Dire Straits or Money for Nothing?
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
As discounts reach historically narrow levels across the board – our analysts debate whether a premium is a price worth paying…
According to JPM Cazenove, during 2020 average investment company discounts widened slightly by between 0.2 and 1% points. Whilst they have widened, in the context of the past five years (and longer), discounts are relatively narrow. Within the average, there are clearly plenty of outliers, and there remain some interesting discount opportunities (click here to read our recent note). An increasing number of trusts now trade at a premium to NAV. At the start of February, there were 77 trusts from a total universe of c. 300 trading at a premium, of which 33 were on a premium of greater than 5%.
Our analysts debate whether investors should be happy to pay premiums to NAV.
That ain’t workin’
In approximately 7-8 billion years time (a reasonable margin of error), the sun will burn out and finally die. At that point, presumably even Scottish Mortgage will probably see some of its premium disappearing.
Even on a (slightly) shorter timescale, impressions of permanence with regards premiums are likely to prove dangerous to shareholders.
A premium indicates demand for a trust is such that demand exceeds the shares in issue. You are paying more for an asset than it is currently worth by market prices; this is not a subjective opinion, like a stock valuation, but a 5% premium literally means you are paying £1.05 for £1 of assets by current market prices.
Possibly your analyst is just cheap (my choice of barber in recent years has primarily been determined, after all, by their offer of every 10th haircut for free), but there are few realms in which rational buyers will willingly pay more.
Of course, for most investors it is not necessarily possible to simply replicate the underlying assets (and thus buy equivalent exposure), even if you knew exactly the underlying weightings.
And dealing costs and spreads would, in any event, likely outweigh any saving on the premium. Nonetheless, in standard equity products, investors can likely identify and access spread-free open-ended equivalents which allow access to a similar strategy at NAV.
Buying a trust at a premium is either a ‘greater fool’ theory gamble, that subsequent to your purchase there will be others willing to pay an even greater premium, or it is a willingness to pay up for the potential of the underlying NAV.
At an individual level, certainly this can and often has made sense. At the market level, relative discounts often reflect a sweep of emotions and crowd investors into momentum plays.
Discount/premiums are typically a secondary momentum effect; investors are chasing NAV returns that have been strong, and are adding another layer of momentum to their investments by doing so through a vehicle which has done well.
Yet the evidence suggests that, on average, this has not been a successful manner in which to allocate to investment trusts.
In the table below, we have compared data series going back to June 2008 (the longest we have available), looking at the average discount by sector from four major equity regions: Europe, Global Emerging Markets, Japan, and the UK.
We have compared the average subsequent 12-month NAV and share price returns at every date since June 2008 between the sector with the widest average discount (or highest premium) and narrowest average discounts.
As we can see in the table below, on average the sector with the narrowest discount or highest premium subsequently underperformed that with the widest discount on both a NAV and share price basis.
Momentum reversals in NAV seem to have typically left shareholders even more out of pocket at the median level; and this is before we address the cataclysm that can befall shareholders when previously beloved managers or strategies fall dramatically out of favour.
This was seen, for example, in what was previously Woodford Patient Capital. Having traded on a premium for much of the first couple of years of its life, a substantial widening in the discount has exacerbated the NAV losses experienced even further.
Past performance is not a reliable guide to future returns
In general, we think the trust structure offers advantages to investors. The ability to deploy gearing should typically be seen as a positive over the long-term for shareholders (after all, if you do not believe the trust is likely to rise, why are you buying it?).
A lowering of liquidity risk and the ability to take longer term views on illiquid positions offers greater opportunities to exploit pricing inefficiencies and reduces the risk of being a forced seller at disadvantageous prices.
Revenue reserves, and their deployment to support income streams, have demonstrated their value in recent months, as has the ability to pay income out of capital.
Yet paying a premium to NAV essentially represents an incremental cost to the investor that diminishes the value of the above factors as the premium paid increases.
Buying at par offers the above benefits, essentially, for free. Buying at a 10% premium adds significant share price downside as a potential cost for the basic underlying portfolio, and can perhaps be considered a potential additional cost to access these benefits.
Of course, premiums represent the greater weighting of demand relative to supply. We see this replicated across entire sectors at times, such as is the case with renewables.
Yet an assumption that renewables, for example, will structurally trade at a premium is a dangerous assumption to make in our opinion. Supply deficiencies in the number of trust shares in renewables is likely to be met ultimately by further issuance or new listings.
Ultimately a point of equilibrium will be met and, when supply inevitably starts then to outstrip captive demand, sector level premiums can be expected to diminish.
