A market signal that can be taken on trust

The first ever investment trust was founded in 1868 and Foreign & Colonial has traded through to this day, with sufficient success to establish itself as a member of the FTSE 250.

Their long history and also the method in which they trade mean these pooled investment companies can be useful ways of both judging the market, as well as accessing it. They are quoted on the stock exchange, just like any other public company, and returns to shareholders are driven by two factors: share price performance and dividend yield.

Share price performance in turn has two key influences: the performance of the assets selected by the fund manager and the discount or premium at which the quoted share price trades to the worth of those underlying assets, or Net Asset Value (NAV) of the portfolio.

That premium or discount changes all the time, but generally a narrow discount (or premium) suggests a sector is in favour and the fund manager doing well. A big discount could imply the opposite on one or both counts.

The question then to address is whether a premium or narrow discount means it is time to sell and a big discount whether it is time to investigate a potential contrarian buy.

The table below shows the current discounts to NAV for the four major UK categories monitored by Morningstar and industry body the Association of Investment Companies.

UK investment trust discounts to NAV show a clear pecking order

Source: Morningstar, Association of Investment Companies

The pecking order shows how income is currently prized more highly by advisers and clients, while smaller companies are being treated with greater caution.

Past trends

It may however be worth looking at these figures in greater depth, not least because the universe tracked by the Association of Investment Companies (some 293 collectives with a combined market cap of just less than £100 billion) is trading quite close to historic lows when it comes to discount to NAV.

This is a potential source of concern. The chart below shows that previous lows in the discount (2000 and 2006) came shortly before market tops (and steep declines), while previous highs came amid market panics (1998, 2003, 2008) and actually – with the benefit of hindsight – were signals to start buying. At least the discount has widened out of late, to suggest some optimism has seeped away.

Overall investment trust discount to NAV is near to historic lows

Source: Morningstar, Association of Investment Companies

It should therefore be worth looking at the key quartet of UK investment trust categories to look at their discounts to NAV not just relative to each other but to their own histories.

UK investment trust discounts to NAV are roughly in line with historic averages

Source: Morningstar, Association of Investment Companies

This offers some reassurance, as discounts are not unusually tight. Long-term charts offer some comfort, too, although the historic pattern of narrow discounts near market tops and big ones at market bottoms can be clearly observed, at least in certain cases (notably small-caps).

Intriguingly, the UK Equity Income sector’s discount to NAV has widened of late, even as the FTSE All-Share has gone higher. It is to be hoped that this is not the (early) warning signals seen in 1998 and very early 2007 which foretold of trouble ahead and a broad market sell-off.

UK All Companies discount to NAV has widened of late

Source: Morningstar, Association of Investment Companies, Thomson Reuters Datastream

With regard to UK Equity Income, the discount to NAV has also widened here of late. This may reflect how many reliable income-payers are now being classified as ‘expensive defensives’, or perhaps the dozen or so dividend cuts seen in the FTSE 100 over the last 12 to 18 months.

It may also be a hint that the market’s preference is changing. Note how the Equity Income discount to NAV opened up hugely in 1998-2000 and 2003-07 as the market dashed for tech stocks in the first instance and cyclicals like banks and miners in the second. Growth was all the rage. Perhaps this is a subtle sign that someone, somewhere is preparing themselves for the sort of inflation that will erode the real-terms value of dividend yields and moving into more cyclical names.

The small premium to NAV reached in summer 2013 by UK Equity Income has certainly never been repeated since.

UK Equity Income sector’s discount to NAV has widened of late

Source: Morningstar, Association of Investment Companies, Thomson Reuters Datastream

It is harder to read the tea-leaves for the hybrid UK Bond & Equity Income sector. The scramble for yield leaves it trading at a slight premium to NAV, as advisers and clients reach for both yield and relative certainty in an uncertain world. At least the category does not seem to be acting strangely relative to either the FTSE All-Share or the benchmark 10-Year Gilt, for example:

UK Bond & Equity Income sector’s trade at a slight premium to NAV ...

Source: Morningstar, Association of Investment Companies, Thomson Reuters Datastream

... as the quest for reliable yield continues

Source: Morningstar, Association of Investment Companies, Thomson Reuters Datastream

Perhaps the strongest (contrarian) signal comes from the world of small-cap stocks. A discount to NAV as low as 10% has historically called the top in both the FTSE Small Cap and FTSE AIM All-Share indices. A gap of 20% has tended to represent the bottom in both benchmarks.

A current discount to NAV of 13.8% sits in the middle of that range, although this did get to barely 5% in December 2015.

UK small-cap investment trusts’ discount to NAV has been a fair guide ...

Source: Morningstar, Association of Investment Companies, Thomson Reuters Datastream

... to sentiment toward key small-cap indices

Source: Morningstar, Association of Investment Companies, Thomson Reuters Datastream

Conclusions

While no such research can provide a definitive signal to buy or sell – if it was that easy, everyone would be doing it, erasing any advantage conferred by such a system in the first place – there are some useful conclusions which can be drawn from this analysis.

  • First, trying to time the market is generally a bad idea, as it brings two decisions – when to sell and when to buy – which both incur trading costs and the danger of being wrong. But it does seem as if, in certain cases, investment trusts can be a useful gauge of broader market sentiment, both near the top of bull runs and the bottom of bear ones. The discount to NAV across different sectors can be used to compare the market’s general level of bullishness, both in absolute and relative terms. An unusually high discount relative to the category’s own history and its peers could suggest an area is unloved and oversold (potentially presenting a buying opportunity). An unusually narrow discount could signify the asset class is overbought and overvalued and potentially an accident waiting to happen, should something go wrong and it suddenly fall from favour.

Income categories are showing the lowest discounts to NAV ...

Source: Morningstar, Association of Investment Companies

... while income-generating sectors even trade at a premium

Source: Morningstar, Association of Investment Companies

  • Second, the recent widening of UK investment trusts’ discounts to net asset value provides some comfort, in that it suggests markets are not indulging themselves in the sort of irrational exuberance which traditionally calls the top.
  • Third, investment trusts can be a good way to gain access to the UK equity market (and for that matter, many other asset classes, geographies and sectors) as a closing discount to NAV can supplement returns gained from rising markets. Equally, advisers and clients should remember that a widening discount, owing to a loss of faith in an asset class or the individual manager, could magnify losses on the way down.

Investment trust checklist

As a final point, discount to NAV is by no means the only tool that advisers and clients should use to assess the potential merits of these useful instruments (or markets in general).

Good performance and costs will be the most natural starting points for most advisers and clients but the other points on the checklist kindly provided by Peter Hewitt, the manager in charge of the trusts of trusts F&C Managed Portfolio Trust Growth and F&C Managed Portfolio Trust Income, are just as important as they will all help shape an investment trust’s total returns.

Investment trust check list

Source: F&C Asset Management

AJ Bell Investment Director

Russ Mould has 24 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as an equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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