Waiting for the Patience Pay-off
Patience is a virtue, a phrase believed to have originated from the poem “Piers Plowman,” written in 136O by English poet William Langland, might well have been written for the investment trust shareholder of 2023. Fortitude has certainly been an asset these last 12 months as the average discount (to NAV) of an investment trust has widened to levels last seen in the depths of 2008’s financial crisis. Back at the start of 2022, the average discount stood around 2.2 per cent, based on figures from the Association of Investment Companies (AIC). By the summer of this year, that figure had widened to around 16%-17%. In November, it briefly exceeded 18% before recovering to nearer 15% as we hit early December1.
In 2008, the triggers for the wide discounts were considered fairly unique. Today, the causes are much more common-or-garden; inflation took off, the Bank of England responded with a succession of rate hikes and some investors decided that a 5 per cent “risk free” return on cash was a more attractive option than wait and see acceptance for a medium-term return on equities. Such sentiment has affected markets generally, not just investment trusts.
We believe this will, of course, pivot at some point and there is every reason to expect that it could happen in 2024. A small risk of recession lingers but if that can be dispelled, on the first signs of a rate cut emerging a rapid resurgence could be in the offing. The UK equity market should be among the strongest beneficiaries of such a signal, based on its prevailing undervaluation. The p/e ratio of the FTSE All Share is just over 10. Its long-term average since 2000 is 14. Europe’s p/e ratio is nearly 12.5, close to consistent with its long-term average of 13, while the US is at 20.5, a premium. Its longer-term average is about 15-162.
Potential in undervalued UK equities
There are many reasons why the UK lags on this measure including its lack of big tech stocks, high concentration of out of favour oil stocks, tobaccos, banks and miners, the overhang of Brexit and political uncertainty. On the opposite side of this equation is very attractive valuations which offer excellent return potential when the market recovery arrives. Aside from valuations, which we believe are overly hampered by sentiment, many UK companies are in reasonable to good shape, based on profits and earnings metrics. The latter have generally been okay and dividends could even be described as strong.
Buying now into well-regarded trusts at big discounts, with good dividend yields, should make for a solid investment on a two- to three-year horizon. There is no escaping that sentiment presently is horrendous but it won’t always be. And, all you need to benefit is for it to improve to be average.
There are a few red flags to watch out for though. The level of debt or gearing an investment trust has, is one of them. The ability to borrow to buy shares or other assets sets trusts apart from other funds but investors need to be aware of how much a manager is paying to borrow. Some trusts have secured long-term deals at a low cost, before interest rates rose, so are in a good place, others not so.
On consolidation watch
On a wider view, increasing consolidation in the sector could be a potential tailwind. A number of trusts have this year announced plans to merge. They include Abrdn New Dawn with Asia Dragon; Henderson Diversified Income with Henderson High Income Trust; and a double merger of Nippon Active Value with Abrdn Japan and Atlantis Japan Growth. Investors want bigger, more liquid and cost-effective companies. As trusts merge or one acquires another, investors may be offered a cash option at a premium to the share price, or shares in a bigger, more liquid fund, to support the deals.
Continuing on a positive note in this defined ‘season of cheer,’ the last time investment trust discounts were as wide as they presently are, at the end of 2008, the average investment company returned 39 per cent over the next year and 119 per cent over the next five years, according to AIC data.3
1 Bloomberg 7 December 2023
2 Bloomberg as at 7 December 2023. Intraday p/e’s for MSCI Europe and S&P 500.
3 Association of Investment Companies as at 7 December 2023