Many investors buy renewables for a relatively uncorrelated income stream, deeming the level of yield on offer without NAV being tied to stock market fluctuations attractive (particularly given the paucity of income available from bonds in recent years).
This is, of course, entirely reasonable, but buying a renewable energy infrastructure trust at a 12% premium (the current sector average) realistically means you should be assuming a return to par which would mean at least a 10.7% reduction in the capital value of your investment over the longer term.
You may not care particularly if you are investing solely for income. If you think the dividend stream is highly sustainable and are viewing it as almost akin to an annuity, why would fluctuation in the capital value matter so long as you continue to receive dividends at the level you targeted on entry?
Again, this is fair, but buying at a premium axiomatically requires you to put more capital to work to achieve targeted income levels. It mechanically lowers your starting yield.
Look below at a hypothetical trust, paying 5p per share income from £1 NAV value (for the sake of argument, let us assume this is rock solid and discounts/premiums are only a reflection of changing market sentiment).
You as a prospective shareholder need to generate £5,000 of income a year; you intend to do so from this trust, and then seek to grow the rest of your capital.
All of a sudden, by buying at a 10% premium, you are committing £20,000 in extra capital to generate the same level of income.
Let us take a real-world example now. Starwood European Real Estate (SWEF) is set to rebase its dividend to 5.5p per share, giving a yield at present of c. 6.1%. The trust trades at a discount of c. 11.7%, so the yield to NAV is c. 5.4%.
By buying a dividend stream which looks robust to us at a sizeable discount to NAV, you can achieve target income levels with a smaller capital deployment. By contrast, the Tritax Big Box REIT (BBOX) is on a premium of c. 22.1% at present, and its yield accordingly on the current share price is only c. 3.4%. . A 1.3% differential in yield on NAV has become a 2.7% yield differential because of the disparities to NAV in the share prices!
This might seem abstract, but an investor looking to generate £10,000 p.a. income would need to allocate roughly £130.2k more to BBOX than to SWEF. If they were both trading at NAV, the difference would be c. £58.7k.
This is capital that can otherwise be deployed elsewhere.
Undoubtedly there are cases where a premium is justified. Sometimes a premium is merely optical: private equity trusts, for example, only update their NAVs quarterly, and in between these periods a premium is more likely to reflect the market’s ‘best guess’ at where NAV has progressed to.
In other instances, complexity and scarcity may justify a premium. There are plenty of examples where a trust offers a solution that is not easily replicable and where there are few if any readily available alternatives with the same approach available to most investors.
If the market wishes to pay a small to middling premium for such trusts, in our view it is understandable against this backdrop. However, in the main, for most products a premium should be taken as a sentiment indicator, and quite potentially a warning sign.
The other side of the argument is that premiums are acceptable to an extent, but clearly not to excess. As with any excess, what really constitutes excess is entirely subjective.
However, as readers of our research (and other commentators, such as Merryn Somerset-Webb) will know, we believe investment trusts are attractive vehicles for long term investors.
Their objective remains the same now as it was in 1868 when the first investment trust (Foreign and Colonial Investment Trust) launched: “to give the investor of moderate means the same advantages as the large capitalists in diminishing the risk by spreading the investment over a number of stocks.”
Aside from allowing the spread of risks (not unique to investment trusts, since the launch of the first unit trust in 1931), investment trusts also have a number of other advantages.
These include the ability to borrow to enhance returns (although this does add to risks), the potential to smooth dividends over time through a revenue reserve, to allow investment in illiquid assets (less liquid listed stocks, but also unlisted private investments) as well as the oversight that an independent board provides (to represent shareholder interests, where they might conflict with the manager).
As a package (especially relative to those late-comers, the unit trusts), a casual observer might expect that this neat little investment engine known as an investment trust might be worth paying something for!
By which we mean – above and beyond the mere sum of its parts (or NAV). Indeed, investors in unit trusts pay NAV without any grumbling. So why should investors in investment trusts not?
Well… there has been plenty of water under the bridge since 1868. But for some reason, discounts (like the black rat) once established, just seem to stick around.
However, in some places and at some times, trusts or sectors seem to be able to miraculously move from crawling around on the ground unable to lift off, to cocoon themselves and then with chrysalis shed, emerge as a beautiful butterfly trust on a premium, able to move effortlessly by extending wings and growing through share issuance.
When you look at it over the long-term, investment trusts outperform unit trusts – perhaps because of the higher hurdle required to launch and/or be appointed to manage it by an independent board.
Or perhaps – assuming the skills between unit trusts and investment trust managers are equally dispersed – the elements of the structure add ‘alpha’ and outperformance.
