See my earlier article on investment trust NAVs, discounts, and premiums [1] if you don’t know what those terms mean.
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 at a price below what its assets are worth (that is, at a discount) – let alone why some people would be dumb enough to pay more for it (a premium).
Actually, there can be good reasons for both situations. Discounts are especially common.
In late summer 2008, for instance, I posted about numerous income investment trusts [2] trading on 10% discounts [3] in that 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. Most trusts are less liquid [4] than their underlying holdings. This can mean the trust’s share price falls faster than its NAV, increasing the discount.
- Investors may be skeptical that the trust’s NAV is really as much as is claimed. Private equity trusts – where valuations are infrequent and often off-market – are typically discounted for this reason. Commercial property trusts (REITs) may trade at a discount if investors suspect real world prices are falling faster than management is updating the trust’s NAV.
- 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. Simply the whims of fashion. Discounts often close and widen from month to month with little apparent rhyme or reason.
Theoretically a very large discount should be arbitraged away by the market before long. In reality sometimes discounts can persist for years before action is taken.
For example, when I first published a version of this article in August 2010 I wrote:
Alliance Trust 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.
Interestingly, the discount finally began to narrow a few weeks later! It’s now around 10%.
What happened? Well, from memory Alliance Trust’s performance improved a tad – or at least investors took a more generous view of it.
But more importantly, an activist investor called Laxey Partners targeted [5] the trust in late 2010, demanding the board take action to limit the size of Alliance’s discount. This interest was enough to close the discount to 15% even before Alliance’s board implemented any explicit measures in response (such a formal share buyback plan).
The Alliance story went through many twists and turns, including the involvement of another activist and much boardroom drama. A Telegraph article [6] from last October provides a recap.
The takeaway for our purposes – apart from wondering whether activist investors read Monevator – is to note that big discounts do not necessarily mean a trust is permanently impaired. They can be and often are reversed.
But sometimes big discounts do portend doom. I’ve seen the value of several specialist property trusts implode over the years. Usually they were overwhelmed with debt. In every case a huge discount preceded their demise.
Finally, discounts may persist when for some reason it’s not possible for an outsider to stir up much of a threat to the status quo.
Typically there’s a large controlling shareholder – perhaps the family that initially set-up the trust. Hansa Trust [7] is a good example.
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 [4] trusts in their mania.
- Suspected undervaluation in reported NAVs. As with the equivalent situation with discounts, this will typically involve unquoted investments, such as property or private equity. Investors may guess the NAV of a trust has risen beyond its officially reported value. The Lindsell Train [8] investment trust is a great example, currently trading at a 58% premium! Investors seem to believe the trust’s holding in its own management company is dramatically undervalued, despite said management urging otherwise. A clue that this is the cause of the premium (besides the sheer enormity) is that the Finsbury Growth Trust [9] has the same manager and very similar holdings – except it has no stake in Lindsell Train. Finsbury currently trades around NAV.
- Strong faith in management. For example, Anthony Bolton’s China trust [10] initially traded on a premium. Investors believed Bolton’s superb record with his UK fund implied he would grow the China trust’s NAV fast enough to make up for the premium and more. But it turned out he couldn’t – at least not in the short-term – and the premium evaporated. The fund now boasts new management and a 15% discount.
- Fashionable. If an investment trust has been in the news or is one of the only trusts 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 sizeable premium, as you may lose money if it narrows.
However I wouldn’t quibble over just a 1-2% permium if you’re a hardcore investment trust owner. Refusing to pay anything but a discount can keep you out of excellent trusts with strong multi-year records for years.
Equally, a trust trading on a discount may not be the bargain it first appears – or at least the discount may not be set to narrow anytime soon. As always, it’s vital to do your own research.
Want more? Please do peruse our other articles on investment trusts [11].