Measure for measure

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.

Gearing

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.

Gearing is calculated as net borrowings (that is, borrowings minus cash) divided by net assets, then multiplied by 100 to give a percentage. So if an investment company has borrowings of £13m, no cash, and net assets of £87m, its gearing is 15 per cent.

This means that the company’s return will be 15 per cent better than the market in rising markets, and 15 per cent worse in falling markets (ignoring borrowing costs).

Because gearing magnifies returns in this way, geared investment companies are likely to deliver performance that is more volatile than ungeared ones, with bigger losses in down markets. Over time, though, if markets rise, they may deliver better returns.

With plenty of assets to use as collateral, investment companies can often borrow at pretty good rates. Many have been using today’s historically low interest rates as an opportunity to lock in cheap debt for the long term, while others prefer the even lower rates available on short-term loans.

However, debt is not the only way to gear. Investment companies can also buy derivatives, or use a special share class (called zeroes) to achieve gearing. Needless to say, they will choose the method that gives them the flexibility they want at the lowest cost.

Investment companies are likely to use gearing in a couple of ways. Some might employ a fairly constant level of gearing, while others will be more tactical, using more gearing when they believe markets are undervalued, and reducing gearing when valuations are toppy. A mixed approach is also possible. Advisers can get a better idea of the kind of gearing investment companies might use by looking up the ‘gearing range’ on the AIC website, which is the minimum and maximum levels of gearing the investment company’s board expects to be deployed in normal market conditions.

Like discounts and premiums, gearing makes investment company performance more volatile compared to open-ended funds. But it is a factor that may enhance performance for those with longer investment horizons.

Nick Britton is head of training of the Association of Investment Companies

Key points

* 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

* Over half of investment companies now have discount control policies

* Investment companies can often borrow at pretty good rates