Investment trusts’ deep discounts could offer an opportunity, history shows

The near-impossibility of calling the top or bottom of a market is well-known by all experienced investors. However, investing in assets that offer value is a tried and tested strategy, 

For investment trusts, the key measure of value is the discount (or premium) to NAV. This measure expanded to 14% earlier in the summer and is now standing at around 15% for the average investment trust, comparable to the levels last seen during the global financial crisis or in March 2003, when US-led forces invaded Iraq.

We thought it would be interesting to take a look at what happens next, or rather, what has happened in the past when investment trust discounts have reached these levels. Specifically, we looked at three discount “troughs”, based on month-end figures and equity-based investment companies: March 2003 (-12.8%), February 2009 (-16.4%) and June 2016 (-11.9%).

Beginning with March 2003, the following three years saw the average investment trust return a very creditable 142%. The top performing sectors were Latin America (377%) and Financials (353%) – admittedly both were headed for a fall.

The three years following the nadir of the financial crisis (February 2009) saw the average investment trust generate a 79% return. Top of the charts in this recovery were Commodities and Natural Resources (145%) and Property Direct Europe (137%).

Finally we come to June 2016 and the fateful vote to leave the EU. In global terms this hardly counts, but it was significant to the UK and saw investment trust discounts widen. The average investment trust returned 31% in the next three years, led by Technology and Media (79%) and Japanese Smaller Companies (50%).

At first glance, it’s hard to spot a pattern here, except that investment trusts tend to do well (sometimes exceptionally well) in the years following a discount trough.

However, if we look down the list beyond the two top-performing sectors, there are a few sectors that did well in all three recoveries.

Smaller companies is a common theme, and especially UK smaller companies which outperformed the average investment company in all three periods. In the three years from March 2003 the sector would have almost tripled your money, returning 197%; post financial crisis the three-year return was 132%; and in the three years following the EU referendum the sector returned 35%.

There is plenty of choice in the sector, with 26 investment companies, many of them long-established, and trading at an average discount of 13%.

Other sectors that came up trumps in all three recoveries were global emerging markets and private equity. The private equity sector has some very deeply discounted trusts, though investors should remember that the valuations discounts are based on are only estimates.

Elliott Hardy, research analyst at Winterflood, believes the significant sell-off of investment trusts over the past 18 months could present opportunities for long-term investors, who might benefit from a “double-whammy” if underlying performance improves as discounts simultaneously tighten.

“In particular,” says Hardy, “interest rate sensitive asset classes, such as Infrastructure, Property and Private Equity, are likely to be beneficiaries once rates peak.”

Ewan Lovett-Turner, head of investment companies research at Numis Securities, agrees. He comments in a recent note that wide discounts have generally been short-lived and therefore, in his view, the current environment presents attractive opportunities “if investors can identify high quality assets and managers with strong long-term track records that are currently out of favour”.

We may not be in the trough yet – and trying to time it is a mug’s game – but it’s hard to believe that this isn’t a reasonably attractive entry point for a long-term investor, especially in some of the more deeply discounted investment trust sectors.