This mini-series has previously explained investment trust discounts and premiums [1] and why they arise [2]. Read those articles first if you need to.
Bear markets are when you make your money. You just don’t know it at the time. Beaten-up markets enable you to buy future cashflows cheap, boosting your expected returns [3]. That’s as true for investment trusts as for any other assets.
Indeed: pick-up unloved investment trusts on a discount and you can extra-juice your future returns, should that valuation gap narrow over time.
But alas! I haven’t just whispered the secret to getting rich quick into your ear.
Because it’s no easier to pick winners in a bear market than in a bull one. You’re still statistically likely to lag a tracker fund. (Although I’d argue it’s little easier to avoid outright losers once the froth has come off.)
Besides, even if you buy the indices you can’t know how long a recovery will take.
You can’t even be absolutely certain a recovery will come at all. Just ask anyone with a tin full of share certificates from Tzarist Russia…
However with those caveats out of the way, it’s a fact that investment trust discounts and premiums do wax and wane.
People overpay in the good times. While in miserable periods someone will sell at almost any price.
Check out [4] this graph from Numis showing how discounts widening and narrowing is an age-old story:
[5]I don’t believe it’s fanciful to try to profit from these cycles.
2022 and all that
Average discounts blew out towards historically extended levels [6] in the ‘Sell Everything’ market of 2022.
Some trust sectors have rallied since, at least off the Mini Budget [7] lows. You won’t find infrastructure or blue chip equity income trusts on a double-digit discounts anymore.
But what about technology, private equity, commercial real estate, or growth trusts priced at anything from 10% to 50%-off the value of their underlying assets?
You know – all the stuff we couldn’t get enough in the good old days of… 18 months ago?
All that is still priced to go.
So if you’re an adventurous (/misguided) active investor and you’re ready to take a hit if you get it wrong, some bargains are surely out there.
Don’t discount it
The most important thing we need to think about when buying any investment trust – whether it’s trading at a discount or a premium to its underlying value – is obviously the potential impact on our wealth.
Recall that investment trusts are listed companies that own other assets. When you buy shares in an investment trust [8], you effectively become the owner of a portion of those assets.1 [9]
Your ownership of the trust’s assets is proportionate to your ownership of the trust.
For all but the oligarchs among us, this is most easily worked out by taking the total number of shares you own, and multiplying by the net asset value (NAV) per share of the trust:
- If you own 1,000 shares of a trust with a NAV per share of £2, then your economic exposure to its assets is £2,000.
But as we’ve previously seen, a trust’s share price may be higher than the NAV per share. (It’s trading at a premium to net assets.)
Or it may be lower. (The trust trades at a discount).
And this complicates things!
Two ways to win (or lose)
Premiums and discounts come about for all sorts of reasons. We covered that earlier in this series.
The key point today is we have two moving parts when it comes to the returns we see from buying shares in a trust:
- The movement of the trust’s share price. This determines how much we’ll get for our shares if we sell today.
- The movement of the trust’s NAV. This reflects the underlying returns of the trust’s investments. NAV changes tell us how well the trust is performing, ignoring the gyrations in its share price.
As I said earlier, as a shareholder you have an economic interest in a proportion of the trust’s net assets. Thus it’s the movement of the trust’s NAV over time – ideally upwards – that’s most important over the long-term.
However over the short-term, share prices are kerrraaazy! They can do anything.
This means that if you want to sell on any given day, you’ll have to take the price you’re offered for the trust’s shares. Regardless of whether the shares trade at a discount (boo!) or a premium (yay!) to NAV. (Aka ‘What they are really worth’.)
Sadly you can’t demand the trust is liquidated just so you get the correct value for your assets. Well, not unless you own enough shares to influence the board of directors.
Sometimes trusts do wind themselves up. They’ll sell their assets and gradually return the NAV to shareholders via capital returns or dividends.2 [10]
But that’s rare, and it’s outside your control.
No, in practical terms your shares are worth what someone else will pay you for them. Whatever the underlying NAV might be.
This means that any movement in the discount or premium while you hold the shares can greatly affect the returns you see.
NAV growth and the share price
Provided the discount or premium remains unchanged during your ownership of the shares, the share price will simply capture the increase or decrease in the underlying assets.
People get confused about this. So here’s a quick example:
Let’s say you buy Monevator Investment shares at a 25% discount to the £1.60 NAV.
That is, you pay £1.20 a share.
The simply brilliant manager [ahem] makes great stock picks. The NAV doubles from £1.60 to £3.20.
Despite this superb performance, the discount remains unchanged at 25%.
Your shares now trade at £2.40 (75% of £3.20) against the NAV of £3.20.
You’ve made the same 100% return in the share price as the NAV has doubled, despite the persistent – but constant – discount.
