equally, a trust trading on a discount may not be the bargain it first appears.
I’ll look at how to make these buying decisions about investment trusts in the concluding part of this mini-series, so subscribe to make sure you get it.
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Exactly what I needed – well explained
One of the things property companies expected upon conversion to REIT status in 2007 was that their shares would swing from trading at a discount to NAV to a premium to NAV.
Could you outline some of the reasons behind this – what is the benefit to a company if shares trade at a premium? I’m doing a dissertation on REITs, but i don’t fully understand why there is such emphasis placed upon a REITs shares trading at a premium.
Thanks
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