Investment trusts at historically large haircuts

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  • Will investment trust stock prices bottom before the rest of the market?
  • Some trusts are extremely cheap relative to their historical level of premium or discount

There is arguably much more turbulence ahead in financial markets and any investor tempted to grab what look like long-term bargains should now brace themselves for volatility. Owners of investment trusts should be prepared for the double whammy of the sale of shares in the fund’s portfolio and the fall in the trust’s share price, increasing the discount to net asset value (NAV) .

The widening of the discount is very disconcerting to holders of investment trust shares during difficult times and is the reason why our criteria for selecting investment trusts have underperformed the FTSE All-Share indices and MSCI World in what has been a bad year for equities in general. But is it possible that these haircuts now represent a safety margin for investors looking to buy quality companies held in the trusts’ underlying portfolios?

An extremely interesting point regarding the history of our investment trust methodology (dating back to July 2004) is that in the bear market of 2007-2009, the maximum decline (fall in value from peak to trough) of our portfolio to 10 trusts occurred three months (December 2008) before the bottom was hit by its benchmarks FTSE All-Share and MSCI World. It was in March 2009 before the nadir for the two stock market indices of this period.

Of course, the past doesn’t predict the future, but some of the trusts reported historically look very cheap relative to their long-term premium/discount to NAV. The z-scores this month show that several of our funds are close to or more than two standard deviations below their average valuation relative to net asset value. That’s incredibly cheap, especially when some of their underlying holdings have already sold off considerably.

Given that some of the stocks held by high-ranking funds on our screen retain long-term quality characteristics and many others play on longer-term growth trends, investors may reasonably wonder whether this is a golden buying opportunity.

Of course, there is a lot of room for uncertainty. This week’s inflation in the US is higher than expected (at 8.3%, it was down but higher than expected) with core inflation still at 6.3%. The figures saw markets quickly price in the possibility of more hawkish rate hikes from the US Federal Reserve, with stocks selling in anticipation of higher interest rates.

The dynamic is that more expensive rates increase investors’ equity rate of return requirements (so they maintain a risk premium over safer investments like government bond yields). Since many big tech stocks have been offered at incredibly high multiples of their earnings per share, even highly profitable companies have seen their valuations plummet.

Inflation and the methods to deal with it will likely lead to recessions (and have seen countries like the US plunge into a technical recession – two successive quarters of falling GDP), which will be bad for corporate earnings . Downward revisions to analyst expectations would lower the stock price.

But will investment trusts continue to sell? These juicy discounts provide a margin of safety in case the value of the underlying assets falls further, potentially reducing entry point risk for investors looking to support long-term growth trends.

This argument must be weighed against the obvious risk that the shares of investment trusts are themselves dragged down by the markets or if they have problems in their own capital structures (e.g. high leverage) that are exacerbated by higher interest rates. Yet, as the experience of our ten-trust portfolio methodology in 2007-2009 shows, there is a precedent for stock prices of investment trusts to remain low but not to decline before the recovery occurs.

Of course, a rebound from this period of malaise should not be expected to come from such a powerful catalyst as quantitative easing (QE), as happened in 2009. For investors who don’t like trying to time re-entry points, however, a heavily discounted investment trust sector is certainly food for thought.

This report provides the full list of investment companies that make up our portfolio of ten stocks selected using the Alpha investment trust ranking methodology. We feature two trusts in the report and will cover more trusts in a second article next week.

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