How a narrowing discount increases your return
So far so straightforward.
But what’s more likely to happen is that the performance of a manager who has doubled the trust’s net asset value will be noticed by other investors. And these envious hordes will want a piece of the action.
More people wanting to buy the shares would typically lead to the discount being reduced (narrowing) as demand hots up:
Let’s say the discount narrowed from 25% to just 5%.
At a 5% discount to the £3.20 NAV, the shares would be trading at £3.04.
In this case, the doubling of the NAV – plus the closing of the discount – has boosted the return you see on your initial purchase price of £1.20 a share.
In fact, you’ve made a 153% return, compared to just the 100% growth in the NAV.
Conversely, premiums can clobber your returns
A discount narrowing from 25% to just 5% is an unusually good outcome, unless you’re lucky enough to purchase shares in a trust when the market is going through one of its fits [11].
But the general point is clear. It’s great to buy an investment trust at 25% less than the value of its assets and then to see that markdown narrow due to good performance. You get a double whammy of a return!
If these things happened predictably we could all meet on a tropical island by Christmas.
In practice, discounts can persist for years – or ‘forever’ in practical terms. But they do often close, and it’s great when it happens.
On the other hand, when you buy a trust at a premium to its underlying assets then the converse of all the above can unfold.
If you buy an investment trust on a premium to NAV and that premium closes – either because the share price doesn’t keep up with NAV growth, or because the NAV doesn’t grow or shrinks, and the share price falls even faster – then the premium narrowing will reduce your return, versus the performance of the trust’s underlying portfolio.
For this reason, I almost never buy trusts on a meaningful premium.
When premiums fade
Some people – especially those who manage investment trusts – will tell you that it doesn’t matter if you buy at a premium. What is important is the performance of the underlying portfolio.
And it’s true that if you buy on say a 10% premium and in future sell at the same mark-up, then your returns will not be affected. Just as with static discounts, like we saw above.
However in my experience, premiums do not generally persist. Even trusts that more often than not trade at a premium – infrastructure trusts, for example – go through spells on a discount.
Why not buy them then, and get rid of the risk of paying over the odds?
Managers will point to graphs showing how delaying purchasing like this foregoes returns. But it’s a false choice. There’s almost always something else you can do with your money while you wait to buy near par.
RIT’s faded glory
In the original version of this article in 2010, I wrote:
One of my favourite investment trusts, RIT Capital Partners [12], frequently trades at a premium to its NAV, thanks to its great track record and investors taking optimistic views on the value of its illiquid holdings [13].
I don’t sell my RIT holding just because of the premium. I’d just have to buy back in later. But I have only ever bought the shares when they were priced at or below net asset value.
This is a cautious approach, and it will mean you will sometimes miss out on an excellent performance from a trust that’s become popular with investors.
Better safe than sorry [14] is my view, but you’ll have to make your own mind up.
While it only goes back ten years, this graph from the AIC shows how RIT’s fading premium has taken the edge off shareholder returns:
[15]
Source: AIC [16]
Starting in early 2015 RIT’s shares began to trade at a persistent premium to NAV. You can see this in the bottom chart. (Click to expand). The premium was over 10% by 2018.
No doubt investors at that time shrugged off paying a near-12% surcharge for exposure to RIT’s underlying assets. After all the record looked good – and with RIT your gains tend to be come with less downside than you get in the market, which is always nice too.
Happy days!
Sadly though, as I write the shares now trade at a thumping 22% discount to NAV.
This huge shift from premium to discount has scythed away about a third of the return that shareholders would have enjoyed if the premium had instead remained static.
Investors get off the Lindsell Train
An even more startling example comes with the Lindsell Train Investment Trust.
For many years investors paid an expanding premium for this trust.
Initially this seemed to be down to enthusiasm for manager Nick Train’s market-beating stock picks. But in time a more sophisticated analysis had it that the trust’s large shareholding in Train’s (unlisted) fund management company was undervalued. The premium, it was said, reflected the market correctly divining the true value of this large and fast-growing private holding.
To his credit, Nick Train was himself cautious. For example in 2016 [17] Train warned:
“We would advise investors to think carefully before buying shares at such a steep premium to NAV.”
A fund manager telling people not to buy his fund? Needless to say, not the usual run of things.
It’s worth knowing though that Train had been warning about the trust being on a precarious footing for many years before that. In fact he said much the same [18] when the trust was on a 21% premium to assets in 2012. The share price more than tripled over the next five years!
So perhaps we can almost understand how some shareholders persuaded themselves it was worth paying a roughly 90% premium – nearly double the NAV – to buy the shares in 2019.
Unfortunately, the music finally stopped and the years since have been rubbish:
[19]
Source: AIC [20]
Notice here that – while hardly racing away – the NAV (orange line) has continued to grow since the date of the peak premium in 2019.
