Widening discounts to net asset value (NAV) can often deter some investors from buying into a trust, but this can lead them to miss out on some spectacular gains.
Alex Paget, research analyst at Kepler Trust Intelligence (pictured), said research by the firm showed investors have been able to make “significant returns” when discounts in the UK All Companies sector widen.
The analyst said the chart below showed a clear trend of wide discounts leading to significant absolute returns over the following 12 months, while tighter discounts led to losses.
Discounts and rolling 12-month share price returns
Source: Kepler Trust Intelligence
He said: “Not only have investors witnessed strong returns by backing trusts on a wide discount, but they have also been able to significantly outperform the wider market – both in terms of the IA UK All Companies sector and the FTSE All Share.”
The analyst added there was a trend of trusts trading at wide discounts outperforming over the following 12 months.
The scatter chart below again shows the past 20 years of average discounts across the peer groups, with performance of trust’s share prices relative to the FTSE All Share. The y-axis shows average discount, while the x axis-shows the average 12-month relative return from that discount level.
Discounts and relative rolling 12-month share price returns
Source: Kepler Trust Intelligence
“Again, although there are outliers, there is a clear trend of the wider the discount, the greater the performance over the next 12 months and the narrower the discount, the larger the underperformance,” he said.
Further research by Kepler showed that UK All Companies trusts trading at low discounts have underperformed the FTSE All Share index.
“For example, historically, when the average discount across the sector has been less than 4 per cent, the average absolute share price loss has been 1.32 per cent over the following 12 months, while trusts have underperformed the index by 7.47 percentage points,” Paget continued. “It’s a similar story of losses/low returns and underperformance when discounts have been below 5 per cent, 6 per cent, 7 per cent and 8 per cent.”
He added: “On the other hand, investors have been rewarded handsomely in the past when the average discount has widened into double-digit territory across the peer group.”
Trusts trading on a discount wider than 12 per cent have generated a 14.8 per cent average share price return over the following 12 months, he said.
The current outlook for trusts has been less clear for investors given many of the challenges facing the UK market and British economy.
“As we are all very aware, the UK has quickly turned into a minefield for investors,” said Paget. “Indeed, over the past 18 months, rarely has anyone said or written about the UK equity market without including the word ‘uncertainty’, with Theresa May’s weak and wobbly government, ongoing Brexit negotiations and steadily rising inflation all adding to the ambiguity towards the future of UK stocks."
Paget said uncertainty was also being seen in the UK All Companies sector. While discounts are wider than their peers in other sectors, they have narrowed.
As at 19 July, the average discount of UK All Companies trust stood at 8 per cent, narrower than the 20-year average of 9.94 per cent, said Paget.
Historical returns from current discounts
Source: Kepler Trust Intelligence
“At this level our analysis shows investors in the past have either benefited from the latter stages of an upswing or have caught a falling knife – which is somewhat frustrating for those looking for inspiration,” he said.
“Given the varying outcomes for investors at the 8 per cent-ish discount level, our model for highlighting potential returns could turn out to be very wide of the mark indeed – but at first glance, investors haven’t often been rewarded when buying at these levels.”
“While it is a relatively poor outlook from a sector level, there are individual trusts that are trading at discounts that have historically proved to be an attractive entry point,” he said.
One such trust highlighted by Paget is Schroder UK Mid Cap, which is currently trading at a discount of 17.9 per cent.
Co-managed by FE Alpha Manager Andy Brough and Jean Roche, the trust invests in UK mid-cap stocks and aims to provide a total return in excess of the FTSE 250 (ex-Investment Companies) index.
Paget said “While investors will undoubtedly have to stomach a degree of volatility given the FTSE 250 index is home to numerous domestically orientated stocks, the trust has on average delivered a share price return of 16.5 per cent on a 12-month view when the discount has been 50 basis points either side of that level.
“Also, when the discount has been around the current level, the share price has beaten the FTSE All Share on a 12-month view 85 per cent of the time.”
Performance of trust vs sector & benchmark over 1yr
Source: FE Analytics
Over one year the trust has delivered a return of 19.48 per cent compared with a gain of 17.94 per cent for the benchmark index, as the above chart shows.
According to the most recently available data from the Association of Investment Companies (AIC), the 15-strong, £5.3bn AIC UK All Companies sector has five trusts, including Schroder UK Mid Cap, trading on double-digit discounts.