03 May 2010 | James Budden

Discounts 

One of the biggest gripes about investment trusts is that more often than not their share prices stand at a discount to their Net Asset Value (NAV).

Of course this is true of many listed companies but in the investment trust sector the numbers are there to see on a daily basis. The real issue is not the level of the discount but its volatility. An investor does not want to buy into a trust on a 10% discount to see it drift to 18%. But the investor will be satisfied to see the discount remain steady around 10% and happy if it snuck in a few points.

Theoretically discounts are a product of supply and demand. If more people want to buy shares in a trust than want to sell, the discount will tighten and vice versa. Hence trusts managers actively promote their funds to potential investors to increase demand. Shares will change hands on a daily basis but what upsets the process is the dumping of large lines of stock into the market place. Inevitably, it is difficult to find a buyer in size at short notice, as most buyers of trust shares these days are small and frequently incremental. In this case the trust itself can step in and repurchase the shares for cancellation. This transaction enhances the NAV for all remaining shareholders. 

Before the great credit crisis, it was a popular move for trust boards to formalise their share buy-back policies by announcing Discount Control Mechanisms (DCMs). These DCMs stated a level of discount at which the trust would promise to buy back its shares. The idea being that its investors would thus escape the volatility wrought by too much supply.

In reality many boards have failed to live up to these promises which does not reflect well on the sector. Some, like Foreign & Colonial and Witan, are examples of probity in this respect and as a result, their lack of discount volatility is marked.  Witan has bought back over 40% and Foreign and Colonial just under 30% of their capital over the last five or six years. Alliance Trust Savings (ATS) finally repurchased some of its own shares relatively recently but is reluctant to offer any ongoing enthusiasm for this practice. Hence ATS sits on a discount in the high teens. Surprisingly some sector analysts see this as an “outperform” signal expecting the discount to contract at some stage when this attitude changes. They could be in for a long wait.

Arguably our own Scottish Mortgage has suffered from too much discount volatility in the past given its strong performance record over most periods (we like to concentrate on the five year figure). This year we are promoting the Trust harder than ever and we have bought back some 4% of stock, year to date, as a couple of large institutions quit the building.

We can’t help wondering if a trust like Scottish Mortgage, which currently ticks all the boxes (performance, promotion and buybacks), offers more discount value (currently around 12% at Fair value*) than many of its peers with or without their DCMs or do analysts know something we don’t?

 
*As at 4 May 2010, source Morningstar.

 
Standardised Past Performance

Source: Morningstar, share price mid to mid, total return.

Stock market investments and any income from them can fall as well as rise and investors may not get back the amount they invested. Changes in the rates of exchange may cause the value of investments to go down or up. Past performance is not a guide to future performance.