However the share price (blue, shaded) has sunk like a stone as the premium (bottom chart) has completed evaporated.
If you were unlikely (or foolish) enough to buy at the peak premium then your shareholding has been pretty much cut in half. Again that’s despite the NAV being modestly up since then.
When something can go wrong, it usually will
Now, in the case of both RIT Capital Partners and Lindsell Train there’s other stuff going on besides the gilding coming off an excessively buffed-up share price.
RIT had a rotten 2022 for a trust that some – incorrectly – expected to never lose money. Meanwhile Lindsell Train has seen market-lagging returns and fund outflows as its style has fallen out of favour.
In the face of these headwinds, there’s no eagerness to pay a premium for the assets. Hence the demise of those premiums.3 [21]
I would argue however that some similar rough patch will nearly always come along to take the sheen off shares that are priced to perfection.
If I like the long-term investment case, I’d far rather buy in that rough patch, and with a margin of safety. As opposed to in the best of times, where the potential downside is magnified by paying well above NAV for the shares.
Indeed I currently own both these investment trusts. And I bought them on a discount.
I wouldn’t avoid a trust on a small premium of 2-3%, if everything else checked out. And I’d probably hold if the price subsequently got carried away – at least within reason.
Generally, though, anything beyond that is a no-go. I like to stack the deck in my favour!
Cut-price trusts boost your income, too
Finally it’s worth knowing there’s an advantage for income seekers buying investment trusts [22] priced below NAV.
You will get a superior dividend income [23] from a trust on a discount. That’s because the trust will usually pay out the same cash stream from its net assets, regardless of the discount.
And since you’ve bought more exposure to those underlying assets for the same money, you’ll get more income than if the trust traded at NAV:
- A 10% discount to NAV will boost your income from that trust by 10%, compared to if you bought when the share price at NAV.
There’s not many free lunches in investing, but buying a good equity income investment trust on a big discount may be one of them.
For this very reason, income-focused investment trusts usually trade close to their net asset value.
Not all that glisters is gold – or even cheap
Beware: a really big discount or one that is out of whack with other trusts in its sector can be a warning sign. Investors may rightly fear something is amiss with the trust (or know that it is) and so require a big markdown to assets before buying in to help protect their downside.
Look closely at such a trust’s gearing (debt), the sort of assets it holds, and management’s plans and track record. Consider the macro-economic backdrop, too.
A classic example right now are commercial property investment trusts. These are on a big discounts for a host of reasons.
Offices are half-empty, with people still working from home. Financing is dearer. Yields on alternative investments (particularly bonds) are higher.
These trusts have already written down the value of their assets. But there could be further to go, so NAVs could yet head lower. And all this could get worse with a recession.
Or… it could get better? Maybe interest rates will be cut, bond yields will fall, and workers keen to keep their jobs will show their faces in the office more, boosting occupancy.
Nobody (should have) said this stuff was easy.
By all means be contrarian if you’re an active investor with reason to believe you know better about one of these factors.
That’s my game [24], I won’t judge.
But if you don’t – don’t!
Buying trusts on a discount: naughty, but nice
In conclusion, I think rifling around for excessively unloved investment trusts is one of the more accessible ways to play the active investing game. Should you be inclined.
But before I get pilloried in the comments, I certainly am not saying it’s a sure thing. Nor that you will do better than buying a tracker [25], or anything like that.
This is still stockpicking. Most people do it poorly, especially on a risk-adjusted basis.
For related reasons, I’ve not bothered citing academic research into whether buying investment trusts on a discount is a way to capture market-beating returns.
I’ve read a few bits [26] and bobs [27] over the years. Most do detect ‘price signals’ – that is, they find evidence of future returns captured in today’s prices.
But I don’t really think such studies are especially relevant to private investors.
You won’t be buying a basket of every investment trust on a discount, weighted by the degree of apparent under-valuation, for instance. You probably can’t hold indefinitely. And you certainly won’t also be shorting trusts on a premium, which is the sort of thing academics love to do in their models but is both costly and risky in real-life.
You’re also unlikely to have the muscle to agitate for corporate change – a strategy often employed by professional bargain-hunters in closed-end funds.4 [28]
No, you’ll be looking for good trusts with decent prospects, priced more cheaply than you judge they should be.
Nothing more complicated. Nothing less simple. Fun, if you’re that way inclined.
Happy hunting!
- Remember you need to subtract any debt or other obligations carried by the trust, to determine the value of its net assets. [↩ [33]]
- After subtracting any costs for doing so. [↩ [34]]
- Lindsell Train’s board has also tweaked the valuation of that unlisted fund management business. [↩ [35]]
- Investment trusts are a variety of closed-end fund. [↩ [36]]