If investment companies were football, discounts would be the offside rule. They are not that complicated, but can seem so to outsiders.
The discount of an investment company is the gap between its market valuation (share price) and the company’s own estimate of the value of the assets it holds (net asset value or NAV per share). So if an investment company has an NAV per share of 100p and a share price of 90p, it is trading on a 10 per cent discount. If the NAV was 100p and the share price 110p, it is on a 10 per cent premium.
Why would the share price differ from the underlying assets of the investment company? There are lots of reasons. To start with, if you liquidated the investment company and returned all the cash to shareholders, there would be wind-up costs, meaning that shareholders would get back slightly less than the stated NAV. So a small discount is reasonable (wider for illiquid assets that are harder to value and sell).
But the more important driver of discounts and premiums is market sentiment. When asset classes and funds are out of favour, discounts widen – the commodities sector is currently on a discount of 15 per cent, for example. And the reverse is true too: infrastructure funds, highly valued for income streams that are backed by long-term government contracts, are on an average premium of 11 per cent.
Buying investment companies on discounts clearly has its advantages, not least for income investors, who get a higher yield than they otherwise would (if you buy 100p of assets for 90p, you still get income on 100p of assets).There are also tactical opportunities to go shopping in out-of-favour sectors, hoping to benefit from discounts narrowing when those sectors come back into fashion.
But if discounts bring opportunities, they also mean risk. That is why advisers who use investment companies tend to hold them for the long haul, riding out the additional volatility engendered by discounts.
In an attempt to manage discounts, over half of investment companies now have discount control policies. These often involve the investment company buying back its own shares in the open market when they are trading at a discount, then cancelling the shares. This provides an uplift to NAV (because the shares were bought back at a discount) and tends to narrow that discount too because it reduces the supply of shares in the market.
Across all investment companies today, the average discount is 5 per cent. Discount control policies are a likely contributor to the narrowing of discounts in recent years (see chart), but it is worth remembering that they are not guarantees. Discounts will always be a feature of investment companies, and are likely to widen at times of market stress.
Investment companies, unlike open-ended funds, are able to borrow money to invest. Not all of them do – just over half of investment companies have zero gearing at present, and that excludes VCTs, which do not tend to gear. Average gearing across the industry at present is 7 per cent, more modest than many imagine.