An investment trust is trading at a discount when the share price is below the net asset value per share (NAV) of the trust’s underlying holdings. When the share price is above NAV, the shares are trading at a premium.
Most of the time investment trusts trade at a discount, but this need not be a bad thing, particularly if you are looking to invest.
So why is there a difference between the share price and NAV? Because the share price fluctuates depending on how many investors want to buy and sell the shares at any given moment and the NAV moves in line with the underlying value of the holdings in the trust. The share price tends to move more – and this volatility can be disconcerting for investors. It is worth understanding what is going on because it can be used to work in favour of the investor.
If you invest £100 in investment trust A that is trading at a 10 per cent discount you are buying £111 of value for £100. Nice and tidy. If you invest £100 in investment trust B trading at a 5 per cent premium (a premium above 5 per cent is rare) you are buying £95.23 of value for £100. @Image-de4ada71-c51f-4a0d-b1aa-5ee84085554d@
But consider the long term. If investment trust A then generates 5 per cent NAV growth each year for five years you will now own shares with an NAV of £142. But if investment trust B generates 10 per cent NAV growth a year (which may be the reason it was trading at a premium in the first place) you will end up with £153.
This is assuming the discount and premium of each trust does not move, which is unlikely, and almost unheard of for a trust to trade at a premium for five years.
In order to bring the impact of the discount into perspective, investors should develop a discipline that gives them guidance as to whether a particular discount level is good value or bad value. Below is a list of the main factors that may that affect the level of the discount.
Negative factors that will cause a discount to increase:
A generally bearish stock market
The sector, country or region in which the trust invests is out of favour
The Illiquidity of the underlying assets
A spell of underperformance
The investment trust has no discount management strategy in place
Positive factors that may cause a discount to reduce or for the trust to move to a premium
A generally bullish stock market
A sector, country or region that is in favour
A reliable income stream in the form of dividends
A manager with a consistently good track record
The investment trust has a discount management strategy in place
Every investment trust will have its own volatility characteristics and there is no hard and fast rule that can be laid down as to which discount levels are cheap and which are expensive. It is plainly better to buy shares in an investment trust when they are cheap and to sell them when they are expensive, and correspondingly buy when the discount is wide and sell when the discount is narrow, or has turned into a premium. Before handing over their cash, investors will already have researched the investment trust and established the track record of the managers, the growth prospects of the region or sector, the valuation metrics and the macro factors that are likely to influence the shares. But selecting the optimum entry point is greatly enhanced by studying the volatility of the discount over an extended period of time. Anyone who buys an investment trust trading on a discount of 5 per cent which then increases to 10 per cent has lost money even if the value of the underlying assets – the NAV - has not moved.
To start, compare the share price to the NAV on a daily or weekly basis over several preceding years. If this data is then plotted, a chart similar to the one below will result. The yellow line moving along the centre of the chart is the 12-month average of the discount. It can be clearly seen that the discount fluctuates between peaks and troughs at frequent intervals. Depending upon the volatility of the discount, the next stage is to plot a set percentage above and below the 12-month average. The actual percentage depends upon the volatility of the discount. In this example, 5 per cent above and below the average would cut through the peaks and troughs of the discount as the chart below illustrates.
The lower line plots the average 12-month discount less 5 per cent and the upper line, the average 12-month discount plus 5 per cent. When the discount crosses below the lower line this indicates that the risk to the shares of further discount widening is low. When the discount crosses above the upper line the possibility of further discount narrowing is less. Investment trusts with higher discount volatility will demand a higher than 5 per cent offset from the 12-month average. Experimenting with different offsets will quickly establish the optimum percentage.
Although buying when the discount is the wider and selling when the discount is narrower is not a trading system and carries no certainty of profit, it does reduce the risk of getting on the wrong side of a widening discount swing.
The advantage of applying this methodology is that it automatically adjusts to changes in the market’s perception of what the discount should be, as it uses the 12-month average discount to determine good value and bad value levels.
As the 12-month average moves down, so do the value levels. The same principle applies equally to investment trusts that trade at a premium. The good value level may well be at a discount but the bad value level will be at a premium. The ability to use fluctuations in the discount to optimise entry and exit points is one of the many advantages that investment trusts have over unit trusts and open-ended investment companies.
Nick Wilson is chairman of the Qatar Investment Fund
| Key points |
Most of the time investment trusts trade at a discount. Investors should develop a discipline that gives them guidance as to whether a particular discount level is good value or bad value. buying when the discount is the wider and selling when the discount is narrower reduces the risk of getting on the wrong side of a widening discount swing. |