Either way, the increasing prevalence of premiums might be considered symptomatic of a broader recognition of the attractiveness of the structure? Or perhaps it is just good old fashioned irrational exuberance?
We wouldn’t be so bold as to suggest that premiums will not disappear as soon as markets start to struggle, because they will, as sure as eggs is eggs.
As such, we would never advocate investors paying more than a small premium (say a maximum of 3%) for a trust – particularly a trust that invests in highly liquid listed equities – that reflects its unique qualities.
Any significant premium is dangerous, due to the effect a sudden change in sentiment (or a fall in NAV) can have.
Share prices are driven by liquidity and sentiment, and discounts can widen very quickly at times of stress, or on specific news (such as a manager leaving). If the discount widening is a result of a NAV fall, share price returns will exacerbate NAV losses.
The manager and board are in no position to help investors who have bought shares on a significant premium: trust boards cannot buy shares back to protect a discount until there is a discount, and even then usually only at a c. 2% discount at the minimum.
As such, in our view, a basic rule of thumb is that a premium of up to 3% is acceptable, but anything over that is usually getting into danger territory.
There are exceptions however, and it may be that a higher premium is justifiable. For unlisted or alternative assets, the discussion is a bit more nuanced.
One reason for justifying a significant premium is the way the NAV is calculated. Unlisted investments are not (by definition) marked to market – given there is no market.
As such there is likely to be a certain degree of subjectivity in the calculation of the NAV. With regards to private equity investments, managers tend to value investments conservatively.
There are sound reasons why an investment that has not been sold should be valued at less than the price someone else is confirmed as willing to pay – until they have signed a contract to do so! In the private equity space, industry convention dictates that managers generally like to be able to report an uplift to current valuation when they do achieve a sale.
However, as Electra Partners learnt to their cost, managers shouldn’t be too conservative on their valuations.
The experience of the LPE sector over the past ten years, where significant discounts to these (conservative NAVs) have been the order of the day, contrasts to the situation in 2004-2007 where many trusts stood at premiums.
At the time, investors justified premiums because of the strong momentum in equity markets, and the time-lags between NAV calculations. Prices anticipated NAV write-ups, and so ‘effective’ premiums were not as great as those optically paid by investors.
The experience of 2008/09 (in which several trusts were terminally wounded) was so traumatic in terms of premiums turning into discounts, has perhaps scarred investors in the sector ever since – which means the sector trades on unjustifiably wide discounts currently, in our view.
We would argue that the experience of the LPE sector doesn’t necessarily represent what will happen to other sectors that are currently sitting at hefty premiums.
In many (Infrastructure, Renewables) there is evidence that a) institutions are paying higher prices for assets than listed funds are currently valuing their assets, and b) the portfolio effect is having, well, an effect (assembling a portfolio of illiquid assets takes time and skill) which one might argue should attract a premium rating.
Sectors that are worth contemplating even though they trade on premiums:
Renewable energy infrastructure – With recent news of some of the global oil companies bidding hefty prices for offshore windfarm development plots, it is clear that there is a lot of capital chasing assets here.
The existing trusts in this sector that are fully invested have high quality assets that are tried and tested, and generating electricity. They have operational track records and have delivered dividends to investors for several years. Greencoat UK Wind and TRIG – Renewables Infrastructure Group are institutional sized trusts with total assets of north of £2.5bn and are a case in point.
Royalties – This is a new area, but one that is seeing huge interest from institutional investors around the world. Not for the first time, the closed-ended universe seems to be ahead of the game (having the perfect structure to invest and hold these investments for the long term). Hipgnosis (SONG) has a high quality and very large portfolio already built up, with Round Hill Music following in its steps.
In our view SONG’s NAV doesn’t account for the “portfolio” value of having assembled the portfolio such as it is. Both managers have also highlighted that the independent valuer to both is likely to reduce the discount rate applied to value the portfolio, implying that investors who anticipate this should be happy to pay a premium now on the assumption that the formualic valuation will be increasing.
Environmental – ESG has become mainstream. However, the likes of Impax Environmental Markets and Jupiter Green have been here for many years, and so the world is finally waking up to their investment propositions.
Three years ago, both traded on discounts of greater than 10%, yet both now trade on premiums reflecting strong interest in this area. The closed ended structure is a good way to access small and mid-cap stocks which are benefitting from a shift to a sustainable economy without having to worry about flows diluting the impact from these stocks on returns. There are risks though – and the points further above especially apply to equity strategies such as those in this sector.
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First published 27th February 2021